The H theory of Money Supply

Concepts and measures of money supply relate to the supply of ordinary money (M),
referring to money, as people generally understand it. Monetarists often distinguish it from
what they call the high-powered money (H) while discussing the theories of money supply.
According to them, the single-most factor determining money supply is the high-powered
money (H), defined as money produced by the central bank and the government and held by
the public and the banks. It consists of
(i) Currency, C, including coins and notes in circulation with the public;
(ii) Cash reserves, R, held by commercial banks as vault cash;
(iii) Other Deposits, OD, of the central bank High-power money (H) can thus be expressed
as

Money supply is thus directly proportional to the high-powered money, H. Differentiating the
expression for M with respect to H, we have (dM/dH) = m, defined as the ratio of increase in

money supply (M) per unit increase in high-powered money (H) and known as the money
multiplier.
In short run analysis, TD may be treated as insignificant. Expression for money supply can
now be expressed as
M = (1 + c) / (c + r) H
Expression for money multiplier would then change to
dM / dH = m = (1 + c) / (c + r)
In either case, when increase in H is not infinitesimally small, increase in M may be given as
M = (m) H
This shows that change in money supply (M) is directly proportional to the change in highpowered money (H).
Inferences drawn from Equations 7.13 and 7.14 support the statement that high- powered
money (H) is the single-most determinant of money supply (M), given c, r and t. It is for this
reason that high-powered money (H) is at times called the money base.
Equilibrium of the market of high-powered money refers to equilibrium of demand and supply
of high-powered money.
At a given stock of high-powered money, its supply,
Hs = H
In the same way, demand for high-powered money can be expressed as
HD = CD + Rd
HD can thus be obtained by vertical summation of CD and RD, where CD and RD represent
demands for currency and cash reserves. Fig. 7.1 demonstrates the equilibrium of the Hmarket.

To demonstrate the money multiplier process, let us have an illustration.

Illustration 7.1:
Government purchases goods and services from public worth Rs. 90.00 crores. Currencydeposit ratio is 0.50 and reserve-deposit ration is 0.10. Determine deposit and money
multipliers and hence calculate the additional volumes of deposits and money created in
consequence of an increase in high-powered money by Rs. 90.00 crores.

The mechanism can also be explained without the use of the formulae developed above.
As soon as public receives the cheque of Rs. 90.00 crores from government for goods and
services sold by it and deposits the same with its bank, the cheque is sent for collection by
the bank.
The amount becomes available to the public in a few days time. Currency deposit ratio
being 0.50, public divides the amount between currency held and deposit made in such a
way that 50% of the deposit forms the currency withdrawn by the public. As result, C = 30
crores and D = 60 crores so that C/D = 1/2. Thus bank deposits increase by Rs. 60 crores in
consequence.

As soon as the bank of deposit comes to know of it, reserve-deposit ratio being 0.10, it holds
10% of the deposit (Rs. 6.00 crores) as vault cash and lends out the rest (Rs. 54.00 crores)
to borrowers, who in turn split it between cash held and deposit made in the ratio 1:2. That
is, the borrowers withdraw Rs. 18 crores leaving Rs. 36 crores by way of deposits with the
bank.
In the next round, the bank holds back 10% of the new deposits, that is, Rs. 3.60 crores as
vault cash and lends out the remainder, that is, Rs. 32.40 crores to the borrowers. The
borrowers divide Rs. 32.40 between cash held and deposits made in the ratio of 1:2 as C/D
= 0.50. As a result, they withdraw Rs. 10.80 crores and leave the rest, Rs. 21.60 crores as
deposits with the bank.
The process continues indefinitely until nothing is left with the bank to lend. Deposits in
respective rounds increase by Rs. 60, 36, 21.60, crores while currency held by public
increases by Rs. 30, 18, 10.80, crores and that held as vault cash by the bank increases
by Rs. 6.00, 3.60, 2.16, crores.
Total additional deposits work out at Rs. 150.00 crores and total additional currency held by
the public and the bank works out at Rs. 75.00 crores. Addition money pumped into the
economy increases by Rs. 225.00 crores

Theory of Money Supply: Ordinary Money and High-Powered Money!

