A) Meaning and Functions of Money

Meaning

Money is a concept which we all understand but which is difficult to define in exact terms.

Money is anything serving as a medium of exchange. Most definitions of money take ‘functions
of money’ as their starting point. ‘Money is that which money does.’ According to Prof.
Walker, ‘Money is as money does.’

This means that the term money should be used to include anything which performs the
functions of money, viz., medium of exchange, measure of value, unit of account, etc. Since
general acceptability is the fundamental characteristic of money, therefore, money may be
defined as ‘anything which is generally acceptable by the people in exchange of goods and
services or in repayment of debts.’

Functions of Money:

In general terms, the main function of money in an economic system is “to facilitate the
exchange of goods and services and help in carrying out trade smoothly.” Its basic
characteristic is general acceptability. Functions of money are reflected in the following well-
known couplet:

“Money is a matter of functions four A medium, a measure, a standard, a store.”

Thus conventionally money performs the following four main functions, each of which
overcomes one or the other difficulty of barter. Medium of exchange and measure of value are
primary functions because they are of prime Importance whereas standard of deferred payment
and store of value are called secondary functions because they are derived from primary
functions.

1. Money as the Medium of Exchange:

Money came into use to remove the inconveniences of barter as money has separated the act of
purchase from sale. Medium of exchange is the basic or primary function of money. People
exchange goods and services through the medium of money. Money acts as a medium of
exchange or as a medium of payments. Money by itself has no utility (except perhaps to the
miser). It is only an intermediary.
The use of money facilitates exchange, exchange promotes specialisation Increases productivity
and efficiency A good monetary system is, therefore, of immense utility to human society.
Money is also called a bearer of options or generalised purchasing power because it provides
freedom of choice to buy things he wants most from those who offer best bargain.

2. Money as a Unit of Account or Measure of Value:

Money serves as a unit of account or a measure of value. Money is the measuring rod, i.e., it is
the units in terms of which the values of other goods and services are measured in money terms
and expressed accordingly Different goods produced in the country are measured in different
units like cloth m metres, milk in litres and sugar in kilograms.

Without a common unit, exchange of goods becomes very difficult Values of all goods and
services can be expressed easily in a single unit called money Again without a measure of
value, there can be no pricing process. Without a pricing process organised marketing and
production is not possible. Thus, the use of money as a measure of value is the basis of
specialised production.

The measuring rod of money is also indispensable to all forms of economic planning.
Consumers compare the values of alternative purchases m terms of money Producers also
compare the values of alternative purchases m terms of money. Producers compare the relative
costliness of the factors of production in terms of money and also plan their output on the basis
of the money yield. It is, therefore, highly important that the value of money should be stable.

3. Money as the Standard of Deferred Payments:

Deferred payments are payments which are made some time in the future. Debts are usually
expressed in terms of the money of account. Loans are taken and repaid in terms of money.

The use of money as the standard of deterred or delayed payments immensely simplifies
borrowing and lending operations because money generally maintains a constant value through
time. Thus, money facilitates the formation of capital markets and the work of financial
intermediaries like Stock Exchange, Investment Trust and Banks. Money is the link which
connects the values of today with those of the future.

4. Money as a Store of Value:

Wealth can be stored in terms of money for future. It serves as a store value of goods in liquid
form. By spending it, we can get any commodity in future. Keynes places great emphasis on
this function of money. Holding money is equivalent to keeping a reserve of liquid assets
because it can be easily converted into other things.

People therefore normally wish to keep a part of their wealth in the form of money because
savings in terms of goods is very difficult. This desire is known as liquidity preference. Clearly
money is the best form of store of value. Wheat or any other product which will command a
value cannot be stored for a long period.

Another Function ‘Liquidity of Money’ is added these days. Money is perfectly liquid.
Liquidity means convertibility into cash. Thus, the ability to convert an asset into money
quickly and without loss of value is called liquidity of asset. Modern economists are laying
stress on liquidity of money.

Since, by definition, money is the most generally accepted commodity, it is also the most liquid
of all resources. Possession of money enables one to get hold of almost any commodity in any
place and money never locks a buyer. It is this peculiarity which distinguishes money from all
other commodities. A preference for liquidity is preference for money.

Money, thus, acts as common medium of exchange, a common measure of value, as standard of
deferred payments and a store of value.

B) THE EVOLUTION OF MONEY AND THE PAYMENTS SYSTEM

The payments system refers to the method of conducting transactions in the economy. The
payment system and money have been evolving over centuries from commodity money at one
point in history to e-money in the recent days, and innovations will not stop here. Commodity
Money Commodity Money is money that is made up of precious metals or other valuable
commodities that have intrinsic value (are valuable in their own right). Examples of commodity
money could include gold, cows, and pretty shells. From ancient times until several hundred
years ago commodity money functioned as the medium of exchange in most of the societies. In
ancient times, people used rocks, leather, salt and shells as money The Roman Byzantine used
gold coins (denarius) and the Persians used silver coins (drachma) as currency
Gold played the role of money throughout human history Gold continued to be part of the
international monetary system until the breakdown of Bretton Woods in 1971. The problem
with a payments system based on precious metals is that

1. Such a form of money is very heavy and is hard to transport from one place to another

2. Another problem is when the value of the precious metal increased more than its value as
money, people used to melt the coins to use them as precious metal rather than as money.

