Definition of Money Supply in Indian Context

We know that 'money' in any modern economy constitutes currency notes and coins issued by the
monetary authority of the country. The supply of money in any country refers to the stock of
money hold by the public at any particular point of time. So, money supply is a stock concept.
The total amount of money in an economy consists of various components: currency demand
deposits of commercial banks, time deposits of commercial banks and other types of deposits in the
economy. We get different definitions of the supply of money depending on which particular
components are included and which are left out.
Measures of Money Supply (M 1, M2, M3 and M4)
Some of the measures of the supply of money are mentioned below :
M1 = Rupee notes and coins with the public (C) + demand deposits with the commercial banks (DD)
+ other deposits with the Reserve Bank (OD).

Here, C = Rupee notes and coins held by the public at a particular point of time (say, as on 30th
June, 2021);
DD = The amount of demand deposits (the deposits in savings account and current account) with
the commercial banks ; and
OD = Other deposits with the RBI These other deposits include:

(i) Demand deposits of some foreign central banks and foreign governments with the Central
Bank
(ii) Demand deposits of some Development financial institutions (say, Industrial Develop ment
Bank of India, Industrial Finance Corporation of India, etc.) with the RBI; and
(iii) Demand deposits of some international financial institutions (e.g., International Monetary Fund
(IMF), World Bank, Asian Development Bank (ADB) etc.) with the RBI.

Here, OD does not, however, include (i) the statutory deposits of the commercial banks with the
RBI and (ii) the government deposits with the RBI.
It is also important to note that while measuring the M 1 the net demand deposits (or the net demand
liabilities) with the commercial banks are to be considered.
Here, net demand deposits = gross demand deposits – inter-bank claims.

Since the inter-bank claims do not enter into the demand deposits of the people with the commercial
banks, so this portion is subtracted from the gross demand deposits.
Other measures of money supply:
(i) M2 = M1 + Postal savings bank deposits.
In this measurement the deposits of the people with postal savings banks are also included in the
money supply. This is because the people can withdraw money from their postal savings bank
deposits on demand. The short-term time deposits (or fixed deposits) of smaller denominations are
also included in M 2.
(ii) M 3 = M1 + (Net) Time deposits with the commercial banks.
In this measure, the net time deposits or term deposits (or long-term deposits) of the public with the
commercial banks are also treated as a constituent of the money supply in an economy. This is
because the people can take loan from the commercial banks against such term deposits.
Here, the time deposits are considered in the 'net' sense because only the term deposits of the people
with the commercial banks are included in the money supply. The inter-bank term deposits are
deducted from the gross term deposits to determine the net term deposits with the commercial banks.
Hence, Net time deposits = Gross time deposits – inter-bank time deposits with the commercial
banks.
(iii) M4 = M3 + Total deposits with the postal savings organisations (excluding National Savings
Certificates).
In this measure of money supply, both demand and time deposits of the public (except National
Savings Certificates) with the postal savings organisations are included in the money supply in
addition to M 3.
In India, M1 and M 2 are considered as Narrow Money, while M 3 and M4 are treated as Broad Money.

Since M 1 and M 2 include lesser constituents of money supply, they are considered as Narrow
Money. On the other hand, M 3 and M4 include greater number of the constituents of money supply,
and hence, they are considered as Broad Money. Generally, M 3 is used to measure the 'Aggregate
supply of monetary resources' of a country.
However, from the view point of liquidity of an asset, M 1 is supposed to be most liquid and M 4 is
supposed to be least liquid. The ease with which any asset can be converted into cash, is considered
as the liquidity of that asset. Thus, cash is the most liquid asset.
Balance sheet of the Commercial Banking sector and accounting of money supply
Balance Sheet of Commercial Banks

