CHAPTER 4

Supply of Money

“Money supply” is the pool of liquid assets that can be used to make payments. The amount of money is determined through a complicated process involving the public, the depository financial institutions, and the central bank of the country. The financial market for securities and the demand for and supply of money are closely related. Public and private sector analysts have long monitored the changes in money supply because of its effects on the rate of interest, the price level, inflation, the exchange rate, and the business cycle.

In economics, money supply or money stock refers to the total amount of monetary assets available in an economy at a specific point of time. There are various concepts of money supply based on the variations in the assets included as money, ranging from narrow to broad, depending on how substitutable different assets are for definitive money. Substitutability in this case refers to liquidity, the cost at which an asset can be converted to definitive money. Supply of money in an economy at any point of time refers to the volume of money held by the households and firms for transactions and settlement of debts, which consists of currency and demand deposits. The most narrow money measure is definitive money itself, which is the conventional measure of money supply. A broad measure would include other assets that could be easily converted to cash.

“Narrow” and “Broad” Money

Modern money has several components. Apart from just cash and coins, money also consists of deposits with the banks, both interest-free demand deposits and interest-bearing time deposits, such as fixed deposits. The different components of money can be aggregated in the order of liquidity. Since money is primarily used to settle the day-to-day transactions, it needs to be readily usable as a means of doing so. Clearly, cash and coins are the most liquid forms of money, since they can be used instantaneously and universally to settle unlimited transactions. The sum of currency in circulation and the demand deposits with banks are often termed as M_1, narrow money. Demand deposits, or accounts with banks, are also quite liquid as the depositor can write checks against them for settling daily transactions. Though they are neither liquid nor instantly available as transaction-settling medium as M_1, and despite this, they are considered as money, since it will be available at some point, and very often, as in the case of a fixed deposit, can be converted to cash for some penalty. Usually, time deposits are much larger volume than both currency in circulation and demand deposits. The sum of M₁ and time deposits is called broad money.

High-Powered Money

High-powered money (also called the monetary base) is the sum of the currency in circulation with the public and the cash reserves held by banks. It is called high-powered money because it forms the base on which money stock is created as a multiple. A part of the monetary base is held by banks as a cash reserve ratio (CRR), which is a fraction of the deposits created by the banking system. This proportion is determined by a country’s central bank. The currency with the public is also a part of the monetary base because people do not hold all their wealth as cash and may deposit part of their cash holding into the banking system as demand deposits. This raises the cash assets of banks, which can again use a part of the additional cash receipts to create more demand deposits and thereby increase the supply of money in the system. The high-powered money is basic money; real money supply is something more, because the deposits with commercial banks have a multiplying effect as an outcome of the credit-creation process.

Institutions Influencing Money Supply

Money supply with the public is influenced mainly by the central bank of the country and its commercial banks. Through its fiscal policy, the government also affects, to some extent, the supply of money.

Central Bank

The central bank of the country (in India, the RBI) is the major source of money supply in the form of currency in circulation. The RBI is the note-issuing authority of the country. The RBI ensures availability of currency to meet the transaction needs of the economy. The total volume of money in the economy should be adequate to facilitate the various types of economic activities, such as production, distribution, and consumption.

Although the overall stock of money can be altered in various ways, in modern times it is very common that the stock of money available for transactions usually altered by monetizing government deficits. The stock of money in circulation or that available for transactions can be altered by using various ways of increasing the stock of money is by monetizing government deficits. The government borrows money from the RBI against government securities (g-secs), and the RBI prints new notes to finance such loan. The government pays its expenditures with this new cash, and money stock increases. The RBI can raise or lower the CRR¹ if it wants to decrease or increase the leverage that the commercial banks can exercise on their cash holdings. A lower CRR means that the same amount of cash can be used to finance the higher level of demand deposits. Another alternative to change the stock of money with the public is to use the open-market operations, in which the RBI can buy or sell its holdings of g-secs and treasury bills (another form of government borrowing) to change the public’s cash holding. A buy operation will increase the stock of money with the public, while a sell operation will mop up the cash in exchange for bonds.

Commercial Banks

Commercial banks form the second most important source of money supply. The money that commercial banks supply is called credit money, bank money, or credit creation.

