MONEY

DEFINITION OF MONEY
 The word "money" can mean many things. It is used with different connotations in our
everyday speech. On the one hand, if people say that a person has a lot of money, they usually
mean that the person is wealthy. On the other hand, to economists money has a very specific
meaning. They define money as “anything that is generally accepted in payment for goods
and services or in the repayment for debts.” (Mishkin, 1992, p.G-7) Definition:
 In general the term ‘money’ means currency notes and coins held as cash in hands or
chequable deposits with banks. In economics, however the term ‘money’ is used in a much
wider sense. There is no unique definition of money. The definition of money has been rather
controversial issue. Conceptually, money can be defined as any commodity that is generally
accepted as a medium of exchange and a measure of value.
 It should be mentioned at this point that currency, e.g. the euro (€), is one type of money.
However, to define money merely as currency would be too narrow for economists.
 Velocity measures how quickly money changes hands. I mean how quickly money moves
from one hand to another hand.
Evolution of Money
BARTER SYSTEM

In barter system one good is exchanged with other goods. Here there is absence of
money.
The barter system will be feasible if there is double coincidence of wants. For
instance, one person is having a cow and he wants to have dog. Another person is
having a dog and he wants to have a cow. The person who is having a cow will look
into a person who is having a dog and vice versa. Then do you think exchange will
takes place quickly. Not necessarily. For instance, the person who is having a cow is
not aggreging with one dog. He is telling my cow is healthy and your dog is less
healthy compared to my cow. I will exchange my cow if you will give me two dogs .
The person who is having dog may or may not agree. If both the party agrees, then
exchange will possible. Otherwise, the person who is having a dog will look into
another person who is having a cow where 1: 1 exchange is possible. In the real
world, it is very difficult. We cant say barter system is not existing now a days. In
very remote place still people exchange their goods with each other.
Barter system is possible due to double coincidence of wants.
COMMODITY MONEY
 Money as a medium of exchange first came into human history in the form of commodities. A
great variety of items have served as money at one time or another such as cattle, olive oil,
wine, gold, silver, copper , diamond, cigarette etc. In order to function as money, the
commodity had to be widely acceptable, which means that everyone had to be willing to
accept it as a payment for goods or services. Early forms of commodity money were, for
example, animal skins in Alaska, salt in Nigeria, cattle in East Africa, tobacco in America, or
shells in Thailand. (Rabley, p.3) Objects like these were not only used to buy goods, but also
to pay for marriages, fines, and debts. By the eighteenth century, commodity money was
almost exclusively limited to metals like gold and silver. Although everyday objects were
extremely practical forms of money, they nevertheless had disadvantages as well. Firstly, it
was a problem to store some of them for a long time. Secondly, the accurate measurement of
their value was not easy. The metallic money has some short comings because scarce
resources are required to dig it out of the ground. Difficulties arose when using these objects
to plan financial activities for the future or when splitting commodities into smaller amounts
or units.
COMMODITY MONEY
PRECIOUS METAL SUCH AS GOLD AND SILVER
 For the above reasons, some societies started to use precious metal, such as gold and
silver. They have been popular commodity monies because they could be used for
various purposes – jewellery, dental fillings etc. - as well as for transactions. Until
several hundred years ago, these metals functioned as a medium of exchange in most
societies, except for the most primitive ones. This new metal money was an important
advance, since it was easier to carry and lasted for a long time. This money could be
divided into different values, and it made planning for the future easier. When people
only used gold as money, the economy was said to be on a Gold Standard. The Gold
Standard was common throughout the world during the late nineteenth century.
 Despite the advantages of metal money, these metals were still quite heavy and it was
hard to transport bigger sums, e.g. for large purchases, such as land or houses. It was
also easy to steal them. Furthermore, some countries only had limited amounts of
precious metals. They could not use all their resources to make coins, for instance.
 PAPER MONEY
 The paper money consists of currency notes printed authenticated and issued by the Central Bank of the
country. Initially, paper money was guaranteed to be convertible into an adequate quantity of precious
metal or coins. In most countries this system has evolved into paper currency that is issued by the
government’s. In most of the countries, paper money/notes are issued by the Central Bank of a country.
In India, paper money or notes are printed by dual monetary system. One rupee note and one rupee coin
is printed by Government of India and higher denomination of notes ( Rs. 2, 5,10, 20, 50,100, 200, 500,
2000) and coins such as( Rs. 2, 5, 10) are printed by Reserve Bank of India. In higher denomination of
notes you will find RBI Goerner signature. It is called as promissory note. The currency issued by the
Reserve Bank of India is in the form of promissory notes but enjoy the status of legal tender. Each
currency note issued by the RBI bears a promise by the Governor of the RBI “I promise to pay the
bearer a sum of…. Rupees. Here, the sum means one rupee currency notes or coins issued by the
Government of India and the RBI currency notes of other denomination. The use of paper money
becomes widespread because it is a convenient medium of exchange. Paper currency can be easily
carried and stored.

