Question

Discuss a) the monetary base, b) the money multiplier, and c) the money supply. How do these variables interrelate and interact with each other?

Answer 1

a) The monetary base is also called high powered money, Reserve money or Base Money. It is the sum total of currency with the public, other deposits with Central Bank, Cash with Banks and Banker's deposits with central Bank. The various sources of high powered money are:

1) Claims of Central Bank on government

2) Net Foreign Exchange Assets of Central Bank

3) Government currency liabilities to the public

4) Net Non-monetary liabilities of Central Bank

b) The money multiplier - It is the ratio of money supply to the high powered money, thereby showing the extent to which the money supply is as proportion of the high powered money. The money supply grows by a multiple times of high powered money as the banks has the capacity to create money by extending loans to different economic agents by opening up an account. The reserves with the banks that include deposits forms the basis for creation of loan that eventually leads to the creation of money.

Where, M=Money Supply, H=High-powered money, C=Currency with public, D=Deposits with Bank, ER=Excess Reserves; RR=Required Reserves

C. The money supply is the quantum of currency & liquid instruments used as medium of exchange, a store of value & unit of account that is in circulation in the economy. The money supply is measured using four measures of money supply:

M1: Currency with public + Demand deposits with the Banking system (current account, saving account) + Other deposits with Central Bank - M1 is called Narrow Money

'M2 = M1 + Savings deposits of post office savings bank

M3 = M1 + Time deposits with the banking system

M4 = M3 + All deposits with post office savings banks

Monetary Base, Money Supply and Money multiplier are related to each other with a formula as described above.

Money multiplier will grow, as ratio of money supply to monetary base increases, thereby indicating rising economic activity in the economy. The deposits that public keeps with the bank form the basis of loan creation capacity of the bank, which in turn helps increase money supply in the economy.