Q1. What are the different components of
money which the RBI defines?
A1. There are 5 ✋broad
components of money which the RBI defines and I have listed them as below:
· M0 – Currency in circulation +
Banker’s deposit with the RBI (popularly called as CRR) + other deposits with
RBI. M0 is popularly called as 💡“Reserve Money”💡
· M1 – Currency in circulation - cash
available with the banks + demand deposits with the banks (eg: savings account)
+ other deposits with RBI. M1 is popularly called as 💡“Narrow Money”💡
· M2 – M1 + post office saving bank
deposits
· M3 – M1 + time deposits with banks
(eg: fixed deposits). M3 is popularly called as 💡“Broad Money”💡
· M4 – M3 + Total post office deposits
Though there are 5 components, I would like
you’ll to focus on “reserve money – M0”, “narrow money – M1” and “broad money –
M3”.
In simple terms, narrow money includes the
money which is available with the public ➕ money in savings bank accounts. Broad money includes the
component of narrow money ➕ various time deposits (like fixed deposits).
Q2. What is the concept of money multiplier?🤔
A2. If your grandmother🧙♀️ gives you a
gift of Rs 50,000/- on completion of your post-graduation🏆🏆, say your immediate
response is to deposit the money into your bank account. The money which your
grandmother had is called as currency in circulation. Once the money is
deposited into the bank account, the bank will keep some portion of it aside
(say 20%) and lend the balance (80%). The amount which is kept aside is called
as 💡“reserve
requirement”💡 which in India’s case is popularly called as “Cash reserve
ratio and statutory liquidity ratio”. The amount which is lent falls into the
bank account of some other person and thus will be a deposit in either the same
bank or another bank. This deposit can again be lent and this process keeps on
going.
*Therefore the original currency in
circulation multiplied across this process of deposit and lending and thus
created “money supply” in the economy*
In case you are confused as to how this
original currency in circulation came from, then the answer to it is that it
was printed by the RBI and formed part of the “Reserve Money/ M0”. Thus the
reserve money multiplied and led to money supply in the economy.
*In mathematical terms, we calculate money
multiplier as Broad Money (M3) / Reserve Money (M0).*
Q3. What is income velocity of money?
A3. The income velocity of money tells us
about the average number of times a unit of currency is used to purchase goods
and services within a given period of time. In simple words it means the speed
at which the money is getting exchanged in the economy.
*Higher this number would mean higher exchange
of goods and services in the economy which is reflective of healthy and
expansionary economy.*
*Mathematically this term is calculated as
(GDP of the economy in a year / Broad money).* However we can also have narrow
money in the denominator. When we have narrow money in the denominator , it
will be called income velocity of narrow money.
Q4. How have these indicators changed over
the years, especially after demonetization ?
A4. The money multiplier and income velocity
of narrow money have fallen since 2016-17 (year of demonetization), while the
income velocity of broad money rose during 2016-17 and 2018-19 but has fallen
in 2019-20. What do I mean when I say the money multiplier and income velocity
of narrow money is falling?
*This means that the money in the economy is
multiplying at a slower pace (i.e people are keeping money with themselves and
not injecting it into the banking system) and spending on economic activities
has moderated.*
This phenomenon was happening in the
Indian economy even before the COVID-19 development and these ratios could
further worsen if people hoard cash with them and do not spend the same in the
economy.
Therefore, in simple terms, the fall in these
monetary indicators in 2019-20 indicates that people are hoarding money with
themselves and not spending it on different economic activities. No wonder,
India’s economy slowed down to its lowest level in 2019-20 (since global
financial crisis in 2008-09) and the impact could be worse after considering
the COVID-19 lockdown effect.
Q5. Are people really hoarding money? How can
one see this using numbers?
A5. The *“currency in circulation with the
public”* has increased by 14% from 20.8 lakh crs on April 12, 2019 to Rs 23.9
lakh crs on April 10, 2020 (span of 1 year). This cannot be directly related
with hoarding of money, but yes the money with the people has seen a
significant increase. On the other hand, the growth in bank deposits (savings
plus fixed deposits) was 7.9% in 2019-20, much slower than the currency in
circulation. Another ratio of currency with the public and demand deposits can
be looked at with this ratio from 1.4 to 1.5 during 2019-20. This is again an
indication that people👨🦰👩🦰👨🦲 have preferred to keep money with themselves.
We usually look at a number of indicators like
GDP growth, inflation, credit growth, and a number of high frequency indicators
to gauge the health of the economy. However, these monetary indicators also
explain a lot about the health of the economy with a broad view that people
have been holding the money with themselves and the spending activity also reduced
in 2019-20. These numbers will fall further considering the impact of COVID-19
on India’s GDP. Though the movement in these numbers is a post-facto analysis
about the health of the economy but in order to increase these ratios the
psychological view of holding cash among individuals and risk aversion towards
lending by banks will be critical determinants to reverse this trend.
Regards,
Sushant
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