Unit II: The Concept of Money Supply | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


3.30 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: CONCEPT OF MONEY SUPPLY 
At the end of this unit, you will be able to: 
? Define money supply and describe its different components  
? List out  the need for and rationale of measuring money 
supply 
? Elucidate the different sources of money supply 
? Illustrate the various measures of money supply 
? Distinguish between money multiplier and credit multiplier, 
and  
? Describe the different determinants of money supply 
 
 
Money 
Market
The concept 
of Money 
Supply
The Sources 
of Money 
Supply
Measurement 
of Money 
Supply
Determinants 
of Money 
Supply
The concept 
of Money 
Multiplier
UNIT OVERVIEW 
Page 2


3.30 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: CONCEPT OF MONEY SUPPLY 
At the end of this unit, you will be able to: 
? Define money supply and describe its different components  
? List out  the need for and rationale of measuring money 
supply 
? Elucidate the different sources of money supply 
? Illustrate the various measures of money supply 
? Distinguish between money multiplier and credit multiplier, 
and  
? Describe the different determinants of money supply 
 
 
Money 
Market
The concept 
of Money 
Supply
The Sources 
of Money 
Supply
Measurement 
of Money 
Supply
Determinants 
of Money 
Supply
The concept 
of Money 
Multiplier
UNIT OVERVIEW 
3.31 
 
CONCEPT OF MONEY SUPPLY 
 2.1 INTRODUCTION 
In the previous unit, we have discussed the theories related to demand for 
money. Money plays a crucial role in the smooth functioning of an economy. 
Money supply is considered as a very important macroeconomic variable 
responsible for changes in many other significant macroeconomic variables in an 
economy and is therefore considered as a matter of considerable interest to the 
economists and policy makers.  
Economic stability requires that the supply of money at any time should to be 
maintained at an optimum level.  A pre-requisite for achieving this is to accurately 
estimate the stock of money supply on a regular basis and appropriately regulate 
it in accordance with the monetary requirements of the country. In this unit, we 
shall look into various aspects related to the supply of money.     
The term money supply denotes the total quantity of money available to the 
people in an economy.  The quantity of money at any point of time is a 
measurable concept. It is important to note two things about any measure of 
money supply: 
(i) The supply of money is a stock variable i.e. it refers to the total amount of 
money at any particular point of time. It is the change in the stock of money 
(say, increase or decrease per month or year,), which is a flow. 
(ii) The stock of money always refers to the stock of money available to the 
‘public’ as a means of payments and store of value. This is always smaller 
than the total stock of money that really exists in an economy.  
The term ‘public’ is defined to include all economic units (households, firms and 
institutions) except the producers of money (i.e. the government and the banking 
system). The government, in this context, includes the central government and all 
state governments and local bodies; and the banking system means the Reserve 
Bank of India and all the banks that accept demand deposits (i.e. deposits from 
which money can be withdrawn by cheque mainly CASA deposits). The word 
‘public’ is inclusive of all local authorities, non-banking financial institutions, and 
non-departmental public-sector undertakings, foreign central banks and 
governments and the International Monetary Fund which holds a part of Indian 
money in India in the form of deposits with the RBI. In other words, while 
discussing the definition of ‘supply of money’ and the standard measures of 
money, interbank deposits and money held by the government and the banking 
system are not included.  
Page 3


3.30 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: CONCEPT OF MONEY SUPPLY 
At the end of this unit, you will be able to: 
? Define money supply and describe its different components  
? List out  the need for and rationale of measuring money 
supply 
? Elucidate the different sources of money supply 
? Illustrate the various measures of money supply 
? Distinguish between money multiplier and credit multiplier, 
and  
? Describe the different determinants of money supply 
 
 
Money 
Market
The concept 
of Money 
Supply
The Sources 
of Money 
Supply
Measurement 
of Money 
Supply
Determinants 
of Money 
Supply
The concept 
of Money 
Multiplier
UNIT OVERVIEW 
3.31 
 
