Module 2

Money supply
The term money supply refers to the total stock of domestic
means of payment owned by the public (private individuals and
business firms) in a country.
This definition includes money held by the public and in
circulation but it does not include money held by the central bank,
commercial banks and the state treasury because they are
money- creating agencies. money held by them is not an actual
circulation in the country.
The value of stock of money (money supply) can be measured at
a given time or on a particular date.
Constituents of money supply

Constituents of Money
Supply

Traditional Modern measure (broad

Measure(narrow money) money)
Monetary Aggregates: Old
• M1 = Currency with the public + Demand deposits with the banking system
+ ‘Other’ deposits with the RBI. Traditional measure (narrow money)
• M2 = M1 + Savings deposits of post office savings banks
• M3 = M1 + Time deposits with the banking system
• = Net bank credit to the Government + Bank credit to the commercial
sector + Net foreign exchange assets of the banking sector + Government’s
currency liabilities to the public – Net non-monetary liabilities of the
banking sector Modern measure (broad money)
• M4 = M3 + All deposits with post office savings banks (excluding National
Savings Certificates).
Monetary Aggregates: New
NM1 = currency (with public)+ demand deposits with
• NM0 = Monetary Base
the banking system + 'other deposits with the Reserve
= currency in circulation+ Bankers deposits with RBI Bank of India

+ 'other deposits' with the Reserve Bank of India

Traditional measure (narrow money)

Significance of NM1: M1 includes currency with

the public and non-interest bearing deposits with
the banking sector including that of RBI.
NM2 NM3 (Broad Money)
• NM3 = NM2 + Term deposits
(excluding foreign currency
NM2 = NM + time liability deposits with a contractual
1
maturity of over one year with the
portion of savings deposits + banking system + call
certificates of deposits + Term borrowings from 'non-depository
deposits (excluding foreign currency financial corporations' by the
deposits with a contractual maturity banking system
of up to one year with the banking
system
• Modern measure (broad money)
• Significance : captures the
complete balance sheet of the
banking sector.
 Determinants of money supply
The change in total money supply is obtained by the product of high powered money and money multiplier
• A. High powered money or reserve money as RBI calls it, is the base of money supply
and thus, it is called as base money. High- powered money includes currency with
public (C), cash reserves of banks (R) and other deposits (OD) with the Reserve Bank. it
can be expressed as follows
• H=C+R+OD
• H is denoted as M0 by the RBI.
• B. Money Multiplier:- The total money supply in an economy is more than what was
initially supplied by the monetary Authorities.
• The value of money multiplier is determined by Currency Deposit Ratio and Reserve
Ratio.
• The preference by the public between currency and demand deposits is called currency
-deposit ratio (k). This ratio depends on the banking habits of people, level of income,
rate of interest, etc.
• The reserves of banks can be divided into two types: required reserves which are the statutory
reserves to be maintained by the commercial banks with the central bank & Excess reserves
which are voluntarily held by the banks- this is to meet their currency drain (which is the
withdrawal of cash by the depositors) and clearing drain (cash required to meet the cross clearing
of cheques among the banks) and these two together determine the Reserve - deposit ratio (r).
This is the ‘r’ which finally determines the volume of credit that can be created by commercial
banks.
• Thus money Multiplier is :-
• mm=(1+k)/(r+k)
• Illustration-
• If the currency deposit ratio is 0.40 and reserve ratio is 0.20 then the mm will be
(1+0.40)/(0.20+0.40)=2.33
• The change in total money supply is obtained by the product of high powered money and money
multiplier.
• So if High powered money is 10,000 billion then money supply will be 10,000*2.33= 23300.
C. Other factors
• The high powered money and money multiplier are influenced by some other factors also known as the
ultimate factors, these are as follows:-
• 1. Community's choice:- The community's choice regarding currency -deposit ratio is affected by banking
habits, availability of banking services, the price level, level of income, etc.

• 2. Velocity of circulation:- Money supply is influenced by velocity of circulation higher the velocity of
circulation higher is the money supply and vice versa the velocity of circulation as influenced by savings,
price level, payment habits etc.

• 3. Rate of interest:- Higher the interest rate less money will be held in cash and vice versa.
• 4. Monetary policy:- Monetary policy of the central bank plays an important role in credit creation and
therefore in money supply.

