Various measures of money supply published by the Reserve Bank of India!

Money is something measurable. Once we have settled on a theoretical definition of money, we can identify empirically the things that serve as money in an economy. Then, the total stock of moneys of various kinds at a particular point of time can be computed. By repeated measurements at different points of time, a whole time series of money supply can be constructed.

This will show the time behaviour of money supply. Coupled with other data and helped by theory, this information can be used to throw light on the effect of changes in the supply of money on several key variables such as income, prices, wages, employment, rate of interest, balance of payments, etc., and how to control changes in the supply of money to attain certain policy goals.

At the outset, we must note two things about any measure of money supply. First that, the supply of money refers to its stock at any point of time. This is because money is a stock variable in contrast with a flow variable, such as real income, which refers to its rate per unit time (say, per year). It is the change in the stock of money (say) per year, which is a flow.

Second, the stock of money always refers to the stock of money held by the public. This is always smaller than the total stock of money in existence. The term public is defined to include all economic units (households, firms and institutions) except the producers of money (such as the government and the banking system). For the most common definition of money, the government means the Central Government plus all state governments: the banking system means the RBI plus all banks which accept demand deposits.

This means that the word public is inclusive of all local authorities, non-bank financial institutions, and non-departmental public-sector undertakings (such as Hindustan Steel. Indian Airlines, etc.) and even the foreign central banks and governments and the International Monetary Fund who hold a part of Indian money in India in the form of deposits with the RBI. In other words, in the standard measures of money, money held by the government and the banking system is not included.

The primary reason for measuring the stock of money in this way is that this separates the producers or the suppliers of money from the holders or the

demanders of it. For both monetary analysis and policy formulation, such a separation is essential.

The measurement of money supply is an empirical matter. We study the various measures of money supply published by the RBI. Till 1967-68 the RBI used to publish only a single measure of money supply (M) defined as the sum of currency and demand deposits, both held by the public.

Following convention, we call it the narrow measure of money supply. From 1967-68 the RBI started publishing additionally a ‘broader’ measure of money supply, called ‘aggregate monetary resources’ (AMR). It was defined empirically as money narrowly defined plus the time deposits of banks held by the public. From April 1977 yet another change was introduced. Since then the RBI has been publishing data on four alternative measures of money supply in place of the earlier two. The new measures are denoted by M1, M2, M3 and M4. The two earlier measures were represented by M and AMR.

The respective empirical definitions of these measures are given below:

M or M1 = C + DD + OD.

M2 = M1+ savings deposits with post office savings banks,

AMR or M3 = M1+net time deposits of banks,

M4 = M3 + total deposits with the Post Office Savings Organization (excluding National Savings Certificates).

In the above definitions,

C = currency held by the public,

DD = net demand deposits of banks,

OD = ‘other deposits’ of the RBI.

The contents of each of the components of M to M4 are explained briefly below:

Currency consists of paper currency as well as coins. Paper currency is predominant in the form of Reserve Bank of India currency notes of the denomination of rupees two and above (rupees five, ten, twenty, fifty, and one hundred notes). In addition, we also have small amounts of Government of India rupee one notes.

Though made of paper, they are counted as rupee one coins. Together with rupee one coin and other small coins, they constitute the small-corns component of money supply. They are direct monetary liability of the Government of India. However, they are put into circulation by the RBI as the agent of the Central Government. The RBI does this by holding stocks of government currency on hand and by maintaining full convertibility of this currency into the rest of the country’s currency and vice versa.

We have already explained in the previous section the meaning, nature and the composition of demand deposits. What get included in any measure of money supply are the net demand deposits of banks, and not their total demand deposits. This is because we have defined money (and any one of its components) as something held by the ‘public’ only and total deposits include both deposits from the public and inter-bank deposits.

The latter are deposits which one bank holds with others. Since they are not held by the public, they are netted out of the total demand deposits to arrive at net demand deposits. We may remind the readers that demand deposits comprise the current- account deposits and the demand deposit portion of savings deposits, all held by the public.

‘Other deposits’ of the RBI are its deposits other than those held by the government (the Central and state governments), banks, and a few others. They include demand deposits of quasi-government institutions (like the IDBI), foreign central banks and governments, the IMF and the World Bank, etc. Empirically, whatever the measure

of money supply, these ‘other deposits’ of the RBI constitute a very small proportion (less than one per cent) of the total money supply. Therefore, no harm will be done, if in our future discussion we ignore these ‘other deposits.’

