Money Supply refers to the total amount of money available in an economy at a particular point of time. Money supply includes currency with the public and various types of bank deposits that can be used for transactions and savings. The level and growth of money supply directly influence inflation, interest rates, economic growth, and financial stability, which is why central banks like the Reserve Bank of India (RBI) closely monitor and regulate it.
Meaning and Concept of Money Supply
Money supply represents the stock of money in circulation in the economy. It includes all financial assets that are generally accepted as a medium of exchange and can be easily used to make payments. From an exam perspective, it is important to note that money supply is a stock concept, not a flow concept. This means it is measured at a particular point in time, such as at the end of a month or a year, and not over a period.
In India, money supply mainly consists of:
- Currency with the public, which includes coins and paper notes issued by the RBI.
- Demand deposits with banks, such as savings and current account balances, which can be withdrawn on demand through cheques, ATMs, or digital modes.
The definition of money supply depends on how broad or narrow we consider money to be. Therefore, economists and central banks classify money supply into different measures based on liquidity.
Measures of Money Supply in India
The RBI uses different monetary aggregates to measure money supply. These aggregates differ in terms of liquidity and usage.
Narrow Money (M1) is the most liquid form of money. It includes currency with the public, demand deposits with banks, and other deposits with the RBI. M1 is mainly used for day-to-day transactions and reflects the immediate purchasing power in the economy.
M2 includes M1 plus savings deposits with post offices. Although post office savings are not as liquid as bank demand deposits, they are still easily accessible and widely used by households.
Broad Money (M3) is the most important measure of money supply in India from an exam and policy perspective. It includes M1 plus time deposits with banks, such as fixed deposits. M3 represents the total money available in the economy for spending and investment. RBI uses M3 as the main indicator while formulating monetary policy.
M4 includes M3 plus total deposits with post offices. It is the broadest measure of money supply but is less commonly used for policy analysis.
It is crucial to remember that RBI focuses mainly on M3 while analysing monetary conditions.
Determinants of Money Supply
Money supply in an economy is influenced by both the central bank and the banking system. The RBI plays a key role by controlling the supply of base money, also known as high-powered money. High-powered money includes currency issued by the RBI and reserves held by commercial banks with the RBI.
Commercial banks also influence money supply through the process of credit creation. When banks accept deposits and give loans, they create additional money in the form of bank deposits. The extent of credit creation depends on factors such as:
- Cash Reserve Ratio (CRR), which determines how much banks must keep with the RBI.
- Statutory Liquidity Ratio (SLR), which requires banks to hold a certain portion of deposits in safe liquid assets.
- Public’s preference to hold cash versus deposits.
- Banks’ willingness to lend and overall credit demand in the economy.
A lower CRR and SLR generally increase banks’ lending capacity and expand money supply, while higher ratios restrict credit and reduce money supply growth.
Role of RBI in Controlling Money Supply
The RBI regulates money supply to achieve its objectives of price stability, economic growth, and financial stability. It uses various quantitative and qualitative monetary policy tools.
Quantitative tools include repo rate, reverse repo rate, open market operations (OMOs), CRR, and SLR. For example, when RBI wants to reduce excess money supply and control inflation, it may increase repo rate or CRR, making borrowing costlier and reducing credit creation. To increase money supply during economic slowdown, RBI may cut interest rates or inject liquidity through OMOs.
Qualitative tools such as selective credit controls are used to regulate credit to specific sectors, thereby indirectly influencing money supply and allocation of resources.
Importance of Money Supply in the Economy
Money supply has a direct impact on inflation. Excessive growth in money supply without a corresponding increase in goods and services leads to inflation. On the other hand, inadequate money supply can result in deflation, reduced economic activity, and unemployment.
Money supply also affects interest rates and investment. An increase in money supply generally leads to lower interest rates, encouraging borrowing and investment. This supports economic growth. However, if not properly managed, it can create asset price bubbles and financial instability.