• 5. Fiscal policy:- Public authorities can also influence money supply through changes in public expenditure
and taxation policy. Deficit financing and public borrowing (reduces the money supply as it’s used for
repaying debts) also influences money supply.
 Velocity of circulation of money
• To know money supply over a period of time we should multiply the stock of money (M) by the velocity of circulation of
money (V). Velocity of money is further classified as-

• A. Transaction Velocity:-
• It is the ratio of annual volume of transaction to the stock of money.
• For example, suppose the total supply of currency and demand deposits in a given period is Rs.5000 crores and the
transactions conducted are of rupees 1,00,000 crores, then the transaction velocity is 20. Thus, a given unit of money, say,
rupees 1 performs the function of rupees 20 - this indicates the average speed of a unit of money.

• Factors determining transaction velocity

• 1. Volume of production and trade:- Higher the volume of production of goods (with money supply being constant),
greater will be the transaction and thus, more velocity.
• 2. Savings:- if people increase the savings, less money spent and thus, the velocity reduces and vice versa.
• 3. Changes in the price level:-during inflation or during the prosperity period in the business/trade cycle, money circulates
faster and during deflation the velocity declines.
• 4. Institutional arrangements:- if there are different payments, then the velocity will be lower and vice versa.
• 5. Regularity and certainty if income receipt:- if people are confident about regular income receipts, then money
circulation is faster and vice versa.
• B. Income velocity of money:-
• It refers to the average number of times a unit of money is used for making payments for final goods and
services. The concept is more popular with national income accounting techniques. It is the ratio of GNP to
the money stock, if the GNP is Rs 50,000 crores and Money stock (M1) is rupees 10,000 crores, the income
velocity of money is 5. the income velocity is always lower than the transaction velocity. Since, the former
confines itself to the final goods and services, while, the transaction velocity includes financial assets and
sales of existing land and building, these all things are excluded from income velocity.
• Factors determining income velocity
• 1. Growth of GNP:- increase in GNP (with money supply being constant) will require money to circulate
faster so as to purchase a large quantity of final goods and services and vice versa.
• 2. Demand for idle cash:- if the demand for idle cash increases, expenditure on final goods and
services declines, this reduces income velocity.
• 3. Quantity of money supply:- if the stock of money increases faster than the final goods and services, the
income velocity decreases, since there are less goods and services available to purchase.
Keynes : Demand for Money
• The demand for money refers to how much assets
individuals wish to hold in the form of money (as opposed to
illiquid physical assets.) It is sometimes referred to as
liquidity preference. The demand for money is related to
income, interest rates and whether people prefer to hold
cash(money) or illiquid assets like money.
Diagram shows that the demand for money is inversely
related to the interest rate.
•At high-interest rates, people prefer to hold bonds
(which give a high-interest payment).
•When interest rates fall, holding bonds gives a lower
return so people prefer to hold cash.
•Liquidity trap is a phenomenon where at low level of
RoI and the speculative demand for money becomes
perfectly elastic (horizontal curve of demand for
money).
• Types of demand for money
1.Transaction demand –related to income.
2.Precautionary demand – related to income.
3.Asset motive/speculative demand – related to interest rate
• Transactionary demand for money (is interest inelastic)
• Transaction demand for money – the money we need to purchase goods and services in day to day life.
• It is further divided into income motive and business motive(it depends on level of income expected,
time interval, price level, volume of employment- if these factors show rising trend, more will be the
demand for money).
• Precautionary demand for money (is interest inelastic)
• Precautionary demand for money – the money we may need for unexpected purchases or emergencies.
->Asset motive
• The asset motive states that people demand money as a way to hold wealth. This may occur during
periods of deflation or periods where investors expect bonds to fall in value.
• Speculative demand/ asset demand for money (is interest elastic)
• Keynes explained the asset motive through what he termed ‘speculative demand’. In this theory, he argued
that demand for money is a choice between holding cash and buying bonds.
Inverse Relationship Between Interest Rate
and Bond Prices
• E.g. :- Face Value=$1000
• Coupon Rate= 10% /year

Rise in Interest Rate Fall in Interest Rate

Interest Rate=15% Interest Rate=5%

Price of bond=Face Value ÷ (1+interest rate)2 Price of bond=Face Value ÷ (1+interest rate)2
= 1000 ÷ (1+15/100) 2 = 1000 ÷ (1+5/100) 2
=1000 ÷ (1+0.15) 2 =1000 ÷ (1+0.05) 2
=1000 ÷ (1.15) 2 =756.1436 =1000 ÷ (1.05) 2 =907.02
If interest rates are high, and people expect interest rates to
fall, then there is likely to be greater demand for buying bonds
and less demand for holding money. If interest rates fall, then
the price of bonds will rise.

