The wheel of money supply that runs our economy comes in different sizes. Right from M1, M2, M3 to M4 and, in some countries, even M8. If there is so much variety, then which “M” gives a true picture of money supply? Unless we understand what constitutes money supply, we cannot know for sure whether it is increasing or decreasing. We also cannot understand what factors cause the increase or decrease in money supply. Let us take Jinny and Johnny’s help to understand the various constituents of money supply.
Johnny: I am fed up with spinning the same wheel of daily routine. I, too, need variety, just like the monetary economists who use different wheels of money supply in the form of M1, M2, M3 and M4. What do you say?
Jinny: I think it is better not to spin many wheels at the same time. Otherwise, like monetary economists, you too will end up guessing which wheel is spinning faster.
Johnny: But what makes monetary economists so obsessed with the varieties of “M”? Is there anything special about them?
Jinny: Well, you keep hearing about so many kinds of “M”, such as M1, M2 and M3, and so on. All of these give different measurements of money supply. Each “M” uses different components for measurement. For instance, M1 gives you the money supply in narrow terms, which is also popularly called narrow money. M3 gives you the measurement of broad money.
Don’t look so puzzled. Narrow money is something that is ready to be used as a medium of exchange for day-to-day transactions. It mostly includes currency in circulation as well as all the demand deposits lying with banks.
Now, that may prompt you to ask what we mean by currency in circulation. Well, as you may be aware, our government, mostly through the central bank, prints paper currencies and mints coins that we use as mediums of exchange for all our transactions. But all printed notes and minted coins do not end up in the hands of the public. Some portion of it lies in the vaults of the central bank. So, currency in circulation is that portion of the notes and coins that is in the hands of the public.
It does not matter whether you keep your notes ready for use in your wallet or you keep them under your mattress. As long as the currency is with you, it is deemed to be in circulation. Even if you part with the currency for purchasing something, it remains in circulation. But the moment you deposit it in a bank, it ceases to be in circulation. At the same time, a corresponding demand or term deposit comes into existence and becomes part of the money supply. So, depositing money in a bank does not lead to either increase or decrease in money supply.
Johnny: That’s fantastic. Even when a pickpocket takes away my wallet, there is no decrease in money supply. But, tell me, why are demand deposits considered part of narrow money?
Jinny: Demand deposits are as good as currency. You can withdraw them any day from your bank on demand. You can also write a cheque against the amount lying in your account to make payments for your day-to-day transactions. Therefore, demand deposits are considered a good substitute for cash in your wallet and, hence, we treat them as narrow money.
Johnny: So far, so good. Now, tell me, what constitutes broad money?
Jinny: We use M3 to reflect a broader constitution of money supply. Other than currency in circulation and demand deposits with banks, it also includes term deposits with banks. Unlike demand deposits, you cannot write a cheque against money lying in your term deposits. That makes term deposits less liquid than demand deposits. Nevertheless, you can still convert your term deposits into cash. That’s why term deposits are treated as part of broad money.
Johnny: So far, you have talked about M1 and M3. What about M2 and M4?
Jinny: Well, different countries may use M2, M4 or M8 to capture broader information about money supply. As a general rule, the farther you move from M1, the more illiquid components of money supply are included. For instance, in our country, M2 includes deposits in post office savings accounts as a component of money supply, apart from currency in circulation and demand deposits.
M4 includes total deposits of the post offices and not just deposits in post office savings accounts. But you should not get confused by so many kinds of “M”. For all practical purposes, M1 and M3 are most commonly used as indicators of the increase or decrease in money supply.
Johnny: You said depositing money in a bank neither increases nor decreases the money supply. Then what causes increase in money supply?
Jinny: Let us save that question for next week.
What:Money supply is measured in terms of M1, M2, M3, M4 and, in some countries, even M8 by using different components of measurement.
How: In India, narrow money (M1) is measured by adding the currency in circulation, demand deposits with banks and other deposits with the Reserve Bank of India. Broad money (M3) is measured by adding M1 and term deposits with banks.Why: Understanding money supply is important because changes in money supply affect the whole economy.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at firstname.lastname@example.org