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Supply of Money – Components, Ratios and Velocity of Money

Definition – Supply of Money is the total stock of domestic means of payment owned by the public (private individuals and business firms) in a country. The money includes only the stock of money in hand in a spendable form at any time. The money supply is stock at a point in time, but it is a flow over a period.

What is the Supply of Money?

Money flow comprises a given stock of money multiplied by the velocity of its circulation. The velocity of money circulation is the number of times a unit of money is circulated in a given period or year.

Money supply = M * V (as a flow concept), where M denotes money stock and V denotes the velocity of circulation. For Example: If M is Rs. 5,000 and the value of V is 5, the money supply as a flow concept = 5,000 * 5 which is Rs. 25,000.

Constituents of Money Supply

Traditional Measures include

  1. Currency (that is, coins and notes)
  2. Demand Deposits

Modern Measures include

  1. Currency (coins and notes)
  2. Demand Deposits
  3. Saving Deposits in Post Office
  4. Time Deposits
  5. Government Securities
  6. Credit

Traditional Measure

  1. The traditional measure is termed Narrow Money because the components of money supply are restricted to currency and demand deposits.
  2. It is also called “transaction measure” or “transaction money’” because it includes the items actually used for transactions.
  3. It can be expressed as: M1 = C + DD, where M1 denotes traditional/narrow money, C denotes currency (coins and notes), and DD denotes demand deposits.
  4. The measure M1 is very close to RBI’s concept of M1, which is M1 = C + DD + OD, where OD denotes other deposits
  5. Because they are negligible, other deposits are ignored for all practical purposes.

Modern Measure

  1. Modern money is also termed Broad Money because it brings in those items that are not rather liquid but are nonetheless available as a transaction-settling medium.
  2. It consists of M1and other liquid assets or near money.
  3. The items included in the list of liquid assets are savings deposits with limits on the amount and number of withdrawals.
  4. Savings deposits include:
  • Post-office savings bank deposit
  • Time deposits with banks, which can be withdrawn by notice and incurring a penalty interest
  • Government securities, bonds and other financial assets
  • Credit, which is all debt of domestic non-financial sectors in the form of mortgages, bonds and similar instruments.

5. It can be expressed as M2 = M1 + a + b + c + d, where M2 denotes modern measure or broad money

6. The items included in M2 differ in terms of liquidity as it declines from a to d.

7. Broad money can be subdivided into M2, M3, and M4: M2 = M1 + a + b , M3 = M2 + c,  M4 = M3 + d

8. Monetary authorities of each country decide the items be included based on their impact on economic activities.

Money Supply – Exclusions

  1. Cash balances held by the central and state governments because such money is not in circulation.
  2. Time deposits held by the public with commercial banks because the associated money can be withdrawn only after maturity.
  3. Overdrafts until used by concerned individuals.
  4. Monetary gold held in reserve by the central bank because it is not circulated in the economy.
  5. Cash balances held by the central bank and by commercial banks as reserves to support demand deposits.

Determinants of Money Supply

  1. High-powered or Reserve Money
  2. Money Multiplier
  3. And, Other Factors
  4. Let’s understand each of these in detail.

High-powered or Reserve Money

  1. High-powered money (H, also denoted as M by RBI) or reserve money is the base of money supply; hence, it is also called “base money.”
  2. It comprises cash deposits with the public (C), cash reserves of banks (R), and other deposits (OD) with the Reserve Bank: H = C + R + OD
  3. It is different from M1 in terms of the second component as M1= C + DD + OD
  4. DDs are held and created by commercial banks. By contrast, all components of H are created by the monetary authority.
  5. R is the base on which DD expansion depends. Hence, R imparts to H the quality of high-power, qualifying it to be termed high-powered money.

