Proximate Factors Affecting H Theory of Money in Supply

Some of the Proximate Factors Affecting H Theory Money in Supply are:

(1) Net RBC to government, (2) RBC to banks, (3) RBC to development banks, (4) Set foreign exchange assets of the RBI and (5) Set non-monetary liabilities of the RBI.


H as policy-determined and so exogenously it is not as simple as that in actual life. To know the truth, we examine the factors affecting H in this article.

The whole discussion relates to India of 1970s. We recall that H is money produced by the monetary authority (the government and the RBI) and held by the public and banks. Speaking concretely, it is government currency plus the Reserve Bank money (RBM hereafter)—all held by the public and banks. Government currency comprises one-rupee notes and coins and small corns.

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RBM comprises all currency notes other than one-rupee notes, deposits of banks with the RBI, and ‘other deposits’ of the RBI. Of the total stock of H, government currency constitutes a rather small proportion (only 7.3 per cent in 1975-76); the RBM is its dominant component. Then, changes in government currency are determined by changes in the RBM, as they are governed by the public’s demand for small coins in relation to currency of higher denominations issued by the RBI.

Therefore, changes in the RBM are virtually responsible for all the observed changes in H. We analyse below the factors governing the RBM, since the RBI does not change it completely arbitrarily. What is given here is a purely accounting analysis. This is only a necessary first step in understanding the complex of forces operating on H, not the final analysis.


We begin with the balance-sheet identity for the RBI in the following form:

Monetary liabilities +non-monetary liabilities = financial assets-+- other liabilities.

Let us define ‘net non-monetary liabilities’ (NNML), as the excess of non-monetary liabilities over other assets. Then, the above identity can be rewritten as

Monetary liabilities= financial assets + net non-monetary liabilities.

Monetary liabilities of the RBI are the same thing as the RBM. Therefore, the factors governing the RBM are the same that govern the entities on the right-hand. Financial assets are what the RBI acquires as a result of its transactions with others in discharges to its central-banking functions. So they can be broken down sector-wise. A similar sector-wise breakdown of the net non­monetary liabilities is not available in the books of the RBI. So, the RBI does not unscramble them.

To Identity the proximate factors governing H, all the RBI’s transactors may be divided into four sectors, viz.:

(1) The government

(2) Banks,

(3) Development banks, and

(4) The foreign sector.

The RBI provides them its credit, acquires its financial assets, and creates RBM in the process.

Therefore, using this four-sector classification of the RBI’s financial assets (or net credit) and denoting Reserve Bank credit by RBC, (15.14) can be rewritten as:

RBM = (1) net RBC to government

+ (2) RBC to banks

+(3) RBC to development bank.

+ (4) net foreign exchange assets of the RBI

– (5) net non-monetary liabilities of the RBI. (15.15)

Then, the five factors (with appropriate algebraic signs) listed above are the proximate factors governing the RBM.

Each of these proximate factors is explained briefly below:

(1) Net RBC to government:

As banker to the government, the RBI, provides credit to both the Central Government and state governments through investment in their securities (including treasury bills of the Central Government) and through short-term advances to state governments. The Central Government is empowered to borrow any amount it likes from the RBI. The state governments do not enjoy such unlimited borrowing power.

Yet often times they do borrow above authorised limits and thus give birth to the problem of unauthorised overdrafts. The Central and state governments keep their deposits with the RBI. The value of these deposits is deducted from the gross RBC to the government to arrive at the net figure for this RBC. Increase in the net RBC to the government is a rough (not exact) measure of the deficit financing of the government. Among the factors affecting H, this factor has been the most important, contribut­ing more than three-fourths of the increase in H.

(2) RBC to banks:

The RBI provides credit to banks through loans and advances against government securities, usance bills or promissory notes as collateral, and through the purchase or rediscounting of internal commercial bills as well as treasury bills.

The RBI, however, does not regard its purchase or rediscounting of bills for banks as a part of its credit to banks. Instead, it classifies it as RBC to whatever sector, commercial or government, which issued these bills in the first instance. This is not a defensible procedure, because thereby a part of the Reserve Bank accommodation provided directly to banks is not counted as such.

(3) RBC to development banks:

A number of development banks have been established in the country through the initiative and help of the RBI for the provision of long and medium-term finance to industry and agriculture. The RBI provides them credit by investing in their securities and through loans. This also leads to the generation of H.

(4) Set foreign exchange assets of the RBI:

These assets which are net holding of the RBI represent RBC to the foreign sector, because they are financial liabilities of the foreign sector. Most of these assets are held abroad in the form of foreign securities and cash balances. The RBI comes to acquire them as the custodian of the country’s foreign exchange reserves. As the controller of all foreign exchange transactions, whether on private or government account, it regularly buys and sells foreign exchange against Indian currency.

All such transactions have a direct impact on H. When the RBI buys foreign exchange, it pays for it in terms of its own money and the supply of H in the economy increases. When the RBI sells foreign exchange, it receives payment from the buyer of foreign exchange or its bank in the form of H and the supply of H goes down. Since the buying and selling of foreign exchange by the RBI goes on all the time, what matters for a change in H is the difference between the two. Thus, a deficit in the balance of payments decreases the supply of H. whereas a surplus in it increases the supply of H, other things being the same.

That is why the vast accumulation of foreign exchange reserves (mainly due to large inward remittances from Indians’ working abroad) in recent years (after 1975) had led to substantial increases in H and thereby in M. For the same reason, if the accumulated foreign exchange reserves are drawn down by spending abroad, the result will normally be anti-inflationary on two counts. On the one hand, the supply of H and so of M and therefore of the aggregate money demand for output will go down; on the other hand, the import surplus will increase the supply of goods in the market.

(5) Set non-monetary liabilities of the RBI:

The net RBC to various sectors that we have been talking about under the above four points is financed by the RBI partly by creating its monetary liabilities (RBM) and partly by its net non-monetary liabilities (NNML), which financed as much as 25 per cent of the net RBC during 1976-77.

The NNML in large part, are owned funds of the RBI (capital and reserves and accumulated contributions to National Funds) and compulsory deposits of the public. Obviously, the larger these non-monetary resources of the RBI, the less it has to depend upon the creation of new H to finance its credit to various sectors.

RBM = (1) net RBC to government

+ (2) RBC to banks

+(3) RBC to development bank.

+ (4) net foreign exchange assets of the RBI

– (5) net non-monetary liabilities of the RBI.

Hence this factor enters equation (15.15) with negative sign.

Adjusted H:

So far we have been talking about H and the statutorily required cash reserve ratio (CRR) for banks without asking what changes in the latter do to the former. It is, however, clear that, given the amount of total H, such changes affect the amount of disposable H available to the public and banks, because these changes either impound or release reserves of banks.

When the CRR is revised upwards, some reserves are impounded “by the RBI and when the CRR is revised downwards, some reserves get released. Obviously, impounding of reserves reduces and release of H adds to the amount of disposable H.

In the literature on money supply analysis, such disposable H is generally called adjusted H.In the presence of changes in CRR, it is H, which is relevant for the theory of money supply spelled out above.

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