What is Money Supply? 💸
Money Supply is the total stock of money circulating in an economy at a specific point in time. It includes currency in circulation, demand deposits with banks, and other liquid assets.
In simple terms, it’s the total amount of money available in the country. The Reserve Bank of India (RBI) is responsible for measuring and managing the money supply.
Measures of Money Supply
The RBI uses different measures, from most liquid (easiest to spend) to least liquid.
- M1 (Narrow Money): Currency with the Public + Demand Deposits with Banks (like current and savings accounts) + Other Deposits with RBI.
- M2: M1 + Savings deposits with Post Office saving banks.
- M3 (Broad Money): M1 + Net Time Deposits with the banking system (like Fixed Deposits and Recurring Deposits). This is the most commonly used measure of money supply.
- M4: M3 + All deposits with post office savings banks.
What is Inflation? 📈
Inflation is the rate at which the general level of prices for goods and services rises, leading to a fall in the purchasing power of money.1
Simple Meaning: Your money buys fewer things than it could before.2 A ₹100 note becomes less valuable because prices have gone up.
The Relationship: How Money Supply Affects Inflation
The relationship between money supply and inflation is direct and is a cornerstone of economics.3
The basic principle is called the Quantity Theory of Money.4
- If the money supply in an economy grows faster than the real output of goods and services, it will cause inflation.5
Simple Analogy
Imagine a small island economy with only one product: 10 coconuts. The total money supply on the island is ₹100. Based on this, the price of each coconut would be ₹10 (₹100 / 10 coconuts).
Now, imagine the island’s government prints an extra ₹100, so the total money supply becomes ₹200. However, the number of coconuts is still only 10.
- There is now more money chasing the same amount of goods.6
- This will naturally push the price of each coconut up to ₹20 (₹200 / 10 coconuts).
This price rise from ₹10 to ₹20 is inflation, caused directly by an increase in the money supply.
How the RBI Controls Money Supply to Manage Inflation
The RBI uses its monetary policy tools to manage the money supply and keep inflation in check.
| Tool | Action to Reduce Money Supply (Fight Inflation) |
| Repo Rate | Increase the repo rate. This makes borrowing more expensive for commercial banks, who in turn increase their lending rates. This discourages borrowing and reduces money supply. |
| Cash Reserve Ratio (CRR) | Increase the CRR. This forces banks to keep a larger portion of their deposits with the RBI, leaving them with less money to lend out. |
| Open Market Operations (OMO) | Sell government securities (bonds). When the RBI sells these bonds, it sucks out the excess money from the banking system, reducing liquidity. |
Conclusion: The money supply is a powerful lever for managing the economy. An excessive increase in it without a corresponding increase in the production of goods and services is a primary cause of inflation.7 The RBI’s main job is to maintain a delicate balance—ensuring there is enough money to support economic growth, but not so much that it triggers high inflation.