1. Prologue
  2. Factors affecting money supply
  3. WHY should we measure money supply?
  4. M0: Reserve money
  5. M1: Narrow Money
  6. M2
  7. M3 (Broad Money)
  8. M4
  9. Liquidity and ranking
  10. Money multiplier
  11. Velocity of money circulation
  12. Factors affecting Velocity of money circulation
  13. Assertion reasoning type Question

Prologue

Chapter 4: Prices and Monetary Management. FIVE subparts

  1. Inflation indexed bonds
  2. measures of money supply
  3. Monetary policy trends, RBI restructuring
  4. Indexes’ Theory: WPI, CPI, IIP, Services index and others
  5. Indexes’ Current: Survey observations on WPI, CPI & IIP, How to combat inflation

Factors affecting money supply

 

List not exhaustive
Season Nov to April: crops harvest. Industries buy their raw material = money supply rise
Trade cycle
  • Boom: money supply increases
  • Depression: money supply falls
Fiscal policy
  • Money supply will decrease IF:  higher Taxation and sale of G-sec.
  • But, when Government spends the same money=> money supply will increase => inflation. (e.g. MNREGA)
  • In other words, deficit financing = inflation; bigger fiscal deficit => inflation
Junta’s choice Junta deposits higher portion of their income in banks => bank can expand loans => money supply rises
Monetary policy
  • RBI’s dear money policy (or Tight money policy)=> supply down
  • RBI’s cheap money policy=> supply rise.

WHY should we measure money supply?

  • So far we learned, what factors affect the money supply.
  • We also know that RBI’s job is to control inflation, by controlling money supply through quantitative and qualitative tools- Repo, MSF, LAF etc. Make sure you’ve read the basics CLICK ME.
  • But for that, first, RBI has to make an objective assessment of “how much” money supply is there in the system? Only then Rajan can make a rational policy to control the money supply. Therefore, they came up with following system:
Table not important, except for RBI interviews
Upto 1967 Just “M” = money with public + junta’s demand deposits in banks. (Current account and savings account, CASA)
Upto 1977 Aggregate monetary resource (AMR)

  1. Coins and currency
  2. Time Deposits (e.g. Fixed deposit, recurring deposits)
  3. Demand deposits (CA, SA)
From 77 onwards present system M0, M1, M2, M3, M4

M0: Reserve money

  • M0 is the base for creating Broad money supply (M3). HOW? Technical explanation given in class12 Macroeconomics page 39 to 44 but cost : benefit not that great.
  • PS: NCERT uses the term High powered money. According to Nadar’s Banking book: M0 = Reserve money = High powered money.
  • Anyways, M0 is the sum of following components:
Numbers not important, just for illustration
Components Billion Rupees in Aug’2014
i) Currency in Circulation 13610
ii) Bankers’ Deposits with RBI 3567
iii)’Other’ Deposits with RBI 97
Total M0: Reserve Money 17274

M1: Narrow Money

Measures of Money supply M1 M2 M3 M4 broad money narrow money

M1 includes Excludes
  1. Currency with public
  2. Demand deposit in all banks (e.g. current account, savings account)
  3. Other deposits with RBI
  • India’s deposits with IMF, World bank, Foreign Government etc.
  • Interbank deposits

M2

  • M2= M1 + Post office bank savings*
  • *Similar to regular banks, Post office also offers their time savings account, recurring deposit account, time deposit account. Here we count the Post office savings (=”DEMAND deposit” type) only.

M3 (Broad Money)

  • also called Money aggregate
  • M3 = M1 + Time deposits with commercial banks (Fixed deposits, Recurring deposits).
  • MIND IT: M3= M1+time and NOT M3=M2+time.
Here is real data from RBI:
As of August 2014 Billion Rupees
Currency with public 13003.9
Bank’s Demand deposits 8142.3
Bank’s Time deposits 77963.5
other deposits with RBI 96.2
Total M3 (Broad Money) 99205.8

Numbers not important but interpretation is:

  1. Banks receive more money in TIME deposits than in Demand deposits.
  2. If Banks received more money in  Demand deposits [current account-savings account (CASA)], They’ve to pay less interest (0% and 4%) compared to Time deposits [e.g.Fixed deposits (9%)] = cheaper raw material (money) for loaning to others @13-18% and earning big margin.
  3. Banks have more money >> than with currency with juntaa.

M4

  • M4= M3 + total post office deposits.*
  • *meaning those Post Office “time deposits” and “recurring deposits” also. But excludes national savings certificate etc.

Liquidity and ranking

NAME TYPE LIQUIDITY*
M1 Narrow money highest
M2 Narrow money less than M1
M3 Broad money less than M2
M4 Broad money lowest liquidity
  • *liquidity in the sense the how quickly you can get”Value” into cash.
  • M4 has variety of “TIME DEPOSITS” (Fixed deposits etc) so you can visualize it takes time to “BREAK” those deposits and takeout cash. Hence lowest liquidity among the given.

Money multiplier

  • It is the ratio of Broad money (M3) divided by Reserve Money (M0)
  • Therefore, Broad money (M3) = Reserve Money (M0) x money multiplier
  • In other words, when Reserve money increases, Broad money will also increase. (Direct correlation).
  • For 2013-14, Money multiplier was 5.5.

Just for conceptual clarity, let’s derive for August 2014, using the data from earlier tables

August 2014
M3 Broad money 99205
M0 Reserve money 17274
Money multiplier (M3 divided by M0) 5.74

Velocity of money circulation

  • It is the avg. number of times money passes from one hand to another, during given time period.
  • e.g. you bought pen worth Rs.10 from shopkeeper, he uses same 10 rupee note to buy Cocacola=> then same currency note performed function of TWENTY Rupees. This is called “Velocity of money”
IF Velocity of money ___, Then money supply will__.
Increases Increase
Decreases decrease

Factors affecting Velocity of money circulation

  1. Income distribution. Poor people immediately use their money. so, money in the hands of poor=> has higher velocity.
  2. Booming period = higher velocity
  3. If More people use EMI loans for purchase=> higher velocity
  4. Low financial inclusion =>less velocity, because banking penetration is low. People tend to save more in physical assets hence money doesn’t change hands much.
  5. Developed countries => higher velocity, because people save less and spend more because of lifestyle and confidence in Government social-security  e.g. USA

Assertion reasoning type Question

All the answers based on Economic Survey statements. I’ve included some questions from other chapters as well:

Q1.

Assertion (A) Ratio of Broad money M3 to gross domestic product (GDP) has increased in recent years
Reason (R) The penetration of banking services has improved in India.
Correct Answer both right, R explains A

Q2.

Assertion (A) In 2013-14, there has been significant rise in Reserve money (M0)
Reason (R) RBI’s net credit to centre has increased in 2013-14
Correct Answer both right, R explains A

Q3

Assertion (A) developing countries will require trillions of dollars for moving towards Sustainable development path
Reason (R) Sustainable development implies higher input cost per unit of outcome in the short run.
Correct Answer both correct, R explains A

Q4

Assertion (A) in 2013-14, there has hardly any growth in mfg + mining sector.
Reason (R) There has been a deceleration in private investment in these two sectors.
Correct Answer both correct, R explains A

Q5

Assertion (A) In IIP, coal, fertilizer, electricity, crude oil, natural gas, refinery products, steel, and cement are considered ‘core’ industries.
Reason (R) Their performance has impact on general economic activity as well as other industrial activity.
Correct Answer Both correct, R explains A

Q5

Assertion (A) India’s capital goods segment is a weak performer.
Reason (R) In past three years, there has been a steady deceleration in the investment in capital goods sector
Correct Answer Both correct, R explains A