MONEY & MONEY SUPPLY

There is no unique definition of ‗money‘, either as a concept in economic theory or as measured in practice.
Money is a means of payment and thus a lubricant that facilitates exchange. Money also acts as a store of
value and a unit of account. In the real world, however, money provides monetary services along with
tangible remuneration. It is for this reason that money has to have relationship with the activities that
economic entities pursue. Money can, therefore, be defined for policy purposes as the set of liquid financial
assets, the variation in the stock of which could impact on aggregate economic activity. As a statistical
concept, money could include certain liquid liabilities of a particular set of financial intermediaries or other
issuers. Thus, like other countries, a range of monetary and liquidity measures are compiled in India.

Measures of Monetary and Liquidity Aggregates

 Reserve Money = Currency in circulation + Bankers‘ deposits with the RBI + ‗Other‘ deposits with the
RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI‘s claims on banks
+ RBI‘s net foreign assets + Government‘s currency liabilities to the public – RBI‘s net non-monetary
liabilities
 M1 = Currency with the public + Demand deposits with the banking system + ‗Other‘ deposits with the
RBI.
 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
 M4 = M3 + All deposits with post office savings banks (excluding National Savings Certificates).

Explanation:

 Currency in circulation‟ includes notes in circulation, rupee coins and small coins. Rupee coins and
small coins in the balance sheet of the Reserve Bank of India include ten-rupee coins issued since
October 1969, two rupee-coins issued since November 1982 and five rupee coins issued since November
1985. Currency with the public is arrived at after deducting cash with banks from total currency in
circulation, as reported by RBI. ‗
 Bankers‟ deposits with the Reserve Bank‟ represent balances maintained by banks in the current
account with the Reserve Bank mainly for maintaining Cash Reserve Ratio (CRR) and as working
funds for clearing adjustments. „Other‟ Deposits with the Reserve Bank, for the purpose of monetary
compilation, include deposits from foreign central banks, multilateral institutions, financial institutions
and sundry deposits net of IMF Account No.1.
  ‗Net Reserve Bank credit to Government‟ includes the Reserve Bank‟s credit to Central as well as
State Governments. It includes ways and means advances and overdrafts to the Governments, the
Reserve Bank‘s holdings of Government securities, and the Reserve Bank‘s holdings of rupee coins less
deposits of the concerned Government with the Reserve Bank.
 The Reserve Bank‟s claims on banks include loans to the banks including NABARD. In case of the
new monetary aggregates, the RBI‘s refinance to the NABARD, which was earlier part of RBI‘s claims
on banks, has been classified as part of RBI credit to commercial sector
 ‗Other liabilities of the Reserve Bank‟ include internal reserves and provisions of the Reserve Bank
such as Exchange Equalisation Account (EEA), Currency and Gold Revaluation Account.
 ‗Time deposits‟ are those which are payable otherwise than on demand and they include fixed
deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings
bank deposits, staff security deposits, margin money held against letters of credit if not payable on
demand, India Millennium Deposits and Gold Deposits.
 „Currency with the public‟ is currency in circulation less cash held by banks.
 ‗Demand deposits‟ include all liabilities which are payable on demand and they include current
deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/
guarantees, balances in overdue fixed deposits, cash certificates and cumulative/ recurring
deposits, outstanding Telegraphic Transfers (TTs), Mail Transfers (MTs), Demand Drafts (DDs),
unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for
advances which are payable on demand. Money at Call and Short Notice from outside the Banking
System is shown against liability to others.

Factors affecting Money Supply

The supply of money in a modern economy and financial system is determined by three key factors:

1. “Open market operations” – this is effectively the same as Quantitative Easing. The Central Bank
buys government bonds, effectively creating money

2. The “reserve requirement” imposed on banks – this is the % of deposits made by customers at the
bank that the bank must keep hold of rather than lending it out

3. The policy interest rate set by the central bank – the rate of interest will influence how many
households and businesses are willing and able to borrow. Most money in a modern economy is
created by commercial bank lending so the rate of interest ultimately does have a bearing on the
supply of money
 Key factors affecting the demand for money

1. The rate of interest on loans

2. The number / value of monetary transactions that we expect to carry out
3. The extent to which we also want to hold other financial assets, such as bonds, property, saving (this is
also influenced by the rate of interest) – this is known as the speculative motive for holding money
4. Changes in GDP
5. The extent to which it is possible to use debit cards / credit cards i.e. the pace of financial innovation
6. The extent to which we might have to pay out large unexpected payments, for example, for i.e. the
precautionary motive
7. The rate of anticipated inflation

Basics of Printing Currency in India

The Reserve Bank has monopoly to issue currency notes of all denominations except one rupee notes. Since, the
one rupee note issued by the Ministry of Finance but distributed by the RBI through currency commercial
banks.

