Question

What do you understand by supply of money ? Explain the three factors affecting it.

Hint:

The central bank controls the "high-powered money" (currency and reserves), but the final money supply is determined by the interaction of the central bank's policies, the lending behavior of commercial banks (the money multiplier), and the public's preference for holding currency versus deposits.

Answer 1

Part 1: What is Supply of Money?
The supply of money refers to the total stock of money available in an economy at a particular point in time. It is a stock concept, not a flow concept. "Money" here includes currency (coins and paper notes) held by the public and demand deposits that the public holds in commercial banks. It is important to note that the money supply only includes the money held by the "public" and excludes the money held by the central bank and the government, as they are the suppliers of money, not the holders.
In India, the RBI uses various measures of money supply, such as: \begin{itemize} \item M1 = Currency with public (C) + Demand Deposits (DD) + Other Deposits with RBI (OD) \item M2 = M1 + Deposits with Post Office savings banks \end{itemize} Part 2: Three Factors Affecting Supply of Money
The supply of money in an economy is determined by several factors, with the central bank playing the most crucial role. Three key factors are: \begin{enumerate} \item Monetary Policy of the Central Bank: The central bank (like the RBI in India) is the primary controller of the money supply. It uses various instruments to influence the amount of money in circulation and the credit-creating capacity of commercial banks. Key tools include: \begin{itemize} \item Reserve Ratios (CRR and SLR): The Cash Reserve Ratio (CRR) is the percentage of deposits commercial banks must keep with the central bank. The Statutory Liquidity Ratio (SLR) is the percentage of deposits they must maintain as liquid assets. By increasing these ratios, the central bank reduces the funds available for lending, thus contracting the money supply, and vice versa. \item Open Market Operations (OMO): This involves the buying and selling of government securities by the central bank in the open market. Selling securities soaks up liquidity from the system (reducing money supply), while buying securities injects liquidity (increasing money supply). \end{itemize} \item Credit Creation by Commercial Banks: Commercial banks are a major source of money supply through the process of credit creation. Based on the initial deposits they receive and the reserve requirements set by the central bank, they can lend out a multiple of their excess reserves. This process, known as the money multiplier effect, significantly expands the total money supply. The higher the public's propensity to deposit and the lower the reserve ratio, the greater the credit creation. \item Government's Fiscal Policy (Deficit Financing): When the government's expenditure exceeds its revenue, it runs a budget deficit. One way to finance this deficit is by borrowing from the central bank. When the government borrows from the central bank, the central bank prints new currency to provide the loan. This is called deficit financing or monetizing the deficit, and it directly increases the high-powered money and the overall money supply in the economy. \end{enumerate}