Paper Currency Paper currency refers to pieces of paper that function as a medium of exchange.
Originally, paper currency carried a guarantee that it was convertible into a fixed quantity of
precious metal.

Fiat Money Fiat money refers to paper currency decreed by governments as legal tender. Legal
tender means that money must be legally accepted as payment for debts. Today all national
currencies are fiat, that is, neither backed by nor redeemable for gold. Currencies such as
dollars or dinars do not have intrinsic value, because they are not really useful other than as
money. Without legal tender they are nothing but pieces of paper. Fiat money is lighter but it
has the problem of counterfeiting and it is hard to transport large amounts because of their bulk.

A check is an instruction from you to your bank to transfer money from your account to
someone else’s account when he deposits the check. The introduction of checks was a major
innovation that improved the efficiency of the payments system. The use of Checks has the
advantage of:

1. Reducing transaction costs associated with the payments system, and

2. Improve economic efficiency.

3. Another advantage of checks is that they can be written for any amount up to the balance in
the account, making transactions for large amount much easier.

The disadvantage of using checks is that

1. It takes time to get checks from one place to another which creates problems for the needed
urgent payments.

2. In addition it takes several days to clear a check you have deposited before you can use its
funds.
3. The paper work to process checks has its cost too. Electronic Payment The development of
inexpensive computers and the spread of the internet now make it cheap to pay bills
electronically.

Electronic payments result in cost saving compared to payments by checks. Electronic

payments technology can substitute not only for checks, but also for cash in the form of
electronic money (or e-money). E-money refers to money that exists only in electronic form
and involves transfer of money. Some forms of e-money include:

A debit card, which looks like credit cards, enables consumers to purchase goods and services
by electronically transforming funds directly from their bank accounts to the merchant’s
account. o Automatic bill-paying: whereby money is transferred straight from your bank
account to the phone company, the power company, the local tax collector, according to prior
arrangements you have made. Pay-by-phone works similarly.

E-cash, which is used on the internet to purchase goods or services. A consumer get e-cash by
setting up an account with a bank that has links to the internet and then has the e-cash
transferred to his PC. Then he can buy goods and services by transferring money directly from
his PC to the seller.

A more advanced form of e-money is the stored-value card. The simplest form of the stored
value card is purchased for a preset amount that the consumer pays upfront, like a prepaid
phone card. The more sophisticated stored-value card is known as a smart card. A smart card
contains a computer chip that allows it to be loaded with digital cash from the owner’s bank
account whenever needed.

Are electronic payments considered part of the money in the country? Actually no. They
provide access to bank accounts, which are already in the money supply. These are really just
more efficient and convenient ways of making payments than the old ones.

C) CHARACTERISTICS OF MONEY

The forms that money has taken on depend heavily on how well it performs the three functions
we have discussed earlier. The following are some of the characteristics that an item should
have in order to perform the three functions of money efficiently

1. Must be easily standardized, making it simple to ascertain its value.

2. Must be widely accepted in payments for goods and services and for settling other business
obligations; i.e., must have intrinsic value or made acceptable by decree of law (assigned legal
tender status)

3. Must be divisible, so that it can be used for exchange of a range of values

4. Must be stable and durable; i.e., does not deteriorate, perish or erode due to its own structure
and composition

5. Must be easy to carry around

6. Must be limited in supply

7. Must not be easily counterfeited

MONETARY AGGREGATES

Economists and governments have a broader measure of what money is than cash. M1 The
narrowest measure of money is M1, which includes assets that can be used directly as a
medium of exchange. M1 = Currency +Traveler’s Checks + Demand deposits + Other
checkable deposits Note that the currency component of M1 includes only paper money and
coins in circulation in the hands of the non-bank public and does not include cash that is held in
ATMs or banks vaults.

The traveler’s checks component of M1 includes only traveler’s checks not issued by banks.
The demand deposits component includes business checking accounts that do not pay interest
as well as traveler’s checks issued by banks. The other checkable deposits item includes all
other checkable deposits, particularly checking accounts held by households that pay interest,
such as NOW (negotiated order of withdrawal) and ATS (automatic transfer from savings). M1
is considered by the central bank perfectly liquid assets, i.e. pure medium of exchange.

