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CONCEPT & DEFINITIONS

For any policy formulation the money supply is a key variable. In modern economy money being a complex phenomenon, for the monetary economists defining money supply has always been a difficult task because there are differences of opinions on conceptual and empirical grounds on the question of the composition of money supply in a country.

In a broad sense however, the term money supply refers to the total stock of domestic means of payments which is held by the public. Here, public refers to local government bodies, etc. all categories of holders of money other than the state Treasury, central & commercial Banks, all being money creating agencies.

The cash balances held by the central Bank and in treasuries are not to be considered as part of money supply since they arise out of the non-commercial and refers to the stock of money held by the public in disposable form only. Thus, money supply is the quantity or stock of money which is held by the commercial banks in their tills as cash reserves and with the central bank, and the money stock held by the central bank in non-disposable form is obviously not regarded as money supply in the economy.

Definition

“Money supply refers to the amount of money which is in circulation in an economy at any given time.”

It follows that, at a point of time, the total stock of money and total supply of money differ in an economy. Stock of money held by the public is considered as money supply and the rest that lies with the money – creating agencies (central Bank, Commercial Banks, and state treasury) is not a part of money supply.

When viewed over a period of time, money supply becomes a flow concept. A unit of money is spendable as well as respendable. Thus, it may be spent several times during a given period, passing from one hand to another. The average number of times a unit of money circulating from one hand to another in the spending process during a given year is referred to as the ‘velocity of circulation of money.’ The flow of money is measured by multiplying a given stock of money held by the public with the velocity of circulation of money.

According to fisher, the flow of money supply over a period of time is MV where M=stock of money held by the public and V= velocity of circulation.

CONSTITUENTS OF MONEY SUPPLY

According to monetary analysists, there are different views regarding composition of money supply. These views may be classified into following two approaches.

A) Traditional Approach B) Modern Approach

A) Traditional Approach

According to the traditional approach, the money supply is composed of.

a) Coins.

b) Currency Notes

c) Demand Deposits

B] THE MODERN APPROACH

According to the modern approach, money supply should include money as well as near money. Thus in a wider sense, the money supply is composed of

a) coins

b) Currency notes

c) Bank’s demand deposits

d) Time deposits with Banks

e) Financial assets such as deposits with non Banking financial intermediaries like the unit trust building societies post office saving banks, etc

f) Bills Treasury & Exchange Bills

g) Bonds and equities.

In short, the modern view extends the phenomenon of money to the whole spectrum of liquidity in the Asset portfolio of individuates in a modern economy.

This controversy about the components of money supply has arisen on account of the difference of opinion regarding the significance and relationship between money supply and price level and the efficiency of monitory policy in a modern economy..

DETERMINANTS OF MONEY SUPPLY

Presently there are broadly two different opposite approaches to the supply of money. The monetarists are of the view that the supply of money is preliminary determined exogenously by the central Bank.

The Keynesian led by Nicholas Kaldor hold that the total money supply in the economy is mainly determines endogenously in response to the economy’s need for money. The Keynesian approach started by A.B.cramp. He states,. “It is strongly arguable that, in practice, the quantity of money has been largely determined ‘endogenously’ by the demands / needs of economy rather than ‘exogenously’ imposed on the economy by the central bank as monetarist doctrine presumes.”

Most modern economist however take a balanced view. In their opinion, the supply of money in an economy depends on the degree of responsibility and the judgments of the central bank and the supply response of the commercial banks to the demand for credit. There is no doubt that the total supply of money is determined by the following.

1) The central Bank

2) Commercial Banks, and

3) The public.

1) The central Bank affects the supply of money by controlling the total issue of high powered money. The total supply of nominal high powered money issued by the central Bank consists of,

i) The nominal currency held by the public &

ii) Cash reserves held by the commercial banks against their deposit liabilities.

2) Commercial banks by creating credit determine total amount off nominal demand deposits.

3) The pubic influences the size of nominal currency in hand & thereby affects the excess cash reserves of commercial banks which, in turn, exercises its influence on the amount of nominal demand deposits of commercial banks .

Now we can see that the joint behavior of the central bank, commercial banks and the public determine the supply of money.

