RBI’s Role in Money supply:

The Reserve Bank is the sole institution capable of issuing currency and providing funds to commercial banks for credit creation, shaping the nation’s money supply. The Central Bank provides funds through various instruments and is considered the lender of last resort due to its constant lending capacity to banks.

How does RBI balance the Money supply? 

The RBI uses both quantitative and qualitative tools to regulate the money supply in the economy. 

• Quantitative tools involve adjusting the Central Reserve’s (CRR) or bank rate, while 
• Qualitative tools involve persuasion by the RBI to discourage or encourage lending in commercial banks.

RBI’s Money Control: How Reserve Ratio impacts lending and alters Money supply?

• The Central Bank’s change in the reserve ratio can affect banks’ lending, which in turn affects deposits and money supply. 
  • Example: From the previous example, If the Reserve Bank of India increases the reserve ratio to 25%, the banking system would only be able to loan Rs 300, leading to a decrease in the money supply.
• Open Market Operations: It involves buying and selling government bonds in the open market, which is entrusted to the RBI. 
  • The Reserve Bank of India (RBI) uses Open Market Operations to influence the money supply. 
  • When the RBI buys a government bond, it pays with a cheque, increasing the total reserves in the economy and the money supply.
  • Open market operations, such as outright and repo, involve central banks injecting money into the system without any promise to sell or withdraw it later. 
• Repo Operations: It specifies the date and price of resale, 
  • While reverse repo operations specify the date and price of repurchase. 
• Repo Rate: It is the interest rate at which money is lent in repo operations.
  • The Reserve Bank of India conducts repo and reverse repo operations at various maturities, including overnight, 7-day, and 14-day, and has become the main tool of monetary policy. 
• Bank Rate: It is the rate at which the central bank lends money to commercial banks, the RBI can affect the amount of money in circulation by its alteration. 
  • In India, this rate is known as the Bank Rate.
  • Raising of the Bank Rate: Commercial banks must pay more for the loans which reduces the amount of reserves they hold and the amount of money in circulation decreases. 
  • Lowering of the Bank Rate: The amount of money available may rise if the bank rate declines.

Money Supply: Currency Issuance, Bank Deposits, Transaction Impacts

• Issuance of Currency Notes and Coins: Demand deposits, such as currency notes and coins are issued by the monetary authority in the country.
  • In India, currency notes are issued by the Reserve Bank of India (RBI) and coins are issued by the Government of India. 
• The Inclusion of Bank Deposits as Money: In addition to currency notes and coins, savings or current account deposits held by the public in commercial banks are also considered money.
• Since cheques drawn on these accounts are used to settle transactions.
• Distinguishing Deposit Types: Demand vs. Fixed Deposits
  • Demand Deposits: These deposits are payable on demand from the account holder, 
  • Fixed Deposits: While fixed deposits have a fixed maturity period also known as Time Deposits.
• Backing by Issuing Authority: The assurance that the issuing authority of these objects has offered gives the currency notes and coins their worth.
  • The paper itself has little value—certainly less than Rs 100—even though a hundred rupee note can be used to buy goods from a business for Rs 100. 
  • Similar to this, a five rupee coin’s metal content is probably not worth five rupees.
• Fiat Money: Currency notes and coins are fiat money, with the RBI promising to provide purchasing power equal to the value printed on them.
  • They are legal tenders, as they cannot be refused by any citizen for transaction settlement. 
  • However, cheques drawn on savings or current accounts can be refused by anyone, making demand deposits not legal tenders.

Money Supply: Legal Definitions and Classification into Narrow and Broad Measures

• Money supply: It is a stock variable that represents the total amount of money in circulation among the public at a specific time.
• RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows: 
  • M1 = CU + DD 
  • M2 = M1 + Savings deposits with Post Office savings banks 
  • M3 = M1 + Net time deposits of commercial banks 
  • M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates)
  • where CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks. 

• The word ‘net’ implies that only deposits of the public held by the banks are to be included in the money supply. 
• The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of the money supply.
• M1 and M2 are known as narrow money. 
• M3 and M4 are known as broad money. 
• These measures are in decreasing order of liquidity.
  • M1 is the most liquid and easiest for transactions.
  • M3 is the most commonly used measure of money supply. 
    • It is also known as aggregate monetary resources.
  • M4 is the least liquid of all.