Determinant of money supply


money supply
five determinant of money supply

There two theories of the determinant of the money supply. According to the first view the money supply is determined endogenously by the central bank. The second view holds that the money supply is determined endogenously by changes in the economic activity in the society which affects people desire to hold currency relative in deposits, the rate of interest, etc.

Thus the determinants of money supply are both exogenous and endogenous which can be described broadly as: the minimum cash reserve ratio, the level of bank reserve, and the desire of the people to hold currency relative to deposit. The last two determinants together are called the monetary base or high powered money.


5 determinant of money supply

1.      The required reserve ratio

2.      The level of bank reserve

3.      Public’s desire to hold currency and deposits

4.      High powered money

5.      Other factors


The required reserve ratio:


The required reserve ratio (or the minimum cash ratio of the reserve deposit ratio) is an important determinant of the money supply. An increase in the required reserve ratio reduces the supply of money with commercial banks and a decrease in required reserve ratio increase the money supply. The RRr is the ratio of cash to current and time deposit liabilities which is determined by law. Every commercial bank is required to keep a certain percentage of these liabilities in the form of deposits with the central bank of the country. But notes or cash held by commercial banks I their tills are not included in the minimum required as the liquid assets of a commercial bank. In some countries the statutory liquidity ratio has been fixed by the law of such country as an additional measure to determine the money supply in that country. Statutory liquidity ratio is called secondary reserve ratio in other nations while the required reserve ratio is referred to as the primary ratio. The raising of the statutory liquidity ratio has the effect of reducing the money supply with commercial banks for lending purpose, and the lowering of the statutory liquidity ratio tends to increase the money supply with banks for advances.


The level of bank reserves:


The level of bank reserve is another determinant of the money supply. Bank reserve consists of reserve on deposit with the central bank and currency in their tills or vaults. It is the central bank of the country that influences the reserve of commercial bank in other to determine the supply of money. The central bank requires all commercial banks to hold reserve equal to a fixed percentage of both time and demand deposit. These are legal minimum or required reserves. Required reserve is determined by the required reserve ratio and the level of deposit of a commercial bank, a commercial bank advance loan equal to its excess reserve which is an important component of the money supply. To determine the supply of money with a commercial bank, the central bank influences its reserve by adopting open market operation and discount rate policy. Open market operations refer to the purchase and sale of government and private in the open market. When the central bank buys or sells securities in the open market, the level of bank reserve expand or contracts. The purchase of securities by the central bank is paid for with cheques to the holder of securities who, in turn, deposit them in commercial banks thereby increasing the level of bank reserve. The opposite is the case when the central bank sells securities to the public and banks who make payment to the central bank through cash and cheques thereby reducing the level of bank reserve.

The discount rate policy affects the money supply by influencing the cost and supply of bank credit to commercial banks borrow from the central bank. A high discount rate means that commercial banks get fewer amounts by selling securities to the central bank. The commercial banks, in turn, raise their lending rates to the public thereby making advances dearer for them.

Thus there will be contraction of credit and the level of commercial bank reserve is affected significantly only when open market operations and discount rate policy supplement each other. Otherwise, their effectiveness as determinant of bank reserve and consequently of money supply is limited.


Public’s desire to hold currency and deposit:


Peoples desire to hold currency or cash relative to deposits in commercial banks also determines the money supply. If people are in the habit of keeping less in cash and more in deposits with the commercial banks, the money supply will be large. This is because banks can create more money with larger deposit. On the contrary, if people do not have banking habits and prefers to keep their money holdings in cash, credit creation by banks will be les and the money supply will be at a low level.


High powered money:


The current practice is to explain the determinants of money supply in terms of the monetary base or high powered money is the sum of commercial bank reserves and currency held by the public. High powered money is the base for the expansion of bank deposits and creation of the money supply. The supply of money varies directly with changes in the monetary base, and inversely with the currency and reserve ratios.


Other factors:


Money supply is a function not only of the high powered money determined by the monetary authorities, but of interest rates, income and other actors. The latter factors change the proportion of money balances that the public holds as cash. Changes in business activity can change the behavior of banks and the public and thus affect the money supply. Hence the money supply is not only an exogenous controllable item but also an endogenously determined item.




We have discussed above the factors which determine money supply through the creation of bank credit. But money supply and bank credit are indirectly related to each other. When the money supply increases, a part of it is saved in banks depending upon the depositor’s propensity to save. These savings become deposits of commercial banks who, in turn, lend after meeting the statutory reserve requirements. Thus with every increase in the, money supply, the bank’s credit goes up. But it may not happen in exactly the same proportion due to the following:

1.      The marginal propensity to save does not remain constant; it varies from time to time depending on changes in income levels, prices, and subjective factors.

2.      Banks may also create more or less credit due to the operation of leakages in the credit creation process.

3.      The velocity of circulation of money also affects the money supply. If the velocity of money circulation increases, the bank credit neither may nor fall even after a decrease in the money supply. The central bank has little control over the velocity of money which may adversely affect bank credit.

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