Measures of Money Supply Flashcards
Why does the RBI need to measure the money supply?
The RBI measures the money supply to inform its monetary policy decisions. Understanding the amount of money in circulation helps the RBI control inflation and influence interest rates.
List the measures of the money supply used by the RBI and explain the key differences between them.
The RBI uses M0, M1, M2, M3, and M4. The key differences are based on asset liquidity:
M0 (Reserve Money): Currency in circulation and deposits banks hold with the RBI.
M1 (Narrow Money): M0 plus demand deposits.
M2: M1 plus short-term deposits
M3 (Broad Money): M1 plus long-term deposits, the most common measure.
M4: M3 plus Post Office Savings Bank deposits (excluding National Savings Certificates)
A large company deposits significant cash into a commercial bank. How would this likely affect the various measures of the money supply? Analyze the immediate and potential longer-term effects.
Immediate Effects:
M0 would remain unchanged (cash moves from circulation to bank deposits).
M1, M2, M3, and M4 may increase depending on the type of deposit made.
Potential Longer-term Effects:
Increased lending capacity of the bank, potentially leading to the creation of new money through loans.
This could influence economic activity and inflation in the long run.
You’ve learned that Narrow Money (M1, M2) and Broad Money (M3, M4) exist. If you were an economic advisor to the RBI, under what economic conditions would you recommend focusing more on narrow money measures, and when would you recommend a focus on broad money?
Focus on Narrow Money: When there is concern over rapid changes in spending in the economy, as narrow money components are directly linked to transactions.
Focus on Broad Money: When there’s a need to gauge potential spending or long-term trends in the economy. Broad money reflects savings that may influence future economic activity.
The text mentions that the RBI focuses on M3 (Aggregate Monetary Resources). Do you agree this is the best measure? Could a case be made for a different measure being a better primary focus?
While M3 is a widely used measure, it’s debatable whether it’s always optimal:
M3 focus advantages: Reflects a large portion of the money potentially available for spending and investment.
Alternatives: In a rapidly changing economy, M1 or M2 might be better short-term indicators due to their focus on highly liquid assets.
The text states, “Corona-2020: Initial months of lockdown (May2May-2020) → deposit⏬⏬ because people withdrew money in panic / precautionary motive…” Analyze other potential factors that could have influenced bank deposits during this time, aside from those mentioned in the text.
Reduced income for certain sectors might have decreased deposits.
Government support payments may have been kept as cash initially.
Uncertainty may have led to increased investment in alternative assets, reducing deposits.
The text mentions the difference between “NET demand/time deposits” and interbank deposits when calculating money supply. Why is focusing on the public’s deposits important for the RBI’s monetary policy?
Focusing on the public’s deposits provides a clearer picture of the money available for spending and investment in the economy. Interbank deposits reflect internal banking transactions and don’t directly affect economic activity the same way public deposits do. Understanding the true “money in circulation” helps the RBI create effective policies.
The FAQ mentions the terms “Hard Money” and “Soft Money” but suggests not investing significant study time on them. In a broader context, could these concepts have any relevance when understanding money supply and monetary policy?
While not directly part of RBI measurements, understanding Hard/Soft money offers insight:
Hard Money: Typically, physical assets like gold, with intrinsic value.
Soft Money: Paper money, digital currency, with value based on trust.
Relevance: The evolution from hard to soft money has given central banks greater control over the money supply and monetary policy. Debates on whether to “back” currency with hard assets periodically resurface and can influence economic thought.
Assume a country sees a significant increase in foreign remittances (money sent back home by citizens working abroad). How might this impact different measures of the money supply?
M0 might remain unchanged if the remittances are deposited in bank accounts.
M1, M2, M3, and M4 would likely increase, with the extent depending on whether funds are saved or used for immediate spending. This influx could boost economic activity and potentially lead to inflation if not carefully managed.
Imagine the government introduces a policy that drastically reduces taxes on savings accounts. How could this potentially affect the proportion of M1 and M3 within the broader money supply? What economic implications might this have?
This policy would likely increase M3 relative to M1 as people shift funds from demand deposits (M1) into savings accounts (M3) to take advantage of the tax savings. Implications:
It could limit the readily available money for spending, potentially slowing down the economy in the short term.
However, increased savings could lead to greater long-term investment and growth potential.
