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12.

Reserve Bank of India Classification of Money

Objectives:

After studying this lesson, you will be able to understand,

• The Narrow definition of Money


• RBI Measures of Money
• Narrow Money
• Broad Money

12.1 Introduction

12.2 Debate on constituents of Money Supply

12.3 RBI Classification of Money

12.4 High Powered Money and Money Supply

12.5 Summary

12.6 Check your progress

12.7 Key concepts

12.8 Self Assessment questions


12.9 Answers to check your progress

12.10 Suggested Readings

12.1 Introduction:

There is no clear-cut distinction between what is money and what are the measures of
money supply. Money supply means the total amount of money in an economy. The
effective money supply consists of mostly of currency and demand deposits. Currency
includes all coins and paper money issued by the government and the banks. Bank
deposits are regarded part of money supply and they constitute about 75 to 80 percent of
the total money supply in the U.S. Some economists also include near money, or such
liquid assets as savings, deposits and government bills in the money supply. The total
supply of money determined by banks, the Federal Reserve, businessmen, the
government and consumers.

Money is something, which is measurable. Supply of money refers to its stock at any
point in time; it is because money is a stock variable as against a flow variable (real
income). It is the change in the stock of money during a period, which is a flow. The
stock of money always refers to the stock of money held by the public. Through out
history the question of not only what constitutes money but where it comes from has been
both important and controversial.

12.2 Debate on constituents of Money Supply:

There is a debate whether the time and saving deposits to be included in money supply or
not. What distinguishes these deposits is the fact that they earn an interest income and can
be converted as means of payments only after some delay and not at once. As such these
time and saving deposits are excluded from the pool of the money supply. However,
alternative definitions of money have adopted by many writers. Notably, the Chicago
school led by Milton Friedman opts to include all bank deposits, time and demand, in
money supply. In fact, Schwartz and Friedman are willing to consider as money all
marketable government securities, which are supported at par. By the same logic, there is
no reason why the liabilities of saving institutions should not also be included in money.

The debatable question is whether the measure of money should be extended to include
other deposits liabilities of the commercial banks, e.g., time deposits in USA and deposit
accounts in the UK. Some investigators go further and include the liabilities of some
other deposits taking institutions, such as savings and loan associations in the USA and
saving banks in Britain, on the grounds that their fixed monetary value makes them good
substitutes for interest bearing bank deposits. It has therefore, to be observed that various
measures of money supply keep on changing from country to country and from time to
time within the country.

12.3 RBI Classification of Money:

The Reserve Bank of India does not follow or clearly states any theory of money supply
or money stock. It simply publishes a purely accounting analysis of what it calls sources
of change in money supply stock. The main constituents of money stock are a) currency
with the public b) Deposit money. These can be further split into what may be called
sources of money stock (a) Net Bank Credit to Government Sector (including RBI credit
to Government Sector) (b) Bank credit to commercial sector. (c) Net foreign exchange
assets of banking sector (d) Governments currency liabilities to the public minus (e)
Banking sectors net non-monetary liabilities.

Up to 1968, the Reserve Bank of India published a single measure of money supply
called M and latter on M1 defined as currency and demand deposits held by public. It was
called the narrow measure of money supply. After 1968 the RBI started publishing
broader measure of money supply called aggregate monetary reserves defined as M or M1
plus the net time deposits of banks by the public (M3).
However, since 1977 Reserve Bank of India is publishing data on four alternative
measures of money supply in place of the old measure based on a narrow conception of
money. As stated above, the old measure of money supply consists of currency and
demand deposits are generally regarded as too narrow and clearly inadequate. They are:

M1 = C + DD + OD

Where C = currency, DD = demand deposits and OD = other deposits of the RBI as are
in the nature of demand deposits.

M2 = M1 + saving deposits with post-office saving banks

M3 = M1 + Net time deposits with banks

M4 = M3 + All types of deposits with post-offices – National Saving Certificates

Out of these four measures, M1 has the greatest degree of liquidity. Other measures have
liquidity in the descending order with M4 having the lowest degree of liquidity.