CONCEPT OF MONEY SUPPLY 
 2.1 INTRODUCTION 
In the previous unit, we have discussed the theories related to demand for 
money. Money plays a crucial role in the smooth functioning of an economy. 
Money supply is considered as a very important macroeconomic variable 
responsible for changes in many other significant macroeconomic variables in an 
economy and is therefore considered as a matter of considerable interest to the 
economists and policy makers.  
Economic stability requires that the supply of money at any time should to be 
maintained at an optimum level.  A pre-requisite for achieving this is to accurately 
estimate the stock of money supply on a regular basis and appropriately regulate 
it in accordance with the monetary requirements of the country. In this unit, we 
shall look into various aspects related to the supply of money.     
The term money supply denotes the total quantity of money available to the 
people in an economy.  The quantity of money at any point of time is a 
measurable concept. It is important to note two things about any measure of 
money supply: 
(i) The supply of money is a stock variable i.e. it refers to the total amount of 
money at any particular point of time. It is the change in the stock of money 
(say, increase or decrease per month or year,), which is a flow. 
(ii) The stock of money always refers to the stock of money available to the 
‘public’ as a means of payments and store of value. This is always smaller 
than the total stock of money that really exists in an economy.  
The term ‘public’ is defined to include all economic units (households, firms and 
institutions) except the producers of money (i.e. the government and the banking 
system). The government, in this context, includes the central government and all 
state governments and local bodies; and the banking system means the Reserve 
Bank of India and all the banks that accept demand deposits (i.e. deposits from 
which money can be withdrawn by cheque mainly CASA deposits). The word 
‘public’ is inclusive of all local authorities, non-banking financial institutions, and 
non-departmental public-sector undertakings, foreign central banks and 
governments and the International Monetary Fund which holds a part of Indian 
money in India in the form of deposits with the RBI. In other words, while 
discussing the definition of ‘supply of money’ and the standard measures of 
money, interbank deposits and money held by the government and the banking 
system are not included.  
3.32 ECONOMICS FOR FINANCE 
 2.2 RATIONALE OF MEASURING MONEY 
SUPPLY 
The empirical analysis of money supply is important for two reasons: 
1. It facilitates analysis of monetary developments in order to provide a deeper 
understanding of the causes of money growth.  
2. It is essential from a monetary policy perspective as it provides a framework 
to evaluate whether the stock of money in the economy is consistent with 
the standards for price stability and to understand the nature of deviations 
from this standard. The central banks all over the world adopt monetary 
policy to stabilise price level and GDP growth by directly controlling the 
supply of money. This is achieved mainly by managing the quantity of 
monetary base. The success of monetary policy depends to a large extent 
on the controllability of the monetary base and the money supply.  
 2.3 THE SOURCES OF MONEY SUPPLY 
The supply of money in the economy depends on:  
(a) the decision of the central bank based on the authority conferred on it , and 
(b) the supply responses of the commercial banking system  of the country to 
the changes  in policy variables initiated by the central bank to influence the 
total money supply in the economy. 
The central banks of all countries are empowered to issue currency and, therefore, 
the central bank is the primary source of money supply in all countries. In effect, 
high powered money issued by monetary authorities is the source of all other 
forms of money. The currency issued by the central bank is ‘fiat money’ and is 
backed by supporting reserves and its value is guaranteed by the government.  
The currency issued by the central bank is, in fact, a liability of the central bank 
and the government.  Therefore, in principle, it must be backed by an equal value 
of assets mainly consisting of gold and foreign exchange reserves. In practice, 
however, most countries have adopted a ‘minimum reserve system’ wherein the 
central bank is empowered to issue currency to any extent by keeping only a 
certain minimum reserve of gold and foreign securities. 
Page 4


3.30 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: CONCEPT OF MONEY SUPPLY 
At the end of this unit, you will be able to: 
? Define money supply and describe its different components  
? List out  the need for and rationale of measuring money 
supply 
? Elucidate the different sources of money supply 
? Illustrate the various measures of money supply 
? Distinguish between money multiplier and credit multiplier, 
and  
? Describe the different determinants of money supply 
 
 
Money 
Market
The concept 
of Money 
Supply
The Sources 
of Money 
Supply
Measurement 
of Money 
Supply
Determinants 
of Money 
Supply
The concept 
of Money 
Multiplier
UNIT OVERVIEW 
3.31 
 
