Money Supply: Importance, Concepts,

Determinants
Importance of Money Supply:
Growth of money supply is an important factor not
only for acceleration of the process of economic
development but also for the achievement of price
stability in the economy.
There must be controlled expansion of money supply
if the objective of development with stability is to be
achieved. A healthy growth of an economy requires
that there should be neither inflation nor deflation.
Inflation is the greatest headache of a developing
economy.
A mild inflation arising out of the creation of money
by deficit financing may stimulate investment by
raising profit expectations and extracting forced
savings.
But a runaway inflation is highly detrimental to
economic growth. The developing economies have to
face the problem of inadequacy of resources in initial
stages of development and it can make up this
deficiency by deficit financing. But it has to be kept
strictly within safe limits.
Thus, increase in money supply affects vitally the
rate of economic growth.
In fact, kept within proper limits it can accelerate
economic growth but exceeding of the limits will
retard it
. Thus, management of money supply is essential in
the interest of steady economic growth.
Concept of Money Supply and Its Measurement:

By money supply we mean the total stock of

monetary --media of exchange available to a society
for use in connection with the economic activity of
the country.
According to the standard concept of money
supply, it is composed of the following two
elements:
1. Currency with the public,
2. Demand deposits with the public.
Before explaining these two components of money
supply two things must be noted with regard to the
money supply in the economy.
First, the money supply refers to the total sum of
money available to the public in the economy at a
point of time. That is, money supply is a stock
concept in sharp contrast to the national income
which is a flow representing the value of goods and
services produced per unit of time, usually taken as
a year.
Secondly, money supply always refers to the amount
of money held by the public.
 In the term public are included households, firms
and institutions other than banks and the
government. The rationale behind considering money
supply as held by the public is to separate the
producers of money from those who use money to
fulfill their various types of demand for money.
Since the Government and the banks produce or
create money for the use by the public, the money
(cash reserves) held by them are not used for
transaction and speculative purposes and are
excluded from the standard measures of money
supply.
This separation of producers of money from the users
of money is important from the viewpoint of both
monetary theory and policy.
Two components of money supply

 Currency with the Public:

 In order to arrive at the total currency with the public in India
we add the following items:
 1. Currency notes in circulation issued by the Reserve Bank
of India.
 2. The number of rupee notes and coins in circulation.
 3. Small coins in circulation.
 It is worth noting that cash reserves with the banks has to be
deducted from the value of the above three items of currency
in order to arrive at the total currency with the public. This is
because cash reserves with the banks must remain with them and
cannot therefore be used for making payments for goods or by
any commercial bank’s transactions.
It may further be noted that these days paper currency
issued by Reserve Bank of India (RBI) are not fully
backed by the reserves of gold and silver, nor it is
considered necessary to do so. Full backing of paper
currency by reserves of gold prevailed in the past when gold
standard or silver standard type of monetary system existed.
According to the modern economic thinking the magnitude
of currency issued should be determined by the
monetary needs of the economy and not by the available
reserves of gold and silver. In other developed countries,
since 1957 Reserve Bank of India follows Minimum
Reserve System of issuing currency.
Under this system, minimum reserves of Rs. 200 crores of
gold and other approved securities (such as dollars, pound
sterling, etc.) have to be kept and against this any amount
of currency can be issued depending on the monetary
requirements of the economy.
RBI is not bound to convert notes into equal value of
gold or silver. In the present times currency is
inconvertible. The word written on the note, say 100
rupee notes and signed by the governor of RBI that ‘I
promise to pay the bearer a sum of 100 rupees’ is only a
legacy of the past and does not imply its convertibility
into gold or silver.
Another important thing to note is that paper
currency or coins are fiat money, which means that
currency notes and metallic coins serve as money
on the bases of the fiat (i.e. order) of the
Government.
In other words, on the authority of the Government no
one can refuse to accept them in payment for the
transaction made. That is why they are called legal
tender.
Demand Deposits with the Public:

 The other important component of money supply are demand

deposits of the public with the banks. These demand deposits
held by the public are also called bank money or deposit money.
 Deposits with the banks are broadly divided into two types:
demand deposits and time deposits.
 Demand deposits in the banks are those deposits which can be
withdrawn by drawing cheques on them.
 Through cheques these deposits can be transferred to others for
making payments from whom goods and services have been
purchased.
 Thus,cheques make these demand deposits as a medium of
exchange and therefore make them to serve as money.
 It may be noted that demand deposits are fiduciary money .
Fiduciary money is one which functions as money on
the basis of trust of the persons who make payment
rather than on the basis of the authority of
Government.
Thus, despite the fact that demand deposits and
cheques through which they are operated are not legal
tender, they function as money on the basis of the trust
commanded by those who draw cheques on them.
They are money as they are generally acceptable as
medium of payment.
 Bank deposits are created when people deposit currency
with them. But far more important is that banks themselves
create deposits when they give advances to businessmen
and others. On the basis of small cash reserves of
currency, they are able to create a much larger amount of
demand deposits through a system called fractional reserve
system which will be explained later in detail.
 In the developed countries such as USA and Great Britain
deposit money accounted for over 80 per cent of the total
money supply, currency being a relatively small part of
it. This is because banking system has greatly developed
there and also people have developed banking habits.
On the other hand, in the developing countries banking
has not developed sufficiently and also people have
not acquired banking habits and they prefer to make
transactions in currency. However in India after 50
years of independence and economic development the
proportion of bank deposits in the money supply has
risen to about 50 per cent.
Four Measures of Money Supply:

 Different components of money supply have been

distinguished on the basis of the different functions that
money performs.
 For example, demand deposits, credit card and currency
are used by the people primarily as a medium of exchange
for buying goods and services and making other transactions.
 Obviously, they are money because they are used as a medium
of exchange and are generally referred to as M1. Another
measure of money supply is M 3 which includes both M1 and
time deposits held by the public in the banks.
 Note: Time deposits are money that people hold as store of
value.
The main reason why money supply is classified into
various measures on the basis of its functions is that
effective predictions can be made about the likely
effects on the economy of changes in the different
components of money supply.
For example, if M1 is increasing firstly it can be
reasonably expected that people are planning to
make a large number of transactions.
On the other hand, if time-deposits component of
money supply measure M3 which serves as a store
of value is increasing rapidly, it can be validly
concluded that people are planning to save more and
accordingly consume less.
Therefore, it is believed that for monetary analysis and
policy formulation, a single measure of money
supply is not only inadequate but may be misleading
too. Hence various measures of money supply are
prepared to meet the needs of monetary analysis and
policy formulation.
Recently in India as well as in some developed
countries, four concepts of money supply have been
distinguished. The definition of money supply given
above represents a narrow measure of money supply
and is generally described as M1.
From April 1977, the Reserve Bank of India has
adopted four concepts of money supply in its
analysis of the quantum of and variations in money
supply.
These four concepts of measures of money supply are
explained below.

 Money Supply M1 or Narrow Money:

 This is the narrow measure of money supply and is composed of
the following items:
 Ml = C + DD + OD ,Where,
 C = Currency with the public
 DD = Demand deposits with the public in the commercial and
cooperative banks.
 OD = Other deposits held by the public with Reserve Bank of
India.
 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
 Currency with the public (C) in the above measure of
money supply consists of the following:
 (i) Notes in circulation.
 (ii) Circulation of rupee coins as well as small coins
 (iii) Cash reserves on hand with all banks.
 Note that in measuring demand deposits with the public in the
banks (i.e., DD), inter-bank deposits, that is, deposits held by
a bank in other banks, are excluded from this measure.
 In the other deposits with Reserve Bank of India (i.e., OD)
deposits held by the Central and State Governments and a
few others such as RBI Employees Pension and Provident
Funds are excluded.
However, these other deposits of Reserve Bank of
India include the following items:
(i) Deposits of Institutions such as UTI, IDBI, IFCI,
NABARD etc.
(ii) Demand deposits of foreign Central Banks and
Foreign Governments.
(iii) Demand deposits of IMF and World Bank.
It may be noted that other deposits of Reserve Bank of
India constitute a very small proportion (less than one
per cent).
 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.
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.
Let us summaries the four concepts of money supply as used by Reserve Bank of
India in the following tabular form: