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# Concept of Money Supply
Chapter 8 · Money Market · Unit 2 · Exam-focused Revision Notes
### Crux First
- Money supply means the stock of money available to the public as means of payment and store of value.
- Inter-bank deposits and money held by government and banking system are excluded from money supply.
- Main sources of money supply are central bank and commercial banks .
- Reserve money = central bank money / base money / high-powered money .
- M1 = Currency with public + Demand deposits with banking system + Other deposits with RBI .
- M2 = M1 + savings deposits with post office savings banks .
- M3 = M1 + time deposits with banking system .
- M4 = M3 + total deposits with Post Office Savings Organization excluding NSC .
- M3 is the most widely used measure of broad money in India.
- Money supply equation: M = m × MB .
- Money multiplier = Money Supply / Monetary Base .
- Simple multiplier under strict assumptions = 1 / R .
- General money multiplier: m = (1 + c) / (r + e + c) .
- Higher reserve ratio, higher excess reserves ratio, and higher currency ratio reduce money multiplier.
- Credit multiplier = 1 / Required Reserve Ratio .
### 1. Introduction
- Money performs three primary functions in an economy: medium of exchange unit of account store of value
- medium of exchange
- unit of account
- store of value
- For policy purposes, money is defined as a set of liquid financial assets whose variation affects aggregate economic activity.
- Economic stability requires money supply to be maintained at an optimum level.
### 2. Meaning of Money Supply
- Money supply refers to the stock of money available with the public at a point of time.
- It includes money used for payments and store of value.
- The word public includes households, firms and institutions, but excludes producers of money.
#### Who are excluded from “public”?
- Government
- Banking system
#### Top MCQ Trap
- Since inter-bank deposits are not held by the public, they are excluded from money supply.
- Money held by government and banking system is also excluded while measuring standard money supply.
### 3. Rationale of Measuring Money Supply
- Measurement of money supply is important because: it helps analyse monetary developments and causes of money growth it helps central bank assess whether money stock is consistent with price stability and growth goals
- it helps analyse monetary developments and causes of money growth
- it helps central bank assess whether money stock is consistent with price stability and growth goals
- Monetary policy largely works by influencing monetary base and money supply.
### 4. Sources of Money Supply
- Money supply depends on: decision of central bank supply response of commercial banks
- decision of central bank
- supply response of commercial banks
- The central bank is the primary source of money supply because it issues currency.
- The commercial banking system is the second major source because it creates credit money.
### 5. Role of Central Bank
- In modern economies, currency is issued exclusively by sovereign / central bank.
- This currency is legal tender.
- Paper currency is a liability of central bank and government and an asset of the public.
- High-powered money issued by central bank is the source of all other forms of money.
### 6. Minimum Reserve System
- In principle, currency should be backed by gold and foreign exchange reserves.
- But under the minimum reserve system , central bank can issue currency to any extent by maintaining only a certain minimum reserve of gold and foreign securities.
#### MCQ Trap
- Under minimum reserve system, the central bank is empowered to issue currency to any extent with only a certain minimum reserve backing.
### 7. Role of Commercial Banks
- Commercial banks create money through the process of lending.
- Money created by banks is called credit money .
- Banks create money supply in the process of borrowing and lending with the public.
### 8. Digital Currency and New Forms of Money
- Money has evolved from commodity money to metallic currency, paper currency and now digital currency.
- Reserve Bank broadly defines CBDC as legal tender issued by a central bank in digital form.
- CBDC is exchangeable at par with existing currency and appears as liability on central bank balance sheet.
- Cryptocurrencies are not legally recognized as currency in India and hence are not categorized as money.
#### Top Trap
- CBDC = legal tender issued by central bank in digital form.
- Cryptocurrencies are not legally recognized as currency in India.
### 9. Measurement of Money Supply in India
- RBI has been compiling monetary statistics since 1935.
- After recommendations of the Second Working Group on Money Supply, RBI began publishing four measures: M1, M2, M3 and M4 .
### 10. Monetary Aggregates: M1, M2, M3, M4
- Measure | Formula | Name / Nature
- M1 | Currency with public + Demand deposits with banking system + Other deposits with RBI | Narrow money
- M2 | M1 + Savings deposits with post office savings banks | Broader than M1
- M3 | M1 + Time deposits with banking system | Broad money
- M4 | M3 + Total deposits with Post Office Savings Organization excluding NSC | Broadest conventional measure
#### Top Exam Trap
- M1 = narrow money.
- M3 = broad money.
- M2 adds only savings deposits with post office savings banks.
- M4 adds total post office deposits excluding National Savings Certificates.