The following additional points about the new measures of money-supply vis-a-vis the old measures need to be noted:

(1) M is only a revised measure of M the RBI’s old measure of money supply. The revision is not conceptual, but only in terms of coverage. The new series gives a better coverage of the co-operative banking sector. Formerly, only the demand liabilities of the State co-operative banks were included in money supply.

Other tiers of the co-operative banking sector were neglected on account of the non-availability of data. In the new series net (i.e., excluding inter-bank) demand deposits of State co-operative banks. Central co-operative banks and a segment of primary co-operative banks consisting of (i) urban co-operative banks and (ii) salary earners’ credit societies are included. Similarly, M3 is the revised version of the series on AMR with extended coverage for the co-operative banking sector.

(2) The new series M2 and M4 have been devised to accommodate Post Office deposits. We have already explained the nature of these deposits in the previous section.

(3) The RBI views the four new measures of money stock to represent different degrees of liquidity. It has specified them in the descending order of liquidity, M1 being the most liquid and M4 the least liquid of the four measures.

Which of the alternative measures of money supply to choose and why? We cannot attempt an answer here, as it will involve going into questions to monetary theory, policy, and empirical testing. It should suffice to say at this state that the most common measure of money supply is that provided by M or M1.

Demand for Money or Motives for Liquidity Preference: Keynes’s Theory:

Liquidity preference of a particular individual depends upon several considerations.

The question is: Why should the people hold their resources liquid or in the form of ready money when he can get interest by lending money or buying bonds?

The desire for liquidity arises because of three motives:

(i) The transactions motive,

(ii) The precautionary motive, and

(iii) The speculative motive.

The Transactions Demand for Money:

The transactions motive relates to the demand for money or the need for money balances for the current transactions of individuals and business firms. Individuals hold cash in order “to bridge the interval between the receipt of income and its expenditure”.

In other words, people hold money or cash balances for transactions purposes, because receipt of money and payments do not coincide. Most of the people receive their incomes weekly or monthly while the expenditure goes on day by day.

A certain amount of ready money, therefore, is kept in hand to make current payments. This amount will depend upon the size of the individual’s income, the interval at which the income is received and the methods of payments prevailing in the society.

The businessmen and the entrepreneurs also have to keep a proportion of their resources in money form in order to meet daily needs of various kinds. They need money all the time in order to pay for raw materials and transport, to pay wages and salaries and to meet all other current expenses incurred by any business firm. It is clear that the amount of money held under this business motive will depend to a very large extent on the turnover (i.e., the volume of trade of the firm in question).

The larger the turnover, the larger, in general, will be the amount of money needed to cover current expenses. It is worth noting that money demand for transactions motive arises primarily because of the use of money as a medium of exchange (i.e. means of payment).

Since the transactions demand for money arises because individuals have to incur expenditure on goods and services during the receipt of income and its use of payment for goods and services, money held for this motive depends upon the level of income of an individual.

A poor man will hold less money for transactions motive as he spends less because of his small income. On the other hand, a rich man will tend to hold more money for transactions motive as his expenditure will be relatively greater.

The demand for money is a demand for real cash balances because people hold money for the purpose of buying goods and services. The higher the price level, the more money balances a person has to hold in order to purchase a given quantity of goods.

If the price level doubles, then the individual has to keep twice the amount of money balances in order to be able to buy the same quantity of goods. Thus the demand for money balances is demand for real rather than nominal balances.

According to Keynes, the transactions demand for money depends only on the real income and is not influenced by the rate of interest. However, in recent years, it has been observed empirically and also according to the theories of Tobin and Baumol transactions demand for money also depends on the rate of interest.

This can be explained in terms of opportunity cost of money holdings. Holding one’s asset in the form of money balances has an opportunity cost. The cost of holding money balances is the interest that is foregone by holding money balances rather than other assets. The higher the interest rate, the greater the opportunity cost of holding money rather than non-money assets.

Individuals and business firms economise on their holding of money balances by

carefully managing their money balances through transfer of money into bonds or short-term income yielding non-money assets. Thus, at higher interest rates, individuals and business firms will keep less money holdings at each level of income.