So far we have assumed money supply to be policy determined. This is
not true, because the supply of money is determined jointly by the
monetary authority, banks, and the public. No doubt, most of the time, in
this determination the monetary authority plays the active and also the
dominant role. But the role of the public and banks cannot be ignored, nor
even taken for granted. Proper recognition and understanding of this role is
important for a successful policy of monetary control.
As a preliminary to the study of the theory of money supply, it is
essential to understand the distinction between two kinds of money:
(a) Ordinary money (M) and
(b) high-powered money (H).
They are all measures of ordinary money (M), or money as generally
understood. There it was also stated that in this book we shall define M
narrowly as the sum of currency and demand deposits of banks (including
the RBI) held by the public; and that since other deposits of the RBI
included in the measure of M are a very small proportion (less than one per
cent) of the total supply of M, no harm will be done if in our future
discussion we ignore these other deposits of the RBI. For simplification of
our theoretical discussion, this is what we shall do. Accordingly, for our
theoretical analysis, we define
M=C+ DD (15.1)

High-powered money (H) is money produced by the RBI and the

Government of India (small coins including one-rupee notes) and held by
the public and banks. The RBI calls H reserve money.
H is the sum of:
(i) Currency held by the public (C),
(ii) Cash reserves of banks (R), and
(iii) Other deposits of the RBI (OD).
Again, for simplicity, we leave out of our theoretical analysis OD, as they
constitute only about one per cent of total H. Accordingly, for our theoretical
analysis, we define
H= C+ R. (15.2)
The empirical definition of H in H= C+ R. (15.2) is by its uses or by its
holders, not by its producers (the RBI and the government). At a later
stage, we shall find it fruitful to look at H from the latter angle. On
comparing equations M = C + DD (15.1) and H= C+ R. (15.2) we find that C
is common to both M and H and that the only difference between the latter
two is due to the second component of each, namely DD in M and R in H.
This difference is of crucial importance for the theory of money supply.
It arises from the presence of banks as the producers of demand deposits,
which are counted as money at par with C. But to be able to produce DD,
banks have to maintain R, which is a part of H, produced only by the
monetary authority and not by banks themselves.

Since in a fractional-reserve banking system, DD are a certain multiple of

R, which are a component of H, it lends to H the quality of high-poweredness (as compared to M) the power of serving as the base for the multiple
creation of DD. For this reason, H is also called base money.

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

HS=H (15.3)
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 correlatedthat 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 banks 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, as a simplification, we hypothesise that TDd is an increasing
proportional function of DD:
TDd = t. DD (15.6)
t, then is the ratio TDd to DD. For short, we shall call it the time-deposit
ratio. Since, by definition,
D = DD + TD, the use of TDd = t. DD (15.6) gives us
D = (1 + t)DD. (15.7)
From Rd = r.D. (15.5) and n D = (1 + t)DD. (15.7) we have
Rd= r (1+t). DD (15.8)
Recalling that Hd = Cd+ Rd, from (15.4) and Rd= r (1+t). DD (15.8) we have
Hd = [c + r(1+t)]DD (15.9)
Thus, Hf has been expressed as a function of DD and three behavioural
ratios c,t, and r.

The market for H will be in equilibrium when Hd = Hs or from Hs = H (15.3)

and Hd = [c + r(1+t)]DD (15.9) when
[c+r(1+t)]. DD = H.
The above equation can be solved for DD to give
DD=1/(c + r(1 + t) H (15.10)
The above equation gives us the equilibrium value of DD in terms of H and
the three behavioural ratios c, t, and r3. In the literature on money supply,
the expression l/ c + r(1+t) is called the demand-deposit multiplier.
Next, from M = C + DD (15.1) and Cd = c. DD (15.4) and assuming that C=
Cd we have
M= 1+c /c +r(1=t) H. (15.11)
The above, ultimately, is the key equation of the H theory of money supply.
It makes the supply of money a function of H and the three behavioural
ratios c,t, and r. The Expression 1 + c /c + r (1+t) gives the value of what is
known as the money multiplier. We shall denote it by m. Then, equation M=
1+c /c +r(1=t) H. (15.11) can be more simply written as
M = m () H. (15.12)
The above equation sums up briefly, but very well, the main message of the
H theory of money supply. From its form it can be seen why this theory can
be and has been more popularly called the money-multiplier theory of
money supply.
More important, the equation says that the determinants of the supply
of M can be meaningfully classified under two main heads:
(a) Those that affect H and

(b) Those that affect m.