CONCEPT OF MONEY SUPPLY 
 2.1 INTRODUCTION 
In the previous unit, we have discussed the theories related to demand for 
money. Money plays a crucial role in the smooth functioning of an economy. 
Money supply is considered as a very important macroeconomic variable 
responsible for changes in many other significant macroeconomic variables in an 
economy and is therefore considered as a matter of considerable interest to the 
economists and policy makers.  
Economic stability requires that the supply of money at any time should to be 
maintained at an optimum level.  A pre-requisite for achieving this is to accurately 
estimate the stock of money supply on a regular basis and appropriately regulate 
it in accordance with the monetary requirements of the country. In this unit, we 
shall look into various aspects related to the supply of money.     
The term money supply denotes the total quantity of money available to the 
people in an economy.  The quantity of money at any point of time is a 
measurable concept. It is important to note two things about any measure of 
money supply: 
(i) The supply of money is a stock variable i.e. it refers to the total amount of 
money at any particular point of time. It is the change in the stock of money 
(say, increase or decrease per month or year,), which is a flow. 
(ii) The stock of money always refers to the stock of money available to the 
‘public’ as a means of payments and store of value. This is always smaller 
than the total stock of money that really exists in an economy.  
The term ‘public’ is defined to include all economic units (households, firms and 
institutions) except the producers of money (i.e. the government and the banking 
system). The government, in this context, includes the central government and all 
state governments and local bodies; and the banking system means the Reserve 
Bank of India and all the banks that accept demand deposits (i.e. deposits from 
which money can be withdrawn by cheque mainly CASA deposits). The word 
‘public’ is inclusive of all local authorities, non-banking financial institutions, and 
non-departmental public-sector undertakings, foreign central banks and 
governments and the International Monetary Fund which holds a part of Indian 
money in India in the form of deposits with the RBI. In other words, while 
discussing the definition of ‘supply of money’ and the standard measures of 
money, interbank deposits and money held by the government and the banking 
system are not included.  
3.32 ECONOMICS FOR FINANCE 
 2.2 RATIONALE OF MEASURING MONEY 
SUPPLY 
The empirical analysis of money supply is important for two reasons: 
1. It facilitates analysis of monetary developments in order to provide a deeper 
understanding of the causes of money growth.  
2. It is essential from a monetary policy perspective as it provides a framework 
to evaluate whether the stock of money in the economy is consistent with 
the standards for price stability and to understand the nature of deviations 
from this standard. The central banks all over the world adopt monetary 
policy to stabilise price level and GDP growth by directly controlling the 
supply of money. This is achieved mainly by managing the quantity of 
monetary base. The success of monetary policy depends to a large extent 
on the controllability of the monetary base and the money supply.  
 2.3 THE SOURCES OF MONEY SUPPLY 
The supply of money in the economy depends on:  
(a) the decision of the central bank based on the authority conferred on it , and 
(b) the supply responses of the commercial banking system  of the country to 
the changes  in policy variables initiated by the central bank to influence the 
total money supply in the economy. 
The central banks of all countries are empowered to issue currency and, therefore, 
the central bank is the primary source of money supply in all countries. In effect, 
high powered money issued by monetary authorities is the source of all other 
forms of money. The currency issued by the central bank is ‘fiat money’ and is 
backed by supporting reserves and its value is guaranteed by the government.  
The currency issued by the central bank is, in fact, a liability of the central bank 
and the government.  Therefore, in principle, it must be backed by an equal value 
of assets mainly consisting of gold and foreign exchange reserves. In practice, 
however, most countries have adopted a ‘minimum reserve system’ wherein the 
central bank is empowered to issue currency to any extent by keeping only a 
certain minimum reserve of gold and foreign securities. 
3.33 
 
CONCEPT OF MONEY SUPPLY 
The second major source of money supply is the banking system of the country. 
The total supply of money in the economy is also determined by the extent of 
credit created by the commercial banks in the country. Banks create money 
supply in the process of borrowing and lending transactions with the public. 
Money so created by the commercial banks is called 'credit money’.  The high 
powered money and the credit money broadly constitute the most common 
measure of money supply, or the total money stock of a country. (For a brief note 
on the process of creation of credit money, refer to Box 1, end of this chapter).  
The Crypto currencies face significant legislative uncertainties and are not legally 
recognized in India as currency.  Hence, these are not categorized as money.  
 2.4 MEASUREMENT OF MONEY SUPPLY  
There is virtually a profusion of different types of money, especially credit money, 
and this makes measurement of money supply a difficult task. Different countries 
follow different practices in measuring money supply.  The measures of money 
supply vary from country to country, from time to time and from purpose to 
purpose. Reference to such different measures is beyond the scope of this unit. 
Just as other countries do; a range of monetary and liquidity measures are 
compiled and published by the RBI. Money supply will change if the magnitude of 
any of its constituents changes. 
In this unit, we shall be concentrating on the Indian case only and in the following 
discussion, we shall focus on the alternative measures of money supply prepared 
and published periodically by the Reserve Bank of India.  
Since July 1935, the Reserve Bank of India has been compiling and disseminating 
monetary statistics.  Till 1967-68, the RBI used to publish only a single ‘narrow 
measure of money supply’ (M
1
) defined as the sum of currency and demand 
deposits held by the public. From 1967-68, a 'broader' measure of money supply, 
called 'aggregate monetary resources' (AMR) was additionally published by the 
RBI. From April 1977, following the recommendations of the Second Working 
Group on Money Supply (SWG), the RBI has been publishing data on four 
alternative measures of money supply denoted by M
1
, M
2
, M
3
 and M
4
 besides the 
reserve money.  The respective empirical definitions of these measures are given 
below:  
Page 5


