Worked example 13 — Building the monetary aggregates, item by item

Students memorise M1 = currency + demand deposits and stop. The examinable content is the ordering principle, the difference between the two Indian series, and the components-and-sources identity that connects the money supply to government borrowing. This example builds the aggregates from a single set of balance sheet items so that each boundary can be seen being drawn.

Every monetary aggregate is built on one idea. The narrowest measure contains only what can be spent this instant; each wider measure adds assets that take a little longer, or cost a little more, to turn into spending power. The Working Group recommended compiling its aggregates on the basis of the balance sheet of the banking sector in conformity with the norms of progressive liquidity.

Two consequences follow, and both are worth stating in an answer.

• Nothing is the money supply. The right measure depends on the question being asked.
• The boundaries are conventions, drawn where the compiler chooses to draw them — which is exactly why the series was revised.

These definitions carry small legal points inside them, and the points are examinable.

• Currency with the public is arrived at after deducting cash with banks from total currency in circulation; currency in circulation comprises notes, rupee and small coins. The deduction matters: cash sitting in a bank's till is not in the public's hands and cannot be spent by anyone.
• Notes in circulation comprise notes issued by the Government of India up to 1935 and by the Reserve Bank since then, less notes held in the Banking Department — that is, notes held outside the Reserve Bank by the public, banks, treasuries and so on. One-rupee notes issued since July 1940 are treated as rupee coins and excluded from this head. The split at 1935 is the year the Reserve Bank took over the note issue; a one-rupee note is legally a coin, issued by the Government, not a Reserve Bank note.
• Cash on hand with banks relates to the cash holdings — notes, rupee coins and small coins — of commercial and co-operative banks coming under the purview of the Banking Regulation Act, 1949. The statute decides what counts as a bank for this purpose.
• Demand deposits with banks are the demand deposits with all commercial and co-operative banks, including co-operative societies.
• Other deposits with the Reserve Bank, for monetary compilation, include deposits from foreign central banks, multilateral institutions, financial institutions, balances in the depositor education and awareness fund, and sundry deposits net of IMF Account No. 1.
• Time deposits with banks are the time deposits with all commercial and co-operative banks.

The figures below are invented for this exercise. Units: notional. They are not Indian monetary data.

| Item | Amount | |---|---| | Currency in circulation | 3,400 | | less cash on hand with banks | (200) | | = Currency with the public | 3,200 | | Bankers' deposits with the RBI | 800 | | Other deposits with the RBI | 50 | | Current deposits with the banking system | 1,500 | | Savings deposits — demand liabilities portion | 900 | | Savings deposits — time liabilities portion | 2,100 | | Certificates of deposit issued by banks | 300 | | Term deposits of residents, contractual maturity up to and including one year | 4,000 | | Term deposits of residents, contractual maturity over one year | 9,000 | | Call and term borrowings from non-depository financial corporations | 400 | | Post office savings deposits | 250 | | Total post office deposits | 700 |

The older series: M1 to M4

| Measure | Definition | Working | Result | |---|---|---|---| | M1 (narrow money) | Currency with the public + demand deposits with the banking system + other deposits with the RBI | 3,200 + (1,500 + 900) + 50 | 5,650 | | M2 | M1 + post office savings deposits | 5,650 + 250 | 5,900 | | M3 (broad money) | M1 + time deposits with the banking system | 5,650 + (2,100 + 4,000 + 9,000) | 20,750 | | M4 | M3 + total post office deposits | 20,750 + 700 | 21,450 |

The pattern to hold in the head: M1 and M3 are the banking-system measures; M2 and M4 are the post-office extensions. M3 remains the aggregate most often quoted as money supply.

Notice the shape of the numbers. M2 is barely above M1 while M3 is nearly four times it — because the post office savings add-on is small and time deposits are enormous. That is the ordinary shape of a monetised economy, and it is why the M1/M3 distinction is the one that matters.

The newer series: M0 to M3

The Working Group recommended compilation of four monetary aggregates on the basis of the balance sheet of the banking sector in conformity with the norms of progressive liquidity: M0, the monetary base; M1, narrow money; M2; and M3, broad money.

| Measure | Definition | Working | Result | |---|---|---|---| | M0 (reserve money) | Currency in Circulation + Bankers' Deposits with the RBI + other deposits with the RBI | 3,400 + 800 + 50 | 4,250 | | M1 | Currency with the Public + Current Deposits + demand liabilities portion of Savings Deposits + other deposits with the RBI | 3,200 + 1,500 + 900 + 50 | 5,650 | | M2 | M1 + time liabilities portion of Savings Deposits + Certificates of Deposit issued by Banks + Term Deposits of residents with contractual maturity up to and including one year, excluding CDs | 5,650 + 2,100 + 300 + 4,000 | 12,050 | | M3 | M2 + Term Deposits of residents with contractual maturity over one year + Call/Term borrowings from non-depository Financial Corporations | 12,050 + 9,000 + 400 | 21,450 |

Four points fall out of this table, and each is a mark.

(a) M0 uses currency in circulation, not currency with the public. Compare the two M-series definitions above: M0 counts the whole 3,400 because cash in bank tills is still a liability of the central bank; M1 counts only the 3,200 because till cash is not spendable money. Getting these the wrong way round is the commonest error on this topic.

(b) The definition of reserve money and its components remains unaltered across the revision, and there is no change in the definition of M1 either. What the revision really changed is M2 and M3.

(c) Savings deposits are split. A savings deposit is divided: the part treated as withdrawable on demand goes into M1, and the rest is treated as a time liability and appears only in M2. That refinement is the reason the second form of the M1 definition exists.