M2

M2 is a broader measure of money than M1. It includes items that are contained in M1 and a
few other items. M2 adds to M1 other assets that have check-writing features (money market
deposit accounts and money market mutual fund shares) and other assets that are highly liquid
at a very little cost (savings deposits and small-denomination time deposits) M2 = M1 + savings
deposits + small–denomination time deposits + money market deposit accounts + Money
market mutual fund shares. Saving deposits are non-transactions deposits that can be added to
or taken out at any time. Small–denomination time deposits are certificates of deposit (CDs)
with a denomination of less than $100,000 that can only be redeemed at a fixed maturity date
without a penalty. Money market deposit accounts (i.e. interest bearing accounts) are short term
accounts that pay interest and allow limited withdrawals. They are similar to money market
mutual funds, but are issued by banks. Money market mutual fund shares are retail accounts on
which households can write checks. Money market mutual funds are interest-bearing shares in
pools of funds accumulated by investment companies. The funds are invested in short-term
securities. The components of M2 (other than M1) are considered as the assets that emphasize
the function of money as a store of value. However, they can also be used as medium of
exchange (with some delay). There is another measurement of money which is M3.

M3 is the broadest measure for money, includes some of the “longer-term” money market
instruments. The components of M3 (other than M2) are assets of mostly large businesses and
institutions. They are very non-liquid assets, and hence not used as medium of exchange.

D) Demand for Money

The old idea about the demand for money was that money was demanded for completing the
business transactions. In other words, the demand for money depended on the volume of trade
or transactions. As such the demand for money increased during boom period or when the trade
was brisk and it decreased during depression or slackening of trade.

The modern idea about the demand for money was put forward by the late Lord Keynes, the
famous English economist, who gave birth to what has been called the Keynesian Economics.
According to Keynes, the demand for money, or liquidity preference as he called it, means the
demand for money to hold.

Broadly speaking, there are three main motives on account of which money is wanted by
the people by the people, viz:

(i) Transactions motive

(ii) Precautionary motive

(iii) Speculative motive

(i) Transactions Motive:

This motive can be looked at:

(a) From the point of consumers who want income to meet the household expenditure which
may be termed the income motive, and

(b) From the point of view of the businessmen, who require money and want to hold it in order
to carry on their business, i.e., the business motive.

(a) Income Motive:

The transactions motive relates to the demand for money or the need for cash for the current
transactions of individual and business exchanges. Individuals hold cash in order “to bridge the
interval between the receipt of income and its expenditure.” This is called the income Motive’.

Most of the people receive their incomes by the week or the month, 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 current in the locality.

(b) Business Motive:

The businessmen and the entrepreneurs also have to keep a proportion of their resources in
ready cash in order to meet current 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 of exchange.

Keynes calls it the ‘Business Motive’ for keeping money. 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.

(ii) Precautionary Motive:

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 tor the risk of
unemployment, sickness, accidents and other more uncertain perils. The amount of money held
under this motive will depend on the nature of the individual and on the conditions in which he
lives.

(iii) Speculative Motive:

The speculative motive 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 is a new typically 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 rise, which in other words means that the rate of
interest is expected to fall, businessmen will buy bonds to sell when the price actually rises.

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 being certain in this dynamic
world, where guesses about the future course of events are made on precarious bases,
businessmen keep cash to speculate on the probable further 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 or prevailing 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 rate, holders of cash balances
would lose more by not lending or investing.

Conclusion:

Thus, the amount of money required to be held under the various motives constitutes the
demand for money. It may be borne in mind that, in economic analysis, demand for money is
the demand for the existing stock of money which is available to be held. It is stock of money
not a flow of it over time.
 E) Supply of Money

We have described the demand for money as the demand for the stock (not flow) of money to
be held. The flow is over a period of time and not at a given moment. In the case of commodity,
it is a flow. Goods are being continually produced and disposed of. This is the essential
difference between the demand for money and the demand for a commodity.

Similarly, the supply of money conforms to the ‘stock’ concept and not the ‘flow’ concept. Just
as the demand for money is the demand for money to hold, similarly, the supply of money
means the supply of money to hold. Money must always be held by someone, otherwise it
cannot exist. Hence, the supply of money means the sum total of all the forms of money which
are held by a community at any given moment.

The stock of money, which constitutes the supply of it, consists of (a) metallic money or coins,
(b) currency notes issued by the currency authority of the country whether the Central bank or
the government, and (chequable bank deposits. In old times, the coins formed the bulk of
money supply of the country. Later, the currency notes eclipsed the metallic currency and now
the bank deposits in current account withdraw-able by cheques have overwhelmed all other
forms of money.

Thus, money supply means total volume of monetary media of exchange available to the
community for use in connection with the economic activity of the country. Broadly speaking,
money supply in a country is composed of two main elements, viz., (a) currency with the
public; and (b) deposit money with the public.

In order to arrive at the total amount of currency with the public, we add: (i) currency notes in
circulation; (ii) circulation of rupee notes and coins; and (iii) circulation of small coins; and
from the total deduct- ‘Cash in hand with banks’ The bulk of the currency with the public (over
95 per cent) is in the form of currency notes issued by the Reserve Bank of India. Next in
importance are the rupee notes issued by the Government of India.

