Money Supply, Monetary Base, CRR and Money Multiplier

Money supply in any economy is given as ‘Currency + Deposits’

Currency is the amount of money holding by the individuals. Deposits is the money holding by the bank. Holding 100% funds in currency form by the individuals OR in deposits form in the bank is unrealistic.

In reality we use fractional banking system.

what is fractional banking system? A bank is not required to hold all the money in form of reserves, it is under the assumption that not every account holder will show up at the bank for their cash at one time.

What is Cash Reserve Ratio?: Rule is set by the central bank that at any given point of time commercial banks should hold only a certain amount(20%) of deposits as reserves.

Example:
If say, 1000 Rs is deposited into the bank, then it should keep only 200 Rs with it and lend 800 Rs to others. This will create potential transactions of worth 1800 (1000 Rs which is initially deposited and 800 Rs which is newly created), so it could create economic activity of worth 1800 Rupees. And the remaining 20% (200 Rs) is CRR Cash Reserve Ratio. Others who have received 800 Rs will now deposit that money into another bank in which again 160 Rs (20%) is retained by the bank and remaining 640 Rs is lent to others and this goes on till the deposits reach 5000 Rs. How to arrive at this deposit level of 5000 rupees? is given by CRR itself.

What is Reserve Level?: Initial amount of deposit, i.e, 1000 in above example is called reserve level.

How to compute deposit level from CRR?: Deposit Level = (Reserve Level)/CRR

Reserve level of 1000 will be able to support a deposit level of 1000/0.2 = 5000

What is Monetary Base(MB): is the initial ‘amount of capital’/’Reserve Level’ that is injected into the economy (In above example it is 1000 Rs) It is defined as ‘Currency + Reserves’

The actual amount of money supply in the economy is much higher than the monetary base (In above example it is 5000 Rs). So the Actual Money Supply is a multiple of monetary base, this multiple is called Money Multiplier  (In above example it is 5)

What determines Money Multiplier(MM)? its CRR, the higher the CRR, the lower the MM because the banks cannot indulge in multiple deposit creation.

Now if the Central Bank (CB) wants to decrease the money supply in the economy, it should raise the CRR. This is one instrument CB uses to control liquidity in the economy.

It also depends on the individual on how much to hold the money in his hands in from of currency and how much to put in bank, so central bank has only partial role to control the liquidity through CRR.

Note: CB just sets the floor of CRR but it is up to the commercial banks to decide on the maximum cap of CRR, there is no limit.

During post crisis USA federal reserve’s problem: It can increase the MB as much as it wants. When it is increased by humongous amounts then prices should go up but it is not, because banks are not lending, and instead excess reserves are going up, money multipliers are falling down and hence it is not translating into higher availability of money in the market.

Today both Europe and USA facing similar banking crisis.

1929 Banking Crisis

In 1929 crisis analysis, pattern observed was currency holdings went up and CRR also went up and as a result credit availability in the economy decreased.

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