What is Money Supply?
Money supply mean the total volume of monetary media of exchange available to the community for use in connections with the economic activity of the country. In other words, the money supply is the sum total of all of the currency and other liquid assets in a country’s economy on the date measured.
The money supply includes all cash in circulation and all bank deposits that the account holder can easily convert to cash.
How is the Money Supply determined?
RBI regulates the amount of available money in the country. Through monetary policy, the central bank can undertake an expansionary or contractionary policy.
An expansionary policy aims to increase the money supply. For example, the central bank might engage in open market operations. That means it will purchase short-term Treasury bills using newly-minted money. That money thus enters into circulation. Bank Rate Policy and Open Market Operations
A contractionary policy would require selling Treasuries. That removes some of the money circulating in the economy.
Measures or Constituents or Types of Money Supply
Money Supply M1 or Narrow Money
This is the narrow measure of money supply and is composed of the following items:
M1 = C + DD + OD
where, C = Currency with the public. Public money means that money which is held by everybody other than the government and the banks. It includes companies, general organisations, households. It does not include inter-bank or government deposits in banks.
DD = Means net demand deposits with banks. ‘Net’ here indicates the deposits of only the public in banks.
OD = Other deposits. These are the deposits with the RBI, held by certain individuals and institutions.
• Individuals – like the former governors of the RBI
• institutions- like IMF deposits
The money supply is the most liquid measure of money supply as the money included in it can be easily used as a medium of exchange, that is, as a means of making payments for transactions.
Money Supply M2
M2 is a broader concept of money supply in India than M1. In addition to the three items of M1, the concept of money supply M2 includes savings deposits with the post office savings banks. Thus,
M2 = M1 + Savings deposits with the post office savings banks
The reason why money supply M2 has been distinguished from M1 is that saving deposits with post office savings banks are not as liquid as demand deposits with commercial and cooperative banks as they are not chequable accounts. However, saving deposits with post offices are more liquid than time deposits with the banks.
Money Supply M3 or Broad Money
M3 is a broad concept of money supply. In addition to the items of money supply included in measure M1, in money supply M3 time deposits with the banks are also included. Thus,
M3= M1+ Time Deposits with the banks
It is generally thought that time deposits serve as store of value and represent savings of the people and are not liquid as they cannot be withdrawn through drawing cheque on them. However, since loans from the banks can be easily obtained against these time deposits, they can be used if found necessary for transaction purposes in this way.
Further, they can be withdrawn at any time by forgoing some interest earned on them. It may be noted that recently M3 has become a popular measure of money supply.
The working group on monetary reforms under the chairmanship of late Prof. Sukhamoy Chakravarty recommended its use for monetary planning of the economy and setting target of the growth of money supply in terms of M3.
Therefore, recently RBI in its analysis of growth of money supply and its effects on the economy has shifted to the use of M3 measure of money supply. In the terminology of money supply employed by the Reserve Bank of India till April 1977, this M3 was called Aggregate Monetary Resources (AMR).
Money Supply M4
The measure M4 of money supply includes not only all the items of M3 described above but also the total deposits with the post office savings organisation. However, this excludes contributions made by the public to the national saving certificates. Thus,
M4 = M3 + Total Deposits with Post Office Savings Organisation
Why does the Money Supply expand or contract?
Consider a big bank (such as SBI) as a microcosm of the economy as a whole. Imagine that people are prospering, so they have more money to save. They deposit it in the bank. The bank keeps part of the deposits in a vault but lends most of it out to other individuals and businesses. The loans are repaid with interest, and the bank has more money to loan. Times are good, and the money supply is increasing.
But what happens when times are not so good? Bank deposits fall because people are just getting by or, worse, losing their jobs. The bank has less money to lend. In any case, businesses and individuals shy away from big spending due to the poor economy. The money supply decreases.
Effect of Money Supply on the economy
Economists view the money supply as the main driver of demand in an economy and believe that increasing the money supply faster than the increase in real income leads to inflation.
An increase in the supply of money typically lowers interest rates, which in turn, generates more investment and puts more money in the hands of consumers, thereby stimulating spending. Businesses respond by ordering more raw materials and increasing production. The increased business activity raises the demand for labor.
The opposite can occur if the money supply falls or when its growth rate declines. Banks lend less, businesses put off new projects, and consumer demand for home mortgages and car loans declines.
What happens when RBI limits the Money Supply?
A country’s money supply has a significant effect on its macroeconomic profile, particularly in relation to interest rates, inflation, and the business cycle. When the RBI limits the money supply via contractionary monetary policy, interest rates rise and the cost of borrowing goes higher.
There is a delicate balance to consider when undertaking these decisions. Limiting the money supply can slow down inflation, as the RBI intends, but there is also the risk that it will slow economic growth too much, leading to more unemployment.
For more information: https://en.wikipedia.org/wiki/Money_supply
PRACTICE QUESTIONS
QUES . If you withdraw Rs. 1,00,000 in cash from your Demand Deposit Account at your bank, the immediate effect on aggregate money supply in the economy will be: UPSC 2020
(a) to reduce it by Rs. 1,00,000
(b) to increase it by Rs. 1,00,000
(c) to increase it by more than Rs. 1,00,000
(d) to leave it unchanged
Ans (d) EXPLANATION: There are 4 concepts of money supply: M1, M2, M3 and M4. M3 shows the total purchasing power in the economy. Therefore, when we say money supply in general, it means M3. So, normally, in newspapers etc. when the word money supply is used, it means M3. M3 = M1 + TD = C + DD + OD + TD (Broad money). Now, in the given case, while the ‘DD’ component will fall by Rs. 1,00,000, the ‘C’ component will increase by Rs. 1,00,000, thereby, leaving the money supply unchanged. Hence option (d) is the correct answer.