The inverse relationship between the price of bonds and

interest rate is due to high opportunity cost of holding cash.
 Causes of inflation
• A persistent & appreciable rise in prices over a period of time
generally one year is termed as inflation. Inflation can be due
to real factors like increase in aggregate demand without an
increase in aggregate supply and sometimes could be due to
monetary factors like increase in money supply. Inflation
leads to a decrease in the purchasing power of money.
A. Demand pull inflation
B. Cost push inflation
• Monetarists are of the view that inflation is always and
everywhere a monetary phenomenon. So inflation takes
place when there is a change in supply of money.
• According to modern approach to inflation when the
increase in price level is due to an increase in AD it is
called Demand Pull inflation and when it is due to
constraints on the AS side it is called cost push inflation.
• Economists are of the view that any inflationary process
is an interplay of demand pull and cost push factors,
whatever factor may be the cause of initial inflation.
 Types of inflation-causes
1. Demand pull inflation
 Explanation
• Consider fig. where AD and AS are measured along the x-axis and general
price level along the y-axis. Curve AS represents the aggregate supply which
rises upward in the beginning but when full employment level i.e. when AS
reaches OYF , it takes a vertical shape. This is because after the level of full
employment, supply of output cannot be increased. When aggregate
demand curve is AD1, the equilibrium point is at E1, less than full
employment level, where price level OP1 is determined. Now if the AD
increase to AD2, price level rises to OP2
• But since the AS curve is yet sloping upward, increase in AD from AD2 to AD3,
has increased the output from OY2 to Oyf
• if AD further increases to AD4 only price level rises to OP4 with the output
remaining constant at Yf . Oyf is the full employment level or output and AS
curve is perfectly inelastic at Yf
 Causes
• Increase in money supply: when the money supply is in excess of supply of goods
and services it results in additional demand leading to increase in price level.

• Deficit Financing An increase in money supply also takes place when the
government resorts to deficit financing to meet the public expenditure. Deficit
financing undertaken for unproductive expenditure becomes purely inflationary.
Even when it is used on productive activities, prices would still increase during the
gestation period. Modern governments incur huge expenditure on social security
measures. Besides deficit finance is incurred for promoting economic growth.
Heavy expenditure is also incurred during the war time resulting in increase in
money supply.

• Credit Creation Commercial banks contribute to increase in the quantity of money

in circulation when they give loans and advances through the process of credit
creation.
• Exports: Exports reduce the goods available in domestic market. Export earnings
enhance the purchasing power of the exporters and others linked with export An
increase in exports would aggravate the situation by reducing the supply of goods
and at the same time pushing up the demand.
• Repayment of public Debt: Public debt is a common feature of modern
governments. When such debts are repaid, people will have more income at their
disposal. Additional disposable income tends to raise the demand for goods and
services.
• Black money Social and economic evils like corruption, tax evasion, smuggling and
other illegal activities give rise to unaccounted or black money. People with black
money indulge in extravaganza expenditure, affecting demand and thus the price
level.
• Population : The size of the population is one of the important determinants of
demand. In many developing countries population is large in size and still
increasing . India provides an example where demand outstrips (exceeds)supply
due to the large and increasing population.
• Reduction in taxes, with no change in Government Expenditure.
• Decrease in imports
• Increase in government expenditure with no change in tax rates.
 II. Cost-push inflation
Inflation in terms of supply side is called cost push inflation. In the case
of such type of inflation, the costs are not absorbed by the firms,
which are producing goods but are passed on the consumer of goods.
Generally the cost push inflation takes place when there is an increase
in money wage rate which is in excess of the increase in labour
productivity. This leads to an increase in cost of production and thus,
to and upward shift in the supply curve. This will lead to an increase in
the price level.
As can be seen from the above diagram the AD curve and AS curve
intersect each other at point E. Determining the price level as OP. The
economy is at full employment line. If the cost of production rises due
to an increase in wage rate the new point of equilibrium is E1. The price
level goes up from OP to OP1 There is output reduction in the economy
by MM1. This kind of inflation is called cost push inflation. If there is
further rise in cost of production, the supply curve further shifts to S2
and the point of equilibrium E2 is attained. The price rises by P1 P2 and
the output further decreases by M1M2 amount.
 Causes
• Increase in wages : When prices increase-due to increase in wages it is called wage
push inflation. Trade unions play an important role in deciding the wage rate,
Strong and powerful trade unions succeed in securing higher wages for their
members. Higher wages granted in the organised sector influence the wage rate in
the unorganised sector too, resulting in an increase in cost everywhere. The
burden of higher wages is usually shifted forward to the consumers in the form of
higher prices.
• Higher material cost: Prices of materials used in producing goods constitute a
significant part of the cost. Prices of the materials may increase either due to an
increase in demand for these materials or independently owing to national and
international developments. When the prices of basic inputs like petroleum
products increase, the effect is felt throughout the economy. An increase in the
prices of materials especially the basic inputs alters the cost structure of all goods
and services Higher cost of production leads to upward revision of final prices,
Increase in material cost has become one of the important factors responsible for
continuous upward movement of price level.
• Large profit margin: Firms operating under oligopoly or enjoying
monopoly power may increase prices to have higher profit margin.
While firms enjoying some monopoly power will find easy to increase
prices, others will be compelled to raise their prices due to initial spurt
in prices. The desire to have higher profit margins by all those who
have the power to do so becomes the cause for inflationary trend.