 It has some dis advantages. Paper currency and coins can easily be stolen and can be expensive to
transport because of their size. As a consequence, with the development of modern banking, cheques
were invented.
 Money can be wear and tear as it moves from one hand to another hand during transaction. It can be
damaged due to rain and writing on the note. As a result huge printing cost is involved.
PAPER MONEY EXAMPLE
 Bank Deposits: Bank deposits includes three kinds of deposits: current account deposits, saving bank deposits and
time deposits. Current account deposits are available on demand. That’s why current account deposits are widely
referred as demand deposits. There is no such limit that you can withdraw money 15 times in a month like your
saving bank deposits. Time deposits if your fixed deposits.
 Current account never pays any interest. In modern economies the most familiar form of money is checkable
deposits or bank accounts on which cheque can be written for making payments.
 PLASTIC MONEY
Plastic money is a term used to represent the hard plastic cards used in day to day life in
place of actual banknotes. They come in several forms such as debit cards, credit cards,
store cards and pre-paid cash cards. There is enormous growth potential in the domestic
card industry. It has some dis advantages. It can be misused
ELECTRONIC MONEY
 Due to the development of the computer and advanced telecommunication
technologies, new advances in the payment system were made, like the invention of
the electronic funds transfer system (EFTS). This technology introduced individual
access to the payment system by means of a debit card reader or a personal computer.
Deposits are simply transferred from payer to payee using electronic devices.
Nowadays, for example, Central Banks, Commercial Banks, or Corporations can
transfer funds to other institutions by using EFTS. The whole paperwork can actually
be eliminated by converting it to the EFTS. It is much more efficient than payment
systems based on paper, because it reduces the cost of transferring money and,
therefore, decreases the frequency of using cheques and paper money. Now a days
people have begun to use EFTS more and more in daily life. Innovations of these
electronic payment systems helped to reduce transaction costs a lot and initiated the
creation of digital money.
 ELECTRONIC MONEY

CRYPTOCURRENCY
Cryptocurrency is a form of digital money that is designed to be secure and, in many cases, anonymous.
Cryptocurrencies are almost always designed to be free from government manipulation and control, although as they
have grown more popular this foundational aspect of the industry has come under fire.
 FUNCTIONS OF MONEY

 No matter whether money is gold or paper or beads or knives, in any economy it has
three functions. It is a medium of exchange, a unit of account and a store of value.
(Mankiw, 1999, pp.155-156) These three different functions can be distinguished in
the following ways:
MEDIUM OF EXCHANGE

 Money perform a very useful functions as a medium of exchange between any two
goods. This is the most important and unique functions of money. The importance of
this function lies in that it has solved one of the biggest problem of the barter system.
Without a medium of exchange we would live in a barter economy where goods and
services were exchanged directly for other goods and services. In a barter system , for
exchange to take place, there must be “double coincidence of wants”. (Mankiw, 1999,
p.156). The double coincidence of wants exists when, between any two persons , one
is willing to accept what the other person is willing to give in exchange. Until this
condition is fulfilled, exchange cant take place. In a society with millions of people
and with millions of different goods and services, the system of the barter economy
becomes too complicated to be realized. In a modern market economy , the problem
of double coincidence of wants is solved by money.
UNIT OF ACCOUNT/MEASURE OF VALUE

 The second function of money is that it serves as a unit of account . Unit of account means
that money provides standardised terms in which prices are quoted and debts are recorded. It
is also called the standard of value with which economic transactions are measured. All the
values are measured in terms of money. Today, unlike barter system , the value of all the
goods and services is expressed in terms of money. The way you are measuring your heights,
just as we measure weight measuring vegetables, measuring oil ; likewise all the goods are
services produced in the economy is measured in monetary units. When we express the value
of a commodity in terms of money, it is known as price. With money, all prices, i.e. the values
of goods and services, can be expressed in the same way, in terms of units of money. Money
function as a unit of account because the prices of all goods and services are measured in
terms of money. In the USA, for example, the unit of account is the U.S. Dollar.
Note: You are measuring your weights through Kilogram. You are measuring crude oil in liter.
The value of any commodity is measured in money.
STORE OF VALUE