(d) The M2/M3 boundary is one year of contractual maturity, and it was drawn deliberately — partitioning deposits at one year was recommended in order to elicit information about depositors' preferences in holding money in various degrees of liquidity.

Bankers' deposits with the Reserve Bank are the cash reserve ratio balances of the money-market chapter. A certain percentage of a scheduled commercial bank's net demand and time liabilities, relating to the second preceding fortnight, must be kept with the Reserve Bank as CRR; banks have to maintain a minimum of 90 per cent of the required CRR on a daily basis and 100 per cent on an average basis during the fortnight.

That is why a change in the CRR changes how much wider money the same base can support: raise the ratio and each unit of M0 supports less M3. M0 is compiled weekly; the other aggregates are compiled fortnightly.

Distinguish CRR from the statutory liquidity ratio, which is the proportion a bank must hold in liquid assets held by itself — in addition to investment in unencumbered government and other approved securities, gold, cash and excess CRR balance are also treated as liquid assets for SLR purposes, and the SLR is determined by the Reserve Bank in order to control the expansion of bank credit. CRR is cash parked with the central bank; SLR is liquid assets the bank keeps itself.

The Working Group also proposed an intermediate aggregate, NM2, comprising currency and residents' short-term bank deposits, standing between narrow money M1 — which includes only the non-interest-bearing monetary liabilities of the banking sector — and broad money M3, an all-encompassing measure that includes long-term time deposits.

NM3 would comprise, in addition to NM2, long-term deposits of residents as well as call and term borrowings from non-bank sources, which have emerged as an important source of resource mobilisation for banks. The critical difference between M3 and NM3 lies in the treatment of non-resident repatriable fixed foreign currency liabilities of the banking system, so the divergence between the two depends essentially on the magnitude of non-resident inflows to the banking system in India. In practice the gap was small — between 0.1 and 1.7 percentage points of growth on a point-to-point financial year basis.

And now the paragraph every student should read twice. The Reserve Bank states frankly that data on the maturity structure of time deposits partitioned at the contractual maturity of one year are not readily available with banks; collecting such information required banks to set up a branch-level reporting system, and the data received are new and would have to be subjected over time to tests of robustness and stability. Pending a census, the proportion of short-term time deposits was estimated from a sample of large public sector banks, where it worked out to about 45.0 per cent, and that ratio was applied to the whole banking system.

Apply that to our own table and the point becomes concrete. The split between the 4,000 of up-to-one-year term deposits and the 9,000 of over-one-year deposits — the split that decides the entire M2 figure — was, when the series began, produced by applying a sampled ratio, not by counting. Keep that in mind whenever a monetary aggregate is quoted to three decimal places: treat the aggregates as compiled estimates, not measurements.

Money supply is derived on a balance sheet approach, following from the balance sheets of the Reserve Bank and the rest of the banking sector, which includes commercial and co-operative banks. The components of the money supply are drawn from the liability side of that balance sheet, and the various uses of funds obtained from the asset side constitute the sources of M3.

| Components (liabilities) | Sources (assets) | |---|---| | Currency with the public | Net bank credit to the government | | Demand deposits with banks | Bank credit to the commercial sector | | Time deposits with banks | Net foreign exchange assets of the banking sector | | Other deposits with the RBI | Government's currency liabilities to the public | | | less net non-monetary liabilities of the banking sector |

Each source unpacks further: net bank credit to the Government is net Reserve Bank credit to government plus other banks' investment in government securities; credit to the commercial sector is Reserve Bank credit plus other banks' credit; net foreign exchange assets are the Reserve Bank's net foreign assets plus those of other banks.

Why this identity is the point of the chapter. It says that money enters existence in only a few ways.

1. Lending to the Government. When the Reserve Bank finances a deficit, or banks buy government securities, money supply rises by that amount unless something else offsets it. That is worked example 12 seen from the monetary side.
2. Credit to the commercial sector — ordinary bank lending.
3. Accumulating foreign exchange. When the Reserve Bank buys inflowing dollars it pays rupees, and those rupees are new money. That is worked example 14 seen from the monetary side: the accretion to reserves on a balance of payments basis is, simultaneously, a source of domestic money supply.

So the fiscal chapters and the external chapters are not separate topics. How the Government borrows, and how much foreign exchange flows in, are two of the three sources of the money supply, which is why deficit financing, inflation, monetary policy and the balance of payments cannot be discussed apart from one another. If one connecting sentence is wanted for an examination, that is the one.

1. Aggregates are ordered by progressive liquidity on the banking sector's balance sheet. There is no single money supply.
2. Older series: M1 = currency with the public + demand deposits + other deposits with RBI; M2 = M1 + post office savings deposits; M3 = M1 + time deposits; M4 = M3 + total post office deposits. M1 and M3 are the bank measures.
3. Newer series: M0 = currency in circulation + bankers' deposits with the RBI + other deposits, compiled weekly; M1 unchanged, savings split into demand and time portions; M2 = M1 + time portion of savings + CDs + term deposits up to one year; M3 = M2 + term deposits over one year + call/term borrowings from non-depository financial corporations. Fortnightly.
4. M0 uses currency in circulation; M1 uses currency with the public — the difference is cash with banks. The M2/M3 line is one year of contractual maturity.
5. Components are liabilities; sources are assets — net bank credit to government, credit to the commercial sector, net foreign exchange assets, government's currency liabilities, less net non-monetary liabilities. Money is created chiefly by lending to the Government, lending to business, and accumulating foreign exchange.