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Home / IAS Preparation / Money Supply

Supply of Money Meaning, Components, Measure, Types, Sources, Etc.

Last Updated on Aug 05, 2024
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The money supply is a fundamental concept in economics, representing the total quantity of monetary assets circulating within an economy at a given time. It plays a crucial role in influencing economic activities, inflation, and interest rates. The supply of money is typically categorized into different measures, such as M1 and M2, each representing varying degrees of liquidity. Central banks, through monetary policy, exert control over the money supply to achieve economic objectives. Understanding the dynamics of money supply is essential for policymakers, economists, and individuals alike, as it directly impacts the overall health and functioning of an economy.

Supply of money is a vital topic to be known for economics section in UPSC IAS exam. It covers an important section in General Studies Paper 3.

In this article, the learners will be able to know about the supply of money along with certain other related topics in detail.

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Explain the Concept of Money Supply

The supply of money refers to the total quantity of monetary assets circulating within an economy at a given time. It includes various forms of money that individuals, businesses, and governments use for transactions, investments, and savings. Money supply is a crucial economic indicator as it affects inflation, interest rates, and overall economic activity.

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Components of Money Supply

The money supply is typically categorized into different components based on their liquidity and accessibility. The two main components are M1 and M2:

  • M1 (Narrow Money):
    • Currency in Circulation (C): Physical money, including coins and paper currency, held by the public.
    • Demand Deposits (D): Funds held in checking accounts and other liquid deposit accounts that allow for immediate withdrawal.
  • M2 (Broad Money):
    • M1 Components: Includes all elements of M1.
    • Savings Deposits (S): Funds held in savings accounts, which may have withdrawal restrictions.
    • Time Deposits (T): Fixed-term deposits in banks, such as certificates of deposit (CDs).
    • Money Market Mutual Funds (M): Short-term, low-risk investments that offer higher interest rates than regular savings accounts.

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Measures of Money Supply

The money supply is measured using various aggregates, denoted as M1, M2, M3, and so on. The choice of measure depends on the liquidity and accessibility of the assets included. The commonly used measures are M1 and M2:

  • M1:
    • M1=C+D (Currency in Circulation + Demand Deposits)
  • M2:
    • M2=M1+S+T+M (M1 + Savings Deposits + Time Deposits + Money Market Mutual Funds)

Other measures, such as M3, include broader categories of financial assets and are used in specific economic contexts.

Determinants of Money Supply

Several factors influence the money supply in an economy

  • Central Bank Policy:
    • Open Market Operations: Central banks buy or sell government securities to control the money supply.
    • Reserve Requirements: The percentage of deposits that banks must hold in reserve, influencing the amount of money banks can lend.
  • Commercial Bank Actions:
    • Lending Practices: Commercial banks influence the money supply by deciding how much to lend to businesses and individuals.
  • Public Preferences:
    • Holding Money: The public's preference for holding currency versus depositing money in interest-bearing accounts affects the money supply.
  • Economic Activity: 
    • Velocity of Money: The speed at which money circulates in the economy influences the money supply's overall impact on economic activity.
  • Government Influence: 
    • Government Spending: Government expenditure and fiscal policies impact the money supply, especially if financed through borrowing.
  • Financial Innovation: 
    • New Financial Products: The introduction of new financial instruments and innovations can influence the composition and size of the money supply.

Study in detail about Difference between Demand Deposit and Term Deposit here!

Types of Money Supply

Money supply can be categorized into different types based on their liquidity and accessibility. The commonly used types are M0, M1, M2, M3, and M4:

  • M0 (MB or High-Powered Money): Includes physical currency (coins and paper money) in circulation and reserves held by commercial banks in their accounts with the central bank.
  • M1 (Narrow Money): Includes M0 plus demand deposits (checking accounts) and other liquid assets.
  • M2 (Broad Money): Includes M1 plus savings deposits, time deposits, and money market mutual funds.
  • M3: Includes M2 plus large time deposits, institutional money market funds, and other larger liquid assets.
  • M4: The broadest measure, includes M3 plus all other deposits.

Sources of Money Supply

The sources of money supply involve both the central bank (typically the Reserve Bank of India, RBI, in India) and commercial banks. The key sources include:

  • Central Bank (RBI) Actions:
    • The RBI has the authority to issue currency notes and coins, contributing to the physical component of money supply (M0).
    • Through monetary policy tools, the RBI influences the money supply by adjusting interest rates, conducting open market operations, and setting reserve requirements.
  • Commercial Banks:
    • Commercial banks create money through the process of lending. When banks make loans, they effectively create new deposits in the borrower's account, increasing the overall money supply.
    • Banks also hold reserves with the central bank, affecting the high-powered money component (M0).

RBI Measures of Money Supply

The Reserve Bank of India (RBI) classifies the money supply into four monetary aggregates (M1, M2, M3, and M4) based on the components included in each measure. These classifications help the RBI analyze and manage the money supply effectively.

Expansion of Money Supply

The expansion of the money supply can occur through various mechanisms:

  • Bank Lending: When banks lend money, they create deposits in the borrower's account, contributing to the expansion of the money supply.
  • Central Bank Operations: Open market operations by the central bank, involving the buying or selling of government securities, can impact the money supply.
  • Government Spending: Government expenditure, especially when financed through borrowing, can contribute to an expansion of the money supply.
  • Decrease in Reserve Requirements: If the central bank lowers reserve requirements for commercial banks, it increases their capacity to lend, contributing to an expansion of the money supply.
  • Foreign Exchange Operations: Foreign exchange transactions by the central bank can also impact the domestic money supply.

Read about Difference-between-Microeconomics-and-Macroeconomics.

Conclusion

The supply of money is a dynamic and influential factor in the economic landscape. Its management is a key responsibility of central banks and policymakers, impacting interest rates, inflation levels, and overall economic stability. As economies evolve, so does the nature of the money supply, making it imperative for a nuanced understanding of its components and their interplay. A well-regulated and stable money supply is essential for fostering sustainable economic growth and maintaining financial equilibrium.

Supply of money is a vital topic for several competitive exams. It would help if you learned other similar topics with the Testbook App.

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Supply of Money FAQs

Common measures include M1 (narrow money, including physical currency and demand deposits) and M2 (broad money, including M1 plus savings accounts and time deposits). These measures help assess the liquidity and stability of the financial system.

Central banks control the money supply through monetary policy tools such as open market operations, reserve requirements, and discount rates. By influencing these variables, central banks aim to achieve economic goals like price stability and full employment.

An excessive increase in the money supply can contribute to inflation, as more money in circulation may lead to higher demand for goods and services. Conversely, a decrease in the money supply may have deflationary effects.

Changes in the money supply can influence interest rates. An increase in the money supply may lead to lower interest rates, stimulating borrowing and spending. Conversely, a decrease in the money supply can result in higher interest rates, potentially curbing spending and inflation.
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