 Finally, money also functions as a store of value. The need to store of value must have
arises for several reasons
 (i) need for storing value for future use due to uncertainty of future
 (ii) accumulative nature of people
 Store of value means that purchasing power is transferred from the present to the
future. A person might decide to keep a fraction of the money that she or he received
by exchanging his or her labour in order to spend it later. Then this saved money
serves as a store of value. As a store of value, money is a bridge from present to the
future.
 Keynes argued that money was “... the perfect store of value, that it is the only asset
which possesses perfect liquidity... .” (Hicks, 1989, p.42)
 In times of inflation however, when an increase in the overall level of prices can be observed, money
does not serve very well as a store of value. Thus Keynes’ argumentation was much more true for the
time when inflation did not exist or for times with very low inflation.
 There are other assets which serve much better as a store of value, e.g. stocks, bonds, land, houses, art,
or jewellery, since many of these have advantages over money as a store of value. Among those are the
facts that they pay the owner higher interest rates than money, or that they experience price
appreciation.

 Standard of Deferred payments- It is added recently as a function of money. Credit has become the
life and blood of a modern capitalist economy. Now millions of transactions are done everyday and in
most of the cases payments are not made immediately. This arrangements works because debtor makes
a promise that he/she will make payments on some future date. Money with its well defined value act
as stored of deferred payments.
KEYNES’ THEORY OF THE DEMAND FOR MONEY

 Money demand refers to the demand by households, businesses, and the government,
for highly liquid assets such as currency and checking account deposits.Demand for
money means how much money people wants to hold in the form of cash or checking
accounts. Checking accounts is the savings bank accounts. Demand for money is like demand
for any other assets and influenced by expected return, risk and liquidity. Risk means
uncertainty. Liquidity means the assets which can be easily converted into cash without
decreasing its face value. Money is most liquid assets compared to other assets such as stocks,
bonds etc. For example, you have 1 crore worth of cash and your friend has 1crore worth of
one house. Whose asset is more liquid?. Here cash is 100% liquidity compared to house. In
order to sell this house your friend may take 1month or 6 months it depends on the locality.
The liquidity of an assets indicates the ease with which it can be converted into the medium
of exchange without a significant loss of value. Note: whenever we are talking about liquidity,
means we are talking in relative sense. According to Keynes people demand for money
basically for three reasons(A) Transactions demand for money (B) Precautionary demand for
money ( C) Speculative demand for money.
According to Keynes the demand for money is influenced by income and rate of interest. The transaction
and precautionary demand for money is influenced by income and speculative demand for money is
influenced by interest rate. Hence, the total demand for money is influenced by income and rate of interest
𝑀𝑑 = 𝑀𝑡 + 𝑀𝑝 + 𝑀𝑠𝑝
𝑀𝑑 stands for total demand for money
𝑀𝑡 stands for transaction demand for money which depends on income
𝑀𝑝 stands for precautionary demand for money which depends on income
𝑀𝑠𝑝 stands for speculative demand for money which depends on interest rate
Hence total demand for money(𝑀𝑑 ) depends on income and interest rate.
𝑀𝑑 = ƒ (𝑌, 𝑟)
Here Y is income and r is rate of interest.
TRANSACTION MOTIVE
The Transactions motive:People hold money because it is a medium of exchange that
can be used to carry out everyday transactions. Everyday you are keeping some money
with you might be to buy food coupons, travel expenses and sometimes to buy movie
tickets. Note: transactions demand for money is a function of income. Higher the
income, higher is the transactions demand for money and vice versa. Transaction
demand for money is influenced by income not rate of interest. For instance, suppose
interest rate was 8 % and went to 10% can you tell your landlord that I will pay the
house rent after two months as interest rate has increased I have deposited all of my
money in the bank. You can tell your house owner but you know the consequence.
Transaction demand for money can not be postponed. It is irrespective of rate of
interest. The opportunity cost of holding money is measured by the Interest rate.
THE PRECAUTIONARY MOTIVE

Like transaction demand for money, precautionary demand for money is a function of
income. Higher the money you have, more money you can save for the future. People
also hold an additional amount of money as a precaution against an unexpected need,
e.g. a person might need some medicine immediately, because she or he suddenly feels
ill. Future is unknown and uncertain. Hence, people used to save money for the future.
Future, there might be increase in children education expenses, health care expenses etc.,
hence people used to save money. People tend to demand money for the so-called
“Precautionary motive” because they wish to make some provision against unforeseen
contingencies.
THE SPECULATIVE MOTIVE:

Transaction and precautionary demand for money depends on income whereas speculative
demand for money is influenced by interest rate. As interest rates rises, the demand for money
falls. When the interest rate rises the opportunity cost of holding money increases and the
quantity of money demanded falls. On the contrary, when interest rate falls, the opportunity cost
of holding money falls and the quantity of money demand increases. With lower interest rate,
people will demand more money and borrow more from the commercial banks as it is cheaper
for them and look for the investment opportunities which will give good return to them in future.

