Measures of Money Supply in India

Understanding the money supply is crucial because it directly impacts inflation, interest rates, and economic growth. The money supply is measured using various aggregates, denoted as M1, M2, M3, etc. The choice of measure depends on whether they want to focus on the most liquid and spendable forms of money (like M1) or include less liquid assets (like M2 and M3) to get a broader view of how money flows through the economy. Each measure provides unique insights, from the most accessible cash for daily transactions to broader assets that reflect long-term financial stability. Let us explore more about the measures of money supply in our blog.

What is Money Supply?

Money supply refers to the total amount available in the country's economy at any time. It includes all the cash, coins, and easily accessible deposits that individuals and businesses can use for spending or saving.

Central banks have the power to influence the money supply through their monetary policies, and they use this control to achieve specific economic goals. In India, the management of the money supply is primarily overseen by the Reserve Bank of India (RBI), India's central bank. The RBI ensures the money supply is controlled effectively to maintain economic stability.

There are three essential tools that the Reserve Bank of India uses to regulate the money supply:

1. Open Market Operations (OMO): OMO involves the buying and selling government securities in the financial market. When the RBI buys government securities, it injects money into the economy, increasing the money supply. Conversely, it absorbs money from the economy when it sells government securities, reducing the money supply.
2. Cash Reserve Ratio (CRR): CRR is the portion of deposits banks must keep with the RBI as a reserve. By adjusting the CRR, the RBI can control the money banks have available for lending. Lowering the CRR increases the money available for lending while raising it reduces the money supply.
3. Repo Rate and Reverse Repo Rate: These are interest rates at which banks can borrow money from the RBI. When the RBI reduces the repo rate, it becomes cheaper for banks to borrow money, encouraging them to lend more to the public. This increases the money supply. Conversely, raising the repo rate makes borrowing more expensive, which can reduce the money supply.

Elements of Money Supply

The money supply includes all the money available in an economy for transactions. Here are the main elements that make up the money supply in an economy:

Currency

• Coins: Metallic money used in daily transactions.
• Paper Money: Banknotes issued by the government or central bank.

Demand Deposits

• Checking Accounts: Bank accounts where money can be withdrawn per the customer's requirement.
• Savings Accounts: Accounts with some restrictions but can be easily converted into cash.

Time Deposits

• Fixed Deposits (FDs): Money kept in the bank for a set time at a fixed interest rate.
• Recurring Deposits (RDs): Regular deposits made into an account over time.

Other Liquid Assets

• Savings Bonds: Bonds from the government that can be cashed in.
• Money Market Accounts: Accounts offering higher interest rates with limited withdrawals.

Measures of Money Supply

The measures of money supply, often denoted as M1, M2, M3, etc., represent different categories of money within an economy, each including varying degrees of liquidity and accessibility. Central banks and economists use these measures to analyse and track the money supply in an economy. Here's an explanation of the most commonly used measures:

1. M1 (Narrow Money)

M1 represents the narrowest measure of the money supply and includes the most liquid assets readily available for spending. M1 is calculated based on the below formula -

M1 = C+ D + CB

Where,

• Currency in Circulation (C): This is all the daily physical money, like coins and banknotes, held by individuals, businesses, and banks in circulation within the economy. It's the money you can touch and spend. Imagine the cash in your wallet or purse; that's a part of the currency in circulation.
• Demand Deposits (D): Demand deposits are like checking accounts at your bank. These accounts are super convenient because you can take money from them whenever possible. It's your everyday account for paying bills, buying things, and withdrawing cash from ATMs.
• Other Deposits with the Central Bank (CB): This is more complex. Commercial banks (the banks you and I use) must keep some of their money in an account with the central bank (like the Reserve Bank of India). While not directly accessible to the public, this is an integral part of the money supply. It ensures that banks can meet their financial responsibilities and helps keep the financial system stable.

M1 focuses on the most easily spendable forms of money, making it a crucial indicator for short-term economic analysis and monetary policy decisions.

2. M2 (Broad Money)

M2 is a broader measure of the money supply than M1. It includes all the components of M1 plus some additional assets that are less liquid but can still be quickly converted into cash. The M2 formula is - 

M2 = M1 + S + T + SD + MMMFs

Where,

• M1: Discussed above
• Savings Deposits (S): These are accounts where individuals and businesses save money, usually earning some interest. They are less liquid than demand deposits, but you can easily access them.
• Time Deposits (T): Also known as certificates of deposit (CDs), these accounts require depositors to keep their money with the bank for a specified period at a fixed interest rate. At the same time, less liquid than demand and savings deposits can still be converted into cash with a penalty.
• Small Denomination Time Deposits (SD): SDs are a special type of bank account where you deposit money for a fixed period. They work like regular time deposits (or certificates of deposit), but they have a smaller minimum deposit amount.
• Money Market Mutual Funds (MMMFs): These mutual funds invest in short-term, low-risk securities. They offer a way to earn interest on savings while maintaining a degree of liquidity.

M2 encompasses a broader range of less liquid assets than M1 components but still affects the overall money supply.

3. M3 (Broadest Money)

M3 is an even broader measure of the money supply that includes all the components of M2 plus additional assets that are even less liquid. The formula to calculate M3 is as follows - 

M3 = M2 + L + RPs + IMMMFs

Where,

• M2: Discussed above
• Large Time Deposits (L): Large Time Deposits are similar to regular time deposits but involve more significant sums of money. These deposits require account holders to keep their money with a bank for a specified period at a fixed interest rate. While they offer higher interest rates compared to more liquid accounts, they are less accessible without incurring penalties.
• Repurchase Agreements (RPs): Repurchase Agreements, or repos, are short-term financial agreements. In a repo transaction, one party (a financial institution or a dealer) sells securities (such as government bonds) to another party (often a central bank or another financial institution) with an agreement to repurchase the same securities at a specified future date. RPs are commonly used in money markets to manage short-term liquidity.
• Institutional Money Market Mutual Funds (IMMMFs): IMMMFs are designed for institutional investors, such as corporations, pension funds, or other large entities. These funds invest in short-term, low-risk securities like Treasury bills and commercial paper. These funds allow institutions to earn interest on their short-term cash holdings while maintaining a degree of liquidity.

M3 provides a comprehensive view of the money supply, including less liquid assets than M2.

4. M4 and beyond

Some countries or economists may create additional measures like M1, M2, and M3. These measures expand the money supply to include even more financial assets.

For example, M4 might include longer-term deposits, foreign currency deposits, and certain types of bonds. 

These measures can vary from country to country and are often used for specialised analysis.

M4 = M3 + Total Deposits with Post Office Savings.

Think of it as having different categories to understand all the different forms of money and financial assets within an economy. These categories help policymakers and economists understand the financial landscape and how money is used differently.

Conclusion

A higher money supply can result in a depreciation in currency, which is often accompanied by an increase in the price level of goods and services. The quantity theory of money postulates that, as the quantity of money supplied interacts with its velocity, the number of transactions in the economy and the overall price level are interrelated. This theory suggests that the more money there is in circulation, the higher the prices.

Measures of money supply, such as M1, M2, and M3, play a crucial role in understanding the various forms of money and financial assets within an economy. By categorising money into different measures based on its level of liquidity, we gain insights into how easily individuals and businesses can access funds for spending, saving, and investing. These measures are valuable tools for analysing and managing an economy's overall health and stability.

Explore these online degree programmes–