Money Supply

The money supply is the total amount of money—cash, coins, and balances in circulation in the economy at a given point of time.

Money supply plays an important role in determining the inflation & interest rates in the economy.

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.

Vice versa, if money supply reduce or reduce in growth rates

Sources of Money Supply

The supply of money in the economy depends on:

1. The decisions of the Central Bank (RBI)
2. Response of commercial banks and Individuals for the changes in the monetary policy by the central bank.

Fiat money Reserve Money & Credit Money

The currency issued by the central bank is ‘fiat money’ and is backed by supporting reserves and its value is guaranteed by the government.

Reserve Money (M0) = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI

Reserve money is also known as central bank money, base money or high-powered money. Reserve money determines the level of liquidity and price level in the economy and, therefore, its management is of crucial importance to stabilize liquidity, economic growth, and price level in an economy.

Banks create money supply in the process of borrowing and lending transactions with the public. Money so created by the commercial banks is called ‘credit money’.

Measurement of Money Supply

RBI measures the money supply through the following indicators:

M1 is also called Narrow money and is the most liquid.

M2 is also narrow money.

M4 is the widest measure of money supply that the RBI uses. It is the least liquid measure of all of them.

Points to remember:

• Currency consists of paper currency as well as coins
• Since inter-bank deposits are not held by the public, they are excluded out of the total demand deposits to arrive at net demand deposits.
• Other deposits’ with the RBI are its deposits other than those held by the government (the Central and state governments), and include demand deposits of quasi-government institutions, other financial institutions, balances in the accounts of foreign central banks and governments, and accounts of international agencies such as IMF and the World Bank.

Factors Affecting the Supply of Money

• Policy of the Central bank: RBI controls the money supply by changing the reserve ratios like CRR & SLR, Open market Operations (OMO’s) etc. When RBI adopts a Expansionary monetary policy, the money supply increases.
• The reserve requirement imposed on banks. For eg; If RBI increases CRR & SLR, banks have to keep more reserves and the amount of money available for loans reduces and thus reduces supply of money in the Economy.
• Increased banking penetration & financial inclusion develops banking habits in people which in turn lead to money multiplier.

Factors affecting the demand for money

• The rate of interest on loans
• The number / value of monetary transactions that we expect to carry out
• The extent to which we also want to hold other financial assets, such as bonds, property, saving (this is also influenced by the rate of interest) – this is known as the speculative motive for holding money.
• The rate of anticipated inflation