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Cc-6 (High Powered Money) - 2

The document discusses the use of high-powered money in determining the money supply through the money multiplier process. It defines high-powered money as the total liability of the central bank, consisting of currency in circulation and commercial bank reserves held at the central bank. The money supply is a multiple of the high-powered money and is determined by the required reserve ratio and excess reserve ratio set by commercial banks. An increase in high-powered money, through the money multiplier process, leads to a greater increase in the money supply as commercial banks expand lending.

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321 views10 pages

Cc-6 (High Powered Money) - 2

The document discusses the use of high-powered money in determining the money supply through the money multiplier process. It defines high-powered money as the total liability of the central bank, consisting of currency in circulation and commercial bank reserves held at the central bank. The money supply is a multiple of the high-powered money and is determined by the required reserve ratio and excess reserve ratio set by commercial banks. An increase in high-powered money, through the money multiplier process, leads to a greater increase in the money supply as commercial banks expand lending.

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USE OF HIGH PowERED MONEY IN MONEY MULTIPLIER

MONEY SUPPLY
MONEY IS A FINANCIAL ASSET THAT IS UNIVERSALLY ACCEPTED AS A MEANS OF PAYMENT IN TRANSACTIONS
AND SETTLEMENT OF DEBT. IT REPRESENTS GENERAL PURCHASING POWER IN THE MOST LIQUID FORM, IN THE
SENSE THAT IT DOES NOT NEED TO BE CONVERTED INTO SOMETHING ELSE BEFORE IT CAN BE USED FOR
TRANSACTIONS.

THE MOST IMPORTANT FUNCTION OF MONEY IS TO ACT AS A MEANS OF PAYMENT. WITHOUT MONEY,
EXCHANGE WILL HAVE TO BE IN THE EXTREMELY INCONVENIENT AND LIMITED FORM OF BARTER-DIRECT
EXCHANGE OF GOODS AND SERVICES FOR OTHER GOODS AND SERVICES.

MONEY ALSO ACTS AS A UNIT OF ACCOUNT (VALUES OF GOODS AND SERVICES ARE EXPRESSED IN UNITS OF
MONEY) AND A STORE OF VALUE (WEALTH CAN BE HELD N THE FORM OF MONEY FOR FUTURE USE).
ALL THESE FUNCTIONS, HOWEVER, ARE DERIVED FROM THE PRIMARY ONE ,MEDIUM OF EXCHANGE.

IN A MODERN ECONOMY, MONEY USUALLY CONSISTS OF COINS, CURRENCY NOTES, AND CURRENT/ SAVINGS
ACCOUNT (DEMAND) DEPOSITS OF COMMERCIAL BANKS. THE LAST ITEM IS INCLUDED BECAUSE CHEQUES
DRAWN ON SUCH DEPOSITS ARE READILY ACCEPTED IN THE SETTLEMENT OF TRANSACTIONS AND DEBT. DEMAND
DEPOSITS ARE DEPOSITS PAYABLE ON DEMAND THROUGH CHEQUES OR OTHERWISE. A DEPOSITS HAVE A FIXED
TERM TO MATURITY AND CANNOT BE WITHDRAWN ON DEMAND. THEY ARE CALLED DEPOSITS OR TERM
DEPOSITS.
MEASURES OF MONEY SUPPLY (Monetary Aggregates)
Supply of money is a stock variable whose value can be measured on a particular date. The
RBI publishes figures for four measures of money supply. Also known as monetary aggregates,
they are
M1 = CU +D;
M2 = M1 + savings deposits with post office savings banks;
M3 = M1 +net time deposits of banks (interbank deposits are netted out); and
M4= M3+ total deposits with the post office savings organizations.
In the above definitions, CU = currency (coins plus notes) held by the public, D = demand
deposits of the public in banks (interbank deposits are not included).
Ml is called narrow money, M3 is also known as broad money or aggregate monetary
resources
(AMR). M2 and M4 have been devised to accommodate post office deposits.
HIGH POWERED MONEY
▷ It is the total liability of the Monetary authority. It is also called Monetary Base or Money Base. It is denoted with 'H'.

▷ It consists of:
1) Currency (notes and coins) in circulation with the public and vault cash of commercial banks .
2) Deposits held by commercial banks and the Government with the RBI (R)
H= Currency(CU)+Reserves(R)
The part of currency held by the public forms a part of money supply.
The currency in bank vaults and banks’ deposits at the RBI are used as reserves backing individual and business
deposits at bank. The term "high powered' refers to the fact that an increase in base money by Rs. 1 creates, through
the money multiplier, an increase of more than Rs. 1 in money supply.
Since the RBI's assets and liabilities must be equal by balance sheet identity, it also must be true that H= FA +DC,
where FA is the Central Bank's stock of foreign assets (including gold) and DC is domestic credit. This is an alternative
(asset side) definition of the monetary base or high powered money.
H= CU+R= FA +DC
The RBI has direct control over High powered money, H. We will see how the money supply(M) is linked with Money
multiplier, mm.
DETERMINANTS OF MONEY SUPPLY
WE TURN NOW TO THE IMPORTANT TWO DETERMINANTS OF MONEY SUPPLY :-
THE CURRENCY-DEPOSIT RATIO (α:) The payment habits of the
public determine how much currency is held relative to deposits.
The currency-deposit ratio is affected by the cost and
convenience of obtaining cash; for instance, if there is a cash
machine nearby, individuals will on average carry less cash with
them because the costs of running out are lower. The currency-
deposit ratio has a strong seasonal pattern, being highest
around festive seasons.

