Main determinants of the supply of money are (a) monetary base and (b) the money multiplier

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Main determinants of the supply of money are (a) monetary base and (b) the money multiplier. These two broad determinants of money supply are, in turn, influenced by a number of other factors. Various factors influencing the money supply are discussed below:

1. Monetary Base:

Magnitude of the monetary base (B) is the significant determinant of the size of money supply. Money supply varies directly in relation to the changes in the monetary base.

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Monetary base refers to the supply of funds available for use either as cash or reserves of the central bank. Monetary base changes due to the policy of the government and is also influenced by the value of money.

2. Money Multiplier:

Money multiplier (m) has positive influence upon the money supply. An increase in the size of m will increase the money supply and vice versa.

3. Reserve Ratio:

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Reserve ratio (r) is also an important determinant of money supply. The smaller cash-reserve ratio enables greater expansion in the credit by the banks and thus increases the money supply and vice versa.

Reserve ratio is often broken down into its two component parts; (a) excess reserve ratio which is the ratio of excess reserves to the total deposits of the bank (re = ER/D); (b) required reserve ratio which is the ratio of required reserves to the total deposits of the bank (rr = RR/D). Thus r = re + rr. The rr ratio is legally fixed by the central bank and the re ratio depends on the market rate of interest.

4. Currency Ratio:

Currency ratio (c) is a behavioural ratio representing the ratio of currency demand to the demand deposits.The effect of the currency ratio on the money multiplier (m) cannot be clearly recognised because enters both as a numerator and a denominator in the money multiplier expression (1 + c/r(1 +t) + c). But, as long as the r ratio is less than unity, a rise in the c ratio must reduce the multiplier.

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5. Confidence in Bank Money:

General economic conditions affect the confidence of the public in bank money and, thereby, influence the currency ratio (c) and the reserve ratio (r). During recession, confidence in bank money is low and, as a result, c and r ratios rise. Conversely, during prosperity, c and r ratios tend to be low when confidence in banks is high.

6. Time-Deposit Ratio:

Time-deposit ratio (t), which represents the ratio of time deposits to the demand deposits is a behavioural parameter having negative effect on the money multiplier (m) and thus on the money supply. A rise in t reduces m and thereby the supply of money decreases.

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7. Value of Money:

The value of money (1/P) in terms of other goods and services has positive influence on the monetary base (B) and hence on the money stock.

8. Real Income:

Real income (Y) has a positive influence on the money multiplier and hence on the money supply. A r se in real income will tend to increase the money multiplier and thus the money supply and vice versa.

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9. Interest Rate:

Interest rate has a positive effect on the money multiplier and hence on the money supply. A rise in the interest rate will reduce the reserve ratio (r), which raises the money multiplier (m) and hence increases the money supply and vice versa.

10. Monetary Policy:

Monetary policy has positive or negative influence on the money multiplier and hence on the money supply, depending upon whether reserve requirements are lowered or raised. If reserve requirements are raised, the value of reserve ratio (r) will rise reducing the money multiplier and thus the money supply and vice versa.

11. Seasonal Factors:

Seasonal factors have negative effect on the money multiplier, and hence on the money stock. During holiday periods, the currency ratio (c) will tend to rise, thus, reducing the money multiplier and, thereby, the money supply.

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