MEANING OF MONEY & MONEY

SUPPLY
Meaning Of Money – It is anything which is commonly
accepted as a medium of exchange, measure of value, store
of value and means for standard of deferred payments.

Money Supply – It refers to total volume of money in

circulation among the public at a particular point of time in
the economy.

It includes money held by public only. Public signifies money-

using sector ( individuals + business firms). It is a stock
variable because total stock of money in circulation among
the public is measured at a particular point of time.
Measures / components Of Money Supply
M1 = Currency and coins with public ( C) + Net demand deposits of commercial
banks ( DD)
It is also known as transaction money, as it can be directly used for making
transactions.
C = currency and coins with public. It consists of paper notes and coins held by
the public. It is also called as fiat money, or legal tender money.
Fiat money is defined as the money which is under the fiat or order form the
government to act as money., i.e., under law. It must be accepted for all
transactions & debts.
Legal tender money can be legally used to make payment of debts or other
obligations.
DD = It refers to demand deposits of the public with the commercial banks. It is
also called as ‘bank money’. Net implies that only deposits of the public held by
the banks are to be included in money supply. It does not include interbank
deposits.
High powered money or reserve money is the currency held by public &
commercial banks.
Money/Credit Creation By Commercial
Banks
Money multiplier refers to the process of creation of
credit by the commercial banks, with the help of initial
deposits made by the public and legal reserve ratio.
Or , It is the number by which total deposits can
increase due to a given change in deposits.
It is calculated as : Money multiplier = 1/LRR
Total Credit created = Initial deposit * 1/LRR
Deposit Multiplier = total deposit created / initial
deposit
Credit multiplier = total loans created / initial
deposit
Important concepts related to credit creation
Important concepts related to credit creation
•Assumptions – a) there is a single banking system b) all transactions
are routed through banks i.e., all payments are made through cheques
and all receipts are deposited in the banks.
•Legal reserve ratio ( LRR) = CRR + SLR
Cash reserve ratio – it is the fraction of net total demand and time
deposits that commercial banks must keep as cash reserves with the
central bank
Statutory liquidity ratio – it is a fraction of net total demand and time
deposits that commercial banks must keep themselves in the form of
specified liquid assets.
Banks do not keep all their deposits with themselves. Rather they keep
only a certain percentage as Legal reserve Ratio (LRR) and give balance
to others in the form of loans.
•Primary deposits and secondary deposits –
Primary deposits are the initial deposits.
Secondary deposits are the deposits opened by the commercial banks
while giving loans.
Process of money/credit
creation by banks
•For example, the
initial deposit in banks
is Rs. 1000 and the
LRR is 20 percent.
Further suppose that
banks keep only the
minimum required Rs.
200 as reserve, no more
no less.
•Banks are free to lend the remainder
Rs. 800. Suppose they lend Rs. 800.
Now, since all the transactions are
routed through the banks, the money
spent by the borrowers comes back
into the banks in the deposit
accounts of those who have received
this payment.

•This increases demand deposits in

banks by Rs. 800. When banks
receive new deposits of Rs. 800, the
banks keep 20 percent of it as
reserves and use the remaining Rs.
640 for giving loans.
•The borrower use these loans for
making payments. The money
comes back into the accounts of
those who have received the
payments. Banks deposits again
rise, but by a smaller amount or
Rs. 640.

•In this way in every round 80

percent of loans are converted into
deposit. In this way total deposits
of Rs. 5000 are created.
Money multiplier =
1/LRR  1/ 0.20 
5

Total Credit created =

Initial deposit  1/LRR

 1000  1/0.20
 5000