In 2010, a new rupee sign (₹) was officially adopted. It was designed by D. Udaya Kumar. It was derived from
the combination of the Devanagari consonant "र" (ra) and the Latin capital letter "R" without its vertical bar
(similar to the R rotunda). The parallel lines at the top (with white space between them) are said to make an
allusion to the tricolor Indian flag, and also depict an equality sign that symbolizes the nation's desire to
reduce economic disparity. The first series of coins with the new rupee sign started in circulation on 8 July 2011.
Before this, India used "₨" and "Re" as the symbols for multiple rupees and one rupee, respectively.

In 1861, the Government of India introduced its first paper money: ₹10 note in 1864, ₹5 note in 1872,
₹10,000 note in 1899, ₹100 note in 1900, ₹50 note in 1905, ₹500 note in 1907 and ₹1,000 note in 1909. In
1917, ₹1 and ₹21⁄2 notes were introduced. The Reserve Bank of India began banknote production in 1938,
issuing ₹2, ₹5, ₹10, ₹50, ₹100, ₹1,000 and ₹10,000 notes while the government continued issuing ₹1 note
but demonetized the ₹500 and ₹21⁄2 notes.

After independence, new designs were introduced to replace the portrait of George VI. The government
continued issuing the Re 1 note, while the Reserve Bank of India (RBI) issued other denominations (including
the ₹5,000 and ₹10,000 notes introduced in 1949). All pre-independence banknotes were officially demonetised
with effect from 28 April 1957.

During the 1970s, ₹20 and ₹50 notes were introduced; denominations higher than ₹100 were demonetized
in 1978. In 1987, the ₹500 note was introduced, followed by the ₹1,000 note in 2000 while ₹1 and ₹2 notes
were discontinued in 1995.
The design of banknotes is approved by the central government, on the recommendation of the central
board of the Reserve Bank of India. Currency notes are printed at the Currency Note Press in Nashik, the
Bank Note Press in Dewas, the Bharatiya Reserve Bank Note Mudran (P) Ltd at Salboni and Mysore and
at the Watermark Paper Manufacturing Mill in Hoshangabad. The Mahatma Gandhi Series of banknotes
is issued by the Reserve Bank of India as legal tender. The series is so named because the obverse of each
note features a portrait of Mahatma Gandhi. Since its introduction in 1996, this series has replaced all issued
banknotes of the Lion capital series. The RBI introduced the series in 1996 with ₹10 and ₹500 banknotes. The
printing of ₹5 notes (which had stopped earlier) resumed in 2009. As of 26 April 2019, current circulating
banknotes are in denominations of ₹5, ₹10, ₹20, ₹50 and ₹100 from the Mahatma Gandhi Series and in
denominations of ₹10, ₹20, ₹50, ₹100, ₹200, ₹500 and ₹2,000 from the Mahatma Gandhi New Series.

Printing of currency is based on: how much to print ?

Minimum Reserve System (MRS): Meaning and Objectives

To maintain the adequate supply of money in the economy the RBI prints the money as per the Minimum
Reserve System. Under the Minimum Reserve System, the RBI has to keep a minimum reserve of Rs 200 crore
comprising of gold coin and gold bullion and foreign currencies. Out of the total Rs 200 crores, Rs 115 crore
should be in the form of gold coins or gold bullion and rest in the form of foreign currencies.

Meaning of Minimum Reserve System

Printing of currency notes in India is done on the basis of Minimum Reserve System (MRS). This system
is applicable in India since 1956.

After maintaining the Minimum reserve the RBI can print any number of currency notes as per the requirement
of the economy. Although, RBI has to take prior permission from the government.

Objectives of Minimum Reserve System (MRS)

There are many objectives of MRS but a few are;

1. To ensure the confidence of the Indian currency holders that the currency held by them is a legal tender and
they will receive the value of the currency held by them.

2. The Minimum Reserve System is a token of confidence to the general public that the Indian government is
liable to pay them as per the face value of the notes because the RBI governor promise to the public that ―I
promise to pay a the bearer a sum of 100/500 rupee.‖

3. RBI wants to ensure the appropriate supply of currency in the economy through MRS.
4. Through the MRS the RBI accelerate the economic growth of the country without increasing the rate of
inflation in the economy.