Thus, in the first instance, the equation serves well one of the useful
functions of a theorythat of providing a filing or classificatory device for
various factors affecting a dependent variable, as, for example, is done by
the well-known theory of demand and supply of price determination under
perfect competition.
Whether the classificatory device suggested by the theory of equation M =
m () H. (15.12) is empirically meaningful or not can be known only after a
detailed examination of the factors governing H and the factors governing
m and the extent to which the former can be meaningfully separated from
the latter. We have already summed up the proximate determinants of m in
equation M= 1+c /c +r(1=t) H. (15.11). They are the three behavioural ratios
c. t, and r.
From this discussion we shall see that whereas changes in H are largely
policy-controlled, changes in m are largely endogenous, i.e. are such as
depend mainly on the behavioural choices of the public and banks. This is
a useful distinction, analytically as well as for monetary planning. It implies
that, for policy purposes, the monetary authority will do well to take the
behaviour of m as something outside its control and to concentrate its
efforts on controlling H to control M.
We shall comment on equation (15.12) later in this article, because it is
high time that we explain the economics of what we have already done. We
shall do so with the help of diagrams. The discussion will throw muchneeded further light on the forces determining money supply and its
correlates (such as currency, demand deposits, and time deposits held by
the public and reserves held by banks), given the supply of H.

Either of the two Figures 15.1 and 15.2 can be used to show the
determination of money supply under the H theory. First consider figure
15.1. In it H is measured vertically and DD are measured- horizontally.

Since the supply of H is a Mumed to be given exogenously by the monetary

authority at H (equation 153), the H curve is drawn parallel to the horizontal
axis at the height ft., showing that H is perfectly inelastic to DD. The three
demand curves in the market for H are upward-sloping straight lines going
through the origin in accordance with the hypotheses of equations Cd = c.
DD (15.4), Rd= r (1+t). DD (15.8), and Hd = [c + r(1+t)]DD (15.9).
The Cd curve represents equation Cd = c. DD (15.4), with its slope equal to
c. (In India at present the value of c is about one. So the curve has been
drawn to make an angle of about 45 with the horizontal axis) the Rd curve
represents equation Rd= r (1+t). DD (15.8). Its slope has the value of r (1 +
t). The Hd curve is simply the vertical summation of the Cd and Rd curves.
Thus, it represents equation Hd = [c + r(1+t)]DD (15.9).
The intersection of the Hd curve with the Hs curve gives the equilibrium of
the H market. That is, at this point the public and banks are fully happy to
hold all the amount of H the monetary authority chooses to place in the H
market. In this situation, the equilibrium amount of DD, is that shown by
DDo; the public holds Co amount of currency and leaves the balance of H,
that is, HCo=Ro. for banks to hold. For DDo amount, this is exactly equal

to banks Rd. It will also be noted that, given the Cd function, Co is exactly
the amount of currency the public would like to hold when DD = DDo

The same story is told in Figure 15.2, though in a different way- This figure
depicts the equilibrium of the market for reserves and the consequent
determination of the equilibrium amount of DD. The participants in this
market are also the monetary authority, the public, Rd banks. On the
demand side, the demand for reserves coming from banks is represented
by the Rd curve Rd= r (1+t). DD (equation 15.8), as in figure 15.1.
The supply of R to banks is determined jointly by the monetary authority
and the public. The monetary authority does so by fixing the total supply of
H. Given H, the public determines how much of H it would like to hold in the
form of currency and how much to leave for banks to serve as their
reserves.
The decision is reflected in the Cd function Cd = c. DD (15.4). It is
reasonable to assume that the public has first claim on H to meet its
demand for currency, because banks always stand ready to convert their
demand deposits into currency at par. Therefore, it is assumed that actual
C held by the public is equal to their Cd. This makes banks only residual
claimants for reserves. Consequently the supply of reserves to them is
simply the excess of Ms over Cd.