• Devaluation: Devaluation increases price of imports and thus, leads to

inflation.

• Other factors : Cost of production may increase when input prices go

up due to scarcity - natural or artificial. Natural calamities like drought
or floods adversely affect the supplies of raw materials thus making
them dearer.
Effects
1. Inverse relation between inflation and unemployment rate.
2. Reduces real income or purchasing power. e.g. with Rs. 50 one could
purchase 2 units of a commodity and due to inflation Rs. 70 i.e. extra
Rs. 20 is required for purchasing same amount of the same
commodity.
3. Inflation that occurs after full employment leads to black marketing
and other illegal economic activities.
4. Income distribution- Entrepreneurs including Farmers earn good
profit, while fixed wage/salary earners suffer.
5. Creditors who lend money are losers as interest received turns out to
be less worth due to inflation, while it becomes easy for debtor to
repay loans. e.g. loan at 2% interest rate was lend by creditor and
inflation rate turns out to be 3%, thus creditors are at loss and
debtors can easily make repayment.
 Measures to control Inflation:-

1. Monetary measure:
The central bank can increase bank rate, cash reserve ratio and statutory liquidity ratio so as
that overall money supply comes down and with that the inflation comes down. The
central bank also make use of qualitative methods to reduce credit creation for particular
purposes and sectors in economy.
2. Fiscal measures:
Increase in taxation will reduce disposable income in hands of public, which reduces
consumption expenditure and thereby will reduce demand; and thus with reduction in
demand, prices of goods and services will come down, therefore inflation will be
controlled.

3. Direct Measures:
When inflation is very high govt can import those commodities or can sell it at lower price
through Public Distribution System which operates in the country through the channels of
ration shops, thus inflation can be controlled for essential commodities in the country.
Monetary policy: Objectives and instruments
• What is Monetary Policy?
• Monetary policy is an economic policy that manages the size
and growth rate of the money supply in an economy. It is a
powerful tool to regulate macroeconomic variables such
as inflation and unemployment.
• These policies are implemented through different tools,
including the adjustment of the interest rates, purchase or
sale of government securities, and changing the amount of
cash circulating in the economy. The central bank or a similar
regulatory organization is responsible for formulating these
policies.
Objectives of Monetary Policy
• The primary objectives of monetary policies are the management of inflation or unemployment, and maintenance
of currency exchange rates.
• 1. Inflation
• Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If
inflation is high, a contractionary policy can address this issue.
• 2. Unemployment
• Monetary policies can influence the level of unemployment in the economy. For example, an expansionary
monetary policy generally decreases unemployment because the higher money supply stimulates business
activities that lead to the expansion of the job market.
• 3. Currency exchange rates
• With the help of fiscal authority, a central bank can regulate the exchange rates between domestic and foreign
currencies. For example, the central bank may increase the money supply by issuing more currency. In such a
case, the domestic currency becomes cheaper relative to its foreign counterparts.
• 4. Balance of Payment (BoP) Equilibrium: if monetary equilibrium is maintained that is there is no surplus or
deficit then BoP equilibrium will be maintained