Due to its widespread benefits the Minimum Reserve System still continues in India. Sole purpose of the
Minimum Reserve System is to maintain the money supply in the economy without increasing the inflation and
maintain the confidence of the general public in the currency.

Proportional Reserve System

In order to issue currency notes of different denominations, the RBI followed a system as the backing of the
value of notes issued, which is known as proportional reserve system. The proportional reserve system of note
issue was followed in India until 1956.

Reserve bank of India maintains certain reserves. This is to provide support to the total volume of currency
issued by the Reserve Bank of India. According to proportional reserve system, out of the reserves, certain
percentage or proportion has to be held in the form of precious metals like gold. The remaining amount of
reserves is to be maintained in the form of assets such as commercial bills or government securities. PRS was
adopted in India on recommendations of Hilton Young Commission in 1927.

The proportional reserve system has the following advantages:

o This system guarantees convertibility of paper currency.

o The monetary authority can issue paper currency much more than that warranted by reserves thereby it
ensures elasticity in the monetary system;

o This method of note issue is economical and can be easily adopted by the developing or under-developed
countries.

The proportional reserves system has following drawbacks:

 Under this system, a large amount of precious metal lies locked in the reserve and cannot be put to
productive use. This results in wastage of their use.
 It is easy to expand or increase the currency but very difficult to reduce it. The reduction of currency has
deflationary effects in the economy.
 In practice, high denomination notes are converted into low denomination notes and not into coins.
Therefore the convertibility of paper notes is not practical.

Legal tender Mechanism

About the withdrawal of legal tender status (the action is known as demonetisation) the Section 26(2) of the
RBI Act 1934 says that on recommendation of the Central Board of the RBI, the central government may, by
notification in the Gazette of India, declare that with effect from a date specified in the notification, any series of
bank notes of any denomination shall cease to be legal tender.
According to response to an RTI, the 2016 demonetisation got the ratification of RBI Board hours before PM‘s
announcement
The legal tender character of currency was withdrawn two times in the past. First, higher denomination
banknotes of Rs 1000, Rs 5000 and Rs 10000 were demonetized in 1978. Second, Rs 500 and Rs 1000
denominations were demonetized in 2016.
The Reserve Bank‘s affairs are governed by a Central Board of Directors (CBD). Members of the board are
appointed by the Government of India in accordance with Section 8 of the Reserve Bank of India Act.
The CBD as the administrative apex body of the RBI, contains two sets of directors. First is the official directors
and second, non-official directors.
The official directors comprised of the Governor and not more than four Deputy Governors who are
appointed/nominated by the Central Government under the RBI Act.
Besides the official directors, there can be fourteen non-official directors as well in the CBD. Government can
nominate two government officials into the CBD. As per December 29, 2016, there are 10 members in the CBD.
According to the Government, this CBD has suggested withdrawal of legal tender status to Rs 500 and Rs 1000
notes.

Operations in Printing Currency management by RBI

Issue and management of bank notes has been one of the basic and most publicly visible functions of the Reserve
Bank since its inception. The demand for currency has increased constantly with the growth of the size of the
economy, notwithstanding the progress on non-cash modes of payments due to advances in technology.
Distribution of fresh notes as well as withdrawal and destruction of soiled notes constitute the core of the
currency management operations of the Reserve Bank. With the rising risk of counterfeit notes, preserving
public confidence in the currency has assumed critical significance.
The Reserve Bank gets its role in currency management from the Reserve Bank of India Act, 1934. The
Government, on the advice of the Reserve Bank, decides on various denominations of banknotes to be issued.
The Reserve Bank also co-ordinates with the Government in the designing of banknotes, including the security
features.
For the issue of currency notes and its circulation, the RBI has the Issue Department. It look after the currency
notes in circulation and maintains a minimum reserve needed to issue currencies. Department of Currency
Management has the responsibility of administering the functions of currency management, a core function of
the Reserve Bank in terms of the Reserve Bank of India Act, 1934
The reserves comprise of gold and coring currencies to issue notes. The minimum reserve system was introduced
in 1956 and it requires the RBI to keep a minimum reserve of Rs 200 crores comprising foreign currencies, gold
coin and gold bullion. Out of this, Rs115 crore should be in the form of gold coins or gold bullion. This reserve
is proposed as a token of confidence while printing currency and is not in proportion to the issue of currency
value.
The Issue Department is permitted to issue notes only in exchange for notes of other denominations or against
prescribed assets (foreign exchange and gold).
In pursuing the objective of providing good quality banknotes to the public, the Reserve Bank undertook a series
of initiatives, which included regular supply of fresh banknotes, speedier disposal of soiled banknotes and
extensive mechanisation of cash processing activities. The Reserve Bank has also been examining various
options to enhance the life of banknotes as part of its ‗Clean Note Policy‘. The Bank has been taking several
steps to check the menace of counterfeit notes, such as
 (i) creating awareness through publicity campaigns,
(ii) (ii) enhancing the security features, and
(iii) (iii) using technology to detect fake notes