The total supply of money consists of the currency held by the public and the demand deposits. Thus we may write as,

M = C + D ……….. (1)

Where

M = the money supply

C = Currency.

D = Demand deposits.

The total supply of high powered money (H) is the sum of currency, required reserves and excess reserves. This may be written. As follows;

H = C + RR + ER …….. (2)

H = the supply of the high power money

C = currency

RR= Required cash reserves kept by the commercial banks.

ER= Excess cash reserves kept by the commercial banks.

The commercial banks

The ratio of money of money of high powered money, therefore is

By dividing both the numerator and the denominator of this expression by D we obtain.

Where

C = The ratio of currency to demand deposits (C/D )

R = The legal minimum reserves requirement (RR/D)

E = The ratio of excess reserves to demand deposits (ER/D)

If E is zero, the right hand side of equation (4) reduces to 1 + C

This implies that C + r

This statement of ΔM/ΔH is purely definitional and may be described as the incremental money multiplier.

MEASURES OF MONEY SUPPLY IN INDIA

1) Concept of M1 = M1 is also known as “Narrow Money” concept. It is measured as follows.

 M1 = C + DD + OD

Where

C = Currency held by public

DD = Net Demand Deposits of Banks

OD = Other Deposits of RBI.

The First thing that is included in M1 is currency (c). It is measured as paper money (Notes) and coins. DD that is Demand Deposits of commercial Banks, Co-operative Banks other deposits of quasi governments instructions like IFCT, SFC, IDBI, UTI, NABARDS, deposit of the IMF in Account No.02.

2) Concept of M2 = M2 & M4 are New concepts of money supply It is measured as follows.

M2 = M1 + POSD

Where POSD, = Post office saving Deposits.

M2 is an extension of M1 M2 includes all the components of M1 plus post office savings deposit Broadly post office deposits can be classified as

a) savings deposits b) time deposits. As post office saving deposits are not withdrawable by cheque they cannot be placed in the same category as the bank saving deposits.

3) Concept of M3 = M3 is a broader concept of Money supply in the earlier series. M3 is measured as follows.

M3 = M1 + TD

Where

TD = Net time deposit of banks.

This M3 concept includes M1 and net time deposits of banks. There is one difference between the estimates of M3 in the new and old series that is the new series coverage of co-operative sector banks is for greater than in the old series.

4) Concept of M4 = M4 is a broader concept than M3. It includes all the components M3 plus total deposits with post office savings organizations (excluding National savings certificates)

THE NEW MONETARY AND LIQUIDITY AGGREGATES

For the last quarter of a century, RBI has continued to calculate money supply and monetary aggregates in the form viz., M1, M2, M3 & M4, though in practice only M1 and M3 have been used, M2 and M4 are actually irrelevant as has no Figures for people’s deposits with post offices.

RBI appointed a working Group on Money supply to redefine the parameters for measuring money supply in India. This working Group dropped saving bank deposits of post offices (Included Previously in M2) and also all deposit with post office saving (included in M4). Accordingly there are now only three monetary aggregates viz M1, M2,and M3 the revised monetary measures are

1)M1 = There is no change in the calculation of money supply with the M1. That is M1 continues to be calculated as;

M1 = Currency + Demand Deposits + Other Deposits with RBI

2) M2 = M1 + time Liabilities portion of savings Deposits with Banks + certificates of Deposits issued by banks + Term Deposits, Maturing within a year Excluding FCNR (B) Deposits

It may be noted that the new M2 excludes post office savings bank deposits but includes short – term deposits of one year maturity & certificates of deposits issued by banks All these can be readily converted to money by people. If need arises.

3) M3 = The New revised M3 is calculated as follows:

M3 = M2 + term deposit with banks with maturity of over one year + Call / term borrowing of the banking system. The new M3 can be designated as broad money and will be the significant monetary measures. It may be noted that the new concept of M2 and M3 are improvements and refinements of the corresponding previous concept in that.

a) Post office saving deposits and all other deposits of post office have been excluded.

b) Saving deposits and term deposits held by the public with banks have been divided into deposits into short term maturity (up to one year) and long term maturity (above one year)

c) Borrowing of the banking system (call and short term) have been included for the first time.

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