Money Supply

Money Supply

This article deals with ‘Money Supply .’ This is part of our series on ‘Economics’ which is important pillar of GS-2 syllabus . For more articles , you can click here

Factors affecting Money Supply

Season Nov &  April: Crops harvest and Industries buy their raw material leading to more money in the hands of farmer. Hence, Money supply  will rise.
Trade cycle Boom: Money supply increases
Depression: Money supply falls
Fiscal policy Money supply will decrease if there is higher taxation and sale of G-sec and vice-versa.
People’s choice If people deposit higher portion of their income in banks ( instead of storing in their lockers)  , then  bank can expand loans .  Money supply rises in such cases.  
Monetary policy 1. If RBI follows dear money policy = supply decreases
2. If RBI follows cheap money policy = supply rise

Why should we measure money supply?

  • Job of RBI is to control inflation through qualitative & quantitative tools (ie Repo Rate, Cash Reserve Ratio etc)
  • But for this, RBI must first know how much money supply is there in system . Only then RBI can make policy to control money supply.

Side Topic : Why people don’t simply store Value in Bonds, Gold ?

  • Famous Economist John Maynard Keynes( 1883-1946) answered this question in his book – The General Theory of Employment , Interest & Money.
  • He argued that although if person will invest in Bonds or Gold, Value of his assets will surely increase but even after that people don’t invest and keep cash  because of three reasons
    • Transaction motive – Cash acts as medium of exchange
    • Precautionary motive – In case of sudden expenditure, cash is required .
    • Speculative motive – waiting for  price of anything to fall , then using cash  to buy that.

Types of Money

Money Supply

M0 : Reserve money or High Powered Money

  • Mo is base for creating Broad Money supply(M3)
  • Mo is sum of following things
    • Currency held by Public
    • Bankers’ deposits with RBI plus
    • ‘other’ deposits with RBI

Basically it is Total Currency Printed by RBI . RBI prints money equivalent to Bonds it get from Government.

M1 : Narrow Money

  • M1 includes
    1. Currency and Coins with public
    2. Demand deposit in banks

Basically , it denotes situation when person has money , he can do two things to maintain the liquidity of that. Either he can keep that money in its hard form or can deposit in Bank in Current or Saving Account (not Fixed Account) .

M2 : Narrow Money

  • M2= M1 + Demand Deposits in Post Office
  • M2 includes
    1. Currency and Coins with public
    2. Demand deposit in banks
    3. Demand Deposits in Post Office

M3 : Broad Money or Money Aggregate

  • M3 = M1 + Time deposits with Banks
  • M3 inludes
    1. Currency and Coins with public
    2. Demand deposit in banks
    3. Time deposits with banks
  • M3 is most commonly used for measuring money and is regarded as main indicator of money supply in the economy.

M4 : Broad Money

  • M4 = M3 + Total Post office Deposits
  • M4 includes
    1. Currency and Coins with public
    2. Demand deposit in banks
    3. Time deposits with banks
    4. Demand deposit in post-offices
    5. Time deposits with post-offices

Ranking of Liquidity

Liquidity is the ease of converting an asset into cash .

Name Liquidity Liquidity Rank
M1 highest 1
M2 less than M1 2
M3 less than M2 3
M4 lowest liquidity 4

Liquidity Ranking : M1 > M2 > M3 > M4

Money Multiplier

There are two approaches to look into this concept

a. 1st Approach

  • Money Multiplier is Ratio of Broad Money & Reserve  money ie M3 / Mo

 M3 = Mo X Money Multiplier

  • When  Reserve Money increase , Broad money will also increase
  • In 2018 , India’s Money Multiplier was ~ 6

b. 2nd Approach

  • Money Multiplier is 1/R  (R= Cash Reserve Ratio)
  • Every ‘R’ Cash Reserve Ratio generates ‘1/R’ new money.

Explanation of above formula?

  • Consider a situation in which Person deposited ₹ 100 hard currency in Bank. Let’s assume that , Cash Reserve Ratio (CRR) fixed by RBI was 10%. First Bank will keep aside ₹10 & give ₹90 as loan to some person. Then person who got loan again paid some other person through bank by depositing money in person’s bank account . This Bank will  keep ₹9 (10% of 90) aside and gave 81 as Loan to some other person. And this game keeps on going like this .
Money Multiplier
With 100 rupee of "reserve", banking system generates 
Rs.1000..hence money multiplier is (lox)

Hence , Money Multiplier is 1/R (where R is Cash Reserve Ratio).

Money Multiplier

Note : Presently , Money Multiplier is around 6 but if we consider 4% Cash Reserve Ratio, it should be 25.

Reason for low Money Multiplier than theory = for practical purpose , we cant achieve above series upto end.

  • Since Financial Inclusion is low, there might be case that either Banks  have money but people are not available to take loan or people will not be able to keep their money in banks .
  • Along with that, Banks aren’t always willing to give loans
  • Large number of cash in India is stored as Black Money and is never stored in Banking System.

From Economic Survey (2020) : India’s Money Multiplier has been decreasing since 2017

Velocity of Money Circulation

  • Average number of times, money passes from one person  to another during given time period
Velocity of Money

Factors affecting Velocity of Money Circulation

  • Poor people immediately use their money. Hence, money in the hands of poor has higher velocity.
  • Booming period = higher velocity
  • If more people use EMI loans for purchase, then higher velocity
  • Low financial inclusion means less velocity, because banking penetration is low. People tend to save more in physical assets . Hence, money doesn’t change hands much

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