The money supply in an economy refers to the total amount of money available for use in transactions, including currency, deposits, and other liquid assets.
The key determinants of the money supply include:
i. Central Bank Policies (Monetary Policy)
• Open Market Operations (OMO): The central bank buys or sells government securities to regulate the amount of money circulating in the economy. When the central bank buys securities, it injects money into the economy, increasing the money supply. Conversely, selling securities reduces the money supply.
• The central bank can set reserve requirements, which determine the proportion of deposits that commercial banks must keep as reserves. A lower reserve requirement increases the money supply as banks can lend more. A higher reserve requirement reduces the money supply.
• The central bank sets the interest rate at which commercial banks can borrow from it. A lower discount rate encourages borrowing and, in turn, increases the money supply. A higher discount rate has the opposite effect.
• In extraordinary circumstances, the central bank may implement quantitative easing, where it directly injects money into the economy by purchasing long-term securities, such as bonds, to stimulate economic activity and increase the money supply.
ii. Commercial Bank Lending (Credit Creation)
• Commercial banks play a critical role in the creation of money through their lending activities. When a bank lends money, it credits the borrower's account, effectively increasing the money supply (credit creation). The ability of banks to lend depends on the reserve requirement and the level of demand for loans in the economy.
• The demand for loans also affects the money supply. If businesses and consumers are more willing to borrow, banks lend more, which increases the money supply. In times of economic uncertainty or high interest rates, loan demand may decrease, reducing the money supply.
iii. Public's Demand for Money
• The public's preference for holding cash or deposits influences the money supply. If individuals and businesses prefer to hold more currency (physical money), the money supply in the form of bank deposits will be lower. On the other hand, if people prefer to keep money in banks and use electronic transactions, the money supply will be higher.
• The need for money for day-to-day transactions (like buying goods and services) also affects the money supply. A rise in economic activity or inflation leads to an increase in the transaction demand for money.
• People might hold more money as a precaution (to deal with uncertainty) or for speculative reasons (to take advantage of future investment opportunities). This can affect the total money circulating in the economy.
iv. Government Fiscal Policy: Government Spending and Taxation: Government fiscal policies, such as increased spending or tax cuts, can influence the overall demand for money in the economy. Increased government spending can raise the need for transactions, which may increase the money supply. Conversely, higher taxes could reduce disposable income, potentially lowering the demand for money.
v. International trade and foreign exchange transactions can affect the money supply.For example, if a country exports more than it imports, it may receive foreign currency, which could be converted into the domestic currency and thereby increase the money supply. Additionally, an influx of foreign investment (capital flows) can increase the money supply, as foreign investors exchange their currency for the domestic currency, raising the money supply in the economy.
vi. Technological Developments: Advances in financial technology (FinTech), such as mobile payments, online banking, and digital currencies, can increase the speed and volume of money transactions, effectively increasing the money supply as more transactions can take place with less physical money.