Algebraically, Keynes expressed the speculative demand for money as

𝑀𝑠𝑝 = ƒ(r)
r is the rate of interest.
DEMAND FOR MONEY
Money
demand
curve will
shift when
there is
change in
nominal
GDP
DEMAND FOR MONEY CONTINUES…

 Figure (A) shows the transaction and precautionary demand for money in relation to interest rate.
Transaction and precautionary demand for money is assumed to be interest inelastic. Hence, the
demand for money is a vertical line. Whatever the interest rate, r1, r2 or r3 the demand for money
remains constant at OM.
 Part (B) presents the speculative demand for money (𝑀𝑠𝑝 ) in relation to in relation to interest rate. 𝑀𝑠𝑝
is inversely related to the interest rate.
 Part ( C ) represents the total demand for money (𝑀𝑑 ). The total demand for money is the horizontal
summation of 𝑀𝑡 and 𝑀𝑠𝑝 . 𝑀𝑑 is the total demand for money with relation to interest rate.
DETERMINANTS OF DEMAND FOR MONEY(FACTORS WHICH
AFFECTS DEMAND FOR MONEY)

The demand for money is the quantity of monetary assets such as cash or checking account, that people
choose to hold in their portofolio. Choosing how much money to demand is thus a part of the broader
portfolio allocation decision. In general, the demand for money, like the demand for any other assets –will
depend on the expected return, risk, and the liquidity of money and of other assets.
Two features of money are particularly important. First, money is the most liquid asset. This liquid is the
primary benefit of holding money. Second, money pays a low return( indeed pays a zero nominal return).
The low return earned by money, relative to other assets, is the major cost of holding money. People
demand for money is determined by how they trade off their need for liquidity against the cost of a lower
return.
We look at key macro economic variables affect the demand for money. Although, we primarily consider
the aggregate, or total demand for money, the same economic arguments apply to individual money
demand. This relationship is to be expected , as the aggregate demand for money is the sum of all the
individual money demands.
 The macro economic variables that have a greatest effects on money demand are the price level, real
income and interest rate. Higher prices or income increase people need for liquidity and thus raise the
demand for money. Interest rate affects money demand through the expected return channel.
 Price level: The higher the general level of prices (inflation) the more rupees people need to conduct
transactions and thus, the more rupee people will want to hold. For example, 30 years ago, the price
level in India was about one tenth of its level today; as your grand mother will tell you, in 1990 a good
restaurant meal cost Rs. 100. Hence, less money was needed for transaction. If you will go to the same
restaurant and demand for same meal will you get in Rs. 100 ?. The conclusion is that higher price level
increases the demand for money. In fact, because prices are 10 times higher today than they were in
1990, an identical transaction takes ten times as more rupees today as it did back then.
 Real income: the more transaction that individuals or business conduct, the more liquidity they need
and greater is the demand for money. An important factor determining the number of transactions is
real income. For example, high income super markers has to deal with a large number of customers and
pay more employees than does a grocery shop. Similarly high income individual makes more and
larger purchases than a low income individual. Because higher the real income means more
transactions and greater need for liquidity, the amount of money demand should increase when real
income increases.
 The increase in money demand need not be proportional to an increase in real income. Actually, a 1%
increase in real income usually leads to less than a 1% increase in money demand. One reason that
money demand grows more slowly than income is that higher income individuals and firms typically
use their money more efficiently.
 Interest rates: An increase in the expected return on money increases the demand for money, and an
increase in the expected return on alternative assets cause holders on wealth to switch from money to
higher return alternatives, thus lowering the demand for money.
 For example: Suppose that your total wealth is Rs. 10,000 you have Rs. 8,000 in government earned
bonds earning of 8% interest and Rs. 2,000 is on interest bearing checking account earning 3%. You
are willing to hold checking account at a lower return due to the liquidity it provides. But if interest
rate on bond rises to 10% and now the checking account interest rate remain unchanged, you may
decide to switch Rs. 1000 from checking account into bonds. In making this switch, you reduce your
holding of money (your money demand from Rs. 2,000 to Rs. 1,000. Effectively, you have chosen to
trade some liquidity for the higher return offered by bonds.