Money Multiplier

  1. Currency–Deposit Ratio (k)
  2. Reserve Ratio (r)
  3. Other Factors

Money Multiplier – Currency-Deposit Ratio

  • High-powered money (H) is sought by the public as currency (C) and by banks as reserves (R).
  • Greater the amount of cash demanded, lower is the availability with banks and thus, lower is the amount of credit creation.
  • The ratio of the public’s preference for currency to their preference for demand deposits is called the currency–deposit ratio (k).
  • It depends on the banking habits of people, income levels, interest rate, etc.

Money Multiplier – Reserve Ratio

Required Reserves (RR)

Reserves that commercial banks are statutorily required to hold with the Central Bank. Reduction in RR allows banks to create greater amounts of credit.

Excess Reserves (ER)

This refers to reserves required by banks to meet their currency drain (net cash withdrawal by depositors) and clearing drain (cash required to meet the cross-clearing of cheques among banks). These reserves are held voluntarily by banks.

The Reserve ratio determines the volume of credit that can be created by commercial banks.

Fractional reserve banking is a banking system in which a bank retains only a part of the total deposits received from customers as available reserves to meet customers’ withdrawal demands. The remainder of the total deposits is used for lending and investment.

Multiple credit creation: Most bank-generated loans are later re-deposited into different banks, creating additional credit.

Money Multiplier (mm) is defined as a ratio of the money stock to high-powered money stock.

It is a measure of the maximum amount of commercial bank money that can be created with a given unit of central bank money. Together, reserve ratio (r) and currency deposit ratio (k) determines the money multiplier.

It is expressed as mm = (1+k)/(r+k)

For Example: If k is 0.40, and r is 0.20, mm = (1+0.40)/(0.20+0.40) = 2.33

The smaller the ratio, the higher is the value of the money multiplier.

Change in total money supply is expressed as H*mm

For Example: If H is Rs. 10,000 billion and mm is 2.5, total money supply is = 10,000*2.5 = Rs. 25,000 billion.

Other Factors

  • Community’s choice to hold currency in relation to deposits in commercial banks
  • Money circulation velocity
  • Interest rate
  • Monetary policy (qualitative and quantitative measures) used by the central bank to control the money supply
  • The Fiscal policy, which influences money supply via changes in public expenditure and taxation

Velocity of Circulation of Money or Velocity of Money

The velocity of circulation of money is the number of times a unit of money is circulated in a given period or year.”

It can be classified as:

  1. Transaction velocity
  2. Income velocity

Transaction Velocity 

1. Transaction velocity is the ratio of annual transaction volume to money stock.

2. It is the speed with which a unit of money moves “around the circle of payments, from income to payments for goods and services, and back again to income.”

Example 

If the total supply of currency and demand deposits (M1) is INR 5,000 crores and transactions worth INR 1,00,000 crores are conducted, transaction velocity is 20. That is, the money supply of INR 1 performs the function of INR 20.

Factors determining Transaction Velocity are

  • An increase in production and trade volumes results in an increase in transaction velocity.
  • An increase in Institutional arrangements (that is, deferred payments or credit systems) leads to a decrease in transaction velocity.
  • An increase in Savings leads to a decrease in transaction velocity.
  • An increase in Inflation results in an increase in transaction velocity.
  • An increase in Intervals between income receipts leads to a decrease in transaction velocity.

Income Velocity

Income velocity is defined as the “average number of times a unit of money is used to pay for final goods and services. It is expressed as the ratio of GNP to money stock.

For Example: If the GNP is Rs. 50,000 crores and M1 is Rs. 10,000 crores, then the income velocity of money = 50,000/10,000= 5.

Income velocity is always lower than transaction velocity because the former is confined to final goods and services only. Transactions involving financial assets and sale of existing land and buildings are excluded from income velocity.

Factors determining Income Velocity are

  • Increase in GNP Growth results in an increase in income velocity.
  • An increase in Demand for Idle Cash leads to a decrease in income velocity.
  • An increase in Money Supply Quantity results in a decrease in income velocity.