The H Theory of Money-Supply (Explained With Diagram)!
There is near- unanimity among monetary economists around the theory of money supply that says, that the single most important and dominant factor that determines money supply is H. For short,
The H Theory of Money-Supply (Explained With Diagram)!
There is near- unanimity among monetary economists around the theory of money supply that says, that the single most important and dominant factor that determines money supply is H. For short, we shall call it the H theory of money supply. For reasons that will become clear in the sequel, it is also called the ‘money-multiplier theory of money supply’. But we prefer to call it the H theory, because the entire theory is built around the demand and supply of H and the money-multiplier is only an outcome of this approach, not its starting point.
Calling it the H theory focuses attention on the key variable in the whole drama of money-supply changes. It also provides the theory the standard technique of demand-supply analysis. We shall discuss the H theory in a very simple form. This will be enough to bring out the main contours of the theory and its basic analytical thrust.
As a first approximation and provisionally, it is assumed that the supply of H (Hs) is policy-determined. Later on, we shall examine how far this is a correct assumption to make in the Indian context and in what sense. This assumption gives us
where the bar above H signifies that it is given exogenously to the public and banks.
The analysis of the demand for H (Hd) is much the more important for the H theory. The key insight of the theory is to relate it to DD or M. Let us see how this is done.
We have already said above that H is demanded partly by the public as currency (C) and partly by banks as reserves (R). These are the only two sources of demand for H in our model.
The demand for C (Cd) as a component of M is affected largely by the.same factors as affect the demand for M, such as the level of income and the rate of interest, among other things. The same is true of the demand for DD (DDd).Therefore as a first approximation, it is reasonable to assume that Cd and DDd will be highly correlated—that will be (say) a proportional function of DD. This may be expressed as
Cd= c. DD. (15.4)
c, then, is the ratio of Cd ‘to DD. For short, we shall call it the (desired) currency-deposit ratio of the public c itself will express the preferences of the public as between currency and demand deposits of banks.
As such, this itself will be affected by several factors which in turn reflect the relative advantages (and costs) of the two forms of money. Consequently it can vary over time, not only secularly but also from one season to the other. Therefore, c is a behavioural ratio. But for simple exposition of the H theory, we shall assume it to be a constant.
What about the bank’s demand for reserves (Rd)? The reserves of banks are usually divided under two heads (a) required reserves (RR) and (b) excess reserves (ER). Required reserves are reserves which banks are required statutorily to hold with the RBI. Banks have no choice about them.
Under the law, the RBI is empowered to stipulate the statutory reserve ratio, which may be varied between 3 per cent and 15 per cent of the total demand and time liabilities of a bank. Every scheduled bank is required to maintain all its RR as balances with the RBI. All reserves in excess of RR are called ER Banks are free to hold them as ‘cash on hand’ (also called ‘vault cash’) with themselves or as balances with the RBI.
Banks hold ER voluntarily. They are held to meet their currency drains (i.e. net withdrawal of currency by their depositors) as well as clearing drains (i.e. net loss of cash due to cross-clearing of cheques among banks). These drains may be partly expected and partly unexpected, giving rise to what may be called banks’ transactions demand and precautionary demand for cash reserves.
Thus, the standard theory of the demand for money can be applied to the banks’ demand for excess reserves as well, which alone is their disposable cash. Our objective here is not to go into a detailed discussion of the banks’ demand for excess reserves (ERd). We only hypothesise that ERd will be determined largely by the banks’ total liabilities.
Thus, both RR and ERd and so become increasing functions of the total demand and time liabilities of banks. We can introduce a further simplification here. The demand and time liabilities of banks are predominantly (about 92 per cent of them) due to the demand and time deposits from the public.
Moreover, this ratio between liabilities and deposits has remained stable over the past 20 years.
Therefore, as a simplification, we can revise our earlier hypothesis and say that Rd is largely a proportional function of the total deposits of banks:
Rd = r.D. (15.5)
r, then, is the ratio of Rd total deposits of banks. For short, we shall call it the reserve-deposit ratio.
Let us now introduce in our model the important fact that bank deposits are of two kinds — demand deposits (DD) and time deposits (TD). The former are counted as money; the latter not. Since we are interested in developing a theory of money supply, we must decide how to treat TD.
The division between DD and TD is decided by the public, given the terms and conditions on which banks are willing to sell the two kinds of deposits to the public. In other words, it is the public who decides how much TD to hold in relation to DD.
Again, a