Besides currency, money supply with the public includes the deposit money, i.e., the bank
balances held in current accounts of the banks. In underdeveloped countries, the currency, and
not the bank deposits, occupies a dominant position, because in such countries the bulk of
commercial dealings are done through cash as a medium of exchange and not through cheques
as in advanced countries. Deposit money with the public in India consists of two items, viz., net
demand deposits of bank and ‘other deposits’ with the Reserve Bank of India.

By adding total currency with the public and the total demand deposits, we get the total money
supply with the public.

It is also worth nothing here that in India the deposit money with the public has now come to
exceed, albeit slightly, the total currency money with the public. Compare with it the position in
1950-51, when deposit money with the public was not even one-half of the currency in
circulation among the public.

This shows that the banking habit has steadily been growing in the country and the time will not
be far off when deposit money will far outstrip the currency money.

The total amount of bank deposits in the country is determined by the monetary policy of the
central bank of the country. When the central bank wants to give a boost to the economy of the
country, it follows a cheap money policy, lowers the bank rate, which is followed by lower
rates of interest charged by the commercial banks, thus helping credit creation by the banks.

There are times, however, when in the interest of economic stability, the central bank follows a
policy of credit squeeze by raising the bank rate and purchasing securities through open market
operations and adopting other credit control measures.

Conclusion:

Thus, the supply of money in a country, by and large, depends on the credit control policies
pursued by the banking system of the country.

F) Fractional Reserve Banking System

1) Introduction

Fractional reserve banking is a banking system in which banks only hold a fraction of the
money their customers’ deposit as reserves. This allows them to use the rest of it to make loans
and thereby essentially create new money. This gives commercial banks the power to directly
affect the money supply. In fact, even though central banks are in charge of controlling the
money supply, most of the money in modern economies is created by commercial banks
through fractional reserve banking. To understand how exactly this works, we will look at the
process in more detail below.

100 Percent Reserve Banking

To explain the idea behind fractional reserve banking, we first have to consider its opposite:
100 percent reserve banking. In this system, banks are required to hold all deposits as reserves.
To give an example, let’s assume we have an economy with a money supply of USD 100
million. In this economy, the first-ever bank just opened, we’ll call it the Super Safe Bank. This
bank is only a depository institution. That means, it accepts deposits, but it does not give out
any loans. By keeping all deposits in its vault (i.e. as reserves) the bank provides its customers
with a safe place to keep their money. Nothing more, and nothing less.

Depositors can return anytime and withdraw their deposit. Even if all of them do this at the
same time, there is no shortage of cash, because all the money is stored in the bank’s vault. In
other words, all the bank’s liabilities (i.e. deposits) are covered by the reserves (i.e. assets). We
can illustrate this by creating a T-account for the Super Safe Bank.

Now, let’s look at the money supply in this example. Before Super Safe Bank opened, people
had to hold all USD 100 million in cash. Now they can deposit all their money in the bank.
Every deposit they make reduces the currency in circulation and increases demand deposits by
the exact same amount. As a consequence, money supply (which also includes demand
deposits) remains unchanged. Thus, in the case of 100 percent reserve banking, banks cannot
control or influence the money supply.

Fractional Reserve Banking

For the sake of the example, let’s now assume that Super Safe Bank has USD 100 million in its
vault. Most of this money is just sitting there idle. Of course, there must always be some
reserves for customers who want to make a withdrawal. However, if the flow of withdrawals is
roughly the same as the flow of new deposits, is not necessary for the bank to keep all deposits
as reserves. Instead, it can use some of them to make loans to people who need money (e.g. to
buy a house, a new car, or go to university). This is what we call fractional reserve banking.

In most countries, the fraction of total deposits the banks need to keep as reserves (i.e.
the reserve ratio) is regulated by the government and/or bank policies. Let’s assume that Super
Safe Bank is required to keep 10 percent of all deposits (i.e. USD 10 million) as reserves, it can
use the remaining 90 percent (i.e. USD 90 million) to make loans.

Of course, the bank can also decide to keep reserves above the legal requirements (i.e. excess
reserves), to make sure they don’t run out of cash. After all, an unexpectedly high number of
withdrawals in a short amount of time (i.e. bank run) could put banks in serious trouble. This
becomes clear once we look at our T-account again. As you can see, the assets and liabilities
are still balanced, but now the loans make up most of the assets.
When it comes to the money supply, fractional reserve banking is a game-changer. As long as
Super Safe Bank does not give out any loans, the total money supply remains at USD 100
million. As soon as the bank starts making loans, however, the money supply increases. In this
case, depositors still have their demand deposits totaling USD 100 million, but borrowers now
also hold an additional USD 90 million in cash. Thus, the total money supply now equals USD
190 million. Note that this process can be repeated, which further increases the money supply
(see also Money Multiplier).

When you put your money into a bank, the bank is required to keep a certain percentage, a
fraction, of that money on reserve at the bank, but the bank can lend the rest out. For instance, if
you deposit $100,000 at the bank and the bank has a reserve requirement of 10 percent, the
bank must keep $10,000 of your money on reserve and can lend out the $90,000.