THE RESERVE RATIO(β): Bank reserves consist of deposits banks hold


at the Fed and "vault cash," notes and coins held by banks. In the
absence of regulation, banks would hold reserves to meet (1) the
demands of their customers for cash and (2) payments their customers
make by checks that are deposited in other banks. In addition to these
required reserves, banks held some excess reserves in order to meet
unexpected withdrawals.
MONEY STOCK DETERMINATION:THE MONEY MULTIPLIER
The money supply consists mostly of deposits at bank ,which the RBI does not control directly. Here,
we will see the process by which the money supply is determined. The key concept is to understand
is FRACTIONAL RESERVE BANKING SYSTEM. A system under which bank keep a certain fraction of
their deposit as Reserve. In this section we develop a simple approach to money stock
determination, using as the key variables the currency-deposit ratio, the reserve-deposit ratio, and
high-powered money. The approach is organized around the supply of and demand for high-
powered money. .
Here we are excluding the heterogeneity of deposits and concentrate only on the narrow money
M1 i.e. here, Ms implies M1.
M= C + D(Deposits)….(i)
H=CU+ R…..(ii)
α= C/D , β=R/D
=>C=αD………(iii) =>R=βD……….(iv)
Substituting (iii) and (iv) in (ii);
H=CU+R
=αD+ Βd
=(α+β)D
=>D=(1/α+β)H....(v)
And 1/α+β
M=C+D= αD+D=(α+1)D=(α+1)(1/α+b .H)
M =(α+1/α+B) H
(α+1/α+B)>1
=>Money Multiplier >1
That's why Monetary Base is called High -powered Money.
It is thus clear that
• The money multiplier is larger ,the smaller the reserve ratio .
• In addition , the money multiplier is larger ,the smaller the currency deposit ratio . This is
because smaller is currency deposit ratio ,the smaller the proportion of the high powered
money stock that is used as currency and the larger the proportion that is available to be
reserves .
GRAPHICAL REPRESENTATION OF MONEY
MULTIPLIER
Here we see the relationship between the money supply
and high powered money. At the bottom of the figure we
show the stock of high powered money. At the top, we
show the money supply. They are related by the money
market. The money multiplier is the ratio of the stock of
money to the stock of high powered money.

The money multiplier is larger than 1. It is clear from the


diagram that the larger the multiplier, the larger are
deposits as the fraction of the money stock. This is true
because currency uses up one dollar of high powered
money per dollar of money. From figure 1 , it is clear that
, currency translates high powered money only one –for
one into money whereas reserves translates much more
than one –for –one into money.
USE OF HIGH POWERED MONEY IN MONEY
MULTIPLIER
THE USE OF HIGH-POWERED MONEY CONSISTS OF THE DEMAND OF COMMERCIAL BANKS FOR THE LEGAL
LIMIT OR REQUIRED RESERVES WITH THE CENTRAL BANK AND EXCESS RESERVES AND THE DEMAND OF THE
PUBLIC FOR CURRENCY. THUS HIGH-POWERED MONEY H=C+RR+ER, WHERE С REPRESENTS CURRENCY, RR
THE REQUIRED RESERVES AND ER THE EXCESS RESERVES. A COMMERCIAL BANK’S REQUIRED RESERVES
DEPEND UPON ITS DEPOSITS. BUT A BANK USUALLY HOLDS RESERVES IN EXCESS OF ITS REQUIRED RESERVES.
IN FACT, BANKS DO NOT ADVANCE LOANS UP TO THE LEGAL LIMITS BUT PRECISELY LESS THAN THAT. THIS IS
TO MEET UNANTICIPATED CASH WITHDRAWALS OR ADVERSE CLEARING BALANCES. HENCE THE NEED ARISES
FOR MAINTAINING EXCESS RESERVES BY THEM. THE MONEY SUPPLY IS THUS DETERMINED BY THE REQUIRED
RESERVE RATIO AND THE EXCESS RESERVE RATIO OF COMMERCIAL BANKS. THE REQUIRED RESERVE RATIO
(RRR) IS THE RATIO OF REQUIRED RESERVES TO DEPOSITS (RR/D), AND THE EXCESS RESERVE RATIO (ERR) IS
THE RATIO OR EXCESS RESERVES TO DEPOSITS (ER/D).CURRENCY HELD BY THE PUBLIC IS ANOTHER
COMPONENT OF HIGH-POWERED MONEY. THE DEMAND FOR CURRENCY BY THE PUBLIC IS EXPRESSED AS A
PROPORTION OF BANK DEPOSITS. THUS THE CURRENCY RATIO C/D, WHERE С IS THE CURRENCY AND D
DEPOSITS. THE CURRENCY RATIO IS INFLUENCED BY SUCH FACTORS AS CHANGES IN INCOME LEVELS OF
THE PEOPLE, THE USE OF CREDIT INSTRUMENTS BY THE PUBLIC, AND UNCERTAINTIES IN
ECONOMIC ACTIVITY.
CONCLUSION
THUS THE FORMULA OF MONEY MULTIPLIER TELLS US HOW
MUCH MONEY WILL BE CREATED BY THE BANKING SYSTEM
FOR A GIVEN INCREASE IN HIGH POWERED MONEY. THE
MONEY SUPPLY WILL BE MONEY MULTIPLIER TIMES THE
MONETARY BASE. ALTHOUGH ,WE SEE THAT THE FRACTIONAL
RESERVE BANKING CREATES MONEY, IT DOES NOT CREATE
WEALTH.

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