Detailed Notes on Money Supply and Liquidity Measures in India

General Liquidity and Money Supply

  • Definition of General Liquidity:
  • Consists of various components including cash, bank deposits, near-money assets, and borrowing facilities.
  • Varies based on the nature and temporal aspects of money constituents.
  • Radcliffe Committee Observation:
  • Money supply measurement is complex due to varying degrees of liquidity among money, near-money, and real assets.

Components of Money Supply

  • Role of Central Bank:
  • Central Banks (like the RBI) are the main source of money supply in an economy.
  • RBI's Measures of Money Supply (from April 1977):
  • M1, M2, M3, M4 introduced for measuring money supply in India.
  • Evolution of measures from a single measure (M1 pre-1968) to various broader measures thereafter.

Money Supply Measures:

  1. M1 (Narrow Money):
  • Includes:
    • Currency with the public (notes and coins).
    • Demand deposits with banks (commercial and co-operative).
    • Other deposits with the RBI.
  • Formula: M1 = C + DD + OD (C=Currency, DD=Demand Deposits, OD=Other Deposits)
  1. M2:
  • Includes everything in M1 plus saving deposits with the post office.
  • Formula: M2 = M1 + SD (SD=Saving Deposits)
  1. M3 (Broad Money):
  • Includes everything in M1 plus time deposits with banks.
  • Formula: M3 = M1 + TD (TD=Time Deposits)
  • M3 is significant for assessing effects on prices and economic growth.
  1. M4:
  • Includes M3 plus total deposits with the post office (excluding National Savings Certificates).
  • Formula: M4 = M3 + TPD (TPD=Total Deposits excluding NSCs).

Importance of M3

  • Popularity of M3:
  • Most preferred measure for credit budgeting and monetary targeting in India.
  • Provides empirical insight in line with practices of developed countries.
  • Chakravarty Committee Recommendation:
  • Suggested using M3 for monetary targeting without reservations.

Recent Changes in Monetary Aggregates (1998)

  • RBI Working Group on Money Supply:
  • Introduced revised concepts of monetary aggregates (M1, M2, M3).
  • Changes in definitions, particularly concerning deposits and liabilities:
  • New Measures:
    • M1 remains unchanged.
    • M2 now includes:
    • Time liabilities portion of saving deposits with banks.
    • Certificates of Deposits (CDs) issued by banks.
    • M3 now includes:
    • Term Deposits maturing over one year.
    • Call/term borrowing of banks.
  • New M2 Exclusion:
  • Excludes post office saving deposits, favoring bank deposits for better liquidity management.

Liquidity Aggregates

  • Introduction of Liquidity Measures:
  • New liquidity aggregates (L1, L2, L3) were created for better assessment:
    • L1 = New M3.
    • L2 includes deposits with post offices, term deposits with financial institutions.
    • L3 adds certificates of deposits and public deposits with non-banking finance companies (NBFCs).

High Powered Money (Reserve Money)

  • Definition:
  • The government money issued by RBI and held by banks and the public.
  • Components:
  • Currency in circulation (coins and notes).
  • Other deposits of the public with the RBI.
  • Cash reserves of commercial banks (includes both the cash reserve and banker's deposits with the RBI).
  • Formula:
  • H = C + OD + CR (H=High Powered Money, C=Currency, OD=Other Deposits, CR=Cash Reserves).

Summary of Monetary Aggregates (Original vs. Revised)

  • Original Measures (since 1977):

  • M1: Currency + Demand Deposits + Other Deposits.

  • M2: M1 + Saving Deposits with Post Offices.

  • M3: M1 + Time Deposits.

  • M4: M3 + Total Deposits with Post Offices (excluding NSCs).

  • Revised Measures (1998):

  • M1: Currency + Demand Deposits + Other Deposits

  • M2: M1 + Time Liabilities of Saving Deposits + Term Deposits, excluding some post office deposits.

  • M3: M2 + Term Deposits, plus term borrowings of the banking system.

  • Liquidity Aggregates:

  • Structured to monitor liquidity more effectively, favoring banking contributions to the economy.