Money Supply

Money Supply

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



Introduction

Money Supply is the total stock of all types of money (currency and deposits) held by the public at any point in time. The term public includes all economic entities other than the government and banking system.


Factors affecting Money Supply

Season For example, during November & April, crops harvest, and industries buy their raw material leading to more money in the hands of a farmer. Hence, the Money supply will rise. 
Trade cycle Boom: Money supply increases.
Depression: Money supply falls.
Fiscal policy Money supply decreases with higher taxation and sale of G-sec and vice-versa.  
People’s choice If people deposit a higher portion of their income in banks (instead of storing it in their lockers), then the bank can expand loans. The money supply rises in such cases.   
Monetary policy If RBI follows dear money policy = money supply decreases. If RBI follows a cheap money policy = money supply increases.

Why should we measure money supply?

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


Types of Money

M0 (Reserve Money or High Powered Money)

  • It is the total stock of currency held by the public and banks.
  • Mo is base for creating Broad Money supply(M3) 
  • Mo is the sum of the following things
    • Currency held by Public and Banks
    • Bankers’ deposits with RBI plus
    • Other deposits with RBI (held by certain individuals like former RBI Governors and certain institutions like IMF)

Basically, it is Total Currency Printed by RBI. RBI prints money equivalent to bonds it gets from Government. 


M1 (Narrow Money)

  • M1 includes
    • Currency and Coins with public
    • Demand deposit in all banks (i.e. Deposit in the current account and savings account)
    • Other deposits with RBI (held by certain individuals like former RBI Governors and certain institutions like IMF)
  • Basically, it denotes a situation when a person has money; he can do two things to maintain liquidity. Either he can keep that money in its hard form or deposit it in the bank in a Current or Savings Account (not a Fixed Account). 


M2 (Narrow Money )

  • M2= M1 + Demand Deposits in Post Office
  • M2 includes
    1. Currency and Coins with public
    2. Demand deposit in all banks
    3. Demand Deposits in Post Office
    4. Other deposits with RBI (held by certain individuals like former RBI Governors and certain institutions like IMF)


M3 (Broad Money or Money Aggregate)

  • M3 = M1 + Time deposits with Commercial Banks  
  • M3 includes 
    1. Currency and Coins with public
    2. Demand deposit in all banks 
    3. Time deposits with banks 
    4. Other deposits with RBI (held by certain individuals like former RBI Governors and certain institutions like IMF)
  • M3 is most commonly used to measure money and is regarded as the main indicator of money supply in the economy. 
  • M3 is the Net Demand and Time Liabilities (NDTL).


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
    6. Other deposits with RBI (held by certain individuals like former RBI Governors and certain institutions like IMF)


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, i.e. M3 / Mo

 M3 = Mo X Money Multiplier

  • Its value depends on the credit creation capacity of banks, which depends on the following
    1. Banking habits of the public
    2. Monetary Policy
  • When Reserve Money increases, Broad money will also increase. 
  • In 2018, India’s Money Multiplier was ~5.55. (150 lakh crore/27 lakh crore).


b. 2nd Approach

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

Explanation of the above formula?

Consider a situation in which a Person deposited ₹ 100 hard currency in the bank. Let’s assume that Cash Reserve Ratio (CRR) fixed by RBI is 10%. First Bank will keep aside ₹10 & give ₹90 as a loan to some person. Then the person who got the loan again paid another person through the bank by depositing money in the person’s bank account. This bank will keep ₹9 (10% of 90) aside and give 81 as a loan to some other person. And the game keeps on going like this. 

Money Multiplier

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 the 4% Cash Reserve Ratio, it should be 25. 

Reason for low Money Multiplier than theory  

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

Economic Survey (2020) observed that India’s Money Multiplier has been decreasing since 2017. 

Money Multiplier Trends


Velocity of Money Circulation

  • The average number of times money passes from one person to another during the given period.
Velocity of Money

Factors affecting Velocity of Money Circulation

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

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