In essence, the bank has taken $100,000 and has turned it into $190,000 by giving you a
$100,000 credit on your deposits and then lending the additional $90,000 out to someone else.

Now, if you take this out a little further, you will see that your original $100,000 can become $
by the time it is all over. Here’s how:

– You deposit $100,000 Your bank loans someone else $90,000

– That person deposits $90,000 Their bank loans someone else $81,000

– That person deposits $81,000 Their bank loans someone else $72,900

– That person deposits $72,900 Their bank loans someone else $65,610

– That person deposits $65,610 Their bank loans someone else $59,049

– That person deposits $59,049 Their bank loans someone else $53,144

– That person deposits $53,144 Their bank loans someone else $47,829

– And so on

Ultimately, your initial $100,000 can grow into $1,000,000 with a 10 percent reserve
requirement. To find out exactly how much money the fractional reserve banking system can
theoretically create with your initial deposit, you can use the Money Multiplier equation:
Money Creation by the Banking System
In a modern economy money consists mainly of currency notes and coins issued by the
monetary authority of the country. In India currency notes are issued by the Reserve Bank of
India (RBI), which is the monetary authority in India. However, coins are issued by the
Government of India. Apart from currency notes and coins, the balance in savings, or current
account deposits, held by the public in commercial banks is also considered money since
cheques drawn on these accounts are used to settle transactions. Such deposits are called
demand deposits as they are payable by the bank on demand from the accountholder. Other
deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits.
Though a hundred-rupee note can be used to obtain commodities worth Rs 100 from a shop, the
value of the paper itself is negligible – certainly less than Rs 100. Similarly, the value of the
metal in a five-rupee coin is probably not worth Rs 5. Why then do people accept such notes
and coins in exchange of goods which are apparently more valuable than these? The value of
the currency notes and coins is derived from the guarantee provided by the issuing authority of
these items. Every currency note bears on its face a promise from the Governor of RBI that if
someone produces the note to RBI, or any other commercial bank,
RBI will be responsible for giving the person purchasing power equal to the value printed on
the note. The same is also true of coins. Currency notes and coins are therefore called fiat
money. They do not have intrinsic value like a gold or silver coin. They are also called legal
tenders as they cannot be refused by any citizen of the country for settlement of any kind of
transaction. Cheques drawn on savings or current accounts, however, can be refused by anyone
as a mode of payment. Hence, demand deposits are not legal tenders.

Legal Definitions: Narrow and Broad Money

Money supply, like money demand, is a stock variable. The total stock of money in circulation
among the public at a particular point of time is called money supply. RBI publishes figures for
four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as
follows

M1 = CU + DD

M2 = M1 + Savings deposits with Post Office savings banks

M3 = M1 + Net time deposits of commercial banks

M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings
Certificates)

where, CU is currency (notes plus coins) held by the public and DD is net demand deposits held
by commercial banks. The word ‘net’ implies that only deposits of the public held by the banks
are to be included in money supply.

The interbank deposits, which a commercial bank holds in other commercial banks, are not to
be regarded as part of money supply. M1 and M2 are known as narrow money. M3 and M4 are
known as broad money. These gradations are in decreasing order of liquidity. M1 is most liquid
and easiest for transactions whereas M4 is least liquid of all. M3 is the most commonly used
measure of money supply. It is also known as aggregate monetary resources.

Measures of money supply in India

There are four measures of money supply in India which are denoted by M1 M2' M3, and M
444' 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 MI,
defined a5 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. From April 1968,
the RBI 'also started publishing another measure of the money supply which it called Aggregate
Monetary Resources (AMR). This included M, 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.

M, 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 !DBI, IFCI, etc, other than of
banks, IMF, IBRD, etc. The RBI characterizes M1 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 inter bank 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, M3 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.

2) Money Creation

Money supply will change if the value of any of its components such as CU, DD or Time
Deposits changes. In what follows we shall, for simplicity, use the most liquid definition of
money, viz. M1 = CU + DD, as the measure of money supply in the economy. Various actions
of the monetary authority, RBI, and commercial banks are responsible for changes in the values
of these items. The preference of the public for holding cash balances vis-´a-vis deposits in
banks also affect the money supply. These influences on money supply can be summarised by
the following key ratios.

The Currency Deposit Ratio: The currency deposit ratio (cdr) is the ratio of money held by the
public in currency to that they hold in bank deposits. cdr = CU/DD. If a person gets Re 1 she
will put Rs 1/(1 + cdr) in her bank account and keep Rs cdr/(1 + cdr) in cash. It reflects
people’s preference for liquidity. It is a purely behavioural parameter which depends, among
other things, on the seasonal pattern of expenditure. For example, cdr increases during the
festive season as people convert deposits to cash balance for meeting extra expenditure during
such periods.

