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Money Supply and Demand

Meaning, features, components and measures of money supply (M1-M4), high powered money, and the three motives for demand for money.

Notes

Money Supply and Demand

Class 12 Macro Economics — Meaning, Measures, High Powered Money, and Motives for Holding Money

Meaning and Features of Money Supply

Money Supply
The total amount of money held by the public in an economy at a specific point in time.
Includes money held by individuals and businesses (money-using sector) only. Excludes money held by the government and the banking system (money-creating sector) — those balances are not in actual circulation among the public.
Money supply is a stock concept — measured at a particular moment in time, making it a stock variable (as opposed to a flow).

Components of Money Supply

Money supply consists of two main components:

Currency with Public + Demand Deposits = Transaction Money

Readily usable for transactions — the most liquid form of money supply.

Measures of Money Supply (M₁–M₄)

The RBI publishes four measures of money supply, each broader than the previous. They represent decreasing liquidity (M₁ most liquid, M₄ least):

Formula

$$M_1 = C + DD + OD$$

Other deposits with RBI: deposits from foreign banks/governments, public financial institutions, World Bank, IMF. Excludes deposits of Indian Government or commercial banks with RBI.

Formula

$$M_2 = M_1 + \text{Savings deposits with POSB}$$

Savings deposits with Post Office Saving Bank are not chequeable.

Formula

$$M_3 = M_1 + \text{Net Time Deposits with Banks}$$

M₃ is called 'aggregate monetary resources of the society'.

Formula

$$M_4 = M_3 + \text{Total Deposits with POSB (excl. NSC)}$$

NSC = National Saving Certificate. M₄ is the broadest measure of money supply.

M₁ and M₂ = narrow money; M₃ and M₄ = broad money. The RBI releases money supply data in India regularly.

Example Calculation

Solved Example

Problem

Given the following data (₹ in crores): (i) Currency with public: 84,000 (ii) Demand deposits with banks: 68,000 (iii) Other deposits with RBI: 3,612 (iv) Total deposits with Post office: 22,500 (v) Net time deposits with banks: 2,00,555 (vi) Savings deposits with post office saving bank: 5,528. Calculate M₁, M₂, M₃, and M₄.

Solution

M₁ = ₹1,55,612 cr, M₂ = ₹1,61,140 cr, M₃ = ₹3,56,167 cr, M₄ = ₹3,78,667 cr

High Powered Money (H) vs Money (M)

High Powered Money (H)
Money directly created by the central bank (RBI) and the government. Comprises: (i) Currency held by the public, (ii) Cash reserves held by commercial banks.
AspectMoney (M₁)High Powered Money (H)
IncludesCurrency held by the public + Demand deposits with banksCurrency held by the public + Cash reserves with banks
Common elementCurrency held by the publicCurrency held by the public
RoleMoney in circulation for transactionsFoundation/base money used by banks to create deposits
Money includes demand deposits (created by banks), while High Powered Money includes the cash reserves that banks use as a base to create those demand deposits. H is ‘high-powered’ because it forms the foundation for the larger amount of Money (M).

Demand for Money — Three Motives

According to Keynes, people hold money for three distinct motives:

Transaction vs Precautionary Motive

AspectTransaction MotivePrecautionary Motive
NaturePlanned, ordinary transactionsUnexpected transactions
DriverConvenience and certainty of valueDegree of uncertainty in the environment
Relation to incomePositively relatedPositively related
ExampleHousehold expenses, business operationsSickness, accidents, crises
Cash balances for both transaction and precautionary motives generally increase with income.