 Similarly, if the interest rate paid on money rises, holders of wealth will choose to hold more money. In
the example if checking account paying 5% instead of 3%, with bond still at 8%, you may sell Rs.
1,000 of your bonds, lowering your holding of bonds to Rs. 7,000 and increasing your checking
account to Rs. 3,000.
OTHER FACTORS WHICH AFFECTS DEMAND FOR MONEY

 Increase your wealth- If you are wealthy, then you will keep more money with you for transaction
purpose. Hence demand for money will be more
 Risk: Money usually pays a fixed nominal interest rate (zero in the case of cash). So holding money
itself usually isn’t risky. If alternative assets are more risky: If alternative assets such as stocks,
bonds, real estate are more risky compared to money, then people may demand safer assets, including
money. Hence, demand for money will be more. Thus, increased riskiness in the economy may increase
money demand. On the contrary, if alternative assets are less risky compared to money, then demand
for money will be less. Less risky of alternative assets means people will prefer to invest there. You
know holding money is risky(I) it can be stolen by someone(2) If you are keeping money with you it
will not provide you any return.
 Liquidity of alternative assets: The more quickly and easily alternative assets can be converted into cash, the
less need to hold money. In recent years, the joint impact of deregulation, competition and innovation in the
financial markets has made alternatives to money more liquid. As alternative assets become more liquid, the
demand for money declines.
 Efficient payment technologies: money demand also is affected by the technologies available for making and
receiving payments. For example, introduction of credit cards allowed people to make transactions without
money-at least until the end of the month. Some experts believes that we will leave in a cashless society in which
all most all payments will be made through immediately accessible computerized accounting systems and that the
demand for money will be close to zero.
SUPPLY OF MONEY
 A country’s money supply is mostly the amount of coin and currency in circulation
and the total value of all checking accounts in banks. Supply of money means the total
amount of money available in an economy during a period of time i.e. one year.
Money supply includes all the money in circulation and money held in banks and
other financial institutions. During one year, supply of money is constant and it is not
affected by the interest rate. Hence money supply curve is vertical. Central Bank(RBI
in India) is the main source of Money supply. But it will narrow view if we will tell
RBI is the only source of money supply. Apart from RBI, depository institutions
(Commercial banks) which accepts deposits and gives loans also source of money
supply. Public also supplies money. For instance, if you will store all the money at
home then money supply will be affected. What we are doing-we are keeping extra
money in commercial banks and banks gives loans to other person and credit creation
occurs. In that way people also the source of money supply. NBFIS such as IDBI and
NABARD are the source of money supply. Increase in money supply means the
central banks needs to increase the amount of currency in circulation.
SUPPLY OF MONEY CONTINUES…..
 If the central banks buy financial assets such as government bonds from the public
then the money will flow from the government to the public. As a result, the amount
of money in circulation increases. When the central bank uses money to purchase
government bonds from the public, thus raising the money supply, it is said to have
conducted an open market purchase. To reduce the money supply, the Central bank
make this trade in reverse, selling government bonds to the public. When Central bank
sells government bonds to the public to reduce the money supply, the transactions is
an open market sale. Open market purchase and sale together are called open market
operation. The supply of money refers to the total quantity of money in the country.
Though the supply of money is a function of the rate of interest to a certain degree,
yet it is considered to be fixed by the monetary authorities. Hence, the supply curve of
money is taken as perfectly inelastic represented by a vertical straight line.
High Powered Money Vs credit Money
The central bank of a country is the main source of money supply in the country. The currency issued by the
Central bank is the liability of the Central bank and the government.
High powered money is the total liability of the monetary authority of a country. This is also called as monetary
base. In India both RBI and Government issues high powered money. Put it simply, high powered money is
money in physical form. Physical form of money is printed by Government of India and RBI. Hence high
powered money is printed by RBI and the Government. High powered money includes currency( such as notes
and coins ) and commercial banks reserves with the RBI. So sum up, high powered money is
H=C+R
H is high powered money
C is currency
R cash reserve by the commercial banks with the RBI

Commercial Banks creates money supply in the process of borrowing and lending money to the public. Money
created by the commercial bank is called “ Credit money”
PURPOSE OF MEASURING MONEY SUPPLY

 Excess of money supply may leads to inflation and shortage of money supply may cause economic
recession. Therefore, the supply of money need to be maintained at an optimum level. That is , money
supply need to be controlled and regulated in accordance with the monetary requirements of the
country.
 Excess money supply creates inflationary situation in an economy
 Shortage of money supply creates deflationary situation in an economy.
HOW CENTRAL BANK CONTROL MONEY SUPPLY