Department of Currency Management

The Department of Currency Management has the responsibility of administering the functions of currency
management, a core function of the Reserve Bank in terms of the Reserve Bank of India Act, 1934. Currency
management essentially relates to issue of notes and coins and retrieval of unfit notes from circulation. This
work is performed through 18 issue offices of the Reserve Bank and a wide network of 4195 currency chests,
488 repositories and 3562 small coin depots managed by banks and Government treasuries.
Organisational Setup
The Department of Currency Management (DCM) is headed by a Chief General Manager. The Department has
planning division; resource management and remittance of treasure division; note processing and data analysis
division; note exchange division; currency chest division; security and discipline cell; inspection follow-up, co-
ordination and development division; staff cell, administration division; and forged note vigilance cell and the
museum cell.
The Department receives notes from four currency note printing presses. Two of the currency note printing
presses are owned by the Government of India and two are owned by the Reserve Bank, through its wholly
owned subsidiary, the Bharatiya Reserve Bank Note Mudran Ltd. (BRBNML). The government owned presses
are at Nasik (Western India) and Dewas (Central India). The other two presses are at Mysore (Southern India)
and Salboni (Eastern India). Coins are minted in four mints owned by the Government of India. The mints are
located at Mumbai, Hyderabad, Calcutta and NOIDA.
Functions
The Department addresses policy and operational issues relating to :

 designing of banknotes,
 forecasting demand for notes and coins,
 ensuring smooth distribution of banknotes and coins throughout the country and retrieval of unfit notes and
uncurrent coins from circulation,
 ensuring the integrity of bank notes,
 administering the RBI (Note Refund) Rules,
 reviewing/rationalising the work systems/procedures at the issue offices on an ongoing basis and
 dissemination of information on currency related matters to the general public.

The Department also co-ordinates the Bank's endeavour to set up a Monetary Museum in Mumbai. As a
precursor to the Monetary Museum, it has already placed a virtual monetary museum on the RBI site

Concept of Money multiplier: Introduction and Impact of money multiplier on Indian Economy.
Banks create money by making loans. A bank loans or invests its excess reserves to earn more interest. A one-
dollar increase in the monetary base causes the money supply to increase by more than one dollar. The increase
in the money supply is the money multiplier
Money Supply: Money is either currency held by the public or bank deposits:
M = C + D. ( currency + deposits)
Monetary Base: The monetary base is either held by the public as currency or held by the banks as reserves:
(Base)B = C + R (banks).
For example, a one-rupee withdrawal from the bank causes C to rise by one and R to fall by one, so the sum is
unchanged

Simplest Model of the Money Supply

Consider the simplest model of money creation by banks. All money is bank deposits, and the public holds no
currency.

Since C = 0,
M=D
B=R
Banks hold the fraction f of deposits as reserves,
fD = R.

Money Multiplier in India

MM is the amount of money the banking system generates with each rupee of reserves. It works like this:

The money multiplier is equal to the change in the total money supply divided by the change in the monetary
base (the reserves). Here that is represented as a formula:

Money multiplier = Change in total money supply ÷ Change in the monetary base

Let‘s say your reserve ratio is 10% or 0.1 in decimal form. If we plug that into the equation above, it looks like
this:
Money multiplier = 1 ÷ 0.1
Thus, the money multiplier equals 10.
What does this mean in practice? If someone deposits Rs. 50, the bank must reserve 10% of that Rs. 50, or Rs. 5
total. Then, the bank lends out Rs.45. Then other banks experience deposits of Rs. 45, of which Rs. 4.50 is
retained, and Rs. 40.50 is lent out. And this cycle continues… see the table below for the continuation of this
example:

Rs. Rs. lent out by Total deposits so

Step # Rs. reserved
deposited bank far
1 50 5 45 50
2 45 4.50 40.50 95
 3 40.50 4.05 36.45 135.50
4 36.45 3.64 32.81 171.95
5 32.81 3.28 29.53 204.76
6 29.53 2.95 26.58 234.29
7 26.58 2.66 23.92 260.87
8 23.92 2.39 21.53 284.79
9 21.53 2.15 19.38 306.32
10 19.38 1.94 17.44 325.70
Totals 325.70 32.56 293.14 Ends at 325.7

Money Multiplier in the Real World

The equation above does not account for all of the factors that subtly and not-so-subtly influence the way that the
money multiplier effect behaves in the real world. Here are a few of those factors:
 Taxes: A certain fraction of all income is lost to taxes.
 Savings: People don‘t spend all their money at all times—they typically save some of it, and often quite a lot of
it.
 Bad loans: If a bank lends out money to a company and then that company is forced to file for bankruptcy, that
loaned money never returns back to circulation in the banking system.
 Import spending: Money spent on imported products exits the national economy to circulate in other countries.
 Safety reserve ratio: There‘s a certain percentage that banks may want to retain above the required reserve
ratio; for instance, if the reserve ratio is 10%, banks might in fact choose to reserve extra, perhaps something like
10.3% instead.
 Currency drain ratio: Individuals generally hold some of their money in the form of cash rather than depositing
it all in their bank; the percentage of their funds that they keep as cash instead of depositing is the currency drain
ratio.
 Impossible to lend more money: Perhaps there aren‘t enough people taking out loans to actually reach the limit
set by the reserve ratio. For instance, during an economic recession, people tend to save rather than borrowing
money—in this case, banks may be unable to lend out their deposits, due to lack of demand.
 Banks choosing not to lend: Also during recessions, especially, banks may be concerned that recipients of loans
will have a higher risk of needing to default on their loans, so they may choose not to take the risk and be more
conservative about lending out deposits.

The Reserve Ratio

The reserve ratio is the % of deposits that banks keep in liquid reserves.

For example 10% or 20%

In theory, we can predict the size of the money multiplier by knowing the reserve ratio.

 If you had a reserve ratio of 5%. You would expect a money multiplier of 1/0.05 = 20
 This is because if you have deposits of Rs. 1 million and a reserve ratio of 5%. You can effectively lend
out Rs.20 million.
 In theory, if a Central Bank demands a higher reserve ratio – it should have the effect of acting like
deflationary monetary policy. A higher reserve ratio should reduce bank lending and therefore reduce the
money supply.
 Say you deposit 100 Rs with a bank. Banks are required to maintain a percentage of deposits collected as cash
reserves with central bank.
 The central bank imposes this reserve on the bank to manage liquidity situation in an economy. In India we call
this Cash reserve ratio (CRR).
 So let us assume CRR is 10%. Then Bank deposits Rs 10 with RBI and lend the Rs 90 to another customer X.
 X takes the loan and say buys a machinery from Y. Y takes the payment and deposits the money in his bank.
 The bank again gives the money for credit after netting out the reserves. And the cycle goes on this manner. So
100 Rs of deposit with a bank leads to multiplies of the same amount. This is called money multiplier.
Now how to measure it?

It can be measured as: (1+c)/(c+r), where, c is currency-deposit ratio and r is reserve requirement ratio (CRR in
India‘s case).
Currency is currency held by the public for transactions and is given by RBI on a fortnight basis.
Deposits are measured as term deposits at banks and is also given by RBI on a fortnight basis.
Both currency and term deposits form part of the money supply.
We take the ratio of both as people keep part of money as currency and part as deposits. The relation between
currency, term deposit and reserve ration gives us the money multiplier. A reduction in r leads to an increase in
the money multiplier and vice versa.

Loan first multiplier

The money multiplier model suggests banks wait for deposit and then lend out a fraction. However, in the real
world, banks may take it upon themselves to issue a loan, and then seek out reserves from other financial
institutions/Central Bank or private individuals.
For example, in the credit bubble of 2000-2007, many banks were lending mortgages by borrowing on short-
term money markets. They were lending money that wasn‘t related to saving deposit accounts.
In 2009-12 Central Banks pursued quantitative easing. This involves increasing the monetary base. – Buying
bonds off banks gave them greater cash reserves. In theory, this increase in the money multiplier should increase
the overall money supply by a large amount due to the money multiplier
However, in practice, this didn‘t occur. The money supply didn‘t increase because banks were not keen to lend
any extra money.

Also, banks were trying to improve their reserves following the credit crunch and their previous over-extension
of loans.