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What is Money Supply? Calculation of money supply.

MEANING OF MONEY SUPPLY

All the money held with public (in the form of currency or bank deposits), the RBI, and the government is called the total stock of money or monetary aggregate. Money supply is that part of this total stock of money that is with the public. Public includes households, firms, local authorities, companies, etc.

Public money does not include the money held by the government and the money held as CRR with the RBI and SLR with banks because this money is out of circulation.

To conclude, money supply includes the following:

  1. Currency notes and coins
  2. Demand deposits such as saving and current account deposits
  3. Time deposits such as fixed and recurring deposits
  4. Cash with banks and deposit of banks with other banks, except CRR with the RBI

Calculation of money supply in India

The RBI calculates the five types of money supply in India. They are as follows:

M1 (narrow money): At any point of time, the money held by the public with the commercial banks has two components:

  1. Currency component: It consists of all the coins and notes in the circulation.
  2. Demand deposit component: It is the money of the general public with the banks in the form of savings and current account deposits.

M1 is also called narrow money. It is the most liquid form of money supply. To conclude,

M1 = Currency with the public + Demand deposits of public in banks

M2 = When Post Office savings deposits are added to M1, it becomes M2.

M2 = MI + Post Office savings

M3 (broad money): When we add the time deposits with banks into the narrow money, we get the broad money, which is denoted by M3.

M3 = Narrow money + Time deposits of public with banks

Narrow money is the most liquid part of the money supply because the demand deposits can be withdrawn at immediate notice. On the other hand, time deposits have a fixed maturity period and hence cannot be withdrawn before the expiry of this period. When we add the time deposits to the narrow money, we get the broad money.

     M4 = When we add the Post Office savings money to M3, it becomes M4.

Both M2 and M4 include Post Office savings deposits. Post Office savings deposits were once important part of money supply but have now become less relevant because the relative share of Post Office savings deposits out of the total savings deposits has significantly reduced. Presently, narrow money (M1) and broad money (M3) are relevant indicators of money supply in India.

M0 (reserve money): Reserve money is also called “high powered money” or “monetary base”. It has the following components:

  • Currency with the public
  • Statutory reserves of banks held with themselves
  • Cash reserves of banks held with the RBI
  • Other deposits with the RBI

What is the Relevance of Reserve Money?

The RBI manages the money supply in the economy through reserve money. For instance, if the RBI reduces the reserve money, then money supply increases in the economy and vice versa. In other words, if there is more of reserve money in the system, money supply would increase and vice versa. It is to be noted that most of the changes in the money supply are due to changes in the high powered money. Thus, reserve money is also called “monetary base”. Moreover, changes in reserve money have multi-fold impact on the economy.

Money multiplier (m): Money multiplier is the ratio of narrow money (M1) or broad money (M3) to reserve money.

Money multiplier (m) is calculated as follows:

M1

m=    —

RM

M3

It is also calculated as m =

RM

where “m” is the money multiplier and “RM” is the reserve money

Thus, it can also be said that supply of money is the product of money multiplier (m) and the amount of high powered money or the reserve money.

How does money multiplier work?

For instance, let us say that a bank receives ₹100 in deposits. The reserve requirement is 20%. Thus, the bank can lend the remaining ₹80. This ₹80 is then deposited by the borrower into another bank, which In turn must also keep 20%, or ₹16, in reserve but can lend out the remaining ₹64.

This cycle continues as more people deposit money and more banks continue to lend it until finally the initial deposit of ₹100 creates a total of ₹500 (₹100/0.2) in deposits. This creation of deposits is the multiplier effect.

Thus, if reserve requirements are reduced or more currency is released in the economy, it has multiple impact on the overall money supply in the economy. In India, the reserve requirements for both SLR and CRR combined together are nearly 26%. Thus, a ₹100 initial deposit creates a total deposit of 100/0.26 = ₹384, approximately.

 

Indian Economy

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