The primary way in which RBI controls the supply of money is through open market operation ( OMO is
the purchase and sale of government bonds by the RBI). When the RBI wants to increase the money
supply it has to buy government bonds from the public. If RBI will buy government bonds (RBI will pay
money to the public) then money supply in the economy increases.
 On the other hand, if the RBI want to decrease the money supply, it sells government bonds. This open
market sale of bonds takes some rupees out of the hands of the public and thus decrease the quantity of
money in circulation.
 Note: How Central Bank increases money supply : through open market purchase
 Note: How Central Bank decreases money supply : through open market sale
 Although open market operations are the main way that RBI affects the money supply, it has other
methods available : change in reserve requirements and discount window lending.
HOW CENTRAL BANK CONTROL MONEY SUPPLY CONTINUES…

 Reserve requirements: the RBI sets the minimum fraction of each type of deposits that bank must hold
as reserves. An increase in reserve requirements forces commercial banks to hold more reserves and
increases the reserve deposits ratio. A higher reserve deposits ratio reduces the money multiplier and
reduces the money supply.
 Discount window lending: RBI acting as “lender of last resort” –that , by standing reddy to lend reserve
to banks that need cash to meet depositors demand or reserve requirements. The RBI lending of
reserves to banks is called discount window lending.
 Discount rate: the discount rate is the interest rate that RBI charges when it makes loans to banks.
Banks borrows from the RBI when they find themselves with too few reserve to meet reserve
requirements. The lower the discount rate, more banks borrow at the RBI discount window.
COMPONENTS OF MONEY SUPPLY/ MONETARY AGGREGATES

Money supply is the total amount of money available in an economy at a specific time. Money supply data
are recorded and published by the Government and Central bank of the country. there is no single measure
of money supply. Various measures of money supply keep on changing from country to country and from
time to time within a country. Till March 1968, RBI published only one measure of the money supply
which was called M1. This was keeping with the traditional and Keynesian views of the narrow measure
of the money supply. From April 1968, the RBI started publishing another measure of the money supply
which is called broad measures of money supply M3. Since April 1977 there are four measures of money
supply in India which are denoted by M1, M2, M3 and M4.
𝑀1 =Currency with the public + demand deposits with the banking system(deposit money of the public)
+other deposits with the RBI
𝑀1 is the first measure of money supply. Currency with the public which includes notes and coins of all
denominations in circulations (two rupees, five rupees, 10 rupees and small coins are the most liquid
assets. A liquid assets is one which is easily spendable and transferable at face value anywhere and at any
time. It can be turned into the generally acceptable medium of exchange quickly.
COMPONENTS OF MONEY SUPPLY/ MONETARY AGGREGATES
CONTINUES…..

Demand deposits with commercial and cooperative banks excluding interbank deposits
Demand deposits are saving bank accounts and current accounts in banks from which the depositors can
withdraw cheques from any amount lying in their account. Thus, like currency, demand deposits are the
most liquid and posses the medium of exchange function of money.
Other deposits: other deposits of the RBI are its deposits other than those held by the Government
(central and State Government). Other deposits includes RBI Governor deposits with RBI, Commercial
banks and intermediaries). Other deposits constitute very small proportion (less than 1%) of the total
money supply , hence could be ignored.
M1 is called narrow money. Narrow money is the most liquid assets and it is easily used to spend
(currency, checkable deposits). Narrow money are more directly affected and controlled by the monetary
authority.
COMPONENTS OF MONEY SUPPLY/ MONETARY AGGREGATES CONTINUES…..
𝑀2 = 𝑀1 +Post office saving bank deposits
𝑀2 is the second measure of money supply. In India, the majority of people are in rural areas and prefers
to keep their money in the post office saving banks deposits from their safety point of view because they
think that post office are government owned and managed. Still the majority of rural people being
illiterate, they prefer post offices to banks even by force of habit.
But post office saving bank deposits are less liquid than currency and demand deposits because they can
not be easily withdrawn. 10 years before even they don’t have check facility except metropolitan cities
and that too main post offices.

𝑀3 = 𝑀1 +time deposits with the banking system. This is the third measure of money supply in India which
consists 𝑀1 plus time deposits with commercial and cooperative banks excluding interbank time
deposits.
𝑀3 is the broad money which stress the store of value functions of money along with the medium of
exchange. M3 is called as broad money. Broad money is less liquid type of assets (certificates of deposits
and time deposits). This is less liquid than the currency and demand deposits because they are held for a
fixed time period at a fixed rate of interest. So, time deposits do posses liquid but less than demand
deposits. 𝑀3 has been taken into account in formulating macro economic objectives of the economy .
COMPONENTS OF MONEY SUPPLY/ MONETARY AGGREGATES CONTINUES