3.30 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: CONCEPT OF MONEY SUPPLY 
At the end of this unit, you will be able to: 
? Define money supply and describe its different components  
? List out  the need for and rationale of measuring money 
supply 
? Elucidate the different sources of money supply 
? Illustrate the various measures of money supply 
? Distinguish between money multiplier and credit multiplier, 
and  
? Describe the different determinants of money supply 
 
 
Money 
Market
The concept 
of Money 
Supply
The Sources 
of Money 
Supply
Measurement 
of Money 
Supply
Determinants 
of Money 
Supply
The concept 
of Money 
Multiplier
UNIT OVERVIEW 
3.31 
 
CONCEPT OF MONEY SUPPLY 
 2.1 INTRODUCTION 
In the previous unit, we have discussed the theories related to demand for 
money. Money plays a crucial role in the smooth functioning of an economy. 
Money supply is considered as a very important macroeconomic variable 
responsible for changes in many other significant macroeconomic variables in an 
economy and is therefore considered as a matter of considerable interest to the 
economists and policy makers.  
Economic stability requires that the supply of money at any time should to be 
maintained at an optimum level.  A pre-requisite for achieving this is to accurately 
estimate the stock of money supply on a regular basis and appropriately regulate 
it in accordance with the monetary requirements of the country. In this unit, we 
shall look into various aspects related to the supply of money.     
The term money supply denotes the total quantity of money available to the 
people in an economy.  The quantity of money at any point of time is a 
measurable concept. It is important to note two things about any measure of 
money supply: 
(i) The supply of money is a stock variable i.e. it refers to the total amount of 
money at any particular point of time. It is the change in the stock of money 
(say, increase or decrease per month or year,), which is a flow. 
(ii) The stock of money always refers to the stock of money available to the 
‘public’ as a means of payments and store of value. This is always smaller 
than the total stock of money that really exists in an economy.  
The term ‘public’ is defined to include all economic units (households, firms and 
institutions) except the producers of money (i.e. the government and the banking 
system). The government, in this context, includes the central government and all 
state governments and local bodies; and the banking system means the Reserve 
Bank of India and all the banks that accept demand deposits (i.e. deposits from 
which money can be withdrawn by cheque mainly CASA deposits). The word 
‘public’ is inclusive of all local authorities, non-banking financial institutions, and 
non-departmental public-sector undertakings, foreign central banks and 
governments and the International Monetary Fund which holds a part of Indian 
money in India in the form of deposits with the RBI. In other words, while 
discussing the definition of ‘supply of money’ and the standard measures of 
money, interbank deposits and money held by the government and the banking 
system are not included.  
3.32 ECONOMICS FOR FINANCE 
 2.2 RATIONALE OF MEASURING MONEY 
SUPPLY 
The empirical analysis of money supply is important for two reasons: 
1. It facilitates analysis of monetary developments in order to provide a deeper 
understanding of the causes of money growth.  
2. It is essential from a monetary policy perspective as it provides a framework 
to evaluate whether the stock of money in the economy is consistent with 
the standards for price stability and to understand the nature of deviations 
from this standard. The central banks all over the world adopt monetary 
policy to stabilise price level and GDP growth by directly controlling the 
supply of money. This is achieved mainly by managing the quantity of 
monetary base. The success of monetary policy depends to a large extent 
on the controllability of the monetary base and the money supply.  
 2.3 THE SOURCES OF MONEY SUPPLY 
The supply of money in the economy depends on:  
(a) the decision of the central bank based on the authority conferred on it , and 
(b) the supply responses of the commercial banking system  of the country to 
the changes  in policy variables initiated by the central bank to influence the 
total money supply in the economy. 
The central banks of all countries are empowered to issue currency and, therefore, 
the central bank is the primary source of money supply in all countries. In effect, 
high powered money issued by monetary authorities is the source of all other 
forms of money. The currency issued by the central bank is ‘fiat money’ and is 
backed by supporting reserves and its value is guaranteed by the government.  
The currency issued by the central bank is, in fact, a liability of the central bank 
and the government.  Therefore, in principle, it must be backed by an equal value 
of assets mainly consisting of gold and foreign exchange reserves. In practice, 
however, most countries have adopted a ‘minimum reserve system’ wherein the 
central bank is empowered to issue currency to any extent by keeping only a 
certain minimum reserve of gold and foreign securities. 
3.33 
 
