Supply of Money and Its Determinant

IMPORTANCE OF MONEY SUPPLY

• Money supply is a key determinant of price level and interest rates, and although it is often assumed to be controlled by the Central Bank and Government, the public and commercial banks also play an important role in its determination.

• Different measures of money supply exist depending on which types of bank and financial institution deposits are included, and these measures help in analysing monetary conditions in the economy.

• Growth of money supply is vital for economic development as well as price stability, and controlled expansion is necessary to achieve development with stability.

• A healthy economy requires avoidance of both inflation and deflation; while mild inflation caused by deficit financing may stimulate investment and generate forced savings, runaway inflation is harmful to growth.

• Developing economies often face resource shortages in early stages and use deficit financing to bridge gaps, but such monetary expansion must remain within safe limits to prevent instability.

• Proper management of money supply is a legitimate tool for promoting steady economic growth, as expansion within limits accelerates growth, whereas excessive expansion can retard it.

THE CONCEPT OF MONEY SUPPLY AND ITS MEASUREMENT

• By money supply we mean the total stock of monetary media of exchange available to a society for use in connection with the economic activity of the country. According to the standard concept of money supply, it is composed of the following two elements :.
  1. Currency with the public,
  2. Demand deposits with the public.

• Money supply refers to the total amount of money available to the public in an economy at a specific point of time, making it a stock concept, unlike national income which is a flow measured per unit of time, usually a year.

• It includes money held by the public—households, firms, and institutions other than banks and government—because these groups use money for transactions, precautionary, and speculative purposes.

• Money held by the Government and banks is excluded from standard measures since they are producers of money and their cash reserves are not used directly for general spending or speculation.

• This distinction between money producers (Government and banks) and money users (public) is essential for monetary theory and policy, as it helps in accurately analysing money demand and controlling the economy.

Currency with the Public

In order to arrive at the total currency with the public in India we add the following items:

1. Currency notes in circulation issued by the Reserve Bank of India.
2. The number of rupee notes and coins in circulation.
3. Small coins in circulation.

• To calculate currency with the public, cash reserves held by banks must be deducted because these reserves remain with banks and are not used for payments or transactions in the economy.

• Modern paper currency issued by the Reserve Bank of India is not fully backed by gold or silver reserves, unlike earlier gold standard or silver standard systems where full backing was required.

• According to modern economic thinking, currency issuance should depend on the monetary needs of the economy rather than the availability of precious metal reserves.

• Since 1957, the RBI follows the Minimum Reserve System, maintaining minimum reserves of ₹200 crores in gold and approved foreign securities, while allowing issuance of currency as required by economic needs.

• Present-day currency is inconvertible, meaning RBI is not obliged to convert notes into gold or silver, and the promise printed on notes is only a historical legacy.

• Paper currency and coins are fiat money and legal tender, accepted by law for all payments because they carry government authority and cannot be refused in transactions.