The Reserve Deposit Ratio: Banks hold a part of the money people keep in their bank deposits
as reserve money and loan out the rest to various investment projects. Reserve money consists
of two things – vault cash in banks and deposits of commercial banks with RBI. Banks use this
reserve to meet the demand for cash by account holders. Reserve deposit ratio (rdr) is the
proportion of the total deposits commercial banks keep as reserves. Keeping reserves is costly
for banks, as, otherwise, they could lend this balance to interest earning investment projects.
However, RBI requires commercial banks to keep reserves in order to ensure that banks have a
safe cushion of assets to draw on when account holders want to be paid. RBI uses various
policy instruments to bring forth a healthy rdr in commercial banks. The first instrument is the
Cash Reserve Ratio which specifies the fraction of their deposits that banks must keep with
RBI. There is another tool called Statutory Liquidity Ratio which requires the banks to maintain
a given fraction of their total demand and time deposits in the form of specified liquid assets.
Apart from these ratios RBI uses a certain interest rate called the Bank Rate to control the value
of rdr. Commercial banks can borrow money from RBI at the bank rate when they run short of
reserves. A high bank rate makes such borrowing from RBI costly and, in effect, encourages
the commercial banks to maintain a healthy rdr.

High Powered Money: The total liability of the monetary authority of the country, RBI, is
called the monetary base or high powered money. It consists of currency (notes and coins in
circulation with the public and vault cash of commercial banks) and deposits held by the
Government of India and commercial banks with RBI. If a member of the public produces a
currency note to RBI the latter must pay her value equal to the figure printed on the note.
Similarly, the deposits are also refundable by RBI on demand from deposit-holders. These
items are claims which the general public, government or banks have on RBI and hence are
considered to be the liability of RBI. RBI acquires assets against these liabilities. The process
can be understood easily if we consider a simple stylised example. Suppose RBI purchases gold
or dollars worth Rs 5. It pays for the gold or foreign exchange by issuing currency to the seller.
The currency in circulation in the economy thus goes up by Rs 5, an item that shows up on the
liability side of the balance sheet. The value of the acquired assets, also equal to Rs 5, is entered
under the appropriate head on the Assets side. Similarly, RBI acquires debt bonds or securities
issued by the government and pays the government by issuing currency in return. It issues

loans to commercial banks in a similar fashion.

Money creation under fractional reserve banking system

We are now ready to explain the mechanism of money creation by the monetary authority, RBI.
Suppose RBI wishes to increase the money supply. It will then inject additional high powered
money into the economy in the following way. Let us assume that RBI purchases some asset,
say, government bonds or gold worth Rs H from the market. It will issue a cheque of Rs H on
itself to the seller of the bond. Assume also that the values of cdr and rdr for this economy are 1
and 0.2, respectively. The seller encashes the cheque at her account in Bank A, keeping Rs H/2
in her account and taking Rs H/2 away as cash. Currency held by the public thus goes up H/2.
Bank A’s liability goes up by Rs H/2 because of this increment in deposits. But its assets also
go up by the same amount through the possession of this cheque, which is nothing but a claim
of the same amount on RBI. The liability of RBI goes up by Rs H, which is the sum total of the
claims of Bank A and its client, the seller, worth Rs H/2 and Rs H/2, respectively. Thus, by
definition, high powered money increases by Rs H. The process does not end here. Bank A will
keep Rs 0.2H/2 of the extra deposit as reserve and loan out the rest, i.e. Rs (1– 0.2) H/2 = Rs
0.8 H/2 to another borrower. The borrower will presumably use this loan on some investment
project and spend the money as factor payment. Suppose a worker of that project gets the
payment. The worker will then keep Rs 0.8H/4 as cash and put Rs 0.8H/4 in her account in
Bank B. Bank B, in turn, will lend Rs 0.64 H/4. Someone who receives that money will keep
0.64H/8 in cash and put 0.64H/8 in some other Bank C. The process continues ad infinitum.
The second column shows the increment in the value of currency holding among the public in
each round. The third column measures the value of the increment in bank deposits in the
economy in a similar way. The last column is the sum total of these two, which, by definition,
is the increase in money supply in the economy in each round (presumably the simplest and the
most liquid measure of money, viz. M1). Note that the amount of increments in money supply
in successive rounds are gradually diminishing. After a large number of rounds, therefore, the
size of the increments will be virtually indistinguishable from zero and subsequent round
effects will not practically contribute anything to the total volume of money supply. We say
that the round effects on money supply represent a convergent process. In order to find out the
total increase in money supply we must add up the infinite geometric series4 in the last column,
i.e.
H + .8H/2 + .64H/4 +…………….∞
H {1+ (.8/2) + (.8/2)2 + (.8/2)3…………∞} = H/ (1 – 0.4) = 5H/3

The increment in total money supply exceeds the amount of high powered money initially
injected by RBI into the economy. We define money multiplier as the ratio of the stock of
money to the stock of high powered money in an economy, viz. M/H. Clearly, its value is
greater than 1. We need not always go through the round effects in order to compute the value
of the money multiplier. We did it here just to demonstrate the process of money creation in
which the commercial banks have an important role to play. However, there exists a simpler
way of deriving the multiplier. By definition, money supply is equal to currency plus deposits
 M = CU + DD = (1 + cdr) DD where, cdr = CU/DD

