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Money supply - Essay Example

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Money can be held in three common forms; paper money, metallic coins and money deposits to banks. Measurement of money supply is a critical act and various ways have been developed by economists to measure the level of money supply in the economy…

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Download file to see previous pages Money can be held in three common forms; paper money, metallic coins and money deposits to banks. Measurement of money supply is a critical act and various ways have been developed by economists to measure the level of money supply in the economy. The high-powered money multiplier approach is an approach that considers the level of bank deposits by the private sector while determining money supply (Werner, 2005). According to this approach, the level of cash deposits held by the bank plays the major role in determining money supply. High-powered money multiplier approach to credit creation The high-powered money multiplier is denoted by the letter ‘H’ and is measured in terms of the summation of notes and coins held by the common population (C) and notes and coins held by the banks plus deposits maintained by banks at the central bank (R). The mathematical formula for the stock of high-powered money: H = C + R The level of money supply (M.S.) in an economy is measured by: M.S. = C + D; where C denotes notes and coins held by the common population and D denotes bank deposits made by private individuals or agents (D'Souza, 2009). We can represent money supply in terms of the stock of high-powered money (denoted by ‘H’) and the high-powered money multiplier (denoted by ‘h’). The formula for high-powered money multiplier can be derived from the formula for the stock of high-powered money and the high-powered money multiplier (D'Souza, 2009). M.S. = C + D -----------(1) H = C + R ------------(2) On dividing equation (1) by equation (2) we get equation (3): On dividing the numerator and denominator of the right hand side of equation (3) by D we get: Or, Or, Or, M.S. = h* H (7) Where, Therefore, M.S. = h* H, i.e, the level of money supply in the economy is the product of the high-powered money multiplier (h) and the stock of high-powered money (H) (D'Souza, 2009). A number of assumptions are made prior to the development this model measuring money supply. These assumptions have been described below: Firstly, the stock of high-powered money (H) is considered as exogenously determined. It is not dependent on the functioning of the market forces. Secondly, C/D ratio is either a constant or is stable and predictable. If the rates of return on these investments remain constant, then the ratio of C/D would also remain constant. However, in reality, bank deposits offer interest rates whereas cash holding does not. Therefore, households as well as firms would be interested to make more deposits than hold liquid money. Thus, the C/D ratio is not a constant, but, is predictable. Sometimes the C/D ratio becomes unstable and unpredictable due to changes in financial culture of the economy or high end technological innovations and changing trend in spending methods towards use of plastic money (mostly due to technological advancements) leafing to a fall in C/D ratio or lack of confidence on the banking system in the economy leading to an increase in liquid money holding and a subsequent rise in C/D ratio. The final assumption is related to the R/D ratio. It is the ratio of the reserves held by the banks at the Central bank and the liabilities of the bank and is considered as stable and predictable. The banks often try to keep a high reserve with the central bank by acting in a risk-averse manner in order to protect itself in a situation of large sudden withdrawals by depositors. However, depending on the rate of interest, banks decide the amount of money they would hold as interest bearing asset and the amount they would hold as reserves (earning no interest). The stock of high powered money also changes due to the change in government policies or total liabilities of the central bank and daily operations of the central banks. Change in high powered money is denoted by ?H. The value of ?H is given by the following equation: Or, ?H = DEF – ?GD + ET + MMA Where, Budget deficit (DEF), net sales of ...Download file to see next pagesRead More
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