Money Supply, Types, Components, Role of RBI, Impact

What is Money?

Money is anything that is widely accepted in exchange for goods and services. It serves as a medium to buy and sell, a way to measure value, and a store of wealth for future use. Money can exist in physical forms like coins and notes or in digital forms like bank deposits and online payments. It is essential for smooth economic transactions and trade.

Characteristics and Functions of Money

• Medium of Exchange: Money eliminates the inefficiencies of barter trade by providing a common standard accepted by all for buying and selling goods and services.
• Unit of Account: Money provides a consistent measure to value goods and services, enabling price comparison and economic calculation.
• Store of Value: Money retains its value over time, allowing individuals and businesses to save and plan for the future.
• Standard of Deferred Payment: Money is used to settle debts and contractual obligations, facilitating credit and lending.
• Liquidity: Money is the most liquid asset, easily convertible into goods, services, or other forms of wealth.
• Acceptability: Money is widely accepted within an economy for transactions and payments.

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Types of Money

Money exists in different forms depending on its nature, acceptability, and the way it is used in the economy. Understanding the different types of money is essential to study money supply, monetary policy, and banking.

1. Commodity Money

Commodity money is a form of money that has intrinsic value, meaning it is valuable in itself and can be used for purposes other than trade. Historically, people used metals or goods as a medium of exchange. Examples: Gold coins, silver coins, copper coins, salt, or cattle in ancient economies.

2. Fiat Money

Fiat money is money issued by a government and accepted as legal tender, even though it has no value in itself. Its value comes entirely from the trust people place in the issuing authority and its legal acceptance for payments. Examples: Indian rupee notes and coins, US dollar bills.

3. Representative Money

Representative money consists of paper or tokens that represent a claim on a physical commodity, which can be exchanged on demand. It allows people to trade easily without carrying heavy commodities. Examples: Gold certificates, silver certificates, old currency notes backed by gold reserves.

4. Bank Money

Bank money exists as deposits in banks that can be transferred electronically or through instruments like cheques. This type of money is created when banks lend money, effectively increasing the money available in the economy. Examples: Savings account deposits, current account balances, demand deposits.

5. Digital Money

Digital money is money that exists only in electronic form. It is used for online transactions, mobile payments, and cashless banking. This form of money has become increasingly important in modern economies. Examples: UPI transfers, Paytm balances, Google Pay, cryptocurrencies like Bitcoin.

Components of Money Supply

Money supply refers to the total amount of money circulating in an economy at a particular time. Economists classify money into different categories, called aggregates, to measure liquidity and help the Reserve Bank of India (RBI) regulate the economy effectively.

• M0 (Reserve Money/Base Money):
  • Includes all currency notes and coins in circulation with the public.
  • Includes deposits of commercial banks held with the RBI.
  • Forms the foundation for all other money supply measures.
• M1 (Narrow Money):
  • Consists of currency held by the public, demand deposits in banks, and other liquid deposits.
  • Used for day-to-day transactions and payments.
• M2:
  • Includes all of M1 plus savings deposits with post offices.
  • Represents slightly less liquid money than M1 but still readily accessible.
• M3 (Broad Money):
  • Includes M1 plus time deposits with commercial banks.
  • Widely used to measure total money available in the economy.
• M4:
  • Includes M3 plus total deposits with post office savings institutions (excluding National Savings Certificates).
  • Represents the broadest measure of money supply in the economy.

Here’s the money supply hierarchy arranged from most liquid to least liquid: M0 > M1 > M2 > M3 > M4

Factors Affecting Money Supply

The total money circulating in an economy depends on several key factors that influence liquidity, inflation, and economic growth:

1. Banks create money by giving loans and advances, which increases deposits and circulation in the economy.
2. The Reserve Bank of India controls money supply through tools like Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and repo/reverse repo rates.
3. Government borrowing absorbs money from the economy, while government spending injects money into circulation.
4. Foreign inflows like exports, foreign investment, and remittances increase money supply, while imports and capital outflows reduce it.
5. Public preference for cash or bank deposits affects liquidity; more cash holdings reduce deposits, while more deposits increase money supply.
6. Economic activity and business confidence affect circulation; during growth, borrowing and spending increase money supply, while in slowdown, saving increases and circulation decreases.

Role of Reserve Bank of India in Controlling Money Supply

The Reserve Bank of India (RBI) plays a key role in managing the money supply to ensure economic stability, control inflation, and support growth.

1. RBI uses the Cash Reserve Ratio (CRR) to control the amount of money banks can lend, affecting liquidity in the economy.
2. The Statutory Liquidity Ratio (SLR) requires banks to maintain a certain percentage of deposits in approved government securities, regulating credit availability.
3. Through repo and reverse repo rates, RBI controls borrowing and lending rates, influencing money supply and interest rates.
4. Open Market Operations (OMO) involve buying or selling government securities to inject or absorb money from the economy.
5. RBI monitors and regulates credit creation by banks to prevent excessive or inadequate money supply.
6. By maintaining price stability and controlling inflation, RBI ensures that money supply supports sustainable economic growth without destabilizing the economy.

Money Supply Impact on Inflation and Economic Growth

• Excessive money supply increases aggregate demand for goods and services, leading to higher prices and inflation, which reduces the real purchasing power of money.
• A low or shrinking money supply decreases spending and demand, slowing down production, reducing employment, and potentially causing deflation.
• Adequate money supply encourages borrowing and lending by businesses and individuals, promoting investment, industrial growth, and capital formation.
• Increased money circulation stimulates consumption, trade, and entrepreneurship, contributing to higher GDP and overall economic development.
• Changes in money supply influence interest rates; higher liquidity lowers borrowing costs, while lower liquidity increases interest rates, affecting investment and consumption.
• Maintaining a balanced money supply ensures price stability, prevents financial crises, supports smooth functioning of markets, and promotes long-term sustainable economic growth.