### 11. New Monetary Aggregates and Liquidity Aggregates
- Following Working Group on Money (1998), RBI also publishes new monetary aggregates like NM1, NM2, NM3 and liquidity aggregates L1, L2.
- For exam purposes, know them at recognition level.
#### Reserve Money
#### Liquidity Aggregates
- L1 = NM3 + all deposits with post office savings banks excluding NSC
- L2 = L1 + term deposits and borrowings of financial institutions + CDs issued by FIs
### 12. Determinants of Money Supply: Two Broad Views
- Exogenous view – money supply is determined by central bank.
- Endogenous view – money supply is influenced by economic activity, public preferences, rate of interest etc.
- Current practice largely explains money supply through the money multiplier approach .
### 13. Concept of Money Multiplier
- Money created by RBI is the monetary base or high-powered money.
- Banks create more money by making loans.
- A one-rupee increase in monetary base can increase money supply by more than one rupee.
- M = money supply
- m = money multiplier
- MB = monetary base / high-powered money
### 14. Simple Money Multiplier
- Under simplifying assumptions: banks hold no excess reserves public holds no currency
- banks hold no excess reserves
- public holds no currency
- The money multiplier becomes reciprocal of reserve ratio.
- If reserve ratio = 10%, multiplier = 10.
- If reserve ratio = 5%, multiplier = 20.
- Higher reserve ratio means smaller multiplier.
- Lower reserve ratio means larger multiplier.
### 15. Why Currency Holding Reduces Multiplier
- If part of increase in high-powered money goes into currency with public, that part does not undergo multiple deposit expansion.
- Only money entering banking system as deposits gets multiplied strongly.
### 16. Money Multiplier Approach to Money Supply
- Developed prominently by Milton Friedman and Anna Schwartz.
- Three immediate determinants: H = stock of high-powered money r = reserve-deposit ratio c = currency-deposit ratio
- H = stock of high-powered money
- r = reserve-deposit ratio
- c = currency-deposit ratio
- These reflect: central bank behaviour commercial bank behaviour public behaviour
- central bank behaviour
- commercial bank behaviour
- public behaviour
### 17. Behaviour of Central Bank
- Central bank controls issue of currency and hence supply of high-powered money.
- If public and bank behaviour remain unchanged, total money supply varies directly with high-powered money.
### 18. Behaviour of Commercial Banks
- Commercial banks determine credit creation through lending.
- If required reserve ratio rises, banks must keep more reserves and can lend less.
- This reduces deposits and money supply.
- If reserve ratio falls, banks can create more deposits, so money supply rises.
- Reserve ratio and money multiplier are negatively related .
### 19. Excess Reserves
- Excess reserves are reserves kept by banks beyond required minimum.
- Excess reserves are important because money parked as excess reserves does not create new deposits.
- Excess reserve ratio is negatively related to market interest rate.
### 20. Behaviour of Public
- Currency-deposit ratio represents behaviour of the public.
- Higher currency holding means less deposit creation and lower money multiplier.
- The smaller the currency-deposit ratio, the larger the multiplier.
- Financial sophistication, banking habits and ease of access to banking reduce currency ratio.
- Currency ratio reflects public behaviour , not central bank behaviour.
### 21. Time Deposit-Demand Deposit Ratio
- An increase in time deposit-demand deposit ratio means greater availability of free reserves and larger potential multiple expansion.
- Thus, it can support monetary expansion.
### 22. General Formula of Money Multiplier
- Let: M = C + D H = C + Reserves c = C / D r = Reserves / D
- M = C + D
- H = C + Reserves
- c = C / D
- r = Reserves / D
- When excess reserves are included:
- e = excess reserve ratio
#### Most Important Formula Trap
- Money multiplier depends negatively on r , e and c .
### 23. Numerical Logic of Money Multiplier
#### Case 1: If only reserve ratio is given
#### Case 2: If c, r and e are given
#### Case 3: If money supply and monetary base are given
### 24. Monetary Policy and Money Supply
- When central bank wants to stimulate economy, it injects liquidity.
- For example, open market purchase of government securities increases reserves.
- With no excess reserve leakage and no extra currency leakage, money supply increases by a multiple of reserve injection.
- Open market purchase expands money supply.
- Open market sale contracts money supply.
### 25. Can Money Multiplier Become Zero?
- In theory, if interest rate is too low and banks prefer to hold all injected reserves as excess reserves, multiplication may break down.
- Then additional reserves may not lead to new lending.
### 26. Effect of Government Expenditure on Money Supply
- When government cash balances fall short, it can use Ways and Means Advances (WMA) or overdraft facility.
- When RBI lends under WMA/OD, excess reserves of commercial banks may increase.
