Money supply
- Posted by commerce achiever1
- Categories Uncategorized
- Date October 5, 2022
The money supply is all the currency and other liquid instruments in a country’s economy on the date measured. The money supply roughly includes both cash and deposits that can be used almost as easily as cash.
Governments issue paper currency and coin through some combination of their central banks and treasuries. Bank regulators influence money supply available to the public through the requirements placed on banks to hold reserves, how to extend credit and other regulation.
Economists analyze the money supply and develop policies revolving around it through controlling interest rates and increasing or decreasing the amount of money flowing in the economy. Public and private sector analysis is performed because of the money supply’s possible impacts on price level,inflation , and the business cycle. In the United States, the Federal Reserve policy is the most important deciding factor in the money supply. The money supply is also known as the money stock.
In a modern economy, money comprises cash and bank deposits.
Depending on what types of bank deposits are being included, there are
many measures of money1. These are created by a system comprising two types of institutions:
Depending on what types of bank deposits are being included, there are
many measures of money1. These are created by a system comprising two types of institutions:
central bank of the economy and the commercial banking system.
Central bank
Central Bank is a very important institution in a modern economy.
Almost every country has one central bank. India got its central bank in
1935. Its name is the ‘Reserve Bank of India’. Central bank has several
important functions. It issues the currency of the country. It controls
money supply of the country through various methods, like bank rate, open
market operations and variations in reserve ratios. It acts as a banker to the
government. It is the custodian of the foreign exchange reserves of the economy.
Central Bank is a very important institution in a modern economy.
Almost every country has one central bank. India got its central bank in
1935. Its name is the ‘Reserve Bank of India’. Central bank has several
important functions. It issues the currency of the country. It controls
money supply of the country through various methods, like bank rate, open
market operations and variations in reserve ratios. It acts as a banker to the
government. It is the custodian of the foreign exchange reserves of the economy.
It also acts as a bank to the banking system, which is discussed in detail later.
From the point of view of money supply, we need to focus on its function of
issuing currency. This currency issued by the central bank can be held by the
public or by the commercial banks, and is called the ‘high-powered money’ or
‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.
From the point of view of money supply, we need to focus on its function of
issuing currency. This currency issued by the central bank can be held by the
public or by the commercial banks, and is called the ‘high-powered money’ or
‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.
Commercial Banks
Commercial banks are the other type of institutions which are a part of
the money-creating system of the economy. In the following section we look at
the commercial banking system in detail. They accept deposits from the public
and lend out part of these funds to those who want to borrow. The interest ratepaid by the banks to depositors is lower than the rate charged from the borrowers.
This difference between these two types of interest rates, called the ‘spread’ is the profit appropriated by the bank.The process of deposit and loan (credit) creation by banks is explained below.
Commercial banks are the other type of institutions which are a part of
the money-creating system of the economy. In the following section we look at
the commercial banking system in detail. They accept deposits from the public
and lend out part of these funds to those who want to borrow. The interest ratepaid by the banks to depositors is lower than the rate charged from the borrowers.
This difference between these two types of interest rates, called the ‘spread’ is the profit appropriated by the bank.The process of deposit and loan (credit) creation by banks is explained below.
In order to understand this process, let us discuss a story.
Once there was a goldsmith named Lala in a village. In this village,
people used gold and other precious metals in order to buy goods and
services. In other words, these metals were acting as money. People in
the village started keeping their gold with Lala for safe-keeping. In return
for keeping their gold, Lala issued paper receipts to people of the village
and charged a small fee from them. Slowly, over time, the paper receipts
issued by Lala began to circulate as money. This means that instead of
giving gold for purchasing wheat, someone would pay for wheat or shoes
or any other good by giving the paper receipts issued by Lala. Thus, the
paper receipts started acting as money since everyone in the village
accepted these as a medium of exchange.
Now, let us suppose that Lala had 100 Kgs of gold, deposited by
different people and he had issued receipts corresponding to 100 kgs of
gold. At this time Ramu comes to Lala and asks for a loan of 25 kgs of gold. Can Lala give the loan? The 100 kgs of gold with him already has claimants. However, Lala could decide that everyone with gold deposits will not come to withdraw their deposits at the same time and so he may as well give the loan to Ramu and charge him for it. If Lala gives the loan of 25 kgs of gold, Ramu could also pay Ali with these 25 kgs of gold and Ali could keep the 25 kgs of gold with Lala in return for a paper receipt. In effect, the paper receipts, acting as money, would have risen to 125 kgs now. It seems that Lala has created money out of thin air!
