High-Power of Money Multiplier Approach - Essay Example

? Money supply (High-powerd of money multiplier approach) of Introduction Money can be held in three common forms; paper money, metallic coins and money deposits to banks. Measurement of money supply is a critical act and various ways have been developed by economists to measure the level of money supply in the economy. The high-powered money multiplier approach is an approach that considers the level of bank deposits by the private sector while determining money supply (Werner, 2005). According to this approach, the level of cash deposits held by the bank plays the major role in determining money supply. High-powered money multiplier approach to credit creation The high-powered money multiplier is denoted by the letter ‘H’ and is measured in terms of the summation of notes and coins held by the common population (C) and notes and coins held by the banks plus deposits maintained by banks at the central bank (R). The mathematical formula for the stock of high-powered money: H = C + R The level of money supply (M.S.) in an economy is measured by: M.S. = C + D; where C denotes notes and coins held by the common population and D denotes bank deposits made by private individuals or agents (D'Souza, 2009). We can represent money supply in terms of the stock of high-powered money (denoted by ‘H’) and the high-powered money multiplier (denoted by ‘h’). The formula for high-powered money multiplier can be derived from the formula for the stock of high-powered money and the high-powered money multiplier (D'Souza, 2009). M.S. = C + D -----------(1) H = C + R ------------(2) On dividing equation (1) by equation (2) we get equation (3): On dividing the numerator and denominator of the right hand side of equation (3) by D we get: Or, Or, Or, M.S. = h* H (7) Where, Therefore, M.S. = h* H, i.e, the level of money supply in the economy is the product of the high-powered money multiplier (h) and the stock of high-powered money (H) (D'Souza, 2009). A number of assumptions are made prior to the development this model measuring money supply. These assumptions have been described below: Firstly, the stock of high-powered money (H) is considered as exogenously determined. It is not dependent on the functioning of the market forces. Secondly, C/D ratio is either a constant or is stable and predictable. If the rates of return on these investments remain constant, then the ratio of C/D would also remain constant. However, in reality, bank deposits offer interest rates whereas cash holding does not. Therefore, households as well as firms would be interested to make more deposits than hold liquid money. Thus, the C/D ratio is not a constant, but, is predictable. Sometimes the C/D ratio becomes unstable and unpredictable due to changes in financial culture of the economy or high end technological innovations and changing trend in spending methods towards use of plastic money (mostly due to technological advancements) leafing to a fall in C/D ratio or lack of confidence on the banking system in the economy leading to an increase in liquid money holding and a subsequent rise in C/D ratio. The final assumption is related to the R/D ratio. It is the ratio of the reserves held by the banks at the Central bank and the liabilities of the bank and is considered as stable and predictable. The banks often try to keep a high reserve with the central bank by acting in a risk-averse manner in order to protect itself in a situation of large sudden withdrawals by depositors. However, depending on the rate of interest, banks decide the amount of money they would hold as interest bearing asset and the amount they would hold as reserves (earning no interest). The stock of high powered money also changes due to the change in government policies or total liabilities of the central bank and daily operations of the central banks. Change in high powered money is denoted by ?H. The value of ?H is given by the following equation: Or, ?H = DEF – ?GD + ET + MMA Where, Budget deficit (DEF), net sales of government debt to the commercial banks and private sector (?GD), government’s net payments of external transactions (ET ) and short-term lending by the central bank to the commercial banks (‘money marker assistance’) (MMA). Each of these elements can be influenced by government policies. However, they do not fall under of the direct control of the government. Advantages and disadvantages The knowledge exists widely that any variation occurring in the money stock present in the economy is capable of affecting the national income of the country, its national output, rate of employment and most importantly the general price level. In this regard, the high powered money multiplier plays an important role in measuring the money supply in the economy (S. L. Lodha & M. Lodha, 2012). Firstly, using the high power money multiplier approach is that it is easy to use and measure the money stock in an economy. It is a customary analytical device that measures the money stock in the economy. This tool is convenient to use since it takes into consideration the variables such as the bank deposits made by the private sector, money holding by the common public, and the reserves maintained by the banks at the Central Bank. Since the formula to measure high power money multiplier includes the ratio of C/D and R/D, it is used to study the changes made in money supply through control of money supply (Shrestha, n.d.). It therefore, acts as an indicator that of the changes in money stock in an economy and is reliable, free from ambiguities and easy to operate (Gichuki, Oduor & Kosimbei, 2012). Secondly, the money multiplier is not a mechanical apparatus to measure the sock of money mathematically. Although it makes use of mathematical tools to reach the final result, it cannot be considered as a pure mechanical apparatus. Researchers have rather considered this tool to be developed as formal as well as informal interactions between different economic agents, such as, private banks, national banks, other financial institutions and public monetary authorities that taken monetary decisions. This tool provides a summary of the influences cast by all the factors on the stock of money in the economy (Basu, 2011; Papademos & Stark, 2010). There are also certain disadvantages of the high power money multiplier approach. In the modern economic scenario, the monetary economy is characterized by flexible exchange rate and uses fiat currency. The high power money multiplier transmits the changes occurring in the money stock to the changes in the overall money supply in the economy (Kaplan, 2003). Researchers use complex algebraic expressions to find the value of the money multiplier. Other researchers and scholars claim that the value of the