The following are some of the factors affecting money supply.

1. The extent of deficit financing by the government: In case of deficit in budget, the government
borrows from the RBI in the form of deficit financing (printing of new currency notes). This adds to the
money supply in the country.
2. CRR requirements: The CRR requirements affects the extent of credit creation by the commercial
banks. Lower is the CRR requirement, higher is the credit creation which in turn increases the money
supply.
3. Rate of interest: A higher rate of interest encourages savings by the people in the form of time
deposits and demand deposits with the commercial banks and post offices. This adds to the money
supply in the country.
4. Foreign transactions: Greater the foreign transactions in the form of purchase of foreign currency by
the Central Bank or the public, greater is the money supply and vice-versa.
5. Sale and purchase of securities by the Central Bank: When the Central Bank purchases securities
from the public, it adds to the money supply in the country and vice-versa.
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01. Open Market Operations

Open market operations are conducted by the Central bank as it carries out and implements
monetary policy. The open market department of central bank buys and sells Treasury securities
through a series of primary securities dealers.
Open Market Operations (OMO) activities are the primary tool that the Central bank uses in its
implementation of monetary policy. Through the process of buying and selling Treasure securities
through the open market operations, the Central bank either creates or destroys legal reserves in the
banking system.

02. Reserve Requirements

The central bank also has the power to set reserve requirements that apply to different types of
deposits held in depository institutions. While changes in the reserve requirement does not affect the
amount of legal reserve the banking system, a change in the reserve requirements will affect the
money multiplier and the money expansion process.

If the reserve requirement is raised, the money multiplier will shrink and a monetary contraction
process will take place, all other factors held constant. If the reserve requirement is lowered, the
money multiplier and the monetary expansion process will take place, all other factors held constant.
While the Central bank has the power to increase and decrease reserve requirements on all types of
deposits, they seldom choose this monetary policy tool as a means of affecting the money supply.

03. Public’s Demand for Cash Balance

Another major factor that affects legal reserves in the banking system is the public’s desire to hold
cash. There certain times of the year when the public, as a whole, prefers to hold higher cash
balances. For example, during the months prior to Christmas many members of the general public
increase their cash balances in order to do Christmas shopping. There is also often an increase in
the public’s demand for cash during the summer months as many families travel on summer
vacations.

Since legal reserves are defined as vault cash and deposits at the Central bank’s reserve, an
increase in the public’s demand for cash balances lowers the amount of cash held in the vaults of
depository institutions. This lowers legal reserves in the banking system and results in a contraction
of the money supply, all other factors held constant.
As the public’s demand for cash declines, as is the case after the end of summer vacation or the end
of the Christmas buying period, the cash is redeposit into bank. This increases in the amount of vault
cash in the system, and results in the money expansion process taking place, if all of the factors are
held constant.

Main determinants of the supply of money are (a)

monetary base and (b) the money multiplier

Main determinants of the supply of money are (a) monetary base and (b) the money multiplier.
These two broad determinants of money supply are, in turn, influenced by a number of other factors.
Various factors influencing the money supply are discussed below:

1. Monetary Base:

Magnitude of the monetary base (B) is the significant determinant of the size of money supply.
Money supply varies directly in relation to the changes in the monetary base.

Monetary base refers to the supply of funds available for use either as cash or reserves of the central
bank. Monetary base changes due to the policy of the government and is also influenced by the value
of money.

2. Money Multiplier:

Money multiplier (m) has positive influence upon the money supply. An increase in the size of m will
increase the money supply and vice versa.

3. Reserve Ratio:

Reserve ratio (r) is also an important determinant of money supply. The smaller cash-reserve ratio
enables greater expansion in the credit by the banks and thus increases the money supply and vice
versa.

Reserve ratio is often broken down into its two component parts; (a) excess reserve ratio which is the
ratio of excess reserves to the total deposits of the bank (re = ER/D); (b) required reserve ratio which
is the ratio of required reserves to the total deposits of the bank (rr = RR/D). Thus r = re + rr. The
rr ratio is legally fixed by the central bank and the re ratio depends on the market rate of interest.
4. Currency Ratio:

Currency ratio (c) is a behavioural ratio representing the ratio of currency demand to the demand
deposits.The effect of the currency ratio on the money multiplier (m) cannot be clearly recognised
because enters both as a numerator and a denominator in the money multiplier expression (1 + c/r(1
+t) + c). But, as long as the r ratio is less than unity, a rise in the c ratio must reduce the multiplier.

5. Confidence in Bank Money:

General economic conditions affect the confidence of the public in bank money and, thereby,
influence the currency ratio (c) and the reserve ratio (r). During recession, confidence in bank money
is low and, as a result, c and r ratios rise. Conversely, during prosperity, c and r ratios tend to be low
when confidence in banks is high.

6. Time-Deposit Ratio:

Time-deposit ratio (t), which represents the ratio of time deposits to the demand deposits is a
behavioural parameter having negative effect on the money multiplier (m) and thus on the money
supply. A rise in t reduces m and thereby the supply of money decreases.

7. Value of Money:

The value of money (1/P) in terms of other goods and services has positive influence on the monetary
base (B) and hence on the money stock.

8. Real Income:

Real income (Y) has a positive influence on the money multiplier and hence on the money supply. A r
se in real income will tend to increase the money multiplier and thus the money supply and vice
versa.

9. Interest Rate:

Interest rate has a positive effect on the money multiplier and hence on the money supply. A rise in
the interest rate will reduce the reserve ratio (r), which raises the money multiplier (m) and hence
increases the money supply and vice versa.

10. Monetary Policy:

Monetary policy has positive or negative influence on the money multiplier and hence on the money
supply, depending upon whether reserve requirements are lowered or raised. If reserve requirements
are raised, the value of reserve ratio (r) will rise reducing the money multiplier and thus the money
supply and vice versa.

11. Seasonal Factors:

Seasonal factors have negative effect on the money multiplier, and hence on the money stock. During
holiday periods, the currency ratio (c) will tend to rise, thus, reducing the money multiplier and,
thereby, the money supply.