Amity School of Business

Money, measures of money supply, and Quantity

theory of money

(Compiled by: Gaurav Shreekant)

 FUNCTIONS OF MONEY
Amity School of Business

• Medium of exchange
• Measure of value
• Store of value
• Standard of deferred payments
 SOURCES OF MONEY SUPPLY
Amity School of Business

1. High powered money created by the Central

bank (RBI)
2. Credit money created by the commercial Banks
3. Non-Banking financial intermediaries also
contribute to the money supply.
4. The money supplied by the RBI & the Govt. is
called High-Power Money Supply because it is
generally backed by supporting reserves and
its value is guaranteed by the government.
 Measures of Money Supply in India, being published by
RBI since 1977 Amity School of Business
M1(also called ‘Narrow Money’) = (1) + (2) + (3)
(1) Currency with Public, which includes notes, coins of all
denominations in circulation excluding cash on hand with
Banks;
(2) Demand deposits with banks, excluding inter-bank
deposits;
(3) ‘Other deposits’ with the RBI (which includes current
deposits of foreign Central Banks, IMF, World Bank,
financial & quasi-financial institutions such as IDBI, IFCI etc.
M2 = M1 + savings deposits (demand deposits) with post office
M3 (also called ‘Broad Money’) = M1 + time deposits with
banks, excluding inter-bank deposits;
M4 = M3 + total deposits (‘demand’ as well as ‘time’ deposits)
with post office (excluding National Saving Certificates).
 Measures of Money Supply in India, being published by
RBI since 1977 Amity School of Business

Of the aforesaid four measures of money supply, it is M3

(which is taken into account in formulating macroeconomic
policies. It is on the basis of M3 that effects of money supply
on ‘prices’ and ‘growth’ of national income are estimated.
 QUANTITY THEORY OF MONEY
Amity School of Business

• According to Irving Fisher, there is a direct relationship

between quantity of money and prices.
• Fisher’s version of quantity theory of money, or as it was
originally called “the quantity theory of exchange” is
formally expressed as-

• MV= PT,
where, M= money supply
V= velocity of money
P= average price level
T= transactions volume
 QUANTITY THEORY OF MONEY
Amity School of Business

• In quantity theory of money V and T are held to be constant.

• In this case if we go by MV=PT, the change in M and P will be in the
same proportion.
• Fisher expanded the equation MV=PT to include the money supply
created by the banks through the process of credit creation based
on their demand deposits.
• The expanded equation is written as-
• MV=M’V’ = PT
• M’ is credit money
• V’ is velocity of credit money
 Critical Evaluation of Quantity Theory of Money
Amity School of Business

1) Fisher’s transaction equation is a truism

2) It does not explain how a change in M changes P
3) It is a static theory
4) M refers to a point of time and V to a period of time, this means
inconsistency
5) Not only M determines P, but P also determines M.