Assume, for simplicity, that treasury deposit of the Government with RBI is zero. High
powered money then consists of currency held by the public and reserves of the commercial
banks, which include vault cash and banks’ deposits with RBI. Thus

H = CU + R = cdr.DD + rdr.DD = (cdr + rdr) DD

Thus the ratio of money supply to high powered money

M/H = (1 + cdr) DD/ (cdr + rdr) DD = (1 +cdr)/ (cdr +rdr) >1

as rdr < 1

This is precisely the measure of the money multiplier.

G) THE MONEY MULTIPLIER

The current practice is to explain the determinants of the money supply in terms of the
monetary base or high-powered money. High-powered money is the sum of commercial bank
reserves and currency (notes and coins) held by the public. High-powered money is the base for
the expansion of bank deposits and creation of the money supply. The supply of money varies
directly with changes in the monetary base, and inversely with the currency and reserve ratios.
The use of high-powered money consists of the demand of commercial banks for the legal limit
or required reserves .with the central bank and excess reserves and the demand of the public for
currency. Thus high-powered money H=C+RR+ER, where C represents currency, RR the
required reserves and ER the excess reserves.

A commercial bank's required reserves depend upon its deposits. But a bank usually holds
reserves in excess of its required reserves. In fact, banks do not advance loans up to the legal
limits but precisely less than that. This is to meet unanticipated cash withdrawals or adverse
clearing balances. Hence the deed arises for maintaining excess reserves by them. The money
supply is "thus determined by the required reserve ratio and the excess reserve ratio of
commercial banks. The required reserve ratio (RRr) is the ratio of required, reserves to deposits
(RR/D), and the excess reserve ratio (ERr) is the ratio or excess reserves to deposits (ER/D).

Currency held by the public is another component of high-powered money. The demand for
currency by the public is expressed as a proportion of bank deposits. Thus the currency ratio
Cr=C/D, where C is the currency and E> deposits. The currency ratio is influenced by such
factors as changes in income levels of the people, the use of credit instruments by the public,
and uncertainties in economic activity.

The formal relation between the money supply and high-powered money can be stated in the
form of equations as under: The money supply (M) consists of deposits of commercial banks
CD) and currency (C) held by the public. Thus the supply of money

M=D+C ------------------------------------------------------------------(1)

High-powered money (H) (or monetary base) consists of currency held by the public (C) plus
required reserves (RR) and excess reserves of commercial banks. Thus high powered money

H=C+RR+ER------------------------------------------------------------(2)

The relation between M and H can be expressed as the ratio of M to H. So divide equation (1)
by (2):
M_ = __ (1+ C/D) (1/D)______-------------------------------(4)
H (C/D+RR/D+ER/D) (1/D)
1/D cancels out and by substituting Cr for C/D. RRr for RR/D, and ERr for ER/D. equation (4)
becomes

M/H= (1+Cr) / (Cr +RRr +ERR) -----------------------------------(5)

Thus high-powered money

H= (Cr+RRr+Err) / (1+Cr) x M … (6)

M = (1+Cr) / (Cr+RRr+ERr) x H …(7)

And money supply Equation (7) defines money supply in terms of high-powered money. It
expresses the money supply in terms of four determinants, H, Cr, RRr. and ERr. The equation
states that the higher the supply of high powered money, the higher the money supply. Further,
the lower the currency ratio (Cr), the reserve ratio (RRr), and the excess reserve ratio (ERr) the
higher the money supply, and' vice versa.
 H) QUANTITY THEORY of MONEY

The concept of the quantity theory of money (QTM) began in the 16th century. As gold and
silver inflows from the Americas into Europe were being minted into coins, there was a
resulting rise in inflation. This development led economist Henry Thornton in 1802 to assume
that more money equals more inflation and that an increase in money supply does not
necessarily mean an increase in economic output. Here we look at the assumptions and
calculations underlying the QTM, as well as its relationship to monetarism and ways the theory
has been challenged.

Quantity Theory of Money

The classical quantity theory of money is based on two fundamental assumptions: First is the
operation of Say’s Law of Market. Say’s law states that, “Supply creates its own demand.” This
means that the sum of values of all goods produced is equivalent to the sum of values of all
goods bought.

Thus, by definition, there cannot be deficiency of demand or under utilisation of resources.

There will always be full employment in the economy. Second is the assumption of full
employment that follows from the Say’s Law.

Like the price of a commodity, value of money is determinded by the supply of money and
demand for money. In his theory of demand for money, Fisher attached emphasis on the use of
money as a medium of exchange. In other words, money is demanded for transaction purposes.