• 5. Economic Growth: A suitable Monetary Policy would help with the proper utilization of natural and human
resources, more capital formation, more employment, increase in national and per capita income along with an
increase in the standard of living.
 Quantitative Tools/instruments of Monetary
•
Policy
Central banks use various tools to implement monetary policies. The widely utilized policy tools include:
• 1. Interest rate adjustment
• A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to
banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the
banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will
decrease.
• 2. Change reserve requirements Central banks usually set up the minimum amount of reserves that must be held by a commercial bank in form of
CRR and SLR. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the
required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases.
• Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the
commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required
reserves).
• 3. Open market operations The central bank can either purchase or sell securities issued by the government to affect the money supply. For example,
central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.
4. Depending on its objectives, monetary policies can be expansionary or contractionary.
• Expansionary Monetary Policy
This is a monetary policy that aims to increase the money supply in the economy by decreasing interest rates, purchasing government securities by central
banks, and lowering the reserve requirements for banks. An expansionary policy lowers unemployment and stimulates business activities and consumer
spending. The overall goal of the expansionary monetary policy is to fuel economic growth. However, it can also possibly lead to higher inflation.
• Contractionary Monetary Policy The goal of a contractionary monetary policy is to decrease the money supply in the economy. It can be achieved by
raising interest rates, selling government bonds, and increasing the reserve requirements for banks. The contractionary policy is utilized when the
government wants to control inflation levels.
Qualitative tools of the Monetary policy are
given in the following:
1. Margin Requirements: the banks gives us loan against the Mortgage of any kind of property and
asset of us , if margin is greater than lesser will be the loan sanctioned and vice versa.
2. Consumer credit control : under this RBI give the direction to the commercial banks that they
have to increase repayment amount with less no. of installments from the customer -
discouraging the demand for money or decrease the repayment amount with greater no. of
installments from the customer - encouraging the demand for money.
3. Direct action : RBI takes the direct action on the customers for flow of the money in the economy.
4. Moral suasion: under this RBI verbally request the commercial banks for decrease or increase the
interest rates
• 5 Rationing of Credit
RBI fixes a credit amount to be granted for commercial banks. Credit is given by limiting the
amount available for each commercial bank. For certain purposes, the upper credit limit can
be fixed, and banks have to stick to that limit. This helps in lowering the bank's credit
exposure to unwanted sectors. This instrument also controls the bill rediscounting.
• 6 Directives: The central bank can issue written or oral directives to banks to follow certain lines
of action.
Inflation Targeting
• How is Inflation Targeting done?
• A central bank seeks to readjust its monetary policy by doing inflation targeting. This is done by raising or lowering interest rates
based on above-target or below-target inflation, respectively. The conventional wisdom is that raising interest rates usually cools the
economy to rein in inflation; lowering interest rates usually accelerates the economy, thereby boosting inflation. The first three
countries to implement fully-fledged inflation targeting were New Zealand, Canada and the United Kingdom in the early 1990s,
although Germany had adopted many elements of inflation targeting earlier.
• What are the benefits and drawbacks of Inflation Targeting?
• Like all monetary policy instruments, inflation targeting comes with its fair share of benefits and drawbacks, they are the following:
• Benefits
• Inflation targeting allows monetary policy to “focus on domestic considerations and to respond to shocks to the domestic economy”,
which is not possible under a fixed-exchange-rate system.
• Transparency is another key benefit of inflation targeting. Central banks in developed countries that have successfully implemented
inflation targeting tend to “maintain regular channels of communication with the public”.
• An explicit numerical inflation target increases a central bank’s accountability, and thus it is less likely that the central bank falls
prey to the time-inconsistency trap. This accountability is especially significant because even countries with weak institutions can
build public support for an independent central bank.
• Inflation Targeting Drawbacks
• There is a propensity of inflation targeting to neglect output shocks by focusing solely on the price level.
• Leading economists argue that inflation targeting would maintain or enhance the transparency associated with a system based on
stated targets, while restoring the balance missing from a monetary policy based solely on the goal of price stability, thus neglecting
other factors of an economy as well.
Nature of inflation in developing economy
• Both types of inflation plays role, while
only one exerts more than other at Cost push factors
times. Rather it is the by product of the 1. Inelastic supply
development process. 2. Backward agricultural sector
3. Supply shocks
• Demand pull inflation: 4. Change in exchange rate
1. Increase in income 5. Increase in wages
6. Infrastructure bottleneck
2. Huge expenditure 7. Inefficient public sector
3. Gestation period 8. Inefficient public sectors
9. Inefficient and dishonest administration
4. Increasing population
5. Unproductive expenditure
6. Foreign aid capital