Supply of Money – Definition, Explanation and FAQs
Money is the most liquid asset of all. It represents the prime form of a capital asset. Money is accepted as a means of exchange or as a measurement of the value of goods. It is fascinating to imagine a world where the money wouldn't exist.
The supply of money, on the other hand, is a different concept. It is a concept of stocks and shares and is usually perceived in terms of the cumulative effect of the amount of currency that the citizens have and the demand deposits available with the banks of a country.
Understanding the fundamentals of money supply and money demand helps get an idea regarding the country's financial status and the fluidity of the country's currency. In this section, we shall talk about the supply of money, its meaning, components, and the various methods that are involved in the money supply.
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Money Supply: Definition
The concept of money supply can be defined as the total quantity of currency that can be included in a nation's economy. Money supply includes the total money both in the form of cash as well as deposits that can be used as cash easily.
The money supply economics is associated with the government's direct power as it is the government that issues currency either in paper form or in the form of a coin as a combination of treasuries bills and demand drafts of banks. Similarly, the banks also have control over the money supply, and they exert such influence through reserves and credit controls.
Money supply has a major impact on the economy of a country. The inflation of prices of commodities, their demand, and supply change the supply of money. In economics, money supply plays a role in the interest rates and cash flow prevalent throughout the country.
It is important to note here that the money supply does not include the stock of money held by the government or the money under the possession of the banks. These institutions serve as the suppliers of money or are involved in the production of money rather than being a part of the money supply. The term money supply refers only to that share of capital or cash that is governed by the people of the country.
Effect of Money Supply on the Economy
The money supply, meaning the total cash present under a nation's economy, is bound to influence the economics of the market. Therefore, any change in the demand and supply of money will result in a consequent change in the market.
A rise in the money supply will reveal its effect by decreased interest rates and price values of commodities and services. Whereas a decrease in money supply will result in increased interest rates, price values with a coupled increase in banks' reserves.
An effect similar to this occurs on the business as well. As the price levels lower due to increased money supply, the production in business will increase to accommodate people's increased spending. Thus, the money supply and money demand directly impact the macroeconomics of a nation's market.
Components of the Money Supply
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Two components of the money supply regulate its structure and flow. These are:
Currency
Currency forms a major part of the money supply of a nation. As discussed before, the government produces currency in two forms, i.e., coins and paper currency. Thus, money supply through currency can also be divided into:
Paper Currency/ Notes: The production of currency notes is under the control of the government as well as the reserve bank of India. In the country, only one-rupee paper currency is produced by the government, while RBI produces all the other currency notes.
Coins: The second form of currency in India, the coins, are produced in two variants viz token coins and the standard coins characterized as full-bodied coins. The full-bodied currency coins are of little value today under the current currency system. The token coins represent the value of 50 paise and 25 paise.
Did You Know?
The 1-rupee coin available in India does not fall in either category of full-bodied or token.
Demand Deposits
The demand deposits are a part of commercial banks and are used as a non-confidential fund. These accounts are considered money when included in the economy of a country. Such deposits' working mechanism is similar to that of a checking account where withdrawals from the fund can be made without notice.
Different Measures of Money Supply
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After getting an idea about the concept of money supply, we shall now understand the different methods used to measure India's supply of money.
As mentioned before, money production is largely governed by the Reserve Bank of India or RBI. Therefore, it is the RBI that is responsible for the measures of the money supply.
There are four types of methods used by the RBI to measure the supply of money in India. Let's take them one by one:
The first measure is denoted as M1, and it is represented as the formula.
M1 = C + DD + OD
Where C represents the currency, including both paper currency and coins.
DD represents the demand deposits made in the banks.
OD represents the other types of deposits made in RBI, like deposits from public sector financing, foreign banks, or international institutions such as the IMF.
The next measure under the RBI approach to the money supply is denoted as M2. Under the first approach, the deposits made in a savings account are not included as money supply. The second method compensates for this by adding the savings account. Thus,
M2 = M1 + deposits made as savings deposits in Post office savings banks.
The third method under the RBI approach of money supply includes the net deposits made under a specified period with the banks. It includes the normal money supply and net deposits.
M3 = M1 + Net Time-deposits included in banks.
The final measure of money supply included under RBI guidelines accumulates Post office savings banks' deposits and the total deposits except those from National Saving Certificate. Thus,
M4 = M3 + Deposits made with Post-office savings institute.