Liabilities Assets

1. Demand liabilities 1 [(i) + (ii) + 1. 1. Domestic credit (1a + 1b)

(iii)]
(i) Current deposits
(ii) Demand liabilities portion of
savings bank deposits
(iii) Other demand liabilities 2
2. Time liabilities[(iv) + (v) + (vi)
+ (vii) + (viii)]
(iv) Fixed deposits
(v) Cash certificates
(vi) Cumulative and recurring
deposits
(vii) Time liability portion of
savings bank deposits
(viii) Other time liabilities 3
1a. Credit to government (1a 1 + 1a2)
1a1. Investment in short-term4
government securities
1a2. Investment in long-term 5
government securities
1b. Credit to commercial sector
(1b1 + 1b2 + 1b3)
1b1. Bank credit in India in
rupees and foreign
currency6
1b2. Investments in other
approved7 securities
1b3. Other Investments
1c. Net foreign currency assets of
commercial banks 8
1d. Capital account9
1e. Cash with banks

Some relevant notes on the balance sheet:

1. Liabilities payable on demand.
2. Other demand liabilities comprising overdue fixed deposits, demand drafts etc.
 3. Time liabilities like Certificate of Deposit.
4. Short-term refers to a period of 1 year or less.
5. Long-term refers to a period exceeding 1 year.
6. Bank credit including loans and advances, cash credit, overdraft, bills purchased and
discounted etc.
7. Approved securities are those that banks are required to hold a minimum proportion of
demand and time liability in form of cash, gold and unencumbered approved securities
(including government securities) at the closure of business on any day.
8. Net foreign currency assets include foreign currency asset net of non-residents' currency,
repatriable fixed deposits and foreign currency borrowings.
9. Capital account consisting of paid-up capital and reserves.

Accounting of Money Supply and its relation with balance sheet of commercial banks:
We know people hold their savings partly in liquid form in terms of cash/currency and partly in
bank deposit. Suppose, that the ratio of currency holding to deposit holding is given as 'h', then in
reference with the broad measure of money supply, we get the following relation.
M3 = C + D = (1+ h) D [since, C/D = h]

Now given that 'h', it is important to introduce the interest rate as return on deposit holding in this
regard. In particular, an increase in interest rate can be viewed as increase in return on bank deposit
so much so that it gets to become more lucrative as an option of wealth accumulation to non-bank
public relative to currency holding. Similarly, an unanticipated spike in economy's overall inflation
rate will lower the real return on deposit and therefore can potentially induce a portfolio reallocation
towards cash-holding and correspondingly, an alteration in money supply.

Balance sheet of the Reserve Bank of India (RBI) and the accounting interpretation of High-
Powered Money: Balance Sheet of RBI

Liabilities Assets

1. Currency [(i) + (ii)] 1. Domestic credit [(i) + (ii) + (iii)]

(i) Notes in circulation. (i) Credit to government
(ii) Government’s currency liabilities (ii) Credit to commercial sector
to the public comprising rupee (iii) Claims on banks
coins and small coins. 2. Net foreign exchange assets of the RBI
3. Capital account
2. Other deposits [(a) + (b) + (c) + (d)]
a) Deposits of quasi-government and
other financial institutions.
b) Balances in the accounts of
foreign central banks and
governments.
c) Accounts of international
agencies such as the IMF, etc.
d) Provident, gratuity and guarantee
fund of the RBI staff.
e) Profit of the RBI held temporarily
under the deposits pending
transfer to the central
 government.
3. Bankers’ deposits

High-Powered Money
The High-powered money refers to the total liability of the monetary authority (say, the RBI) of the
country. It consists of:
(i) Currency held by the public;
(ii) Cash reserve with the commercial banks;
(iii) Required reserve of the commercial banks to be maintained with the RBI; and
(iv) Other deposits with the RBI.
This High-powered money is also called as the Monetary Base or the Reserve Money of the country.
(The term 'High powered' implies that an increase in this base money by Rs. 1 leads to an increase
in more than Rs. 1 in total money supply. We know that every commercial bank has to keep certain
proportion of its total deposits with the Central Bank. This is called required reserve. For example,
the commercial banks may have to keep 10 per cent of their total deposits as cash reserve with the
Central Bank. The rest 90 per cent can be used by the commercial banks for credit creation as well
as for meeting the regular day-to-day demands of their depositors.
Both these reserves, viz, cash with commercial banks (free reserve) and statutory cash reserves to
be maintained by the commercial banks with the Central Bank (required reserve) are considered as
assets of the commercial banks but liabilities to the Central Bank. This reserve money plays an
important role for the creation of credit money by the banking system or by the commercial banks
as a whole in an economy.
Balance Sheet of the RBI

