Money, Money Supply & Velocity of Money

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Money, Money Supply & Velocity of Money

Money, Money Supply & Velocity of Money

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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.

Note: Fiat Money: Money which does not has any intrinsic value of its own (Currency notes). Generally declared as Legal tender for all transactions within a 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 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 held by public + currency held by banks + deposits of bank with 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.
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:

The Reserve Bank of India 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 post office.

Classification by Liquidity

M3 is the most commonly used measure of money supply and is also called “aggregate monetary resources“.
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.

1.Money Multiplier = Money Supply (M3)/Monetary Base (M0)=1/Cash Reserve Ratio

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

Explanation:
- Higher cdr (more cash preference) → lower multiplier (less money created).
- Higher rdr (banks keep higher reserves) → lower multiplier (less money lent).
- Lower c and r → higher multiplier (more money created).
- Example:
  - If c = 0.2 (people keep ₹20 as cash per ₹100 deposit) and r = 0.1 (banks keep 10% reserves)
  - Money Multiplier = {1 + 0.2}/{0.2 + 0.1} = {1.2}/{0.3} = 4
  - So ₹1 of base money leads to ₹4 of total money supply.
Hence, the value of the money multiplier depends on two key variables:
- Currency-Deposit Ratio (CDR)
  - The currency deposit ratio shows the amount of currency that people hold as a proportion of aggregate deposits.
  - An increase in cash deposit ratio leads to a decrease in money multiplier:If the public holds more currency relative to deposits (higher CDR)–>Less money goes into banks to create credit–>The multiplier falls.
  - An increase in deposit rates will induce depositors to deposit more, thereby leading to a decrease in Cash to Aggregate Deposit ratio. This will in turn lead to a rise in Money Multiplier.
- Reserves Deposit Ratio (RDR) = Required Reserves (CRR and SLR) + Excess Reserves
  - Higher RDR (more reserves held) → less lending capacity → lower Money Multiplier.
  - Lower RDR → more money can be lent → higher Money Multiplier.

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:

It indicates the efficiency of money usage in the economy.
A high velocity suggests increased economic activity and confidence.
A low velocity may indicate sluggish demand, 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 increase the frequency of transactions.
Financial Inclusion: Broader access to banking and credit boosts money movement.
Inflation Expectations: If people expect rising prices, they may spend faster, increasing velocity.

Understanding money, its supply, and the velocity of money is essential to grasp the functioning of a modern economy. While money supply measures the stock of money available, velocity highlights how effectively that money circulates within the economy. Together, they determine inflation, output, and financial stability. For policymakers like the RBI, managing both these variables is key to achieving macroeconomic goals such as price stability, growth, and employment. In an increasingly digital economy, innovations in payments and financial access are likely to influence the future trajectory of money velocity and monetary aggregates.

FAQs

Q1. What is the difference between money and money supply?

Money refers to anything that is generally accepted as a medium of exchange, a store of value, and a unit of account. Money supply refers to the total amount of monetary assets available in an economy at a point in time.

Q2. What are the components of India’s money supply?

Money supply in India is categorized into four aggregates: M1 (narrow money), M2, M3 (broad money), and M4. These include currency with the public, demand deposits, time deposits, and other deposits with the RBI.

Q3. What is the velocity of money?

It refers to the number of times one unit of money is used to purchase goods and services in a given time period. It reflects the dynamism of economic transactions.

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