Supply of Money
The money supply in an economy is typically measured using different monetary aggregates, from M0 to M4 (or even higher, depending on the country’s financial system). These aggregates represent various definitions of the money supply, based on liquidity (ease of conversion to cash). Here’s a breakdown from M0 to M4:
1. M0 (Monetary Base):
- Definition: The narrowest definition of money supply.
- Components:
- Physical currency: Coins and paper money in circulation.
- Reserves held by commercial banks: These are the reserves that banks hold at the central bank.
- Liquidity: Very high; M0 represents money that is fully liquid and can be used for immediate transactions.
2. M1:
- Definition: A slightly broader measure than M0, focusing on money that is highly liquid and can be used for immediate spending.
- Components:
- M0 (currency in circulation).
- Demand deposits: Checking accounts and other forms of highly liquid bank deposits that can be accessed on demand.
- Other liquid assets: Traveler’s checks and other forms of easily accessible funds.
- Liquidity: Very high; it includes money directly available for transactions.
3. M2:
- Definition: A broader measure that includes all of M1, plus slightly less liquid forms of money that are still relatively easy to convert into cash or spending.
- Components:
- M1 (currency and demand deposits).
- Savings deposits: Savings accounts and other near-liquid assets that can be accessed relatively easily.
- Time deposits: Deposits that are locked for a fixed term (e.g., fixed-term savings accounts).
- Money market funds: Short-term investment funds, primarily in debt securities.
- Liquidity: Moderately high; includes funds that can be accessed with a little more delay than M1.
4. M3:
- Definition: A further broadening of M2, adding even less liquid forms of money.
- Components:
- M2 (savings and time deposits, money market funds).
- Large time deposits: Large, long-term deposits, often held by institutions or large corporations.
- Institutional money market funds: Money market instruments that are less liquid and typically involve larger transactions.
- Other larger liquid assets: Includes instruments like repurchase agreements (repos), Eurodollars, and other large-scale assets.
- Liquidity: Low to moderate; includes assets that may take time to convert to cash.
5. M4:
- Definition: The broadest definition of the money supply, often used in some economies for more comprehensive analysis.
- Components:
- M3 (large deposits, money market instruments).
- Other forms of highly liquid assets: This could include things like commercial paper, large savings bonds, or other instruments not included in M3 but still considered liquid.
- Liquidity: Low; includes financial assets that are less readily available for spending but can be liquidated if needed.
Implications:
- M0 to M4 represent increasing levels of liquidity, from cash and reserves (most liquid) to broader financial assets that can still be converted into money but are less easily accessible.
- M1 and M2 are typically most relevant for measuring the money available for immediate spending in the economy.
- M3 and M4 provide a more comprehensive picture of the total amount of money in circulation, including larger, institutional investments that may have implications for long-term economic health.
Determinants of Money Supply:
The supply of money is influenced by several factors, most notably:
- Central Bank Policies:
- The central bank controls the money supply through tools like open market operations (buying and selling government securities), setting interest rates (which affects borrowing), and changing reserve requirements for commercial banks.
- Bank Lending:
- Banks play a role in creating money through the credit creation process. When banks issue loans, they increase the amount of money in circulation since borrowers spend the loaned money.
- Public Preferences:
- The demand for money (whether individuals and businesses prefer to hold cash or invest) can also influence the money supply. If people prefer more liquidity, there may be more money in circulation.
- Government Policy:
- Governments, through fiscal policy (taxation and spending), can influence the overall economy and indirectly affect the money supply.
High-Powered Money?
High-Powered Money, also known as Reserve Money or Base Money, refers to the money created directly by the central bank (RBI in India). It forms the foundation for the entire money supply in the economy. It is called “high-powered” because a small change in it leads to a multiplied effect on the total money supply through the banking system.
1. Components of High-Powered Money
High-powered money comprises:
- Currency held by the public
- Cash reserves of commercial banks with the central bank (CRR)
- Vault cash (cash banks keep in their own branches)
- Other deposits held with the central bank
Formula:
H=C+R
Where:
- H = High-Powered Money
- C = Currency held by the public
- R = Reserves of banks with the central bank
2. High-Powered Money vs Broad Money
High-powered money is not the same as the total money supply. It is the initial supply of money from which the broader money supply is generated using the credit creation process of commercial banks.
- High-Powered Money is directly under the control of the central bank.
- Broad Money (like M1, M3) includes deposits and is the result of multiple rounds of lending and depositing.
3. The Role of Money Multiplier
The money multiplier shows how much money supply is created with one unit of high-powered money.
Formula:
Money Supply (M)=Money Multiplier×High-Powered Money (H)
Money Multiplier depends on:
- Cash Reserve Ratio (CRR)
- Currency-deposit ratio (public’s preference for holding currency)
- Excess reserves held by banks
If the public prefers to hold more currency or banks choose to hold more reserves, the money multiplier shrinks, reducing the money supply expansion.
Determinants of Money Supply:
The supply of money is influenced by several factors, most notably:
- Central Bank Policies:
- The central bank controls the money supply through tools like open market operations (buying and selling government securities), setting interest rates (which affects borrowing), and changing reserve requirements for commercial banks.
- Bank Lending:
- Banks play a role in creating money through the credit creation process. When banks issue loans, they increase the amount of money in circulation since borrowers spend the loaned money.
- Public Preferences:
- The demand for money (whether individuals and businesses prefer to hold cash or invest) can also influence the money supply. If people prefer more liquidity, there may be more money in circulation.
- Government Policy:
- Governments, through fiscal policy (taxation and spending), can influence the overall economy and indirectly affect the money supply.