R s = Hs -Cd (15.13)
This is represented in Figure 15.2 by the downward sloping Rs curve
which is the vertical subtraction of the Cd curve from the Hs curve in Figure
15.1. The intersection of the Rdand Rd curves in E (Figure 15.2) gives the
equilibrium of R market. This equilibrium is attained when the amount of
DD is DDo the same equilibrium amount of DD we had in Figure 15.1.
This is as it should be, because Figure 15.2 has been derived from Figure
15.1 as explained above. In the former figure the amount of C is not shown.
It has to be determined with the help of equation Cd = c. DD (15.4), given
the equilibrium amount of DDo.
Neither of the two figures shows the equilibrium amount of M produced or
supplied. In Figure 15.1 it can be easily inferred, because we know the
equilibrium values of Co, and DDo, that will be produced, given H, and Mo =
Co + DDo.
The crux of the above demonstration is the role the secondary expansion of
money supply plays via the production of DD. The role of banks in moneysupply changes also inheres in this. This will come out well when we study
the money-multiplier process. But preparatory to this discussion and also to
throw further light on what has preceded, we undertake the stability
analysis of the equilibrium of the Markets for H and R. This will also bring
out clearly one crucial assumption of the H theory.
The stability analysis offers an opportunity for studying the disequilibrium
behaviour of the system. For this, let us ask what will happen if, other
things being the same, the public comes to hold DD, amount of demand
deposits which are less than the equilibrium amount DDo.
At this value of DD, both Rd and Cd, and so their sum Hd will be lower than
before (Figure 15.1). Hs remaining the same, there will be excess supply of
H in the H market. Correspondingly, there will be excess supply of R in the

R market, as can be easily seen in Figure 15.2. What will be the

consequences of this excess supply of R?
Before- answering this question, it needs to be pointed out that the excess
supply of R is not the same thing as excess reserves (ER), because
desired excess reserves at each level of DD are already included m the
Rd function. Therefore, the excess supply of R is called undesired ER.
Excess reserves, whether desired or undesired, do not earn banks any
interest income. Therefore, banks try to get out of undesired excess
reserves and move into earning assets (EA) as fast as they can.
Earning assets are broadly sub-divided under two heads:
(i) Investment and
(ii) loans and advances.
Investments are made in marketable securities, whether government or
private. The implicit assumption of the H theory of money supply is that the
supply of earning assets to banks is very highly elastic around prevailing
rates of interest and that banks are generally not deterred from moving into
earning assets out of undesired excess reserves.
In sum, one important assumption of the H theory is that banks restore
equilibrium to their reserve holding pretty fast.
There was a time when the bulk of earning assets of banks consisted of
loans and advances and investments in securities were negligibly small,
because such securities had not grown in volume. The latter was the result
of low level of corporate development as well as of government debt and
securities market. In such a world, during depressions the demand for bank
loans and advances could decline sharply and banks could stay loaded
with undesired excess reserves.

They did not have enough bankable earning assets to buy. The situation
has been substantially different in recent times. For various reasons, most
of the time the market for bank Moans suffers from excess demand rather
than excess supply. Then, the investment market has grown significantly.
Even if good corporate securities are in short supply, government bonds
and bills are not. Ever since the government adopted the policy of planned
economic development through the public sector in the early 1950s, it has
been hard pressed for funds.
That is, it has stood virtually ever ready to borrow from banks and others in
the open market. The RBI as the manager to public debt has tried hard to
widen the market for government debt as much as it can. To that end it has
tried to keep orderly conditions in the market for government securities,
avoid fluctuations in the prices of such securities, and even support it in
time of need.
This has meant virtual perfectly elastic supply of government securities of
different maturities. Therefore, without any risk of capital loss in the short
run, banks can afford to invest large amounts of funds in at least short-term
government securities, especially treasury bills. This means that even if the
demand for bank loans and advances slackens significantly, banks are not
constrained to stay in undesired cash reserves; they can move into
government securities as earning assets. Because of the stable conditions
in the market for government securities (and the borrowing facilities against
government securities as collateral extended by the RBI to banks), banks
are not even encouraged to hold on to their surplus cash on grounds of
speculation.