multiplier is expressed as simply as the “required reserve ratio” (Economicoutlook, 2009). However, the high power money multiplier does not take into account one basic fact (Montes & Machado, 2013). Theoretically, it considers that banks accept deposits from the private individuals and firms so that they get funds that can be lent out to borrowers (Domeher, 2012). Essentially, banks maintain a proportion of these deposits with the Central Bank in the form of reserve. Thus, the entire amount that goes into deposits is not available as credit (Papademos & Stark, 2010). The credit creation process is distorted due to the fraction of deposits that is unavailable to borrowers. The lending standards followed by banks also vary according to the business cycle and the credit worthiness of the borrowers. The money multiplier does not account for this phenomenon. Limitations of high-powered money multiplier approach One major limitation of the theory of high powered money multiplier is that it is considered as exogenously determined. Fundamentally the money multiplier approach envelopes certain impractical concepts regarding cash deposits to the banks and the process of loan giving. The multiplier considers that the deposits accepted by the banks are right away given up to borrowers in the form of loans. However, the fact is different from this assumption. Banks maintain a certain proportion of deposits as reserves with the Central bank (Montes & Machado, 2013). The level of loan extended to the borrowers depends not only on the amount of cash held by the firms but also the present nature of the business cycle. Banks offer credit facilities to borrowers only after judging the creditworthiness this acts as a filter to the process of creating credit in the economy. Loans are extended on the basis of various factors and not only by the consideration of reserve positions of the banks (Hasan, 2008; Wyatt, 2011). The concept that excess reserves balances of a bank are used to finance bank balance sheet expansion is irrelevant and inapplicable. The process of credit creation (through creation of new liabilities for the bank) is distinctly separate from the reserve balance of the bank. Alternative theories One most popular theory of high powered money supply is the Post Keynesian approach to measure money supply. According to this approach, scholars argue that level of money supply in an economy is determined endogenously (Karpestam, 2012). This view lies in contrast to the high power money multiplier approach, in which it is assumed that the stock of money is given exogenously (Masciandaro, 2000; Currie, 2004). The Post Keynesian approach is sensitive to the limitations of high-powered money multiplier approach and addresses this limitation. In this model, the dependent variable is effective demand and it is effective in short run as well as long run. Demand for money is affected by credit facilities provided by banks and plays a key role in affective effective demand. The following equations describe this relationship: g = g0 – ?r + €1 In this theory, scholars view bank credit as a determinant of bank deposit (which is the opposite of money multiplier theory). This is shown by the equation: r = r0 + ? (? - ?t). In the Post Keynesian model, any alteration in money supply brings responses in monetary base via the banks’ lending processes, rather than making money supply respond to monetary base (as in money multiplier theory). The credit theory of money is another alternative approach to measure money supply. Under this theory, banks play the central role of provider of money supply in the economy. In this model, scholars identify two forms of credit creation; one productive and another unproductive. Creation of productive credit leads to economic growth at without increasing inflationary pressure at full employment due to technological progress. Unproductive credit causes higher inflation rather than economic growth (Bortis, 2004). In this case, the credit creation by banks is considered as a separate process from the bank’s reserve. The effect of the credit is seen as a boost for economic growth that increases the national income. Therefore, money supply is determined endogenously unlike the money multiplier theory (Ryan-Collins, Werner, & Jackson, 2012). Current context of monetary policy The developed countries such as, the USA, the UK, Euro zone countries and Japan are currently facing a similar state of economy in the post financial crisis period. Although these economies are recovering, the impact of depression is looming large and effect of credit creation is not acting as the most impeccable boost for economic growth. Therefore, it is important to study the money multiplier approach in the contexts of these economies. With rise in supply of high powered money inflation rises and market demand falls. Unforeseen acceleration in money demand and increased lending activity raises the interest rate (Ryan-Collins, Werner, & Jackson, 2012). Increased rates of interest would reduce borrowing, thereby reducing spending. Government policies are developed according to the level of high powered money in the economy. During times of crisis, financial institutions in the country needs to supervise the money and goods and market and might alter its policy prescriptions according to the high powered money supply. In the Keynesian approach, the level of credit extension by banks would affect the level of deposits, thereby affecting money supply in economy. Crowding out effect reduces consumer expenditure thereby reducing aggregate demand in the economy (Bortis, 2004). In the current economic situation, the government has to reduce supply of high powered money so as to reduce inflation level in the economy and increase aggregate demand. Monetary policies play a dynamic role in this situation to improve level of economic activities increase aggregate demand. Expansionary monetary policies would increase credit creation in the economy, which would reduce bank deposits. Higher credit facilities would increase economic activities in all these economies helping them to pull out of depression. References Basu, K. (2011). A simple model of the financial crisis of 2007-2009, with implications for the design of a stimulus package. Indian Growth and Development Review, 4 (1), 5 – 21. Bortis, H. (2004). Money and inflation – A new macroeconomic analysis. Journal of Economic Studies, 31 (2), 158 – 164. Currie, L. (2004). Money and savings: How definitions affect policies: January 16, 1991. Journal of Economic Studies, 31 (3/4), 371 – 381. Domeher, D. (2012). Land rights and SME credit: evidence from Ghana. International Journal of Development Issues, 11 (2), 129 – 143. D'Souza, E., 2009. Macroeconomics. 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