Money supply refers to the total amount of money available in an economy at a specific point in time, including all forms of money in circulation and held as assets by individuals, businesses, and financial institutions.
In economic terms, money supply is considered a stock when viewed at a fixed point in time and a flow when measured over a period.
Measures of Money Supply
The Reserve Bank of India (RBI) uses four alternative measures to track money supply, known as M1, M2, M3, and M4 .
These are categorized based on their liquidity:
- Narrow Money (M1 and M2):
- M1 is the most liquid measure and includes currency (notes and coins) held by the public, net demand deposits in commercial banks, and other deposits with the RBI
- M2 includes all of M1 plus savings deposits with Post Office savings banks.
- Broad Money (M3 and M4):
- M3 is M1 plus net time deposits of commercial banks and is used by the RBI for macroeconomic policy formulations; it is also known as Aggregate Monetary Resources.
- M4 is the least liquid and includes M3 plus total deposits with Post Office savings organizations, excluding National Savings Certificates.
- Reserve Money (M0): Also called high-powered money or the monetary base, M0 consists of currency in circulation plus bankers’ and other deposits with the RBI. It represents the total liability of the monetary authority.
Determinants and the Money Multiplier
The money supply changes based on the actions of the RBI, commercial banks, and the public’s behavior, which are measured through key ratios:
- Currency Deposit Ratio (CDR): This reflects the public’s preference for liquidity.
- If people prefer holding cash over bank deposits (a high CDR), the money supply decreases because banks have less money to create credit.
- Reserve Deposit Ratio (RDR): This is the proportion of deposits that banks must keep as reserves (via the Cash Reserve Ratio and Statutory Liquidity Ratio) rather than lending out.
- An increase in the RDR reduces the money supply because it lowers the lending power of commercial banks.
- Money Multiplier: This illustrates how an initial deposit can lead to the creation of a larger amount of money through lending and re-depositing. It is calculated as the ratio of Broad Money (M3) to Reserve Money (M0); a higher reserve ratio results in a smaller money multiplier
Demand for Money
The demand for money, often called liquidity preference, is the decision of how much money to hold in liquid form at a given time .
Money is unique because it is the most liquid asset and is universally acceptable for exchange.
However, holding money has an opportunity cost, which is the interest one foregoes by not putting that money into a fixed deposit or investment.
According to the sources, people are driven by three motives to hold cash:
- Transaction Motive: The need for readily available funds to conduct day-to-day transactions, such as buying goods or paying bills. Generally, higher income levels lead to larger cash holdings for transactions.
- Speculative Motive: A tactic used by investors who hold cash to capitalize on future market opportunities, such as waiting for stock prices to fall before investing.
- Precautionary Motive: The desire to hold cash as a safety net to meet unexpected events like sickness or accidents that require immediate outlay.
To visualize this, imagine the money supply as the water in a complex irrigation system; the central bank (the reservoir) releases the water, but the amount that actually reaches the crops depends on how much the soil (the public) soaks up and how much the channels (commercial banks) are allowed to let flow through.