There is a marked preference during the recent years on the part of RBI for M 3 over M1 as
a measure of money supply. The superiority of M3 over M1 is on account of several
reasons. M3 is a broad measure of money supply, whereas, M1 is a very narrow
conception of it. Second, M3 does not suffer from the flaw of arbitrary division of saving
deposits between the demand deposits and time deposit components. Thirdly, from the
credit budgeting viewpoint, M3 is better than M1 because total bank credit is closely
connected with total deposits and not merely the demand deposits of banks. Fourthly, M3
is preferable to M1 on empirical grounds. The Chakravarthy committee also indicated its
preference for M3 over M1.

The Working Group on Money Supply: Analytics and Methodology of Compilation, set
up under chairman ship of Dr Y V Reddy to examine the analytical aspects of the
monetary survey, submitted its report in June 1998. The Working Group recommended
the compilation of comprehensive analytical surveys of the Reserve Bank of India,
commercial and co-operative banks and the organised financial sector at regular intervals.
An inter-departmental Core Group was set up to implement the recommendations of the
Working Group.

The Working Group recommended that the proposed monetary aggregates should be
disseminated from fiscal 1999-2000. However, the monetary series presently in vogue
would need to be continued for some time for the purpose of comparability. For
convenience, the proposed monetary aggregates would be referred to as the new series
and the present ones, the old series.

The proposed Intermediate Monetary Aggregate (NM2)

The Working Group proposed a new intermediate monetary aggregate, to be referred to


as NM2, comprising currency and residents' short-term bank deposits which would stand
in between narrow money (M1) (which includes only the non-interest bearing monetary
liabilities of the banking sector) and broad money (M3) (an all encompassing measure
that includes long-term time deposits).

The recommendation implied the partition of the maturity structure of bank deposits into
short-term and long-term time deposits at one year of contractual maturity in order to
elicit information about depositors' preferences in holding money in various degrees of
liquidity.
Data on the maturity structure of time deposits partitioned at the contractual maturity of
one year are not readily available with banks. Collection of such information has
required the banks to set up a reporting system for the purpose at the branch-level. The
data received are new and would have to be over time subjected to tests of robustness and
stability. For the present, therefore, such data had to be estimated based on the reporting
by a representative sample of large public sector banks.

The proportion of short-term time deposits (with a contractual maturity of up to and


including one year) in total time deposits for the sample banks worked out to about 45.0
per cent. Pending the census data, this ratio has been applied to the aggregate time
deposits of the banking system to obtain estimates of NM2.

Broad Money (NM3)

The new broad money aggregate (referred to here as NM3 for purpose of clarity) in the
Monetary Survey would comprise in addition to NM2, long-term deposits of residents as
well as call/ term borrowings from non-bank sources which have emerged as an
important source of resource mobilisation for banks. The critical difference between M3
and NM3, essentially, lies in the treatment of non-resident repatriable fixed foreign
currency liabilities of the banking system in the money supply compilation.

The difference owing to banks' call/term borrowings from non- bank sources is, at
present, negligible on reporting Fridays as such liabilities are fully subject to reserve
requirements. The divergence between the estimates of M3 and NM3 would, there- fore,
essentially depend on the magnitude of the non-resident inflows to the banking system in
India.

The difference between the growth rates of M3 and NM3 vary within a range of 0.1 to
1.7 percen- tage points on a point-to-point financial year basis. The difference is more or
less the same when monthly data are averaged for the same period, viz., 0.3 to 1.6
percentage points.
The Working Group classified the liabilities of the banking system in India to others
broadly in terms of i) demand liabilities, ii) time liabilities and iii) other demand and
time liabilities (ODTL) in line with the existing practice. Of these liabilities, demand and
time deposits are included in money supply as the monetary liabilities of the banking
sector. The balances under ODTL are essentially non-deposit liabilities, which together
with balances under such liabilities as paid-up capital and reserves constitute the net non-
monetary liabilities (NNML) of the banking sector.