- These excess reserves can lead to increase in money supply through multiplier process.
### 27. Credit Multiplier
- Also called deposit multiplier or deposit expansion multiplier .
- Shows how much additional money can be created by banking system for a given increase in high-powered money.
- It is tied to reserve requirement.
- If reserve ratio = 20%, credit multiplier = 5.
#### Key Distinction
- Credit multiplier is a simplified deposit expansion concept.
- Money multiplier is broader because it includes effects of currency holding and excess reserves.
### 28. Fractional Reserve Banking
- Under fractional reserve banking, banks keep only a fraction of deposits as reserves and lend the rest.
- This lending leads to further deposits and hence multiple expansion of money.
- However, money creation is not the same as wealth creation.
### 29. Difference Between Money Multiplier and Credit Multiplier
- Basis | Money Multiplier | Credit Multiplier
- Main idea | Relates total money supply to monetary base | Relates deposit creation to reserve ratio
- Formula | M / MB or (1+c)/(r+e+c) | 1 / Required Reserve Ratio
- Includes currency leakages? | Yes | No, usually ignored
- Includes excess reserves? | Yes | No, usually ignored
- Scope | Broader | Narrower / simplified
### 30. Ranker Numerical Strategy
- Step 1: Identify what is asked – M1, M2, multiplier, credit multiplier, currency with public, etc.
- Step 2: Use correct definition.
- Step 3: Check whether “cash with banks” has to be subtracted from currency in circulation.
- Step 4: For multiplier questions, identify whether c and e are given.
### 31. Ranker Comparison Table
- Concept | Correct Match
- Reserve money | Central bank money / base money / high-powered money
- M1 | Currency with public + demand deposits + other deposits with RBI
- M2 | M1 + savings deposits with post office savings banks
- M3 | M1 + time deposits with banks
- M4 | M3 + total post office deposits excluding NSC
- Currency ratio (c) | Behaviour of public
- Reserve ratio (r) | Behaviour / constraint of banks under central bank rules
- Excess reserve ratio (e) | Commercial bank behaviour
- Credit multiplier | 1 / Required Reserve Ratio
- Money multiplier | Money Supply / Monetary Base
- WMA | Short-term RBI lending support to governments
### 32. Top MCQ Traps from This Unit
- Reserve money is also called central bank money, base money and high-powered money.
- Inter-bank deposits are excluded from money supply.
- M1 does not include time deposits.
- M3 is broad money in standard Indian usage.
- Central bank is the primary source of money supply in all countries.
- The supply of money depends on central bank decision and commercial bank response.
- If behaviour of public and banks remains constant, nominal money supply varies directly with high-powered money.
- Money supply is increasing function of reserve money and money multiplier.
- Money multiplier is negatively related to excess reserve ratio.
- Currency ratio represents behaviour of public.
- Required reserve ratio, excess reserve ratio and currency ratio together determine size of multiplier.
- Higher required reserve ratio lowers money supply for a given monetary base.
- If commercial banks reduce excess reserves, money supply increases.
- Credit multiplier and money multiplier are related but not identical.
### 33. One-Page Memory Sheet
### Final Quick Revision
- Money supply = stock of money with public.
- Excludes inter-bank deposits and money held by government/banking system.
- Reserve money = central bank money = base money = high-powered money.
- M1 = currency with public + demand deposits + other deposits with RBI.
- M2 = M1 + savings deposits with post office savings banks.
- M3 = M1 + time deposits with banks.
- M4 = M3 + total post office deposits excluding NSC.
- M = m × MB.
- Money multiplier = money supply / monetary base.
- Simple multiplier = 1/R.
- General multiplier = (1+c)/(r+e+c).
- Higher r, higher e, higher c reduce money multiplier.
- Credit multiplier = 1 / required reserve ratio.
- If banks reduce excess reserves, money supply increases.
### The Concept of Money Supply notes built for concept clarity and exam recall.
This chapter page is written for CA Foundation Business Economics students who want quick understanding first and revision support later. Use it to revise definitions, logic, distinctions, traps, and answer-writing points before moving to objective practice.
- Meaning, definitions and core concepts in simple language
- Important distinctions and exam-oriented traps
- Quick revision support before classroom tests or self-study
- Direct bridge from theory revision to chapter-wise MCQ practice
### What students should be able to answer after revising this topic.
- Explain the meaning and importance of The Concept of Money Supply.
- Identify the most common conceptual differences linked to this unit.
- Write short exam answers using the right terminology and logic.
- Solve chapter-wise objective questions without confusion on keywords.
#### Related chapters for stronger internal revision
- The Concept of Money Demand
- Monetary Policy
- Fiscal Policy