Assets (in Rs. Liabilities (in Rs.

crore) crore)

A. Loan to the Government 1. Currency held by the public ……

…… (or currency in circulation)
against Govt. securities) 2. Vault cash held by the commercial banks
B. Loan to commercial banks …
…… 3. Deposits of commercial banks ……
C. Gold reserve with the RBI
…… 4. Treasury deposits of the Govt. of India …..
D. Foreign Exchange reserve
……
Total Assets …… Total Liabilities …..

Now, from the accounting point of view, total assets must always be equal to total liabilities.
So, total liabilities of the RBI or the High-Powered Money consists of (i) Currency held by the
public (C) and (ii) Reserves (R) of the commercial banks (consisting of vault cash held by the
commercial banks + deposits of commercial banks with the RBI).

so, H = C + R

Now, if the assets of the RBI increases through giving more loan either to the government or to the
commercial banks, then the liabilities of the RBI would also rise (i.e., the High-powered Money
would also rise.)
We know that the total supply of money (M) in an economy consists of both currency held by the
public (C) and the demand deposits of the commercial banks (D).

∴M = C + D.
We know that the balance sheet of a commercial bank is as follows:
Balance Sheet of a Commercial Bank

Assets (in Rs. Liabilities (in Rs.

crore) crore)

A. Cash Reserves …… A. Deposits ……

(i) Vault cash (i) Demand deposits
(ii) Deposits with RBI (ii) Time deposits
B. Bank credit ……
(i) Loans
(ii) Investments

Total Assets …… Total Liabilities …..

C
Let  = = Currency-deposit ratio (CDR or the cash-deposit ratio)
D
R
and  = = Reserve-deposit ratio (RDR or the requires reserve ratio).
D
(Here, 0 <𝛼< 1, say, 20% or 0.20)

The CDR refers to the ratio of money held by the public in currency to that they hold in bank
deposits. On the other hand, RDR refers to the proportion of total deposits that the commercial
banks keep as reserves (to meet both the statutory reserves and meeting the demand for cash
withdrawals by the public).

C
+1
M C+D  +1
 = = D =
H C+R C
+
R  +
D D
 +1
Since, 0    1 so, 1
 +
M  +1
Or, =m=  1  M = mH 
H  +
M
Or, 1
H
Or, M>H

Please note that when H = R and M = D [i.e., C = 0]

 M D 1  R
then = =  = 
H R   D
1
or, M = .H

𝟏
Here, the value will be considered as money multiplier.
𝜶
Example 1:
If the money supply = Rs. 150 billion and the base money = Rs. 80 billion then money multiplier
will be (150 ÷ 80) = 1.875.

Example 2:
If the money supply =Rs. 381.82 billion, the base money =Rs. 75 billion, cash-deposit ratio = 12%,
then the value of the required reserve ratio will be as follows:
M  +1
We know that = where
H  +

𝛽 = cash-deposit ratio = 12% = 0.12,

M = Money supply = Rs. 381.82 billion,

H = High-powered or base money = Rs. 75 billion,

𝛼 = Required reserve ratio.

381.82 0.12 + 1
 =
75 0.12 + 

1.12
or, 5.09 =
0.12 + 

or, 5.09(0.12 +  ) = 1.12

or, 0.61 +  5.09 = 1.12

or,  5.09 = 1.12 − 0.61 = 0.51
0.51
or, = = 0.10 = 10%
5.09