Supply of Money

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Supply of Money – Definition, Explanation and FAQs

Money is the most liquid asset of all. It represents the prime form of a capital asset. Money is accepted as a means of exchange or as a measurement of the value of goods. It is fascinating to imagine a world where the money wouldn't exist.

Supply of money, on the other hand, is a different concept. It is a concept of stocks and shares and is usually perceived in terms of the cumulative effect of the amount of currency that the citizens have and the demand deposits available with the banks of a country.

Understanding the fundamentals of money supply and money demand helps get an idea regarding the country's financial status and the fluidity of the country's currency. In this section, we shall talk about the supply of money, its meaning, components, and the various methods that are involved in the money supply.

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Money Supply: Definition

The concept of money supply can be defined as the total quantity of currency that can be included in a nation's economy. Money supply includes the total money both in the form of cash as well as deposits that can be used as cash easily.

The money supply economics is associated with the government's direct power as it is the government that issues currency either in paper form or in the form of a coin as a combination of treasuries bills and demand drafts of banks. Similarly, the banks also have control over the money supply, and they exert such influence through reserves and credit controls.

Money supply has a major impact on the economy of a country. The inflation of prices of commodities, their demand and supply change the supply of money. In economics, money supply plays a role in the interest rates and cashflow prevalent throughout the country.

It is important to note here that the money supply does not include the stock of money held by the government or the money under the possession of the banks. These institutions serve as the suppliers of money or are involved in the production of money rather than being a part of the money supply. The term money supply refers only to that share of capital or cash that is governed by the people of the country.

Effect of Money Supply on the Economy:

The money supply, meaning the total cash present under a nation's economy, is bound to influence the economics of the market. Therefore, any change in the demand and supply of money will result in a consequent change in the market.

A rise in the money supply will reveal its effect by decreased interest rates and price values of commodities and services. Whereas a decrease in money supply will result in increased interest rates, price values with a coupled increase in banks' reserves.

An effect similar to this occurs on the business as well. As the price levels lower due to increased money supply, the production in business will increase to accommodate people's increased spending. Thus, the money supply and money demand directly impact the macroeconomics of a nation's market.

Components of the Money Supply:

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Two components of the money supply regulate its structure and flow. These are:

  1. Currency:

Currency forms a major part of the money supply of a nation. As discussed before, the government produces currency in two forms, i.e., coins and paper currency. Thus, money supply through currency can also be divided into:

  • Paper Currency/ Notes: The production of currency notes is under the control of the government as well as the reserve bank of India. In the country, only one-rupee paper currency is produced by the government, while RBI produces all the other currency notes.

  • Coins: The second form of currency in India, the coins, are produced in two variants viz token coins and the standard coins characterized as full-bodied coins. The full-bodied currency coins are of little value today under the current currency system. The token coins represent the value of 50 paise and 25 paise.

Did You Know?

The 1-rupee coin available in India does not fall in either category of full-bodied or token. 

  1. Demand Deposits:

The demand deposits are a part of commercial banks and are used as a non-confidential fund. These accounts are considered money when included under the economy of a country. Such deposits' working mechanism is similar to that of a checking account where withdrawals from the fund can be made without notice.

Different Measures of Money Supply:

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After getting an idea about the concept of money supply, we shall now understand the different methods used to measure India's supply of money.

As mentioned before, money production is largely governed by the Reserve Bank of India or RBI. Therefore, it is the RBI that is responsible for the measures of the money supply.

There are four types of methods used by RBI to measure the supply of money in India. Let's take them one by one:

  • The first measure is denoted as M1, and it is represented as the formula.

M1 = C + DD + OD

Where C represents the currency, including both paper currency and coins.

DD represents the demand deposits made in the banks.

OD represents the other types of deposits made in RBI, like deposits from public sector financing, foreign banks, or international institutions such as the IMF.

  • The next measure under the RBI approach to the money supply is denoted as M2. Under the first approach, the deposits made in a savings account are not included as money supply. The second methods compensate this by adding the savings account. Thus, 

M2 = M1 + deposits made as savings deposits in Post office savings banks.

  • The third method under the RBI approach of money supply includes the net deposits made under a specified period with the banks. It includes the normal money supply and net deposits.

M3 = M1 + Net Time-deposits included in banks.

  • The final measure of money supply included under RBI guidelines accumulates Post office savings banks' deposits and the total deposits except those from National Saving Certificate. Thus, 

M4 = M3 + Deposits made with Post-office savings institute.

The concept of money supply still has certain elements that need to be explored. This mainly includes figuring out what can be treated as 'money' and what can't. For example, commercial banks' fixed deposits are not treated as 'money' under money supply. In contrast, the savings deposits made under the Post office savings bank cannot be counted as money because they lack exchange via cheque and face no liquidity.

Thus, M1 is the most liquid measure of the money supply, as it only includes currency and demand deposits. The M1 and M2 are considered narrow money supply measures, and M3 and M4 measure the broad money by including other forms of savings.

FAQ (Frequently Asked Questions)

1. State the Components of the Money Supply.

Ans: Money supply measures the quantity of money available to the people of a country and the money that can be included under a nation's economy. The supply of money is comprised of two components that include currency and demand deposits available with banks. The currency is produced in two forms, which include paper currency as well as coins. The other component of the money supply is the demand deposits, which are basically accounts in banks where funds withdrawal can be made without notice. The demand deposits of most banks are often attached to the current account. These components of the money supply are used to determine the cash flow and cash availability among the people.

2. Explain the Concept of the Money Supply.

Ans: Money supply refers to the total money or capital that is present with the nation's economy on the day of measurement. It includes both currencies, as well as demand deposits, as both of these components make up the most liquid form of the money supply. The other forms of deposits, such as savings and fixed deposits, are not considered as money as they lack liquidity. The measurement of the money supply is important because the money supply determines the financial health of a country. The RBI has four methods of measuring money supply in India that include methods of monetary aggregation and measures of both broad and narrow money.