Precautionary Demand for Money:

Precautionary motive for holding money refers to the desire of the people to hold cash balances for unforeseen contingencies. People hold a certain amount of money to provide for the danger of unemployment, sickness, accidents, and the other uncertain perils. The amount of money demanded for this motive will depend on the psychology of the individual and the conditions in which he lives.

Speculative Demand for Money:

The speculative motive of the people relates to the desire to hold one’s resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or bond prices). The notion of holding money for speculative motive was a new and revolutionary Keynesian idea.

Money held under the speculative motive serves as a store of value as money held under the precautionary motive does. But it is a store of money meant for a different purpose. The cash held under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate.

If bond prices are expected to raise which, in other words, means that the rate of interest is expected to fall, businessmen will buy bonds to sell when their prices actually rise. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, businessmen will sell bonds to avoid capital losses. Nothing is certain in the dynamic world, where guesses about the future course of events are made on precarious basis businessmen keep cash to speculate on the probable future changes in bond prices (or the rate of interest) with a view to making profits.

Given the expectations about the changes in the rate of interest in future, less money will be held under the speculative motive at a higher current rate of interest and more money will be held under this motive at a lower current rate of interest.

The reason for this inverse correlation between money held for speculative motive and the prevailing rate of interest is that at a lower rate of interest less is lost by not lending money or investing it, that is, by holding on to money, while at a higher current rate of interest holders of cash balance would lose more by not lending or investing.

Thus the demand for money under speculative motive is a function of the current rate of interest, increasing as the interest rate falls and decreasing as the interest rate rises. Thus, demand for money under this motive is a decreasing function of the rate of interest

Till 1978 the RBI also used to concentrate most of its accounting analysis on this narrow measure of money supply. But things have changed since. Due to the introduction of a change in 1978 in the division of savings deposits of banks as between demand deposits and time deposits, the data on M1 for post-1978 years are no longer comparable with those for the previous years.

So, the RBI has shifted its accounting analysis of changes m money supply in terms of M3. But whatever the measure of money supply used, one thing clearly stands out about its time profile in India that its rate of growth has accelerated over time. Thus in the case of M1 (narrow definition), the annual average rate of growth was 3.6% during the 1950s, 7.6% during the 1960s, 11.75% in the 1970s and 13.16% in the 1980s. The corresponding rates of growth for M3 (broad definition of money) were 6%, 8.9%, 14.7% and 14.7%, respectively.

At this stage we do not have any basis to either explain the sources of increase in M (or M1) or AMR (or M3) or to evaluate such increases as socially beneficial or injurious. But they are very important questions of monetary theory and policy; we shall take them up in Parts Two and Three

Four Measures of Money Supply in India (523 Words)

Some of the important measures of money supply in India are as follows:

There are four measures of money supply in India which are denoted by M1, M2, M3 and M4. This classification was introduced by the Reserve Bank of India (RBI) in April 1977. Prior to this till March 1968, the RBI published only one measure of the money supply, M or defined as currency and demand deposits with the public. This was in keeping with the traditional and Keynesian views of the narrow measure of the money supply.

Money

From April 1968, the RBI also started publishing another measure of the money supply which it called Aggregate Monetary Resources (AMR). This included M1 plus time deposits of banks held by the public. This was a broad measure of money supply which was in line with Friedman’s view. But since April 1977, the RBI has been publishing data on four measures of the money supply which are discussed as under.

M1. The first measure of money supply, M1 consists of:

(i) Currency with the public which includes notes and coins of all denominations in circulation excluding cash on hand with banks:

(ii) Demand deposits with commercial and cooperative banks, excluding inter-bank deposits; and

(iii) ‘Other deposits’ with RBI which include current deposits of foreign central banks, financial institutions and quasi-financial institutions such as IDBI, IFCI, etc., other than of banks, IMF, IBRD, etc. The RBI characterizes as narrow money.

M2. The second measure of money supply is M2 which consists of M1 plus post office savings bank deposits. Since savings bank deposits of commercial and cooperative banks are included in the money supply, it is essential to include post office savings bank deposits. The majority of people in rural and urban India have preference for post office deposits from the safety viewpoint than bank deposits.

M3. The third measure of money supply in India is M3, which consists of M1, plus time deposits with commercial and cooperative banks, excluding interbank time deposits. The RBI calls M3 as broad money.

