TOPIC: - Reserve Bank of India Classification of

Money

12.1 Introduction

12.2 Debate on constituents of Money Supply

12.3 RBI Classification of Money

12.4 High Powered Money and Money Supply

12.5 Summary

INTRODUCTION

There is no clear-cut distinction between what is money and what are the
measures of money supply. Money supply means the total amount of money
in an economy. The effective money supply consists of mostly of currency
and demand deposits. Currency includes all coins and paper money issued
by the government and the banks. Bank deposits are regarded part of money
supply and they constitute about 75 to 80 percent of the total money supply
in the U.S. Some economists also include near money, or such liquid assets
as savings, deposits and government bills in the money supply. The total
supply of money determined by banks, the Federal Reserve, businessmen,
the government and consumers.

Money is something, which is measurable. Supply of money refers to its

stock at any point in time; it is because money is a stock variable as against a
flow variable (real income). It is the change in the stock of money during a
period, which is a flow. The stock of money always refers to the stock of
money held by the public. Through out history the question of not only what
constitutes money but where it comes from has been both important and
controversial.

Debate on constituents of Money Supply:

There is a debate whether the time and saving deposits to be included in

money supply or not. What distinguishes these deposits is the fact that they
earn an interest income and can be converted as means of payments only
after some delay and not at once. As such these time and saving deposits are
excluded from the pool of the money supply. However, alternative
definitions of money have adopted by many writers. Notably, the Chicago
school led by Milton Friedman opts to include all bank deposits, time and
demand, in
money supply. In fact, Schwartz and Friedman are willing to consider as
money all marketable government securities, which are supported at par. By
the same logic, there is no reason why the liabilities of saving institutions
should not also be included in money.

The debatable question is whether the measure of money should be extended

to include
other deposits liabilities of the commercial banks, e.g., time deposits in USA
and deposit accounts in the UK. Some investigators go further and include
the liabilities of some other deposits taking institutions, such as savings and
loan associations in the USA and saving banks in Britain, on the grounds
that their fixed monetary value makes them good substitutes for interest
bearing bank deposits. It has therefore, to be observed that various measures
of money supply keep on changing from country to country and from time to
time within the country.

RBI Classification of Money:

The Reserve Bank of India does not follow or clearly states any theory of
money supply or money stock. It simply publishes a purely accounting
analysis of what it calls sources of change in money supply stock. The main
constituents of money stock are a) currency with the public b) Deposit
money. These can be further split into what may be called sources of money
stock (a) Net Bank Credit to Government Sector (including RBI credit to
Government Sector) (b) Bank credit to commercial sector. (c) Net foreign
exchange assets of banking sector (d) Governments currency liabilities to the
public minus (e) Banking sectors net non-monetary liabilities.

Up to 1968, the Reserve Bank of India published a single measure of money

supply called M and latter on M1 defined as currency and demand deposits
held by public. It was called the narrow measure of money supply. After
1968 the RBI started publishing broader measure of money supply called
aggregate monetary reserves defined as M or M 1 plus the net time deposits
of banks by the public (M3).

However, since 1977 Reserve Bank of India is publishing data on four

alternative measures of money supply in place of the old measure based on a
narrow conception of money. As stated above, the old measure of money
supply consists of currency and demand deposits are generally regarded as
too narrow and clearly inadequate. They are:

M1 = C + DD + OD

Where C = currency, DD = demand deposits and OD = other deposits of the

RBI as are in the nature of demand deposits.

M2 = M1 + saving deposits with post-office saving banks

M3 = M1 + Net time deposits with banks

M4 = M3 + All types of deposits with post-offices – National Saving
Certificates

Out of these four measures, M1 has the greatest degree of liquidity. Other
measures have liquidity in the descending order with M4 having the lowest
degree of liquidity.

There is a marked preference during the recent years on the part of RBI for
M3 over M1 as a measure of money supply. The superiority of M 3 over M1 is
on account of several reasons. M3 is a broad measure of money supply,
whereas, M1 is a very narrow conception of it. Second, M 3 does not suffer
from the flaw of arbitrary division of saving deposits between the demand
deposits and time deposit components. Thirdly, from the credit budgeting
viewpoint, M3 is better than M1 because total bank credit is closely
connected with total deposits and not merely the demand deposits of banks.
Fourthly, M3
is preferable to M1 on empirical grounds. The Chakravarthy committee also
indicated its preference for M3 over M1.

The Working Group on Money Supply: Analytics and Methodology of

Compilation, set up under chairman ship of Dr Y V Reddy to examine the
analytical aspects of the monetary survey, submitted its report in June 1998.
The Working Group recommended the compilation of comprehensive
analytical surveys of the Reserve Bank of India, commercial and co-
operative banks and the organised financial sector at regular intervals. An
inter-departmental Core Group was set up to implement the
recommendations of the Working Group.

The Working Group recommended that the proposed monetary aggregates

should be
disseminated from fiscal 1999-2000. However, the monetary series presently
in vogue would need to be continued for some time for the purpose of
comparability. For convenience, the proposed monetary aggregates would be
referred to as the new series and the present ones, the old series.

The proposed Intermediate Monetary Aggregate (NM2)

The Working Group proposed a new intermediate monetary aggregate, to be

referred to as NM2, comprising currency and residents' short-term bank
deposits which would stand in between narrow money (M1) (which includes
only the non-interest bearing monetary liabilities of the banking sector) and
broad money (M3) (an all encompassing measure that includes long-term
time deposits).