CONCEPT OF MONEY SUPPLY 
The second major source of money supply is the banking system of the country. 
The total supply of money in the economy is also determined by the extent of 
credit created by the commercial banks in the country. Banks create money 
supply in the process of borrowing and lending transactions with the public. 
Money so created by the commercial banks is called 'credit money’.  The high 
powered money and the credit money broadly constitute the most common 
measure of money supply, or the total money stock of a country. (For a brief note 
on the process of creation of credit money, refer to Box 1, end of this chapter).  
The Crypto currencies face significant legislative uncertainties and are not legally 
recognized in India as currency.  Hence, these are not categorized as money.  
 2.4 MEASUREMENT OF MONEY SUPPLY  
There is virtually a profusion of different types of money, especially credit money, 
and this makes measurement of money supply a difficult task. Different countries 
follow different practices in measuring money supply.  The measures of money 
supply vary from country to country, from time to time and from purpose to 
purpose. Reference to such different measures is beyond the scope of this unit. 
Just as other countries do; a range of monetary and liquidity measures are 
compiled and published by the RBI. Money supply will change if the magnitude of 
any of its constituents changes. 
In this unit, we shall be concentrating on the Indian case only and in the following 
discussion, we shall focus on the alternative measures of money supply prepared 
and published periodically by the Reserve Bank of India.  
Since July 1935, the Reserve Bank of India has been compiling and disseminating 
monetary statistics.  Till 1967-68, the RBI used to publish only a single ‘narrow 
measure of money supply’ (M
1
) defined as the sum of currency and demand 
deposits held by the public. From 1967-68, a 'broader' measure of money supply, 
called 'aggregate monetary resources' (AMR) was additionally published by the 
RBI. From April 1977, following the recommendations of the Second Working 
Group on Money Supply (SWG), the RBI has been publishing data on four 
alternative measures of money supply denoted by M
1
, M
2
, M
3
 and M
4
 besides the 
reserve money.  The respective empirical definitions of these measures are given 
below:  
  
 
3.34 ECONOMICS FOR FINANCE 
M
1 
= Currency notes and coins with the people + demand  
deposits with the banking system (Current and Saving  
deposit accounts) + other deposits with the RBI. 
M
2
 = M1 + savings deposits with post office savings banks.  
M
3  
= M1 + time deposits with the banking system. 
M
4   
= M3 + total deposits with the Post Office Savings 
  Organization (excluding National Savings Certificates). 
The RBI regards these four measures of money stock as representing different 
degrees of liquidity. It has specified them in the descending order of liquidity, M1 
being the most liquid and M4the least liquid of the four measures. 
We shall briefly discuss the important components of each.  
• Currency consists of paper currency as well as coins. 
•  Demand deposits comprise the current-account deposits and the demand 
deposit portion of savings deposits, all held by the public. These are also 
called CASA deposits and these are cheapest sources of finance for a 
commercial bank. 
•  It should be noted that it is the net demand deposits of banks, and not 
their total demand deposits that get included in the measure of money 
supply.  The total deposits include both deposits from the public as well as 
inter-bank deposits. Money is deemed as something held by the ‘public’. 
Since inter-bank deposits are not held by the public, they are netted out of 
the total demand deposits to arrive at net demand deposits.   
• 'Other deposits’ with the RBI are its deposits other than those held by the 
government (the Central and state governments), and include demand 
deposits of quasi-government institutions, other financial institutions, 
balances in the accounts of foreign central banks and governments, and 
accounts of international agencies such as IMF and the World Bank.  
Empirically, whatever the measure of money supply, the 'other deposits' of the 
RBI constitute a very small proportion (less than one per cent) of the total money 
supply. 
Following the recommendations of the Working Group on Money (1998), the RBI 
has started publishing a set of four new monetary aggregates on the basis of the