𝑀4 = 𝑀3 +total post office deposits (saving deposits, Fixed deposits, recurring deposits, Sukyana Samrudhi
deposits)
It is the fourth measure of money supply 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. The total post
office deposits are less liquid than the bank deposits.
Demand deposits of banks are also a liquid as currency because they are chequing accounts and easily
serve as medium of exchange. But demand deposits of post office do not posses the same degree of
liquidity as bank deposits. The time deposits of banks, post offices and other non bank financial institution
are less liquid than demand deposits because they can not be easily transferred to depositors in the form of
cash. They serve more as a store of value. They are less liquid because they take more time to be sold and
transferred. Hence, they posses less liquidity than the demand deposits.
FACTORS INFLUENCING SUPPLY OF MONEY
Factors Direction of Change Supply of Money Reasons for Decreased
supply of Money
Required reserve ratio Increase Decrease Reduction of fund available
(CRR & SLR) before the commercial
banks to lend money
Public desire to hold Decreases Increases Increased level of credit
currency with them creation
Public desire to hold Increases Increases Increased level of credit
deposits with bank creation
Price change Increase Increase Value of money decreases
in turn more supply
Exchange rate Appreciate Decrease Declining demand for a
country’s goods abroad

Source: Compiled by author

THE KEYNESIAN THEORY OF DETERMINATION OF INTEREST RATE

Interest rate is the price paid to borrow debt capital or in other words it is the cost of money.
Like the price of any product, the rate of interest is determined at the level where the demand for
money equals the supply of money. In Keynesian model, the supply of money is assumed to
remain constant in the short run. During one year, the quantity of money supplied is fixed .
Money supply is constant because the supply of money in any country is not determined by the
market forces, but by the central bank of the country. The supply of money in India is
determined by the RBI. Central bank don’t increase or decrease the supply of money in response
to the variation of the rate of interest. Therefore, the supply of money in any time period is
assumed to be given and it is vertical line. It is therefore, interest inelastic. Hence, the money
supply curve is vertical line. In the following figure, the vertical line MS represents the supply
of money and the demand for money curve is MD. The total money demand curve which is the
combination of transaction, precautionary and speculative demand for money which is affected
by interest rate. Note that money supply curve is vertical and not sensitive to interest rate
changes. Both demand for money and supply of money curve intersect with each other at point
E and determines equilibrium rate of interest r.
DETERMINATION OF INTEREST RATE

Note: MD and Md uses interchangeably

At point E, the demand for money is equal to supply of money(MD=MS). When demand for money is
equal to supply of money, the interest rate will be stable. Any other points(When MD is not equal to MS),
the rate of interest is not stable(it may increase or fall). If the supply of money is more than the demand for
money or vice versa, then the interest rate will decrease or increase. If interest rate increases, people will
deposit more money in the bank. Likewise, banks will be more interested to lend more with higher interest
rate to enhance their profit. On the other hand, with low interest rate, people will not be interested to
deposit money in the bank as returns are less. In this situation, people prefer to hold cash. Keynes’s theory
believes that the interest rate adjusts to bring money supply and demand into balance. If there is any
deviation from equilibrium position(that is point E) an adjustment will take place through the rate of
interest, and equilibrium E will be re-established.
 At higher interest rate r1 , the supply of money is OM (or MS) and the demand for money is OM1 . At
point r1 the supply of money is greater than the demand for money(OM> OM1). Consequently, the rate
of interest falls from r1 till the equilibrium rate of interest r is reached. Contrary, when the interest rate
falls to r2, the demand for money OM2 and the supply of money is OM. At r2 , OM2 >OM. As a result,
the rate of interest will start increasing till it reaches the equilibrium interest rate r. Note: when interest
rate falls from r to r2, the speculative demand for money increases because at a lower rate of interest
preferences for cash holding increases.
 It may be noted that, if the supply of money is increased by the monetary authorities, but the demand
for money curve MD remains the same, the rate of interest will fall. If the demand for money increases
with given the supply of money, the rate of interest will rise.
 The question arises why the demand for money is downward slopping. The downward slope represents
the important feature of the money demand that it has some interest sensitivity. That is, as interest rate
increases, people and business economize on their transaction demand by shifting funds to high interest
assets more often, by holding less currency on average.
HOW SUPPLY OF MONEY AFFECTS AGGREGATE DEMAND

When RBI increases money supply, interest rate tend to fall and credit becomes more plentiful. As a result,
it becomes more profitable to undertake new investment project, so the investment outlay rise. This shift
aggregate demand curve towards right increasing output and the price.
MONEY MULTIPLIER

 Money multiplier describes how an initial deposits lead to final increase in the total money supply
 Money multiplier means amount of money generated by the banking system with a certain amount of
their reserve
 higher the reserve ratio, lower the money multiplier and vice versa.
 Credit creation means excess of credit.
MONEY CREATION BY COMMERCIAL BANK / CREDIT CREATION

 How commercial banks are creating money?