All this is confirmed strongly by relevant empirical evidence for India. The
ratio of excess reserves to total demand and time liabilities of scheduled
commercial banks declined continuously over the period of the 1950s from
the high of 6.84 in 1950-51 to the low of 2.91 in 1960-61. The reasons of
this decline were many and we need not go into them here. But the fact of
continuous decline in the said ratio is important for our argument.
Further, over the period 1960-611973-74, this ratio stabilised around the
mean value of 2.73, with only minor fluctuations. It fell continuously over
the next three years from 2.58 in 1973-74 to 1.97 in 1976-77. All this goes
to support our theoretical assumption about the capacity of banks to move
into earning assets when they have undesired excess reserves and keep
actual excess reserves equal to desired excess reserves. If this were not
true we would have found large fluctuations in the excess reserves ratio.
After this rather lengthy digression spread over three paragraphs, we come
back to our question of the fourth preceding paragraph: what will the banks
do with their undesired ER? Now we can confidently answer that they will
invest and/or lend such ER. The borrowers from banks as well as sellers of
securities (the government and others) will spend the funds received from
banks.
The recipients of funds so spent will retain a part in the form of currency
and deposit the rest with banks, partly in demand deposits and partly in
time deposits. How this division is made will depend upon the c ratio and
the t ratio. The interesting thing to note is the consequent increase DD in
R d and Cd. Thus, there will be a movement towards DD from DD1.
This movement will continue so long as banks possess undesired excess
reserves. The movement will stop and the process of adjustment
completed only when the original equilibrium is restored at DD0 level of

demand deposits. The reverse will happen when the banks are short of
reserves

In simple terms High Powered Money (HPM) is the net or total liability of the monetary
authority of any nation......in India it is the liability of RBI .
It is simply the sum of all currency in circulation with the people of country , cash kept in
the commercial bank vaults along with the deposits of govt. of the country and
commercial banks.
The term liability basically means that when people/govt/commercial banks produce the
currency/claims....the RBI has to pay value equal to currency/claim.
The RBI uses this H.P.M. for regulation of money supply in the economy . By controlling
the money supply RBI regulates (i.e tries to regulate) the inflation in eco.
RBI uses the H.P.M for process of money creation . Money creation will increase the
supply of money in eco.
When RBI needs to pump extra money in eco. it injects a certain amount of high
powered money (Say H) into eco.(by purchase of govt bonds/assests etc).
This money increases the total money supply in nation ....... but by what amount!!??It
increases money supply( say M) by not 'H' , but by a larger amount.
This increased addition of money supply (over the injected value of H) is due to the
factor called Money Multiplier!!!
The value of money multiplier is determined by two factor , which are
1. CDR: i.e cash-to-deposit ration. It is the ratio of amount of money people tend to keep
with themselves as cash and the amount they deposit in bank acc.
2. RDR: Reserve-to-deposit ratio. It is the ratio of amount of money that a bank will keep
in its vault(or as reserve with RBI) to the amount of the deposits recevied by them.
CDR is a behavioral patter of people which can't be regulated by RBI( eg people will save
more during festive season or for upcoming marriage in familty etc) .However,RDR can
be regulated by RBI.
Depending upon the values of RDR and CDR , the amount of money supply increased in
eco. is determined.
Money multiplier is given as
Money Multiplier= (1+CDR)/(CDR+RDR)
[Theoretically, Money multiplier is ratio of money in economy i.e money supply (M) to
the amount of high powered money(H) ]
So when RBI injects H amount as HPM, the actual increase in money supply is
Money Multiplier*H.

{
Note: Value of money multiplier is greater than one as the value of RDR is less than 1.
}
Thus when RBI needs to reduce inflation it will reduce HPM in eco to slow down money
creation by commercial banks .This will reduce the overall money supply leading to low
purchasing power .....which in turn lower the demands and hence cut inflation.
Similarly to increase the price levels in eco RBI will inject more of HPM to increase
money supply(which will increase purchasing power of the people....thereby increasing
demand).
P.S. HPM is only one of the ways used by RBI to regulate economy.Its has many
powerful ways like SLR , CRR etc etc to regulate economy.
P.S.2 :Commercial banks play a very important role in the process of money creation.(By
giving out loans for further investments etc)