Supply and creation of money
Money supply, money creation by banks and the money multiplier.
The essentials
Money supply is the total stock of money held by the public at a point of time. "The public" means households and firms, excluding the producers of money (the government, the RBI and the banking system). Since money supply is measured on a date, it is a stock.
The RBI publishes several measures. M1 = CU + DD + OD, where CU is currency (notes and coins) held by the public, DD is net demand deposits with commercial banks, and OD is other deposits with the RBI. M3 = M1 + net time deposits of commercial banks. M1 is called narrow money and M3 broad money. M1 is the most liquid measure.
Credit creation
Banks know that depositors do not withdraw all their money at once, so they keep only a part as reserves and lend the rest. Each loan is spent and redeposited in some bank, which again keeps a fraction and lends the rest. In this way an initial deposit leads to a much larger total of deposits.
Key points
- Reserve ratio (r): fraction of deposits kept as reserves (the legally required part is the cash reserve ratio).
- Money multiplier (deposit multiplier) = 1 ÷ r.
- Total deposits created = Initial deposit × 1 ÷ r.
- High powered money (reserve money) = currency held by the public + reserves of banks; it is the base on which the money supply is built.
- A higher reserve ratio means a smaller multiplier and less credit creation.
Exam tips
Learn the formula and check units: a reserve ratio of 20% means r = 0.2 and multiplier 5.
Common mistakes
- Including deposits of banks with each other in money supply.
- Writing the multiplier as 1 ÷ (1 − r).