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Money supply process -- II: Need for flexible money multiplier

Flexibility in money supply from an absolute angle requires credit money to be a larger portion of aggregate money each year. India has a long way to go to reach that state, and if any major crisis flows from external sources because of the lack of flexi bility in money supply, the economy will be put to very great strain, says P. R. Brahmananda.

THE concept of money multiplier, which gained ground post-Second World War, originated from the monetary experience of the US. Given that the supply of money is exogenously determined to the system of production and prices, there was a gap in regard to the explanation of how the supply of money itself was determined. The UK-Cambridge economies pioneered the analysis of demand for money from a theoretical angle.

The demand for money was stated to be determined by real income, the price level and the interest rate. The money used here was M3, which serves as both the medium of exchange and the asset functions of money. Keynes popularised the use of money in his T reatise on Money and in the General Theory. The Cambridge economies took money supply as given, and did not go too much into the factors determining money supply.

The Cambridge economies functioned in a period of the gold standard. Each country's money supply was largely determined by gold reserves in the banks and with the central bank. As most countries did not mine gold, the gold flows to these countries had to be governed largely by trade changes. It was natural to link domestic money with gold reserves, which had to be built up over time through trade surpluses and such means. Except in times of war, the governments did not add to the stock of currencies.

Central banks were not in the habit of lending to the government in normal times. The government's demand for day-to-day funds could, however, be satisfied by the issuance of treasury bills. But, each year, there was no presumption that the average credi t extended through bills to the government would go up. Such bills could be treated as revolving credit, as in the case of loans by banks to firms. Keynes, in his defence of the General Theory made the cryptic statement that credit was, after all, a revo lving fund.

If all credit is treated as a revolving fund, the level of money supply could change year by year only if gold reserves kept increasing. There was, therefore, some implicit distinction between credit, which led to revolving money, and gold accretion, whi ch led to money that did not revolve. As gold reserves were the basis for such money, an increase in gold reserves could lead to an expansion in money. For a single country, the postulate of externally given money supply changes was justified under the t hen institutional conditions for economies, which were very much open to trade.

The Cambridge procedure then was perfectly justified. But in the US, the central bank could vary the reserves ratios and thus vary money supply. The money multiplier approach had, naturally, considerable scope in the institutional environment there. Now, for countries like India, this approach has become pertinent. The British view that loans create deposits ignored that when banks make out loans the borrowers/the spenders could take the credit partly in the form of additions to deposits and partly in t he form of additions to their currency holdings. So, one had to postulate scope for increase in currency whenever loans were increased by banks.

The correct proposition is that loans can create deposits provided the currency stock is augmented from government expenditure, financed by the central bank directly or indirectly or by purchases of government securities in the market by the central bank . A reduction in the reserves ratio creates facility for banks to augment their credit. The increased requirements of reserve money would have been provided by reduction in the reserves ratio. Thus the reserve money variation becomes very fundamental in the money multiplier theory.

But there are two caveats to reserve money increases being followed by money supply increases by the extent of the money multiplier. The problem is that it is only if banks do not take the increase in reserve money in the form of increases in the reserve s ratio that the money multiplier process can work in full. This depends on uncertainties concerning banks and their desire for safety. The second caveat is that the banks must be able to expand their credit.

Credit requires both the borrower and the lender. If the latter has resources and is willing to lend, it does not follow that he will always succeed in getting eligible borrowers. Hawtrey generalised this by his concept of the credit deadlock. This is a situation where banks are willing to lend but there are no borrowers in a position to take the loan and use it profitably, so as to be able to repay the loan with interest.

When there is a credit deadlock, the money multiplier is largely frozen. But in India the government is willing to float securities, for which it requires investors. In India banks have this sort of alternative. But if the government is saturated with fu nds, the money multiplier will again be frozen.

The money multiplier's operation in its usual form and to its usual value depends upon two stabilities. The first stability is the ratio of deposits to reserves. The second is the ratio of deposits to currency. The former is being brought down by the Res erve Bank in India, partly as a part of reforms recommended by the Narasimham Committee. The ratio of deposits to currency has been going up in India.

The ratio of all deposits to currency as well as that of demand deposits to currency both are going up. The savings deposits component of demand deposits is going up. People prefer savings deposits to currency because of the interest they get on the savi ngs deposit. People also prefer time deposits to demand deposits because fixed deposits earn interest higher than on the savings deposit.

Consequently, as the proportion of currency to deposits falls, the money multiplier goes up over the long period. It also goes up because the ratio of reserves to deposits is comes down for various reasons. Because government is borrowing so heavily we a re not getting into the credit deadlock state. Both the broad and narrow money multipliers have been going up, more so after the reforms.

In fact, there is a subtle distinction between credit for business and bank credit to government. The latter does not revolve, the former is expected to do so. Most banks do not call back loans. They most frequently renew the loans or overdraft facilitie s. Strictly speaking, the credit to government is not credit in the classical sense. Money is circulating capital. And credit money is supposed to be a revolving fund.

Somehow, money lent to the government does not have these properties in the short period. Since we do not generally reduce credit and money supply, the money multiplier with us is a relation between reserve money and money stock.

But as and when government borrowing becomes insignificant, and banks get accustomed to calling back loans and making renewals non-automatic, we will reach a stage where money supply variations become two-way.

In the East-Asian crisis money supply fell drastically when reserves went out, and prices also fell, as also nominal and real wages. It is this flexibility that has brought recovery to them so quickly. Flexibility in money supply from an absolute angle r equires credit money to be a larger portion each year of aggregate money. We have a long way to go to reach that state. If any major crisis flows from external sources because of the lack of flexibility in money supply, the economy will be put to very great strain.