Government and Money Supply

The government also affects the supply of money through its fiscal policy. Wherever the government imposes any tax or borrows from the public, it reduces the volume of the available money with the public. On the other hand, when the government finds that its income through taxation and public borrowings falls short of its expenditure, it borrows from the central bank (against its own securities) to pay off its creditors. Consequently, the availability of cash with the public and the banking system will increase. As the availability of cash with the public and the banking system changes, so does the economy’s capacity to expand or reduce credit.

Credit Creation

In a sense, the terms credit, debt, and loan are synonymous; credit or loan is the liability of the debtor and the asset of the bank. In the words of Newlyn (1978), “Credit creation refers to the power of commercial banks to expand secondary deposits either through the process of making loans or through investment in securities.” The entire structure of banking is based on credit. Credit means getting the purchasing power (i.e., money) now by a promise to pay at some time in future. Bank credit means bank loans and advances. A bank keeps a certain proportion of its deposits as the minimum reserve for meeting the demand of the depositors and lends out the remaining excess reserve to earn an income. The bank loan is not paid directly to the borrower; it is only credited to his or her account with the bank; every bank loan creates an equivalent deposit in the bank. Thus, the credit creation results in multiple expansions of bank deposits. The term “creation” refers to the ability of the bank to expand deposits as a multiple of its reserves. This is the distinctive power of the banks to multiply loans and advances, and hence deposits. With a little cash in hand, the banks can create additional purchasing power to a considerable degree. It is because the multiple credit-creating power of the commercial banks has been aptly described by Sayers (1938) that banks are not merely purveyors of money but are, in a sense, the manufactures of money.

A bank differs from other financial institutions because it can create credit. This is because of the fact that demand deposits of the banks serve as the principal medium of exchange, and, in this way, the banks manage the payments system of the country. Demand deposits are an important constituent of money supply, and the expansion of demand deposits means the expansion of money supply.

Process of Credit Creation

The process of credit creation begins with the banks lending money out of their primary deposits. The primary deposits are in the form of cash deposited in banks. After maintaining the required reserves, the bank can lend the remaining portion of the primary deposit. This can be illustrated by an example: Let us assume that an initial deposit of $1,000 is made. The bank keeps a certain percentage (say 10 percent) of the deposited amount as cash reserve and uses the rest for new loans or investments. The process would continue ad infinitum, depending on the reserve requirements, decreasing additional amounts per step. At the end of the process, the originally deposited amount of $1,000 will have induced a 10-fold increase in new deposits or, in other words, will have “created” additional money of $9,000 and led to an increase in the total money supply of $10,000. The ratio of increased bank money to increased reserves is called the money-supply multiplier and is calculated using the following formula:

dM = dCD × (1/r)

where dM is the total additional money supply, dCD is the initial additional cash deposit, and r is the share of the reserve requirements. In the above example, this gives:

10,000=1,000 × (1/0.1)

The above formula indicates the maximum theoretical amount of additional money created within the banking system on the basis of an initial cash deposit. In practice, there are various factors that restrict credit and money expansion to a smaller amount. The credit control policy of the central bank is the major limitation on the part of commercial banks to create multiple expansion of credit.

Measures of Money Supply in India

In India, the RBI has defined certain measures of money as part of its effort to estimate the effects of the money supply on prices and economic activities. RBI compiles and publishes four different money stock measures—M₁, M₂, M₃, and M₄.

M₁ = C + DD + OD

where C is the Currency held by the public, DD is the Demand deposits of banks, and OD is the Other deposits with the RBI.

M₂ = M₁ + Saving deposits with post offices

M₃ = M₁ + Time deposits with banks (C + DD + OD + TD)

M₄ = M₃ + Total post office deposits.

In this measure, M₁ possesses the highest liquidity and is also known as “narrow money,” and M₃ is commonly termed as “broad money.” As the quantum of money stock available in the economy has an important bearing on all economic aggregates, the monetary policy seeks to control the stock of money so as to optimize the growth of national income along with the price stability. The data related to money measures in India is shown in Table 4.1.

Table 4.1 Money stock measures

Note: For scheduled banks, March-end data pertain to the last reporting Friday. As for row 2.2, exclude balances held in IMF Account No.1, RBI employees’ provident fund, pension fund, gratuity, and superannuation fund.

Source: RBI Bulletin, February 2019.