One of the important items appearing under ODTL is the Pension and Provident Funds of
the banking system, wherever such funds are not managed by separate entities and, as a
result, reflected in the balance sheet of the banks. Pension and Provident Funds are
essentially a portfolio of assets created to provide old age and retirement benefits and are,
therefore, treated as different from deposits, in line with international practices.

12.4 High Powered Money and Measurement of Money Supply:

It should be noted that money supply is not always policy determined. In fact, monetary
authority, banks and the public determine money supply jointly. It is true that the role of
monetary authority is predominant in determining the supply of money. Two types of
money must be distinguished i.e., ordinary money and high-powered money. Ordinary
money as we have known is currency plus demand deposits. On the other hand, high-
powered money is the money produced by the RBI and the Government of India held by
public and banks. The RBI calls it as reserve money.

High powered money is the sum of, currency held by public, cash reserves of the banks
and other deposits of RBI, we can ignore other deposits of RBI from theoretical
discussion as it hardly constitutes one percent of total high powered money. Now if we
compare the two types of money, we find currency money is common to both, the
difference between the two is demand deposits in ordinary money and cash reserves of
the banks in High-powered money. This difference is of vital importance. Banks are
producers of demand deposits and these demand deposits are treated as money at par with
currency. But to be able to create demand deposits banks have to maintain cash reserves,
which in turn are a part of High-powered money, produced only by monetary authority
and not by banks.

We know in a fractional reserve banking system, demand deposits are a certain multiple
of cash reserves, which are a component of High-powered money; it gives the high-
powered ness and act as the base for multiple creation of demand deposits. That is why,
high-powered money also called as base money. Thus it becomes single most dominant
factor of determining money supply.

The actual measurement of money in the modern economy has become an extremely
complex matter because a fairly large variety of financial assets exist in the economy that
serves as money in one way or another.

12.5 Summary

Money is something, which is measurable. Supply of money refers to its stock at any
point in time; it is because money is a stock variable as against a flow variable (real
income). It is the change in the stock of money during a period, which is a flow. The
stock of money always refers to the stock of money held by the public.

Through out history the question of not only what constitutes money but where it comes
from has been both important and controversial. The Reserve Bank of India does not
follow or clearly states any theory of money supply or money stock. It simply publishes a
purely accounting analysis of what it calls sources of change in money supply stock.
However, since 1977 Reserve Bank of India is publishing data on four alternative
measures of money supply in place of the old measure based on a narrow conception of
money. They are M1, M2, M3 and M4. Besides, High Powered Money also identified as
single most factor of determinant of money supply. The actual measurement of money in
the modern economy has become an extremely complex matter because a fairly large
variety of financial assets exist in the economy that serves as money in one way or
another.

The Working Group under the chairmanship of Dr Y V Reddy recommended that the
proposed monetary aggregates should be disseminated from fiscal 1999-2000. However,
the monetary series presently in vogue would need to be continued for some time for the
purpose of comparability. For convenience, the proposed monetary aggregates would be
referred to as the new series and the present ones, the old series.

12.6 Check your progress

State whether the following statements are True or False

1. Old measure of money supply based on Narrow conception of money


2. High-powered money also called as base money.
3. Milton Friedman opts to include all bank deposits, time and demand, in money
supply.
4. M3 = M1 + Net Savings deposits with Post-offices

12.7 Key concepts

Currency
Demand Deposits
Time Deposits
Post-office Savings
Narrow Money
Broad Money
Commercial Liabilities
Foreign exchanges
12.8 Self Assessment questions

1 what is meant by Narrow Money


2. Distinguish between Narrow and Broad Money
3. Analyse the RBI Classification of Money
4. Explain about the New Monetary Aggregates.

12.9 Answers to check your progress

1. True 2 True 3 True 4. False

12.10 Suggested Readings

Ward R A: Monetary theory and policy


Rana & Verma : Macro economic analysis
Hajela TN: Monetary economics
Ghatak : Monetary economics in developing economies
Gupta SB: Monetary policy in India

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