Money is a medium of exchange, a measure of value, and a store of value as it can be saved, and a standard for deferred payments. Money is not wealth in itself but a claim on a community’s goods and services, and a means of becoming wealthy.

The ‘rupee’ is the monetary unit of India.  It is based on the decimal system.  The rupee as well as half-rupee coins are limited legal tenders^[1].   Unlimited legal tenders are Rs. 2 and other currency note, Legal tender, e.g. currency notes and coins are also called ‘Fiat Money^[2]’.

The Reserve Bank of India has the monopoly of printing currency notes.  It can print and issue currency of different denominations from two rupees notes onwards.  The Ministry of Finance, Government of India, circulates one rupee notes.  The Issue Department maintains a ‘Minimum Reserve System’, against printing notes.Since 1957, the asset of the Issue Department consists of a minimum of gold and foreign securities to the extent of Rs. 200 crore (of which gold is valued at Rs. 115 crore). The system as it exists today is known as the minimum reserve system.

External value of the rupee is fixed according to market forces and is expressed in terms of a few selected currencies like dollar, pound sterling, etc. which are called “Hard Currencies”[3].

MONEY SUPPLY

The money supply, or money stock, refers to the total amount of money held by the public at a point in time in an economy. The money supply is considered an important instrument for controlling inflation by economists who say that growth in money supply will only lead to inflation if supply remains stable.

Trade cycle: Money supply increases during boom and falls during depression.

Fiscal policy: Money supply will decrease, if the rate of taxation is high. But, when the government spends the same money on development work, the money supply will increase. The high rate of inflation in 2010 and 2011 was attributed to money spend on MGNREGA. 

In other words, deficit financing or monetized deficit also lead to increase money supply in the market, it results in higher rate of inflation.

Public Deposits: If public deposits higher portion of their income in banks, bank can expand their loan portfolio. Thus the money supply will rise. 

Monetary policy: RBI’s dear money policy (or tight money policy) will reduce the money supply in the market. RBI’s cheap money policy will increase the supply of money in the market. (discussedin detail later in the chapter).

Money supply with the public mainly consists of (i) currency and (ii) deposits. 

Currency with the public consists of currency notes plus rupees coins plus small coins minus balances held at commercial banks. 

Total deposits consist of net demand deposits of banks and other deposits with Reserve Bank.

There is no standard worldwide measure of money supply. Each country has its own set of measures, which depend on the state of development of its financial markets. And there are usually not one but a numbers of measures, each differing from the other depending on the liquidity of the monetary variables they measure.

In India there have been so far four measures of the stock of money supply.

M1 =    Currency with The Public + Demand Deposits Of The General Public With The Commercial Banks. (Narrow Money)

M2 =    M1 + Post Office Saving Deposits.

M3 =    M1 + Time Deposits With Banks. (Broad Money)

M4 =    M3 + Total Deposits With Post Office Savings Organization.

The liquidity of M1 is highestand that of M4 is lowest on a continuum.

Liquidity:  M1 > M2> M3> M4

As we know that RBI’s job is to control inflation, by controlling money supply through quantitative and qualitative tools- Repo, MSF, LAF etc (discussed later in the chapter).

For dealing with inflation, first, RBI has to make an objective assessment of “how much” money supply is there in the system? Only then RBI can make a more effective policy to control the money supply.

RBI has to control the rates of interest as well to give impetus to growth. For that also idea about money supply helps. It has been discussed later in the chapter.

RecoomendationsOf RBI Committee OnMonetary Aggregates:

The RBI committee on monetary aggregates under Mr. Y V Reddy has recommended the modification of some of these measures of money supply and suggested the addition of a few new measures of monetary liquidity. These recommendations attempt to keep pace with developments in the financial markets and are in line with changes in other countries. However, the alterations are not many and the committee has been very cautious in the change it has suggested.