Importance of Changes in Money Supply

The effect of the increase in money stock will be spread throughout the whole range of financial assets and interest rates. The supply of money in a modern economy and financial system is determined by three key factors:

Although a number of factors determine the money supply at any point in time, the central bank of a country has considerable control over the process and can offset or reinforce other forces that are changing the money supply. In fact, we can view monetary policy in terms of the central bank’s control over the money supply and the influence that the money supply has on achieving the goals of economic stabilization.

Supply of Money after Demonetization

In this context, it would be worthwhile to examine the money supply position after demonetization. After the old 500 and 1,000 notes were scrapped, and the new 500 and 2,000 notes got widely circulated in the market, money supply was expected to reduce in the short run. To the extent that black money (which is not counterfeit) does not reenter the system, the reserve money and, hence, the money supply will decrease. However, as the new notes gradually get circulated in the market and the mismatch gets corrected, money supply picks up.

The most basic thing for a modern market economy is the stability of the money supply. Demonetization has undermined this. It is generally accepted that money facilitates more trades and improves welfare than what is possible without it. Monetary theorists would call this as money being “essential” because the total set of allocations achievable with money is much bigger than the one achievable without money. While current markets in goods and services facilitate current consumption and investment, credit markets allow economic agents to smooth production and consumption over time. Therefore, a pervasive reduction in liquidity, however short term, is bound to adversely affect both current and future consumption and investment decisions.

Currency in circulation had contracted to almost half the level of note ban on high-value notes of 500 and 1,000, as was evident by December 30, 2016, the last day to surrender the extinguished money, when the cash in circulation amounted to 8.93 lakh crore.² The contractionary effect on money supply produced by demonetization has been reverberating across the economy. As an immediate reaction, there was a spike in various digital channels—Internet and mobile banking, cards, and other new platforms like UPI. Of late, the pace of the switch to digital transactions is slowing. Money supply growth has picked up. It has crossed the levels last seen before the note swap was enforced. According to the latest RBI data, people’s demand for cash continues to rise compared to pre-demonetization level.

Currency held with the public is calculated after deducting cash with banks from the total currency in circulation. Currency with the People (CwP), or people’s demand for cash, was 7 percent higher at 18.25 trillion at the end of April 2018 compared to 17 trillion at the beginning of November 2016. M₃, which is the broadest measure of liquidity in the monetary system, grew 13 percent in May 2018 to 140.3 trillion against 124 trillion prior to demonetization. M₃ includes the value of CwP, current and time deposits, as well as institutional money market funds and other liquid assets, along with deposits with post offices.³ Demonetization has not been able to significantly bring down the circulation of high-denomination notes. In June 2018, the share of the new 500 and 2,000 notes was 80.17 percent.⁴

Several explanations are offered for this trend, though not all are willing to reject that the digitization of payments has not picked up. Some attribute the surge in cash to a revival in rural economic activity, which is predominantly cash based. Others believe the surge could be due to elections in various states in 2018. The election funding is still cash based. The growth in currency in circulation is likely to remain robust. This, in turn, would put pressure on bank deposits as the circulating cash represents a leakage from the banking system.⁵

Demonetization was expected to have a direct effect of reducing currency in circulation, especially in the short run. In other words, the monetary base was expected to decline. In the near term, this would almost certainly lead to a decline in economic activity. At the same time, the currency deposit ratio also goes down and the government’s expectation is that this will lead to an increase in the money multiplier. The money multiplier in India currently stands at 5.8; that is, each rupee that goes back into the banking system increases the broad money supply by 5.80. If prices are sticky enough and the decline in the monetary base is more than offset by the increase in the money multiplier, it effectively amounts to an expansionary monetary policy. The degree of this depends on how proactive banks are in making loans with the new deposits. If the RBI and the banking system can engage in this successfully, then it would lead to a medium-term boost in economic growth. In fact, a lot depends on how crippling the short-run effects are—mainly the apparent freezing of entire local markets due to the lack of liquidity. Second, for the money multiplier to increase, the banking system needs to make loans. Financial inclusion involves providing people not just with bank accounts but also easy access to credit. In fact, the most significant barrier for informal firms is not corruption but borrowing constraints. A large fraction of lending in India, however, is passive—to government-supported enterprises, or as part of its various subsidized credit schemes (Chanda 2016).

Endnotes