MONEY SUPPLY

INTRODUCTION

• In the previous unit, we have discussed the theories related to demand for money. Money plays a crucial role in the smooth functioning of an economy. Money supply is considered as a very important macroeconomic variable responsible for changes in many other significant macroeconomic variables in an economy and is therefore considered as a matter of considerable interest to the economists and policy makers. 
•  Economic stability requires that the supply of money at any time should to be maintained at an optimum level. A pre-requisite for achieving this is to accurately estimate the stock of money supply on a regular basis and appropriately regulate it in accordance with the monetary requirements of the country.
•  In this unit, we shall look into various aspects related to the supply of money.
• The term money supply denotes the total quantity of money available to the people in an economy. 

The quantity of money at any point of time is a measurable concept. It is important to note two things about any measure of money supply:

(i) The supply of money is a stock variable i.e. it refers to the total amount of money at any particular point of time. It is the change in the stock of money (say, increase or decrease per month or year,) , which is a flow.

(ii) The stock of money always refers to the stock of money available to the ‘public’ as a means of payments and store of value. This is always smaller than the total stock of money that really exists in an economy.

• The term ‘public’ is defined to include all economic units (households, firms and institutions) except the producers of money (i.e. the government and the banking system). The government, in this context, includes the central government and all state governments and local bodies; and the banking system means the Reserve Bank of India and all the banks that accept demand deposits (i.e. deposits from which money can be withdrawn by cheque mainly CASA deposits). 
• The word ‘public’ is inclusive of all local authorities, non-banking financial institutions, and non- departmental public-sector undertakings, foreign central banks and governments and the International Monetary Fund which holds a part of Indian money in India in the form of deposits with the RBI. In other words, in the standard measures of money, interbank deposits and money held by the government and the banking system are not included.

 RATIONALE OF MEASURING MONEY SUPPLY 

Empirical analysis of money supply is important for two reasons:

1. It facilitates analysis of monetary developments in order to provide a deeper understanding of the causes of money growth.

2. It is essential from a monetary policy perspective as it provides a framework to evaluate whether the stock of money in the economy is consistent with the standards for price stability and to understand the nature of deviations from this standard. The central banks all over the world adopt monetary policy to stabilise price level and GDP growth by directly controlling the supply of money. This is achieved mainly by managing the quantity of monetary base. The success of monetary policy depends to a large extent on the controllability of money supply and the monetary base. 

THE SOURCES OF MONEY SUPPLY

The supply of money in the economy depends on:

(a) the decision of the central bank based on the authority conferred on it , and

(b) the supply responses of the commercial banking system of the country to the changes in policy variables initiated by the central bank to influence the total money supply in the economy.

• The central banks of all countries are empowered to issue currency and, therefore, the central bank is the primary source of money supply in all countries. In effect, high powered money issued by monetary authorities is the source of all other forms of money.
•  The currency issued by the central bank is ‘fiat money’ and is backed by supporting reserves and its value is guaranteed by the government. The currency issued by the central bank is, in fact, a liability of the central bank and the government.
•  Therefore, in principle, it must be backed by an equal value of assets mainly consisting of gold and foreign exchange reserves. In practice, however, most countries have adopted a ‘minimum reserve system ’wherein the central bank is empowered to issue currency to any extent by keeping only a certain minimum reserve of gold and foreign securities. 
• The second major source of money supply is the banking system of the country. The total supply of money in the economy is also determined by the extent of credit created by the commercial banks in the country. 
• Banks create money supply in the process of borrowing and lending transactions with the public. Money so created by the commercial banks is called 'credit money’. The high powered money and the credit money broadly constitute the most common measure of money supply, or the total money stock of a country. (For a brief note on the process of creation of credit money, refer to Box 1, end of this chapter).