Money is a medium of exchange that facilitates transactions for goods and services. It functions as a unit of account, a store of value, and a standard of deferred payment. Historically, money evolved from barter systems to commodities like gold and silver, and later to fiat currencies issued by governments. Modern money exists in both physical forms (coins, notes) and digital formats. The value of money is largely based on trust in the issuing authority, such as a central bank. In India, the Reserve Bank of India (RBI) is responsible for regulating the supply and stability of the currency. Money’s liquidity, acceptance, and universal recognition make it a cornerstone of economic activity and financial systems worldwide.
Functions of Money:
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Medium of Exchange:
The primary function of money is to act as a medium of exchange, enabling transactions to take place. It eliminates the inefficiencies of barter systems by allowing people to exchange goods and services with universally accepted currency, ensuring smooth economic activity.
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Unit of Account:
Money serves as a common measure of value, allowing goods and services to be priced and compared. This standardization simplifies economic decisions and accounting practices, as prices are expressed in a consistent unit, making comparisons easier.
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Store of Value:
Money retains value over time, allowing individuals to save and store wealth for future use. This function is vital for economic stability, as it provides assurance that money saved today can be used to make purchases later without significant loss in value.
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Standard of Deferred Payment:
Money facilitates transactions involving future payments, such as loans, credit sales, or mortgages. It serves as a standard for contracts that require payments over time, ensuring trust and enforceability in financial agreements.
- Liquidity:
Money is the most liquid asset in an economy because it can be easily converted into other goods and services without losing value. This liquidity is vital for immediate transactions and quick responses to market changes.
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Transfer of Value:
Money can be transferred easily across distances and individuals, enabling the efficient movement of economic resources. It allows both domestic and international trade to flourish, contributing to economic growth.
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Economic Indicator:
The supply and demand of money help in determining economic conditions like inflation, deflation, or stability. Central banks monitor and adjust the money supply to control economic health.
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Basis for Credit Systems:
Money forms the foundation of credit systems, where financial institutions extend loans and credit based on money’s reliability and universal acceptance.
Alternative Measures to Money Supply in India and their Different Components:
Reserve Bank of India (RBI) uses various measures of money supply to assess the liquidity in the economy and to guide monetary policy. The four main alternative measures of money supply are denoted as M1, M2, M3, and M4. Each measure includes different components that reflect varying degrees of liquidity.
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M1 (Narrow Money):
- Components:
- Currency with the Public: Physical money like coins and paper notes held by the public.
- Demand Deposits with Banks: Current account deposits and savings deposits that can be withdrawn on demand.
- Other Deposits with the RBI: Includes deposits of the government and public financial institutions with the RBI.
- Liquidity: M1 is the most liquid measure, representing money readily available for spending.
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M2:
- Components:
- M1: All components included in M1.
- Savings Deposits with Post Office Savings Banks: Deposits in post office savings accounts that are not as liquid as bank deposits.
- Liquidity: M2 includes M1 and adds post office savings deposits, making it slightly less liquid than M1 but still readily accessible.
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M3 (Broad Money):
- Components:
- M1: All components of narrow money.
- Time Deposits with Banks: Fixed deposits and recurring deposits with scheduled commercial banks that are less liquid since they cannot be withdrawn on demand without penalties.
- Liquidity: M3 is broader and includes longer-term deposits, making it less liquid than M1 but more comprehensive in covering the overall money supply in the economy.
- Significance: M3 is widely used by the RBI for policy analysis and is considered the “broad money” measure in India.
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M4:
- Components:
- M3: All components of broad money.
- Total Deposits with Post Office Savings Banks (excluding National Savings Certificates): This includes additional deposits in post office savings accounts, enhancing the coverage of money supply.
- Liquidity: M4 is the broadest measure, encompassing the entire spectrum of liquid and semi-liquid assets held by the public.
Meaning and Changing Relative Importance of each Component:
In India, the components of the money supply, represented by M1, M2, M3, and M4, have varying importance based on factors like economic development, technological advancements, and evolving financial systems.
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Currency with the Public
This refers to physical money (coins and paper notes) held by the public, excluding currency held by banks and the government.
- Changing Importance: Traditionally, currency was the dominant form of money used for transactions. However, with the rise of digital payments, mobile banking, and fintech solutions, its relative importance has declined. Nevertheless, in rural areas and the informal economy, cash still plays a crucial role.
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Demand Deposits with Banks
These are deposits in current and savings accounts that can be withdrawn on demand without any prior notice.
- Changing Importance: Demand deposits have gained importance due to the convenience of electronic fund transfers, debit cards, and online payments. The growth of e-commerce and digital banking has increased the reliance on demand deposits for daily transactions, leading to a shift from physical currency to digital forms of money.
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Other Deposits with the RBI
These include deposits held by the government, financial institutions, and others with the RBI.
- Changing Importance: These deposits have limited direct impact on general economic transactions and are mainly used for interbank settlements or government operations. Their importance is relatively stable and low in the context of overall money supply.
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Savings Deposits with Post Office Savings Banks
Deposits in savings accounts managed by post offices, offering modest interest rates with easy access.
- Changing Importance: Historically significant, especially in rural and semi-urban areas, post office savings deposits have declined in relative importance due to the expansion of commercial banking and the popularity of more flexible financial products. However, they remain vital for financial inclusion in underserved areas.
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Time Deposits with Banks
These include fixed deposits (FDs) and recurring deposits (RDs) held with banks, which have a fixed tenure and yield higher interest than demand deposits.
- Changing Importance: Time deposits have grown in importance as households and businesses seek stable returns with minimal risk. Although not as liquid as other forms of money, their role in broad money (M3) has expanded due to the increased savings habit in both urban and rural populations.
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Total Deposits with Post Office Savings Banks (excluding National Savings Certificates)
These are broader post office deposits that include fixed-term savings products offered by post offices.
- Changing Importance: With the development of more sophisticated financial instruments, the relative importance of these deposits has decreased, especially in urban areas. However, they continue to be significant in rural regions where access to formal banking remains limited.
Key Trends in the Changing Importance:
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Shift to Digital Payments:
The emergence of digital wallets, Unified Payments Interface (UPI), and online banking has reduced the dominance of physical currency and increased the importance of demand deposits and digital forms of money.
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Financial Inclusion and Banking Penetration:
Government initiatives like Pradhan Mantri Jan Dhan Yojana (PMJDY) have expanded bank access in rural areas, increasing demand deposits’ significance.
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Preference for Secure Savings:
In a low-interest-rate environment, time deposits remain attractive for risk-averse investors, strengthening their contribution to M3.