THE SUPPLY

OF MONEY
 Difficulties of Barter System and Inventions

• Double coincidence of wants:

• Lack f Standard unit of account:
• Impossibility of subdivision of goods:
Definition of Money:
“Money can be defined as anything that is generally accepted as a means of
exchange and that at the same time acts as a measure and a store a value.”
Function of Money: There are four main functions of money which are
summed up in the following couplet:
Money is a matter of functions four,
A medium, a measure, a standard, a store
1. Proportional reserve system, (1927- 1956) 2. Minimum reserve
system.(1956-present.
 Meaning of Money Supply
• The supply of money with the public in India or the volume of money in
circulation refers to the volume of money held by the people in the
country, i.e. by individuals, institutions, and business firms.

• We include only the amount of money held and used by the public fro
transactions for making payments, and for settlement of debt.

• Public in the sense of money supply is the private individual and business
firms operating in the economy but it excluded from itself central
government treasury, central bank treasury, state government treasury or
the cash reserve owned by the commercial banks are not included in
‘money supply’ on the ground that they are not in actual circulation in the
country.
• The quantity of money in existence in a country at a particular time consists
of two items,
1. Currency Component: Coins and notes in circulation.
2. Deposit Component: Deposits of the general public with the bank.
 Calculation of Money Supply in India

• Since currency money is issued by the central bank or the central

government, it enjoys a legal tender.
• Legal tender is a medium of payment recognized by a legal system to be
valid for meeting a financial obligation. Paper currency and coins are
common forms of legal tender in many countries.
• Time deposit considered as the quasi-money, but demand deposit is
considered to be full-fledged money.
 Money Aggregate used in India
• Main reason why money supply is classified into various measures on the
basis of its function is that effective prediction can be made about the likely
affects on the economy of changes in the different component of money
supply. Example M1: More transaction as More M1. More saving as
increase in M3.
• Till 1967-68, the R.B.I, used to publish only a single measure of money
supply. From 1967-68 the R.B.I. started publishing additionally a broader
measure of money supply, called aggregate monetary resources, (A.M.R.).
It was explained as M plus the time deposits of banks held by the public.
• From April,1977 the RBI has adopted four concepts of money supply in its
analysis of the quantum of and variations in money supply.

Money Supply (M1) or Narrow Money :-

M1 = C + DD + OD
Other Deposits with RBI = Deposits of institutions like UTI, IDBI, IFCI,
NABARD, DD of foreign central banks, DD of IMF and World Bank.
 Continue….
• M2 concept is broader than M1:
M2 = M1 + Saving deposits with the post office saving bank.

• Saving deposits with the post offices are more liquid than time deposits with the
bank (commercial and cooperative banks etc)
• Money Supply M3 or Broad Money:
M3 = M1 + Time deposits with the bank

• Time deposits serve as a store of value and represents saving of the people.
• Late Prof. Sukhamoy Chakravarty recommended its use for monetary planning of
the economy and setting target of money supply and in terms of M3.

• In the terminology of money supply employed by RBI till april 1977, this M3 was
called Aggregate Monetary Measure (AMR).

• M4 = M3 + Total Deposits of Post office Savings Organisation (Excluding National

Saving Certificate)
 Change in Money Supply
• Three Money creating institutions of the country:-

1.Treasury, 2. Commercial banks 3. Central Bank.

• Factors affecting change in Money Supply

1. The Volume and Character of trade.

2. The price level.

3. Method of payments in system. (Cheques and cash)

4. The volume of Demand deposits.

5. Banking habits of the public.

6. Distribution of national income among various section of the public.

7. Methods of taxation (government borrowing)

 How commercial banks create money?

• Deposits are used to lend by the commercial banks and create money/.

• Demand deposits in the commercial bank arise in two way:

Primary Deposits: Cash deposits from the customers.

Derivative Deposits: Granting of loan and advances.\

• Cash Reserve: Bank keep a part of its deposits in cash to honor the
cheques drawn by its customer. This cash reserve bears a certain ration
with its total deposits. This ratio is called cash ratio.
 Deposit Multipier
• The deposit multiplier depends upon the required rserve ratio which is the base of
g=credit creation.
• RRr = RR/D, or RR = RRr * D
Where, RR is required cash reserve, RRr is the required reserve ratio and D
=demand deposits with bank.
Dividing both side by RRr we will get, D = (1/RRr)*RR
1/RRr is deposit expansion multiplier.
Example: Suppose the RRr is 10 % and the initial change in cash reserve is 1000
Rs. The minimum increase in the demand deposits are
∆D = 1000 * (1/0.10) = 10000 Rs.

Limitations of the Money Multiplier:

1. Higher cash reserve ratio restrict the power of the creating money.
2. Larger the quantity of cash reserve greater the power of bank to create credit.
3. Credit control policy governed by RBI.
4. Banking habits of the people.
5. Demand for loan and advances.