Money has been cowries, silver, paper and an entry in a database. What makes all of them money is not what they are made of but what they do:
Near money is an asset that serves the last two functions but not the first: a fixed deposit stores value well and buys nothing directly. The measures below are built precisely on how near to money each asset is.
Each measure adds assets one step less liquid than the one it builds on. These are the four measures the RBI used until 1998, when it moved to a new set of aggregates; they are the ones examination syllabi still name.
| Measure | Definition | Amount |
|---|---|---|
| M1 | Currency with the public + demand deposits + other deposits with the central bank | 4,260 |
| M2 | M1 + savings deposits with post office savings banks | 4,600 |
| M3 | M1 + time deposits with the banking system | 9,360 |
| M4 | M3 + all post office deposits except national savings certificates | 9,840 |
From the components: currency 1,800 + demand deposits 2,400 + other deposits 60 = 4,260, which is M1. Adding post office savings of 340 gives M2 = 4,600. Adding time deposits of 5,100 to M1 gives M3 = 9,360.
M1 is narrow money and M3 is broad money. M3 is the aggregate normally watched for policy, because time deposits are readily converted and so influence spending even though they cannot be spent directly.
Note that M2 and M3 both build on M1, not on each other. M3 is not M2 plus something — the sequence M1, M2, M3, M4 is ordered by breadth, not by nesting each in the one before. That is a standard objective-paper trap.
Fisher’s equation of exchange states that the money paid must equal the value of what it bought:
\[ MV = PT \]where \( M \) is the money supply, \( V \) its velocity, \( P \) the price level and \( T \) the volume of transactions. It is an identity, not a theory — it becomes the quantity theory of money only when you add the assumption that \( V \) and \( T \) are stable, from which \( P \) moves proportionately with \( M \).
Given \( M = 4,260 \), \( P = 12 \), \( T = 2,130 \). Asked: velocity.
\[ V = \frac{PT}{M} = \frac{12 \times 2130}{4260} = 6 \]Each unit of money financed 6 transactions in the year. Interpreted: the stock of money is 4,260 but the value of transactions is 25,560, so the same rupees were used over and over.
A bank does not lend out the money you deposited and stop there. It keeps a fraction as reserves and lends the rest; the borrower spends it; whoever receives it deposits it in a bank; that bank keeps a fraction and lends the rest. The banking system as a whole ends up with deposits several times the original cash.
Nothing improper is happening. Each bank lends only what it has. But because the loan comes back into the system as a deposit, the system multiplies while no single bank does.
Given: a primary deposit of 1,000, a cash reserve ratio of 4% and a statutory liquidity ratio of 16%, so the total reserve requirement is 20%.
| Round | Deposit received | Reserve kept (20%) | Lent on |
|---|---|---|---|
| 1 | 1,000 | 200 | 800 |
| 2 | 800 | 160 | 640 |
| 3 | 640 | 128 | 512 |
| 4 | 512 | 102.40 | 409.60 |
| … | … | … | … |
| Total deposits | 5,000 | 1,000 | — |
The deposits form a geometric series with first term 1,000 and ratio \( 1 - 1/5 = 4/5 \):
\[ D = \frac{\text{Primary deposit}}{r} = \frac{1000}{1/5} = 5,000 \]The credit multiplier is \( 1/r = 1/0.20 = 5 \). A reserve requirement of 20% supports total deposits of 5,000 on a cash base of 1,000.
Note the last line of the table. Total reserves held across all rounds come to exactly 1,000 — the original cash. That is the check: the system has not conjured cash, it has built a structure of deposits on top of it.
The relationship is inverse and it is sharp. Raise the requirement to 25% and the multiplier falls to 4; cut it to 10% and it rises to 10. This is why the reserve ratios are a policy instrument.
So \( 1/r \) is a ceiling, not a forecast — a distinction examiners reward.
A bank chooses a portfolio of assets against three objectives that pull in different directions:
| Objective | What it favours | What it costs |
|---|---|---|
| Liquidity | Cash and money at call | Earns little or nothing |
| Profitability | Long loans and advances | Hard to convert quickly |
| Safety | Government securities | Lower return than private lending |
Liquidity and profitability are the classic conflict, and the resolution is the ladder: hold a spread of assets maturing at staggered dates, so that something is always about to become cash without anything having to be sold at a loss.
The conventional ordering of a bank’s assets from most to least liquid — cash, money at call, bills discounted, investments, loans and advances — is also the ordering from least to most profitable, which is the whole problem in one line.
| Instrument | How it works | To contract credit |
|---|---|---|
| Bank rate | The rate at which the central bank lends to banks | Raise it |
| Open market operations | Buying or selling government securities, changing banks' reserves directly | Sell securities |
| Cash reserve ratio | The fraction of deposits held as reserves with the central bank | Raise it |
| Statutory liquidity ratio | The fraction held in prescribed liquid assets | Raise it |
| Repo and reverse repo | Short-term lending to and borrowing from banks against securities | Raise the repo rate |
Every one works through the same two channels: the quantity of reserves banks hold, or the price at which they can get more.
Quantitative tools change the total. Qualitative tools steer it, which matters when credit should flow to some sectors and not others:
The central bank’s functions the syllabus asks for follow the same logic: note issue, banker to the government, bankers’ bank and lender of last resort, custodian of foreign exchange reserves, and controller of credit — which is this section.