Credit creation depends on required reserve ratio which is the combination of CRR and SLR. But for simplicity, here we are taking
CRR only.

Suppose you deposited Rs. 1 lakh in your saving bank account. Do you think the bank will give loan to another customer Rs. 1 lakh deposited
by you. If bank will do, then what will happen ? You have deposited Rs. 1 lakh today and bank thought that you may not withdraw in short
term and gave your deposited money to another customer 1 lakh as loan. Unfortunately, you require Rs. 1 lakh and you have only one option
to withdraw that money from the bank. Next day, you came to the bank with one withdrawal form to take your Rs. 1 lakh. If bank will tell you
one day before you deposited Rs. 1 lakh and today you want to withdraw your money. Hence, we can’t give your money now. If bank will tell
like this, then how will be your reaction? You may tell to your friends, relatives, media etc and everyone will be panic to withdraw their
money from that banks and that bank may collapse. Remember when you are depositing money in the bank that is your money and any time (I
mean on working day) you can withdraw that money. That money is your assets and banks liabilities. In order to avoid such type of above
scenario, the Reserve Bank of India made some rules and regulations. Bank can’t give your entire deposited money to another customer.
Banks need to maintain certain percentage of deposits with the Reserve Bank of India in the form of Cash Reserve Ratio (CRR). In worst
case, if bank require money in the short run, then they can utilise their reserve which they kepi in RBI.
MONEY CREATION BY COMMERCIAL BANK / CREDIT CREATION
CONTINUES…..

K=1/CRR=1/10%=10

K is money multiplier. It describes how an initial deposit lead to final increase in the total money supply.

CRR is cash reserve ratio which RBI decides

Let’s assume that there are 3 banks such as SBI, YES bank and AXIS bank. Within these banks no cash transaction
occurs only cheque transactions occurs. Let’s assume CRR is 10 %. Suppose Sunder Yadav deposited Rs. 1 lakh in
SBI. SBI need to keep 10% as CRR, I mean SBI will keep Rs. 10,000 with the RBI and remaining Rs. 90,000 will be
available for loan to another customer. That is Rs. 90, 000 SBI can’t keep with himself for a longer period of time. If
they will do so, how they will pay intersect to Sunder Yadav for his saving deposits. Let’s assume that another
customer named as Sai Ram approached to SBI for loan and Sai Ram has no saving bank account in SBI. However,
he has savings bank accounts in YES bank. SBI gave one cheque of Rs. 90,000 and Sai Ram deposited in YES bank.
Now Rs. 90,000 entered as YES bank book of accounting. That Rs. 90,000 is Sai Ram assets and Rs. 90, 000 is Yes
bank liability. Now YES bank need to keep 10% of RS. 90,000 with RBI (I mean Rs. 9,000 with the RBI) and
remaining Rs. 81,000 is available for loan for another customer. Suppose Prakesh Reddy came to YES bank and
approached for loan. But he has no accounts with YES bank but he has accounts with AXIS bank.
MONEY CREATION BY COMMERCIAL BANK / CREDIT CREATION
CONTINUES…..

Now Yes Bank gave Rs. 81,000 in cheque and Prakesh Reddy deposited in AXIS Bank. Again Rs. 81,000 is Prakesh
Reddy’s assets and banks liabilities and entered the book of accounting. Now AXIS bank needs to maintain 10% of
Rs. 81,000 as CRR with the RBI and remaining (Rs. 81,000-Rs. 8100=Rs. 72,900) is available for loan to another
customer. This process will keep on continuing. A little bit of algebra tells us that the initial deposits of 1 lakh will
lead to a succession of loan that is add up to Rs. 90,000+ Rs. 81,000+Rs. 72,900……

How much credit creation will occur (initial deposits ×by money multiplier (1 lakh ×10)= Rs. 10, 00000. Initial
deposits is 1 lakh. Put it simply, you deposited Rs. 1 lakh in the banks and banks created Rs. 10 lakhs out of it. This is
the way banks creates money and makes profits.

Initial deposits Loan Rs. Loan Rs. Loan Rs.

of 1 lakh 90,000(Rs. 81,000(Rs. 72,900(Rs.
10,000 went 9,000 went 8100 went for
for reserve) for reserve) reserve)
 Thank you
If you have any doubts, you can reach me at 9177695171 / 7013542059 or email akdash@ibsindia.org