Money, Money Supply & Velocity of Money

Money is the lifeblood of a modern economy. It serves as a medium of exchange, a unit of account, a store of value, and a standard for deferred payments. In macroeconomics, the concept of money supply is critical as it directly influences inflation, interest rates, and economic growth. To systematically track and regulate the money circulating in the economy, the Reserve Bank of India (RBI) classifies it into monetary aggregates—namely M1, M2, M3, and M4—based on liquidity and accessibility. Understanding these aggregates is essential for analyzing monetary policy and the broader financial system of the country.

Functions of Money

Money is defined as something that is generally accepted by society as a medium of exchange, which also functions as a unit of account, a store of value, and a means for the repayment of debt.

Key Functions:

• Medium of Exchange: Enables buying and selling without the need for barter.
• Unit of Account: Provides a common measure to value goods and services.
• Store of Value: Allows wealth to be saved and retrieved later.
• Standard of Deferred Payment: Facilitates credit transactions and repayment over time.

Value of Currency Notes and Coins

• How Value is Derived?
  • The value of currency notes and coins comes from the guarantee provided by the Central Government, not from their material.
  • Every currency note carries a promise by the RBI stating:
    • RBI will pay the bearer the amount printed on the note on demand.
• Intrinsic Value vs. Assigned Value
  • No intrinsic value:
    • A ₹500 note is just a piece of paper without RBI’s guarantee.
    • A coin is simply metal without official recognition.
  • Value is derived solely from government backing and legal status. Because of this, currency notes and coins are called fiat money. They are also known as legal tender, meaning no one can refuse to accept them for payment or to settle a debt within the country.

Money Supply

The total stock of money in circulation among the public at a given point in time is called Money Supply. It includes money of the public either in cash form or in deposit form.

• Note:
  • Only the deposits that the public and businesses keep with banks are counted as part of the money supply. Deposits that banks hold with each other (Inter-bank deposits) are not included.
  • Also, the cash reserves that commercial banks keep are not considered money supply, because any cash held by those who create or issue money like the RBI, the Government, or the banks themselves is never counted in measuring money supply.

Reserve Money

• Monetary Base (M0) = Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI
  • Currency in circulation includes notes and coins circulation.
  • Banker’s deposit with the RBI is Bank’s current account deposit with RBI.
  • Other deposits include balance in the account of foreign Central Banks and Government, international agencies such as the IMF, etc.
• The Monetary Base is also called High Powered Money/Reserve Money/ M0.
• It is the total liability of the RBI.

Measures of Money Supply Published by RBI

RBI uses different monetary aggregates to measure money supply. It defines the monetary aggregates as a measure of the amount of money in circulation within a country.

RBI adopts four of them—

• M1 (Narrow Money) = Currency with public + Demand deposits with the Banking system (current account, saving account) + Other deposits with RBI (deposits from foreign central banks etc)
• M2 = M1 + Deposits of post office savings accounts
• M3 (Broad Money) = M1 + Time deposits with the banking system
• M4 = M3 + All deposits with the post office.

Classification by Liquidity

• M1 and M2: Narrow Money
• M3 and M4: Broad Money
• Order of Liquidity: M1 (most liquid) → M2 → M3 → M4 (least liquid)

Money Multiplier

The money multiplier measures the maximum amount of money that banks can create in the economy from a given amount of deposits, after setting aside the required reserves.

• What It Indicates
  • It shows how many times the initial deposit can expand in the total money supply.
  • Reflects the capacity of the banking system to multiply base money (reserves) into credit and deposits.
• In simple words:
  • The money multiplier tells us how much the money supply will increase when deposits increase, considering the reserves banks must hold.

Money Multiplier = Money Supply (M3)/Monetary Base (M0)

Money Multiplier = 1/Cash Reserve Ratio

Money multiplier can also be defined as:

• Money Multiplier = (1+currency deposit ratio)/(currency deposit ratio + reserves deposit ratio)

Velocity of Money

The velocity of money refers to the number of times a unit of currency is used to purchase goods and services within a given time period. It reflects how quickly money circulates in the economy.

Importance

• Indicates the Pace of Money Circulation: It shows how frequently money changes hands for economic transactions.
  • High Velocity: High velocity indicates that money is being spent and circulated more frequently in the economy.
    • A high velocity suggests increased economic activity.
  • Low Velocity: Low velocity indicates that money is changing hands less frequently.
    • A low velocity may indicate sluggish demand, slower economic activity, hoarding, or recessionary conditions.

Factors Affecting Velocity

• Consumer Confidence: In times of uncertainty, people tend to save more, reducing velocity.
• Technological Advancements: Digital payments and fintech innovations can increase the frequency of transactions.
• Financial Inclusion: Greater access to banking and payment services can facilitate the circulation of money and economic transactions.
• Inflation Expectations: If people expect rising prices, they may spend faster, increasing velocity.