MONEY SUPPLY

 EFFECT OF GOVERNMENT EXPENDITURE ON MONEY SUPPLY

• Whenever the central and the state governments’ cash balances fall short of the minimum requirement, they are eligible to avail of a facility called Ways and Means Advances (WMA)/overdraft (OD) facility. 
• When the Reserve Bank of India lends to the governments under WMA /OD, it results in the generation of excess reserves (i.e., excess balances of commercial banks with the Reserve Bank). This happens because when government incurs expenditure, it involves debiting the government balances with the Reserve Bank and crediting the receiver (for e.g., salary account of government employee) account with the commercial bank. 
• The excess reserves thus created can potentially lead to an increase in money supply through the money multiplier process.

The Credit Multiplier

• The Credit Multiplier also referred to as the deposit multiplier or the deposit expansion multiplier, describes the amount of additional money created by commercial bank through the process of lending the available money it has in excess of the central bank's reserve requirements. 
• The deposit multiplier is, thus inextricably tied to the bank's reserve requirement. This measure tells us how much new money will be created by the banking system for a given increase in the high- powered money. It reflects a bank's ability to increase the money supply.

The credit multiplier is the reciprocal of the required reserve ratio. If reserve ratio is 20%, then credit multiplier = 1/0.20 = 5.

                           Credit Multiplier =_____1________________
                                                           Required Reserve Ratio



The existence of the credit multiplier is the outcome of fractional reserve banking. It explains how increase in money supply is caused by the commercial banks’ use of depositors’ funds to lend money. When a bank uses the deposited money for lending, the bank generates another claim on a given amount of deposited money. For example, if A deposits ` 1000/ in cash at a bank (Bank X), this constitutes the bank's current total cash deposits. If the required reserve is 10 percent, the bank would lend` 900/ to B. By lending B ` 900/, the bank creates a deposit for ` 900/ that B can now use. It is as though B owns ` 900/. This in turn means that A will continue to have a claim against ` 1000/ while B will have a claim against ` 900/.

The bank has ` 1000/ in cash against claims of `1900/. In short, the bank has created` 900/ out of "thin air" since these ` 900/ are not supported by any genuine money. At any time, the fractional reserve commercial banks have more cash liabilities than cash in their vaults.

Now suppose B buys goods worth ` 900/ from C and pays C by cheque. C places the cheque with his bank, Bank Y. After clearing the cheque, Bank Y will have an increase in cash of ` 900/, which it may take advantage of and use to lend out ` 810/ to D which may again be deposited in another bank, say Bank Z. Again 10 per cent of ` 810 (` 81) has to be kept as required reserves and the remaining `. 719/ can be lent out, say to E. This sequence keeps on continuing until the initial deposit amount `. 1,000 grows exactly by the multiple of required reserves(in this case, 10%). Ultimately, the expanded credit availability would be 1000 + 900 (90% of 1000) + 810 (90% of 900) + 729 (90% of 810) + (90% of 719) +… …. This summation would end with an amount which is equivalent to 1/10% of 1000, which is `. 10,000. Thus, in our example, the initial deposit is capable of multiplying itself out 10 times. In short, we find that the fact that banks make use of demand deposits for lending it sets in motion a series of activities leading to expansion of money that is not backed by money proper. It is interesting to know that there is no difference between the type of money created by commercial banks and that which are issued by the central bank.

The deposit multiplier and the money multiplier though closely related are not identical because :
a) generally banks do not lend out all of their available money but instead maintain reserves at a level above the minimum required reserve.

b) all borrowers do not spend every Rupee they have borrowed. They are likely to convert some portion of it to cash.