The modern banking system works precisely the way Lala behaves in this example.
Once there was a goldsmith named Lala in a village. In this village,
people used gold and other precious metals in order to buy goods and
services. In other words, these metals were acting as money. People in
the village started keeping their gold with Lala for safe-keeping. In return
for keeping their gold, Lala issued paper receipts to people of the village
and charged a small fee from them. Slowly, over time, the paper receipts
issued by Lala began to circulate as money. This means that instead of
giving gold for purchasing wheat, someone would pay for wheat or shoes
or any other good by giving the paper receipts issued by Lala. Thus, the
paper receipts started acting as money since everyone in the village
accepted these as a medium of exchange.
Now, let us suppose that Lala had 100 Kgs of gold, deposited by
different people and he had issued receipts corresponding to 100 kgs of
gold. At this time Ramu comes to Lala and asks for a loan of 25 kgs of gold. Can Lala give the loan? The 100 kgs of gold with him already has claimants. However, Lala could decide that everyone with gold deposits will not come to withdraw their deposits at the same time and so he may as well give the loan to Ramu and charge him for it. If Lala gives the loan of 25 kgs of gold, Ramu could also pay Ali with these 25 kgs of gold and Ali could keep the 25 kgs of gold with Lala in return for a paper receipt. In effect, the paper receipts, acting as money, would have risen to 125 kgs now. It seems that Lala has created money out of thin air!
The modern banking system works precisely the way Lala behaves in this example.
Commercial banks mediate between individuals or firms with excess funds
and lend to those who need funds. People with excess funds can keep their funds in the form of deposits in banks and those who need funds, borrow funds in form of home loans, crop loans, etc. People prefer to keep money in banks because banks offer to pay some interest on any deposits made. Also, it may be safer to keep excess funds in a bank, rather than at home, just as people in the example above preferred to keep their gold with Lala instead of keeping at home. In the modern context, given cheques and debit cards, having a demand deposit makes transactions more convenient and safer, even when they do not earn any interest.
(Imagine having to pay a large amount in cash – for purchasing a house.)
What does the bank do with the funds that have been deposited with it?
Assuming that not everyone who has deposited funds with it will ask for their
funds back at the same time, the bank can loan these funds to someone who
needs the funds at interest (of course, the bank has to be sure it will get the
funds back at the required time). So the bank will typically retain a portion of the funds to repay depositors whenever they demand their funds back, and loan the rest. Since banks earn interest from loans they make, any bank would like to lend the maximum possible. However, being able to repay depositors on demand is crucial to the bank’s survival. Depositors would keep their funds in a bank only if they are fully confident of getting them back on demand. A bank must, therefore, balance its lending activities so as to ensure that sufficient funds are available to repay any depositor on demand.
and lend to those who need funds. People with excess funds can keep their funds in the form of deposits in banks and those who need funds, borrow funds in form of home loans, crop loans, etc. People prefer to keep money in banks because banks offer to pay some interest on any deposits made. Also, it may be safer to keep excess funds in a bank, rather than at home, just as people in the example above preferred to keep their gold with Lala instead of keeping at home. In the modern context, given cheques and debit cards, having a demand deposit makes transactions more convenient and safer, even when they do not earn any interest.
(Imagine having to pay a large amount in cash – for purchasing a house.)
What does the bank do with the funds that have been deposited with it?
Assuming that not everyone who has deposited funds with it will ask for their
funds back at the same time, the bank can loan these funds to someone who
needs the funds at interest (of course, the bank has to be sure it will get the
funds back at the required time). So the bank will typically retain a portion of the funds to repay depositors whenever they demand their funds back, and loan the rest. Since banks earn interest from loans they make, any bank would like to lend the maximum possible. However, being able to repay depositors on demand is crucial to the bank’s survival. Depositors would keep their funds in a bank only if they are fully confident of getting them back on demand. A bank must, therefore, balance its lending activities so as to ensure that sufficient funds are available to repay any depositor on demand.
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