Measures of Money Supply: M1, M2, M3, and M4 for Economic Analysis

Introduction

Money supply refers to the total amount of money circulating in an economy at a given time. It includes various forms of money, ranging from physical currency to highly liquid assets. Different measures of money supply, such as M1, M2, M3, and M4, provide insights into the liquidity and overall monetary conditions of an economy. 

Measurement of Money Supply

• M1= Currency (notes plus coins) held by the public + ‘net’ demand deposits held by commercial banks. 
  • 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.
• 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 organizations (excluding National Savings Certificates)
• Narrow Money: M1 and M2 
• Broad Money: M3 and M4. 
• Liquidity: M1 is the most liquid and easiest for transactions whereas M4 is the least liquid of all. 
  • Sequence of these assets in the decreasing order of liquidity: Currency > Demand deposits with the banks > Savings deposits with the banks > Time deposits with the banks [UPSC 2013]
• Primary Measures of Money Supply: M3 is the most commonly used measure of money supply. 
  • It is also known as aggregate monetary resources.
• Characteristics of Currency: 
  • Currency issued by the central bank can be held by the public or by commercial banks, and is called the ‘high-powered money’ or ‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.
  • Stock Variable: Money supply is a stock variable that represents the total amount of money in circulation among the public at a specific time.
  • Basis for Credit Creation: The central bank’s currency, known as high-powered money or reserve money, serves as a basis for credit creation.

Determinants of Money Supply: 

• The following determinants help influence and accurately quantify an economy’s supply situation.
• High-Powered Money: Cash and its equivalents are highly liquid, they directly affect the supply of money in an economy.
• Level of Commercial Bank Reserves: The central bank mandates commercial banks to hold a fixed percentage of deposits as reserves in case of any emergency that affects the money supply.
• Reserve Ratio:If the central bank increases the ratio, banks will have to hold more money in reserves, reducing banks’ lending capabilities.
• Liquid Cash Held by the Public: If people have more liquid cash at home, they will only spend a small portion required. 
  • However, if the same cash is deposited in the bank, the supply in the economy will be high.

Conclusion

• The various types of money supply, including M1, M2, M3, and M4, represent different measures of the total amount of money circulating within an economy. 
• These measures offer insights into the liquidity and overall monetary conditions of an economy, with M3 often regarded as the most commonly used measure. 
• Understanding the characteristics and composition of each type of money supply is essential for analysing monetary policy, financial stability, and economic performance.