As a truism, in a given time period, total money expenditure is equal to the total value of goods
traded in the economy. In other words, national expenditure, i.e., the value of money, must be
identically equal to national income or total value of the goods for which money is exchanged,
i.e.,

MV = ∑ piqj = PT ….(4.1)

where

M = total stock of money in an economy;

V = velocity of circulation of money, that is, the number of times a unit of money changes
its hand;
Pi = prices of individual goods;

∑P = p1q1 + p2q2 + … + pnqn are the prices and outputs of all individual goods;

qi = quantities of individual goods transacted;

P = average or general price level or index of prices;

T = total volume of goods transacted or index of physical volume of transactions.

This equation is an identity that always holds true: It tells us that the total stock of money used
for transactions must equal to the value of goods sold in the economy. In this equation, supply
of money consists of nominal quantity of money multiplied by the velocity of circulation.

The average number of times that a unit of money changes its hand is called the velocity of
circulation of money. The concept that provides the link between M and P x T is also called the
velocity of money. V is, thus, defined as total expenditure, P x T, divided by the amount of
money, M, i.e.,

V = P x T/M

If P x T in a year is Rs. 5 crore and the quantity of money is Rs. 1 crore then V = 5. This means
that a unit of money is spent 5 times in buying goods and services in the economy. Thus, the
supply of money or the total expenditure on national income is MV. On the other hand, total
value of all transactions or money demand comprises P multiplied by T.

Fisher assumed fixity in V in the short run. V is determinded by (i) the payment habits of the
people, (ii) the nature of the banking system, and (iii) general factors (e.g., density of
population, rapidity of transportation). As far as T is concerned, Say’s Law suggests that it
would remain fixed because of full employment.

With V and T constant, the above identity is modified as:

MV = PT … (4.2)

or P = V/T x M … (4.3)

where the bar sign over the heads of ‘V’ and ‘T’ indicates that these two are fixed. It now
follows that an increase in M leads to an equiproportional increase in P.
The stock of money, thus, determines the price level. People hold money more than their need
for transactions when money supply increases. Holding of money is useless. So they spend
money. This additional expenditure, given full employment, raises the price level. Obviously, a
rise in the price level means an increase in the value of transactions and, hence, demand for
money rises. The process will continue until the equality between demand for and supply of
money is reestablished.

QTM in a Nutshell

The quantity theory of money states that there is a direct relationship between the quantity of
money in an economy and the level of prices of goods and services sold. According to QTM, if
the amount of money in an economy doubles, price levels also double, causing inflation (the
percentage rate at which the level of prices is rising in an economy). The consumer, therefore,
pays twice as much for the same amount of the good or service.

Another way to understand this theory is to recognize that money is like any other commodity:
increases in its supply decrease marginal value (the buying capacity of one unit of currency). So
an increase in money supply causes prices to rise (inflation) as they compensate for the
decrease in money's marginal value.

The Theory's Calculations

The theory, also known as the Fisher Equation, is most simply expressed as:

MV=PT

where:

M=Money Supply

V=Velocity of Circulation

P=Average Price Level

T=Volume of Transactions of Goods and Services

The original theory was considered orthodox among 17th century classical economists and was
overhauled by 20th-century economists Irving Fisher, who formulated the above equation,
and Milton Friedman
It is built on the principle of "equation of exchange":

Total Spending=M×VC

where:

M=amount of money

VC=velocity of circulation

Thus, if an economy has US$3, and those $3 were spent five times in a month, total spending
for the month would be $15.

QTM Assumptions

The classical quantity theory of money is based on two fundamental assumptions: First is the
operation of Say’s Law of Market. Say’s law states that, “Supply creates its own demand.” This
means that the sum of values of all goods produced is equivalent to the sum of values of all
goods bought.

Thus, by definition, there cannot be deficiency of demand or under utilisation of resources.

There will always be full employment in the economy. Second is the assumption of full
employment that follows from the Say’s Law.

QTM adds assumptions to the logic of the equation of exchange. In its most basic form, the
theory assumes that V (velocity of circulation) and T (volume of transactions) are constant in
the short term. These assumptions, however, have been criticized, particularly the assumption
that V is constant. The arguments point out that the velocity of circulation depends on
consumer and business spending impulses, which cannot be constant.

The theory also assumes that the quantity of money, which is determined by outside forces, is
the main influence of economic activity in a society. A change in money supply results in
changes in price levels and/or a change in supply of goods and services. It is primarily these
changes in money stock that cause a change in spending. And the velocity of circulation
depends not on the amount of money available or on the current price level but on changes in
price levels.
Finally, the number of transactions (T) is determined by labor, capital, natural resources (i.e.
the factors of production), knowledge and organization. The theory assumes an economy in
equilibrium and at full employment.

Essentially, the theory's assumptions imply that the value of money is determined by
the amount of money available in an economy. An increase in money supply results in a
decrease in the value of money because an increase in money supply causes a rise in inflation.
As inflation rises, the purchasing power, or the value of money, decreases. It therefore will cost
more to buy the same quantity of goods or services.