Demand And Supply of Money

Demand and supply of money plays very inportant role in an economy. Money Supply affects many factors in economy like inflation, unemployment etc. In this post we understand Demand of money, Supply of Money, Money Multiplier and Money Creation 

Demand of money

According to liquidity preference theory given by British economist, John Maynard Keynes, people prefer to keep a part of assets in liquid form (cash money) with for three reasons :

  1. Transaction – For using money as a medium of exchange
  2. Precautionary-  to protect against sudden / unforeseen expenditure
  3. Speculative – look for investment opportunities 

The amount of money held in cash form vary inversely with (deposit) interest rates. If higher interest rates are available → people would like to invest money in banks, instead of keeping money in liquid form (cash).

Factors Affecting the Demand of Money

The demand for money refers to the total amount of wealth that individuals choose to hold in the form of money (cash and checking accounts) as opposed to other forms of assets. Several factors can influence this demand:

  1. Income Level: Generally, higher income results in higher demand for money as individuals have more cash for transactions.
  2. Interest Rates: The demand for money is inversely related to the interest rate. Higher interest rates provide incentives for people to invest money rather than hold it as cash, reducing the demand for money.
  3. Prices of Goods and Services: With higher prices, more money is needed to purchase the same goods and services, which increases the demand for money.
  4. Economic Activity: During periods of economic expansion when consumption and investment are rising, the demand for money increases as more transactions take place.
  5. Technological Advancements: Improvements in payment technology can either increase or decrease the demand for money. Digital payment systems may reduce the need to carry cash.
  6. Expectations of Future Prices: If people expect prices to rise in the future (inflation expectations), they are more likely to spend money now rather than hold onto it, which increases the demand for money.

Supply of Money 

The money supply refers to all the money that is in circulation in an economy, whether cash or other liquid assets

Liquidity of assets

Liquidity= ease of converting an asset into cash. Cash is the most liquid asset.

  • Highly liquid assets = Gold, Demand deposits, G-Sec/T-Bill, shares/bonds of reputed companies.
  • Relatively illiquid assets= Home/Real estate, Paintings/Sculptures etc. Because it is difficult to find buyers at the right price instantly.

Liquidity injection / infusion refers to the phenomenon when RBI buys Bank/NBFCs’ GSec/T-bill/financial assets to give them cash.

Liquidity Trap

Measures of money supply

RBI measures the money supply through indicators: M0, M1, M2, M3, M4

  • M0 (M0 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 = C + DD + OD (Narrow Money)
    • C – Currency held by the public
    • DD- Demand Deposits with Banks
    • OD- Other deposits (Demand Deposits held by RBI)
    • Demand Deposits (DD) can be withdrawn on demand from banks.
    • Time Deposits (TD) can be withdrawn only after a specific time.
    • Total Deposits = DD+TD
      • Currency (NOTES PLUS COINS) HELD BY THE PUBLIC + NET DEMAND DEPOSITS HELD BY THE COMMERCIAL BANKS
      • Note: Only deposits of the public held by the banks are to be included in money supply 
  • M2 = M1 + Savings account deposits with Post Offices
    • Note- Post offices have no facility for the opening of current accounts. The types of accounts that can be opened are – Savings account, Fixed deposit, and Recurring deposit.
  • M3 = M1 + TD
    • TD – Time Deposits with Banks Includes fixed deposits, Recurring deposits, and time liability of Savings accounts
    • M3 is the most common measure used for money supply it is also known as Aggregate Monetary Resources / Aggregate Money Supply” because out of all the money supply indicators (M0-M4) this is the indicator RBI will focus the most for its analysis while designing monetary policy.
  • M4 = M3 + total deposit with the post office
    • Notes TOTAL DEPOSITS WITH POST OFFICE SAVINGS ORGANISATIONS (EXCLUDING NATIONAL SAVINGS CERTIFICATES)
      • As the total deposits with the post office are negligible there is not much difference between M3 and M4
  • M1 and M2 are known as Narrow Money. M3 and M4 are also called as Broad Money
  • These measures from M1 to M4 are in the decreasing order of liquidity (M1 being the most liquid and M4 being the least liquid). M3 is the most generally utilised measure of capitalist supply

Objective – to make good monetary policy. RBI will have to find the quantity of money in the system.

Significance – Money supply plays a crucial role in

  1. price level (=inflation) and
  2. interest rates on deposits & loans.

Money supply

In India FRBM Act – fiscal responsibility and budget management act 2003

Monetisation of deficit – RBI printing more currency notes to give as loans to Government but this process is difficult/ not easy due to FRBM Act conditions

Currency in Circulation (CIC) – CIC is an indicator to measure cash as a payment instrument i.e. instead of other payment instruments such as Cheque, NEFT/RTGS, Card etc.

Velocity of Money Circulation – It is the average number of times money passes from one hand to another, during given time period. “Velocity of money circulation” is affected by following factors:

  • Income distribution: Money in the hands of poor people has higher velocity than the rich people.
  • If more people borrow money → higher velocity. Hence developed countries => higher velocity, because people save less and spend more because of consumerist lifestyle and confidence in Government’s social-security/pension system e.g. USA.
  • Boom period in economy = more raw material purchase & hiring = higher velocity.

 

Call Money | Notice Money | Term Money

These terms are used when bank/ NBFC lend/borrow money among themselves for short term (i.e. less than 1 year)

  • Call money – borrowed for one day (this duration also called overnight)
  • Notice money – Two days to 14 days
  • Term money – more than 14 days but less than one year

Money Multiplier 

  • Money creation – The money created by the RBI is the monetary base, also known as high-powered money.
  • Bank create money by making loans
  • A one-rupee increase in the monetary base causes the money supply to increase by more than one rupee. This increase in the money supply is the money multiplier.

So Money multiplier or monetary multiplier is a phenomenon of creating money in an economy which is based on the fractional reserve banking system.

  • It is the maximum limit to which money supply can be affected by bringing about changes in the amount of money deposits.

RBI’s use Cash Reserve Ratio (CRR) to controls the Fractional Reserve Banking & Credit Creation by the commercial banks, in the following manner:

  • Money multiplier = 1/CRR
  • If CRR is 4% then money multiplier is ¼% = 1/1/25 = 25 times

Money Multiplier- Example

Insert a table here

Till the time the total deposits become equal to Rs. 1000, total loans lent become 900, and the total cash reserve becomes Rs. 100, the rounds following round 5 will be continued in the same manner.

Money multiplier = stock of total money (M3) / stock of high powered money (M0)

= 1000/100 = 10

  • If CRR increase MM decrease 
  • Poor banking penetration leads to lower MM
  • MM indirectly improves as the economy develops, consumption / loan demand increases, banking penetration, digital economy, less-cash economy etc.

Impact of SLR on change on Money Multiplier

Money Creation 

Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, money is created by both central banks and commercial banks

  • RBI- issued under RBI Act, by RBI’s ISSUE DEPARTMENT, with condition that ISSUE DEPARTMENT’s assets must match its liabilities.
  • Commercial Banks- by loan interest 

Assets and liability of issues department 

  • Assets- Rupee coins, Gold coin, Gold bullion, Foreign securities including IMF, govt securities (through which Govt borrows money from RBI & returns Principal + Interest at later date)
  • Liabilities- Total Bank notes in circulation, which consists of: held by public and other bank, and other deposits in RBI.

M0 increase when RBI is asset side increase for example

 government borrowing more from RBI using G-sec

Supply of Money in Economy - Types of Money, Money Multiplier