Among the main Recommendations

• Exclusion of the data on post office accounts. The argument is that these deposits were included in measures of money supply at a time when the banking network was under-developed in the rural areas. Since this is no longer the case and as post offices cannot be considered “depositories” these deposits should be excluded. Accordingly, M4 will disappear.
• In order to reflect recent monetary trends, it has been suggested that the monetary measures, M2 and M3 should be altered. M2 should exclude fully repatriable bank deposits (of up to one year maturity) held by non-resident Indians. And M3 should include what the banks borrow in the call market from “non-depository” financial corporations.

Working Group recommended compilation of four monetary aggregates on the basis of the balance sheet of the banking sector in conformity with the norms of progressive liquidity: M0(monetary base), M1 (narrow money), M2 and M3 (broad money).

Weekly Compilation        

M0 =    Currency in Circulation + Bankers’ Deposits with     the RBI + ‘Other’ Deposits with the RBI         

Fortnightly Compilation             

=          Currency with the Public + Current Deposits with the Banking System+ Demand Liabilities Portion of Savings Deposits with the Banking System+ ‘Other’ Deposits with the RBI   

=          Currency with the Public + Current Deposits with the Banking System+ Savings Deposits with the Banking System + Certificates of Deposit issued         by Banks + Term Deposits of residents with a contractual maturity up to         and including one year with the Banking System (excluding CDs) + ‘Other’ Deposits with the RBI

But the above mentioned indicators are not devoid of controversies, deposits with non-banking financial companies and development financial institutions that are increasing in magnitude have been ignored and while certificates of deposit with banks are already included in M2, what about those CDs issued by development financial institutions? Shouldn’t these two categories of deposits also be considered money? The RBI committee has chosen instead to devise three new measures, not of money supply but of liquidity. This is apparently what some other countries have done. While deposits with NBFCs are numerically large, the NBFCs do not provide services similar to banks hence the exclusion of deposits with them from measures of money supply.

Liquidity Aggregates: The liquidity refers to easiness with which an asset (or even financial product such as bank deposits) can be converted into cash. Cash is the most liquid. Deposits (with banks and post offices), Marketable securitiesmay come next in the list.

The three new aggregates of liquidity suggested are:

1.         L1 =     M3 + All Deposits With Post Office Savings Banks

2.         L2 =     L1 + Fixed Deposits With Development Financialinstitutions + Certificates Of Deposit Of These Institutions

3.         L3 =     L2 + Deposits With The Nbfcs

The RBI is expected to compile estimates of these three liquidity aggregates, as it has been doing of M1, M2 and M3. The objective is to track similar and as yet distinctive measures of money. The new liquidity aggregates encompass a much broader notion of money. But it would appear that M3 would continue to be the focus of monetary policy. The RBI is to put out only monthly estimates of the three measures of liquidity while it will continue to make fortnightly compilations of M1, M2 and M3.

Impact of money supply on the economy

Theories regarding the money supply are central to macroeconomics. They are also the subject of debate between Keynesians and monetarists (economists who believe that growth in the money supply is the most important factor that determines economic growth). The classical or pre-Keynes view was that the interest rate led to a balance between savings and investment, which in turn would cause equilibrium in the goods market. Keynes disagreed and believed that the interest rate was largely a monetary phenomenon; its chief function was to balance the unpredictable supply and demand for money, not savings and investment. This view explained why the amount of savings was not always correlated with the amount of investment or the interest rate.

Keynesians and monetarists also disagree about how changes in the money supply affect employment and output. Some economists argue that an increase in the supply of money will tend to reduce interest rates, which in turn will stimulate investment and total demand. Therefore, an alternative way of reducing unemployment would be to expand the money supply. Keynesians and monetarists disagree on how successful this method of raising output would be. Keynesians believe that under conditions of underemployment, the increased spending will lead to greater output and employment. Monetarists, however, generally believe that an increase in the money supply will lead to inflation in the long run.

Reserve Money

It is the money produced by the government. (in reality by the RBI on behalf of the government) and held by the people and by the banks. It comprises of

(i)   currency held by the general public(C)

(ii)  other deposits of general public with the RBI (OD)

(iii) cash reserves of banks (CR) (Cash with the banks themselves and bank deposits with the RBI)

Rm= C+Od+Cr

The RBI can influence the volume of bank credit and bank deposits by manipulating the CR.