M4. The fourth measure of money supply is M4 which consists of M3 plus total post office deposits comprising time deposits and demand deposits as well. This is the broadest measure of money supply.

Of the four inter-related measures of money supply for which the RBI publishes data, it is M3 which is of special significance. It is M3 which is taken into account in formulating macroeconomic objectives of the economy every year. Since M1 is narrow money and includes only demand deposits of banks along-with currency held by the public, it overlooks the importance of time deposits in policy making. That is why, the RBI prefers M3 which includes total deposits of banks and currency with the public in credit budgeting for its credit policy. It is on the estimates of increase in M3 that the effects of money supply on prices and growth of national income are estimated. In fact is an empirical measure of money supply in India, as is the practice in developed countries. The Chakravarty Committee also recommended the use of M3 for monetary targeting without any reason.

Money Creation (Credit Creation) in Commercial Banks

Money Creation (Credit Creation) in Commercial Banks!

It is one of the most important activities of commercial banks. Through the process of money creation, commercial banks are able to create credit, which is in far excess of the initial deposits.

This process can be better understood by making two assumptions:

(i) The entire commercial banking system is one unit and is termed as ‘Banks’.

(ii) All receipts and payments in the economy are routed through the Banks, i.e. all payments are made through cheques and all receipts are deposited in the banks. The deposits held by Banks are used for giving loans. However, banks cannot use the whole of deposit for lending.

It is legally compulsory for the banks to keep a certain minimum fraction of their deposits as reserves. The fraction is called the Legal Reserve Ratio (LRR) and is fixed by the central bank. Banks do not keep 100% reserves against the deposits. They keep reserves only to the extent indicated by the Central Bank.

Why only Fraction of deposits is kept as Cash Reserves?

Banks keep a fraction of deposits as Cash Reserves because a prudent banker, by his experience, knows two things:

(i) All the depositors do not approach the banks for withdrawal of money at the same time and also they do not withdraw the entire amount in one go.

(ii) There is a constant flow of new deposits into the banks.

So, to meet the daily demand for withdrawal of cash, it is sufficient for banks to keep only a fraction of deposits as cash reserve. It means, if experience of the banks show that withdrawals are generally around 20% of the deposits, then it needs to keep only 20% of deposits as cash reserves (LRR).

Let us now understand the process of Money Creation through an example:

1. Suppose, initial deposits in banks is Rs 1,000 and LRR is 20%. It means, banks are required to keep only Rs 200 as cash reserve and are free to lend Rs 800. Suppose they lend Rs 800. Banks do not lend this money by giving amount in cash. Rather, they open the accounts in the names of borrowers, who are free to withdraw the amount whenever the like.

2. Suppose borrowers withdraw the entire amount of X 800 for making payments. As all the transactions are routed through the banks, the money spent by the borrowers comes back into the banks in the form of deposit accounts of those who have received this payment. It will increase the demand deposits of banks by X 800.

3. With new deposits of X 800, banks keep 20% as cash reserves and lend the balance Rs 640. Borrowers use these loans for making payments, which again comes back into the accounts of those who have received the payments. This time, banks deposits rise by Rs 640.

4. The deposits keep on increasing in each round by 80% of the last round deposits. At the same time, cash reserves also go on increasing, each time by 80% of the last cash reserve. Deposit creation comes to end when total cash reserves become equal to the initial deposit.

Refer the following table:

Deposits

Rs

Loans

Rs

Cash Reserves

(LRR = 20%)

Initial Deposit

Round I

Round II

-

-

-

1,000

800

640

-

-

-

800

640

512

-

-

-

200

160

128

-

-

-

Total

5,000

4,000

1,000

As seen in the table, banks are able to create total deposits of Rs 5,000 with the initial deposit of just X 1,000. It means, total deposits become ‘five times’ of the initial deposit. Five times is nothing but the value of ‘Money Multiplier’.

Money Multiplier:

Money Multiplier or Deposit multiplier measures the amount of money that the Banks are able to create in the form of deposits with every unit of money it keeps as reserves.

It is calculated as:

Money Multiplier = 1/LRR

In the given example, LRR is 20% or 0.2. So,

Money Multiplier = 1/0.2 = 5

It signifies that for every unit of money kept as reserves, banks are able to create 5 units of money. The value of money multiplier is determined by LRR. Higher the value of LRR, lower is the value of money multiplier and less money is created by the banking system.