The recommendation implied the partition of the maturity structure of bank

deposits into short-term and long-term time deposits at one year of
contractual maturity in order to elicit information about depositors'
preferences in holding money in various degrees of liquidity.
Data on the maturity structure of time deposits partitioned at the contractual
maturity of one year are not readily available with banks. Collection of such
information has required the banks to set up a reporting system for the
purpose at the branch-level. The data received are new and would have to be
over time subjected to tests of robustness and stability. For the present,
therefore, such data had to be estimated based on the reporting by a
representative sample of large public sector banks.

The proportion of short-term time deposits (with a contractual maturity of up

to and including one year) in total time deposits for the sample banks
worked out to about 45.0 per cent. Pending the census data, this ratio has
been applied to the aggregate time deposits of the banking system to obtain
estimates of NM2.

Broad Money (NM3)

The new broad money aggregate (referred to here as NM3 for purpose of
clarity) in the Monetary Survey would comprise in addition to NM2, long-
term deposits of residents as well as call/ term borrowings from non-bank
sources which have emerged as an important source of resource mobilisation
for banks. The critical difference between M3 and NM3, essentially, lies in
the treatment of non-resident repatriable fixed foreign currency liabilities of
the banking system in the money supply compilation.

The difference owing to banks' call/term borrowings from non- bank sources
is, at present, negligible on reporting Fridays as such liabilities are fully
subject to reserve requirements. The divergence between the estimates of
M3 and NM3 would, there- fore,
essentially depend on the magnitude of the non-resident inflows to the
banking system in India.

The difference between the growth rates of M3 and NM3 vary within a
range of 0.1 to 1.7 percen- tage points on a point-to-point financial year
basis. The difference is more or less the same when monthly data are
averaged for the same period, viz., 0.3 to 1.6 percentage points.

The Working Group classified the liabilities of the banking system in India
to others broadly in terms of i) demand liabilities, ii) time liabilities and iii)
other demand and time liabilities (ODTL) in line with the existing practice.
Of these liabilities, demand and time deposits are included in money supply
as the monetary liabilities of the banking sector. The balances under ODTL
are essentially non-deposit liabilities, which together with balances under
such liabilities as paid-up capital and reserves constitute the net non-
monetary liabilities (NNML) of the banking sector.

One of the important items appearing under ODTL is the Pension and
Provident Funds of the banking system, wherever such funds are not
managed by separate entities and, as a result, reflected in the balance sheet
of the banks. Pension and Provident Funds are essentially a portfolio of
assets created to provide old age and retirement benefits and are, therefore,
treated as different from deposits, in line with international practices.

High Powered Money and Measurement of Money

Supply:

It should be noted that money supply is not always policy determined. In

fact, monetary authority, banks and the public determine money supply
jointly. It is true that the role of monetary authority is predominant in
determining the supply of money. Two types of money must be distinguished
i.e., ordinary money and high-powered money. Ordinary money as we have
known is currency plus demand deposits. On the other hand, high-powered
money is the money produced by the RBI and the Government of India held
by public and banks. The RBI calls it as reserve money.

High powered money is the sum of, currency held by public, cash reserves
of the banks and other deposits of RBI, we can ignore other deposits of RBI
from theoretical discussion as it hardly constitutes one percent of total high
powered money. Now if we compare the two types of money, we find
currency money is common to both, the difference between the two is
demand deposits in ordinary money and cash reserves of the banks in High-
powered money. This difference is of vital importance. Banks are producers
of demand deposits and these demand deposits are treated as money at par
with currency. But to be able to create demand deposits banks have to
maintain cash reserves, which in turn are a part of High-powered money,
produced only by monetary authority and not by banks.

We know in a fractional reserve banking system, demand deposits are a

certain multiple of cash reserves, which are a component of High-powered
money; it gives the high-powered ness and act as the base for multiple
creation of demand deposits. That is why, high-powered money also called
as base money. Thus it becomes single most dominant factor of determining
money supply.

The actual measurement of money in the modern economy has become an

extremely complex matter because a fairly large variety of financial assets
exist in the economy that serves as money in one way or another.

Summary

Money is something, which is measurable. Supply of money refers to its

stock at any point in time; it is because money is a stock variable as against a
flow variable (real income). It is the change in the stock of money during a
period, which is a flow. The stock of money always refers to the stock of
money held by the public.
Through out history the question of not only what constitutes money but
where it comes from has been both important and controversial. The
Reserve Bank of India does not follow or clearly states any theory of money
supply or money stock. It simply publishes a purely accounting analysis of
what it calls sources of change in money supply stock. However, since 1977
Reserve Bank of India is publishing data on four alternative measures of
money supply in place of the old measure based on a narrow conception of
money. They are M1, M2, M3 and M4. Besides, High Powered Money also
identified as single most factor of determinant of money supply. The actual
measurement of money in the modern economy has become an extremely
complex matter because a fairly large variety of financial assets exist in the
economy that serves as money in one way or another.

The Working Group under the chairmanship of Dr Y V Reddy recommended

that the proposed monetary aggregates should be disseminated from fiscal
1999-2000. However, the monetary series presently in vogue would need to
be continued for some time for the purpose of comparability. For
convenience, the proposed monetary aggregates would be referred to as the
new series and the present ones, the old series.