Factors Affecting Money Supply: Monetary & Non Monetary Factors

Monetary Factors Affecting the Money Supply

Monetary factors affecting the money supply are directly related to the policies and actions of a country’s central bank and the government’s monetary authority. These factors are instrumental in controlling inflation, stabilizing the currency, and steering the economy towards growth. Here’s a detailed look at the primary monetary factors:

a. Central Bank Policies

Central banks, such as the Reserve Bank of India (RBI) in India, the Federal Reserve in the United States, or the European Central Bank (ECB) in the Eurozone, play a pivotal role in managing a country’s money supply through various tools:

1. Open Market Operations (OMO)

Definition: These are the buying and selling of government securities in the open market.

Impact on Money Supply:

• Buying Securities: When the central bank buys government securities, it pays for these securities by creating bank reserves. This increases the reserves banks have available to lend, thereby increasing the money supply.
• Selling Securities: Conversely, when the central bank sells government securities, it takes money out of the banking system (as buyers pay for these securities), reducing the reserves available for lending and thus decreasing the money supply.

2. Reserve Requirements

1. Cash Reserve Ratio (CRR)

Definition: CRR is the percentage of a bank’s total deposits that must be kept in the form of cash reserves with the central bank. Banks cannot use this money for lending or any other investment purpose.

Impact on Money Supply:

• Increasing CRR: By increasing the CRR, the central bank can reduce the amount of funds available to banks for lending, thus decreasing the money supply.
• Decreasing CRR: Conversely, lowering the CRR increases the funds available to banks for lending, thereby increasing the money supply.

2. Statutory Liquidity Ratio (SLR)

Definition: SLR is the percentage of a bank’s total deposits that must be maintained in the form of liquid assets, such as cash, gold, or government securities. Unlike CRR, banks do not have to keep this portion with the central bank but must maintain it within their own reserves.

Impact on Money Supply:

• Increasing SLR: By increasing the SLR, the central bank compels banks to hold a larger portion of their deposits as liquid assets, reducing the amount available for lending, which can decrease the money supply.
• Decreasing SLR: Lowering the SLR allows banks to reduce their holdings of liquid assets, making more funds available for lending, which can increase the money supply.

3. Repo/Reverse Repo Rate

Repo Rate (Repurchase Agreement Rate)

Definition: The Repo Rate is the rate at which the central bank of a country (RBI in the case of India) lends money to commercial banks in the event of any shortfall of funds. The lending is done against government securities, essentially allowing banks to borrow money by selling securities to the central bank with an agreement to repurchase them at a predetermined rate.

Impact on Money Supply:

• Increasing the Repo Rate: Makes borrowing from the central bank more expensive for commercial banks. This discourages banks from borrowing, leading to a decrease in the money supply as banks have less money to lend to consumers and businesses.
• Decreasing the Repo Rate: Makes it cheaper for banks to borrow from the central bank. This encourages borrowing, leading to an increase in the money supply as banks have more funds to lend out.

Reverse Repo Rate

Definition: The Reverse Repo Rate is the rate at which the central bank borrows money from commercial banks. This tool is used to absorb excess liquidity in the banking system, ensuring that inflation is kept in check by controlling the money supply.

Impact on Money Supply:

• Increasing the Reverse Repo Rate: Makes it more attractive for banks to park their funds with the central bank, as they earn a higher return on their excess liquidity. This action reduces the liquidity in the banking system, thereby decreasing the money supply.
• Decreasing the Reverse Repo Rate: Makes it less attractive for banks to deposit their funds with the central bank, encouraging them to lend more to the public. This increases the liquidity in the banking system, thereby increasing the money supply.

4. Bank Rate

Definition: The Bank Rate is the rate at which the central bank of a country lends money to commercial banks without any security. It is a long-term measure and is used by the central bank to control the money supply and influence the country’s economic health.

Impact on Money Supply:

• Increasing the Bank Rate: Makes borrowing from the central bank more expensive for commercial banks. This discourages banks from borrowing, leading to a decrease in the money supply as banks have less money to lend to consumers and businesses.
• Decreasing the Bank Rate: Makes it cheaper for banks to borrow from the central bank. This encourages borrowing, leading to an increase in the money supply as banks have more funds to lend out.

The Bank Rate is often used as a signal to the market regarding the central bank’s stance on monetary policy. A high Bank Rate is indicative of a tightening of monetary policy, whereas a low Bank Rate suggests an easing of monetary policy.

5. Marginal Standing Facility (MSF) Rate

Definition: The Marginal Standing Facility is a window for banks to borrow from the Reserve Bank of India in an emergency situation when inter-bank liquidity dries up completely. Banks can borrow funds overnight from the RBI against approved government securities. The rate at which the RBI lends money to commercial banks under this facility is called the MSF rate.

Impact on Money Supply:

• Increasing the MSF Rate: Makes emergency borrowing from the central bank more expensive for commercial banks. This is a disincentive for banks to rely on this facility, potentially leading to a tighter money supply.
• Decreasing the MSF Rate: Makes it cheaper for banks to borrow from the central bank in emergencies. This can encourage banks to borrow in situations of liquidity crunch, thereby preventing a sharp contraction in the money supply.

The MSF rate is usually set higher than the repo rate under normal circumstances, providing a penal rate for banks to borrow only in acute shortage of liquidity. The MSF rate, along with the repo rate and reverse repo rate, forms the corridor for the short-term interest rates in the economy.

Non-Monetary Factors Affecting the Money Supply

Non-monetary factors affecting the money supply are those that are not directly related to the actions of the central bank or monetary policy instruments. These factors can influence the demand for and velocity of money in the economy, impacting overall economic activity and the effectiveness of monetary policy. Here’s a detailed look at some of the key non-monetary factors:

a. Economic Activities

Growth and Recession: During periods of economic growth, businesses expand, and consumers spend more, leading to an increased demand for money. Conversely, in a recession, spending and investment decline, reducing the demand for money. These changes in economic activity can affect the velocity of money, or the rate at which money circulates in the economy, thereby influencing the money supply.

b. Banking Habits of the Population

Preference for Cash vs. Deposits: The public’s preference for holding cash versus depositing money in banks can significantly affect the money supply. More money held in the form of cash reduces the base for banks to create credit, while more deposits can lead to an increased ability of banks to lend, amplifying the money supply through the money multiplier effect.

c. Fiscal Policy

Government Spending and Taxation: Government spending injects money into the economy, potentially increasing the money supply, especially if financed by borrowing from the central bank. Conversely, higher taxes can withdraw money from the economy, reducing disposable income and potentially the demand for money.

d. Foreign Exchange Rates

Impact on Imports and Exports: A stronger domestic currency makes imports cheaper and exports more expensive, potentially increasing spending on imports, which can affect the domestic money supply. Conversely, a weaker domestic currency can boost exports and reduce imports, affecting the money supply through changes in trade balances.

e. Innovation in Financial Products

Ease of Access to Credit: Innovations in banking and financial products, such as digital banking, mobile payments, and fintech services, can make it easier for consumers and businesses to access credit. This can increase the velocity of money and potentially the effective money supply by facilitating more transactions.

f. Psychological Factors

Expectations: Public expectations about future economic conditions, inflation, and interest rates can influence spending and saving behaviors. For example, if people expect inflation to rise, they might spend more now rather than save, increasing the velocity of money and the effective money supply.

g. Regulatory Changes

Banking Regulations: Changes in banking regulations that affect lending standards, capital requirements, and other operational aspects of financial institutions can influence the money supply. For instance, more stringent lending standards can reduce the ability of banks to create credit, thereby affecting the money supply.