The supply of Money

Supply of money

It is the total stock of money in circulation in the economy at a

particular point of time.

Stock variable

Components of money
Currency component- coins & currency notes
Bank deposits- issuing of cheques

A change in supply of money from the point of view of controlling the

economy involves a change in quantity of both of these.

Why do people accept a 100 rupees note

(when the value of paper is negligible) or
a 10 rupee coin (when the value of metal
in 10 rupee coin is not the same)?

Because they are fiat money- it is a promise

by the Governor of RBI that purchasing
power equivalent to the value printed on the
note would be given.

Money is a legal tender- can not be refused by

any citizen of the country for settlement of any
transaction.

However demand deposits (cheques) are not.

Inclusions of supply of money

Currency
Savings deposits of commercial banks
Demand deposits (DD) of commercial banks
Time deposits (TD) of commercial banks
Post office savings deposits
Post office time deposits

Definitions of money/concepts of
money supply

M1: C + DD
M2: M1 + Post office Savings deposits
M3: M1 + Net time deposits of banks
M4: M3 + total deposits with post office savings organisation
(excluding National Savings Certificates)
Declining order of liquidity
M1 is the most liquid & M4 is the least.
M3 / aggregate monetary resources is the most commonly used
measure of money supply.

Narrow Money

Money is primarily a medium of exchange.

Whatever assets perform this function they are included in

supply of money.

C, DD are included.

M1 & M2 are narrow measures.

Broad Money

Based on liquidity approach.

It acts as a store of value.

Includes all others as well.

M3 & M4 are broad measures.

Money supply & velocity of

money
If suppose a unit of money changes hand 5 times, on an
average, we say that the transaction velocity of money is 5.

High Powered Money/Reserve

Money/ Base Money (H)

Money produced by RBI & GOI & held by public & banks.

H=C+R

Recall: M = C + DD

Banks are producers of DD which are counted as money at par with

C.

But to be able to produce DD, banks have to maintain R, which is a

part of H, produced only by monetary authority & not by banks.

Currency Deposit Ratio (c)

It expresses the preferences of public as between C & DD of banks.

c = C / DD

It reflects peoples preference for liquidity.

It is a behavioral ratio

Varies over time.

Example- it increases during festival season as people convert their

deposits to cash balances to meet extra expenditure.

Reserves

Required reserves (RR)- banks are required statutorily to hold with

RBI.

Excess reserves (ER)- reserves in excess of RR. Banks are free to

hold them as cash on hand (vault cash) with themselves or as
balances with RBI.

ER are meant to:

Meet currency drains- net withdrawals of currency by depositors.
Clearing drains- net loss of cash due to cross clearing of cheques.

That is to say to meet banks transaction & precautionary demand for

cash reserves.

Reserve Deposit Ratio (r)

Ratio of reserves (R) to total deposits (D) of banks.

r=R/D

Sample B/S of a Commercial

Bank
Assets

Rs

Reserves
-Vault Cash
-Deposits with RBI

15

Bank Credit
-Loans
-Investment

30

r = 0.2

50

Liabilities

Rs

Deposits

100

Money Multiplier Process/

Money Creation by Banking
system
M=m()H

Where m = 1 + c

C + r (1 + t)

Derivation & analysis

Process

Assumptions of money
multiplier process

Only DD are made.

c = 0.5
r = 0.1
Fractional reserve system of commercial banking As a group, depositors withdraw only a small fraction of their
deposits every day.
If there are withdrawals of some deposits, there are also fresh
inflows .
Banks can meet the demand of depositors for funds from a cash
reserve which is only a fraction of total deposits.
Thus the rest can be given as loan to earn income.

Money Multiplier- It is the ratio of stock of money to the stock of High

powered money in an economy i.e. M/H

M/H > 1

The smaller the value of r, larger is m.

The smaller the value of c, larger is m.

Summing up

Total amount of M in an economy is much greater than the volume

of H.

This extra M is created by commercial banks by giving out a part of

their deposits as loans.

So if all the depositors reach the bank & demand withdrawal of their
money at the same time, bank will not enough funds to pay thembank failure.

So then inspite of being aware of such a situation of bank run

(everyone wants to withdraw their money before the bank runs out
of reserves), you do we maintain deposits with banks?

Because RBI acts as lender of last resort.