The concept of money supply still has certain elements that need to be explored. This mainly includes figuring out what can be treated as 'money' and what can't. For example, commercial banks' fixed deposits are not treated as 'money' under money supply. In contrast, the savings deposits made under the Post office savings bank cannot be counted as money because they lack exchange via cheque and face no liquidity.
Thus, M1 is the most liquid measure of the money supply, as it only includes currency and demand deposits. The M1 and M2 are considered narrow money supply measures, and M3 and M4 measure the broad money by including other forms of savings.
Money Supply—Its Main Components
Coins (standard money): paper currency and demand deposits or credit money issued by commercial banks are the key components of the supply of money:
The word "Monetary Standard" refers to the sort of standard money that is utilized in a monetary system. In reality, a country's monetary system is often characterized in terms of its standard money. As a result, the monetary standard is associated with standard money. (A monetary system includes its standard money as well as all paper and credit substitutes that are linked to and convertible into standard money.) A country is considered to have a gold standard system if the standard monetary unit is defined in terms of both gold and silver; a system is said to be bimetallic if the standard monetary unit is defined in terms of both gold and silver.
However, a country's currency is said to have an inconvertible paper money standard if it is not convertible in gold or silver. Thus, it is conventional to describe a country's monetary system in terms of its standard money, which serves as the primary source of supply. It should be mentioned that the adoption of a specific monetary standard in a country at a given moment is determined by the country's economic conditions. However, the monetary standard, which therefore becomes a key component of the monetary system, must be such that it facilitates elastic money supply, economic progress, and promotes people's wellbeing.
A suitable monetary system is one that satisfies both domestic and international trade requirements. In general, the monetary system and hence the monetary standards are directed by the domestic demands of a certain country, while the international aspects of currency management are important.
FAQs on Supply of Money
1. State the Components of the Money Supply.
Money supply refers to the amount of money available to a country's population as well as the amount of money that can be included in the country's economy. The supply of money is made up of two components: currency and demand deposits held by banks. The currency is manufactured in two forms: paper cash and coins. Demand deposits, which are basically accounts in banks where monies can be withdrawn without notice, are the other component of the money supply. Most banks' demand deposits are frequently linked to the current account. These components of the money supply are utilized to determine people's cash flow and cash availability.
2. Explain the Concept of the Money Supply.
The total amount of money or capital in the economy on the day of measurement is referred to as the money supply. It includes both currencies and demand deposits, as these are the most liquid components of the money supply. Savings and fixed deposits, for example, are not considered money since they lack liquidity. The measurement of the money supply is significant since it determines a country's financial soundness. In India, the RBI has four techniques of measuring money supply, including monetary aggregates and measures of both broad and narrow money.
3. What Does the Term "Money Supply" Mean?
The money supply indicates the amount of liquidity that various financial instruments have in an economy. The money supply is typically categorized as M0, M1, M2, and M3 based on the size and kind of account to which a liquid instrument belongs.
Although these classifications may not apply to all nations, M0 and M1 are the most specific, addressing coins, notes, and travelers’ checks in circulation. M2 covers M1's liquid instruments as well as savings accounts, short-term deposits of less than $100,000, and some money market funds. M3 covers M2 liquid products as well as long-term bank deposits of $100,000 or more and institutional money-market funds.
4. How is the money supply determined?
A central bank controls the amount of money in a country. A central bank can use monetary policy to pursue either an expansionary or a contractionary strategy. Expansionary policies entail increasing the money supply through means such as open market operations, in which the central bank acquires short-term Treasuries with freshly produced money, thus pumping money into the economy. A contractionary strategy, on the other hand, would include the sale of Treasuries, removing money from circulation in the economy.
5. Where can I find the notes on the Supply of Money?
Vedantu provides notes and questions on the supply of money. It covers topics such as the supply of money, supply of money components, various measures of the supply of money, and so on. Professional educators develop content so that students can understand and remember it. Vedantu also provides students in grades 1 through 12 with study materials and a range of competitive exams. Notes, important topics and questions, revision notes, and other material are included in the contents. All of these resources are free to use on Vedantu. Students must first register on the Vedantu website in order to access all of these tools. You may also sign up via Vedantu's mobile app.
