What are 'narrow' and 'broad' money?

ET IN THE CLASS ROOM, TNN Jan 6, 2003, 04.42am IST

Modern money has several components. Apart from just cash and coins, money also consists of deposits with the banking system, both interest-free demand deposits and interest-bearing time deposits, such as fixed deposits. The various components of money can be aggregated together in order of liquidity. Since money is primarily used to settle day-to-day transactions, it needs to be readily usable as a means of doing so. Clearly, cash and coins are the most liquid forms of money, since they can be used instantaneously and universally used to settle unlimited transactions. Demand deposits, or accounts with banks, are also quite liquid, as they can be used to write cheques against, in settling daily transactions. The sum of currency in circulation and demand deposits with banks are called M1, or 'narrow money'.

Time deposits, though not as liquid and instantly available as transactions settling medium as M1, are still money, since it will be available at some point, and very often, as in the case of fixed deposits, can be converted to cash for some penalty. Usually, time deposits are much larger than both currency in circulation and demand deposits. The sum of M1 and time deposits is called 'broad money'. What is high-powered money? The textbook definition of high-powered money (also called the monetary base) is the sum of currency in circulation with the public and cash reserves held by banks. This is called high-powered money because this forms the base on which money stock is created as a multiple. A part of the monetary base is held by banks as a cash reserve ratio, which is a fraction of the deposits created by the banking system. This proportion is determined by the central bank. The logic behind allowing banks to offer loans in excess of their cash holdings is that they do not expect all the dues against the bank to be encashed in a single instant. So, banks are able to economise on the use of cash and create multiple deposits on the basis of their cash holding. Currency with the public is also part of the monetary base because people do not hold all their wealth as cash, and may deposit part of their cash holdings into the banking system as demand deposits. This raises the cash assets of banks which can again use a percentage of the additional cash receipts to create more demand deposits and thereby increase the supply of money in the system. For example, if the cash reserve ratio that banks must maintain is 10%, then a Rs 100 injection of cash into the banking system can create upto Rs 1,000 of demand deposits. M1 goes up by Rs 100 after the initial contraction of Rs 100 that was withdrawn from private circulation and placed in the banking system. How can the stock of money be changed? While the overall stock of money can be changed only by destroying or printing new currency notes, the stock of money in circulation or that available for transactions can be altered by using various policy instruments. One outright way of increasing the stock of money is by monetising government deficits. The government borrows money from the RBI against G-secs (government securities) and the RBI prints new notes to finance this loan. The government pays its expenditures with this new cash, and money stock increases. The RBI can raise or lower the CRR if it wants to decrease or increase the leverage that banks can exercise on their cash holdings. A lower CRR means that the same amount of cash can be used to finance higher level of demand deposits.

Another alternative to change the stock of money with the public is to use open market operations. In an open market operation, the RBI can buy or sell its holding of G-secs and treasury bills (another form of government borrowing) to change the public's cash holding. A buy operation will increase the stock of money with the public, while a sell operation will mop up cash in exchange for bonds. How does money supply affect prices? If the level of output in an economy is fixed in the short run, then an increase in money supply will mean that people are holding more cash than they can buy goods and services with. The supply of money exceeds the value of goods and services. In this case, there will be an excess demand for goods which will push up prices