Money Supply and Money Multipler

Money Supply and Money Multipler

Subject : Economics

Context: C Rangarajan, D K Srivastava write: A word of caution, though: With higher expenditure, financed through borrowings, the impact of liquidity expansion on inflation needs to be monitored.

Concept :

Money Supply:

• The total stock of money in circulation among the public at a particular point of time is called money supply.
• It needs to be noted that total stock of money is different from total supply of money.
• Supply of money is only that part of total stock of money which is held by the public at a particular point of time.
• The circulating money involves the currency, printed notes, money in the deposit accounts and in the form of other liquid assets.
• RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4.

M1 = CU + DD

M2 = M1 + Savings deposits with Post Office savings banks

M3 = M1 + Net time deposits of commercial banks

M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates)

• CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks.
• The word ‘net’ implies that only deposits of the public held by the banks are to be included in money supply.
• The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of money supply.
• M1 and M2 are known as narrow money. M3 and M4 are known as broad money.
• These gradations are in decreasing order of liquidity.
• M1 is most liquid and easiest for transactions whereas M4 is least liquid of all.
• M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources.

Money Multiplier Effect :

• Money multiplier is a term in monetary Economics that is a phenomenon of creating money in the economy in the form of credit creation, based on the fractional reserve banking system.
• Money multiplier is also known as the monetary multiplier. It is the maximum limit to which money supply can be affected by bringing about changes in the amount of money deposits.
• Money multiplier effect is seen in commercial banks as they accept deposits and after keeping a certain amount as a reserve, distribute the money as loans for injecting liquidity in the economy.
• The amount of money that should be kept by commercial banks in their reserve for withdrawal purposes by the customers is referred to as the reserve ratio or required reserve ratio or cash reserve ratio.
• Mathematically, money multiplier formula can be represented as

Money Multiplier = 1/ r

Where r = Required reserve ratio or cash reserve ratio

• It means that if the reserve ratio is higher, then the money multiplier will be lower and the banks need to keep more reserves. As a result, they will not be able to lend more money to individuals and businesses.
• Similarly, a lower reserve ratio results in a higher money multiplier which allows a lesser amount of money to be kept as a reserve and more lending opportunities to the public.