Money and credit, Macroeconomics



In any modern economy, the quantity of money, aggregate volume of credit and its sectoral composition are important variables which exert significant influence on expenditure flows such as consumption, investment, etc. and on the sectoral composition of capital formation. They are among the important instruments of a group of economic policies known as "monetary and credit policy".

As we have mentioned earlier, the primary functions of money are to serve as a medium of exchange and a store of value - a financial asset. Conceptually, therefore, we can give the designation "money" to any financial instrument that can be directly used to make payments for goods, services and other financial assets. However, there are other assets which can be quickly and with little cost converted into means of payment. Such assets can be called "quasi-money" or "near-money". Examples of "money" are currency and coin and current account deposits on which checks can be freely written. Examples of "near-money" are savings and time deposits with banks, post office savings deposits, etc. which can be converted into "money" albeit with a small delay and possibly a little cost in terms of interest foregone. Alternatively, "money" can be borrowed against the security of these assets.

Since nearness of near-money is always a matter of degree a variety of definitions of "quantity of money" can be formulated. In India the Reserve Bank of India's definitions and measures of quantity of money (or money stock) are based on the tenet that the basic monetary aggregates should consist of assets possessing "superior liquidity" i.e. the definitions emphasize the medium of exchange function of money as we have done above.Before turning to RBI measures of money supply, it is to be borne in mind that these definitions refer to money supply held by the "public". By public we mean all economic units - firms, households, institutions - other than the banking system and the government (state and central governments). 

Definition: Money Stock Measures
The RBI has evolved four measures of money denoted M1, M2, M3 and M4. They are defined as follows:
M1:RBI currency notes with public

 + Rupees coins and notes with public

 + Small coins + Demand Deposits with banks + "Other Deposits"

with RBI.

M2:M1 + Post Office Savings Deposits

M3:M1 + Time Deposits with banks

M4:M3 + All Post Office Deposits (Savings and Time). 


i.RBI currency notes are notes of two rupees and above. They are the liability of RBI.

ii.One rupee notes and coins are liability of the Government of India.

iii."Other Deposits" with RBI consist of deposits of quasi-government institutions like IFC, SFCs, IDBI, NABARD, demand deposits of foreign central banks and governments, deposits of RBI Employees' Credit Co-operative, IMF (Account No.2), etc.

iv.M1 is often called 'narrow money' while M3 is called "aggregate monetary resources". When the term "money supply" is used without qualification it generally refers to M3.v.Treatment of savings deposits with banks is slightly complicated. Some savings accounts have cheque facilities. Savings deposits are bifurcated into two categories - those like demand deposits and those like time deposits. The former are merged with demand deposits and included in M1. The latter in M3. The procedure used for this bifurcation need not concern us here.

The monetary aggregates M1 to M4 are in descending order of liquidity. M1 is what we have called "money" above. M2-M4 include various near-monies. For most purposes in this book we would be talking about either M1 or M3. Post office savings and time deposits are treated separately in money supply measurements. They are not as liquid as bank deposits and are not subject to the same control mechanisms.

Money supply at a point in time is a stock concept i.e. a balance sheet concept. It denotes a part of liabilities2 of the banking system including RBI and the government. Currency is the liability of RBI (other than one rupee notes) while deposits of various kinds are liabilities of the banking system. In an accounting sense, therefore, changes in money supply must be reflected in changes on the assets side of their balance sheets. The banking system holds a variety of financial and non-financial assets. For the consolidated balance sheet of the banking system (including RBI) we must have:

Monetary liabilities of banking system + Non-monetary liabilities = Financial assets + Other assets

Now if we define

Net non-monetary liabilities = Other assets - Non-monetary liabilities.

We have

Monetary liabilities = Financial assets - Net non-monetary liabilities.

Therefore, purely in an accounting sense, changes in monetary liabilities (i.e. bank money) can be attributed to changes in financial assets and in net non-monetary liabilities.

Non-monetary liabilities consist of net worth and some deposits with RBI which are not counted as part of RBI money. Other assets consists of, primarily, physical assets like buildings, office equipment, etc.

Financial assets of the banking system consist of

i.RBI's credit to government

ii.Other banks' credit to government

iii.RBI's and other banks' credit to "Commercial Sector"

iv.Net foreign exchange assets of the banking system. RBI's credit to commercial sector really is RBI's loans and advances to development banks like IDBI, NABARD, etc. RBI does not directly lend to the non-government sector; it provides resources for quasi-government agencies to do so. 

There are other liabilities of the banking system called non-monetary liabilities e.g. net worth. Thus, when we talk of "bank credit" we refer to commercial and cooperative banks' credit to non-government sector. Bulk of this is supposed to be short-term credit to finance working capital needs of producers, wholesalers, retailers, etc. The volume of production of goods and services which can be undertaken and the volumes of stocks of raw materials and finished goods that can be held depend crucially on availability of such credit.

Banks as important financial intermediaries channel the surplus funds of savers to those who require credit to finance their current operations. Their ability to expand depends upon the volume of deposits they can attract and the regulatory actions of RBI. As we will see later RBI has evolved an array of controls to influence the total volume and allocation of bank credit.

Changes in bank credit and its composition are closely monitored by the RBI and the relevant statistics are published in its monthly bulletin and several other publications. 

Posted Date: 9/12/2012 4:19:49 AM | Location : United States

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