MONEY MULTIPLIER APPROACH

 THE MONEY MULTIPLIER APPROACH TO SUPPLY OF MONEY

The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, (1963) considers three factors as immediate determinants of money supply, namely:

(a) the stock of high-powered money (H)

(b) the ratio of reserves to deposites, e = {ER/D} and

(c) the ratio of currency to depoists, c ={C/D}

You may note that these represent the behaviour of the central bank, behaviour of the commercial banks and the behaviour of the general public respectively. We shall now describe how each of the above contributes to the determination of aggregate money supply in an economy.

a) The Behaviour of the Central Bank
The behaviour of the central bank which controls the issue of currency is reflected in the supply of the nominal high-powered money. Money stock is determined by the money multiplier and the monetary base is controlled by the monetary authority. If the behaviour of the public and the commercial banks remains unchanged over time, the total supply of nominal money in the economy will vary directly with the supply of the nominal high-powered money issued by the central bank.

b) The Behaviour of Commercial Banks

By creating credit, the commercial banks determine the total amount of nominal demand deposits. The behaviour of the commercial banks in the economy is reflected in the ratio of their cash reserves to deposits known as the ‘reserve ratio’. If the required reserve ratio on demand deposits increases while all the other vari- ables remain the same, more reserves would be needed. This implies that banks must contract their loans, causing a decline in deposits and hence in the money supply. If the required reserve ratio falls, there will be greater expansions of deposits because the same level of reserves can now support more deposits and the money supply will increase.

In actual practice, however, the commercial banks keep only a part or fraction of their total deposits in the form of cash reserves. However, for the commercial banking system as a whole, the actual reserves ratio is greater than the required  reserve ratio since the banks keep with them a higher than the statutorily required percentage of their deposits in the form of cash reserves. The additional units of high-powered money that goes into ‘excess reserves’ of the commercial banks do not lead to any additional loans, and therefore, these excess reserves do not lead to creation of money. Therefore, if the central bank injects money into the banking system and these are held as excess reserves by the banking system, there will be no effect on deposits or currency and hence no effect on money supply.

When the costs of holding excess reserves rise, we should expect the level of excess reserves to fall; when the benefits of holding excess reserves rise, we would expect the level of excess reserves to rise. Two primary factors namely market interest rates and expected deposit outflows affect these costs and benefits and hence in turn affect the excess reserves ratio.

We know that the cost to a bank while holding excess reserves is in terms of its opportunity cost, i.e. the interest that could have been earned on loans or securities if the bank had chosen to invest in them instead of excess reserves. If interest rate increases, it means that the opportunity cost of holding excess reserves rises because the banks have to sacrifice possible higher earnings and hence the desired ratio of excess reserves to deposits falls. Conversely, a decrease in interest rate will reduce the opportunity cost of excess reserves, and excess reserves will rise. Therefore, we conclude that the banking system's excess reserves ratio e is neg- atively related to the market interest rate.

If banks fear that deposit outflows are likely to increase (that is, if expected deposit outflows increase), they will want more assurance against this possibility and will increase the excess reserves ratio. Conversely, a decline in expected deposit outflows will reduce the benefit of holding excess reserves and excess reserves will fall.

As we know, money is mostly held in the form of deposits with commercial banks. Therefore, money supply may become subject to ‘shocks’ on account of behaviour of commercial banks which may present variations overtime either cyclically and more permanently. For instance, in times of financial crises, banks may be unwilling to lend to the small and medium scale industries who may become credit constrained facing a higher risk premia on their borrowings. The rising interest rates on bank credit to the commercial sector reflecting higher risk premia can co-exist with the lowering of policy rates by the central bank. The lower credit demand can lead to a sharp deceleration in monetary growth at a time when the central bank pursues an easy monetary policy.

c) The Behaviour of the Public

We shall now turn to the next determinant viz. the behaviour of the public. The public, by their decisions in respect of the amount of nominal currency in hand (how much money they wish to hold as cash) is in a position to influence the amount of the nominal demand deposits of the commercial banks. The behaviour of the public influences bank credit through the decision on ratio of currency to the money supply designated as the ‘currency ratio’.

What would be the behaviour of money supply when depositors decide to increase currency holding, with all other variables unchanged? In other words, you decide to keep more money in your pocket and less money in your bank. That means you are converting some of your demand deposits into currency. If many people like you do so, technically we say there is an increase in currency ratio. As we know, demand deposits undergo multiple expansions while currency in your hands does not. Hence, when bank deposits are being converted into currency, banks can create only less credit money. The overall level of multiple expansion declines, and therefore, money multiplier also falls. Therefore, we conclude that money multiplier and the money supply are negatively related to the currency ratio c.

The currency-deposit ratio (c) represents the degree of adoption of banking habits by the people. This is related to the level of economic activities or the GDP growth and is influenced by the degree of financial sophistication in terms of ease and access to financial services, availability of a richer array of liquid financial assets, financial innovations, institutional changes etc.
          The time deposit-demand deposit ratio i.e. how much money is kept as time deposits compared to demand deposits, also has an important implication for the money multiplier and, hence for the money stock in the economy. An increase in TD/DD ratio means that greater availability of free reserves and consequent enlargement of volume of multiple deposit expansion and monetary expansion.

To summarise the money multiplier approach, the size of the money multiplier is determined by the required reserve ratio (r) at the central bank, the excess reserve ratio (e) of commercial banks and the currency ratio (c) of the public. The lower these ratios are, the larger the money multiplier is. In other words, the money supply is determined by high powered money (H) and the money multiplier (m) and varies directly with changes in the monetary base, and inversely with the currency and reserve ratios. Although these three variables do not completely explain changes in the nominal money supply, nevertheless they serve as usefuldevices for analysing such changes. Consequently, these variables are designated as the ‘proximate determinants’ of the nominal money supply in the economy.