Supply of money means the stock of money which performs the Junctions of money. Therefore, for properly understanding the concept of money supply, it is essential to know the meaning of money.
Money supply has been defined and explained keeping in view the functions of money. There are many functions of money but from the point of view of money supply only two functions of money have been emphasized – (a) money as a medium of exchange; and (b) money as a store of value. Economists have defined and measured money supply on the basis of these two functions.
1. Money Supply on the Basis of Money as a Medium of Exchange:
According to this approach, money supply means the entire quantity of money which is used as a medium of exchange. According to this concept, money supply includes notes and coins with the public and demand deposits have been used for this measure of money supply. Thus:
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M1 – Coins + Notes + demand deposits with the Public
According to equation, the following are the main constituents of M1.
(i) Coins:
These days, the share of coins in the total currency (quantity of legal tender money) is very less. Coins are used generally for ordinary and small transactions. These days, coins are made of brass, aluminum, gilt and other metals. There are many coins of various denominations upto rupee one in India such as of 5, 10, 20, 25, 50 paisa. Coins are there of the values of Rs. 2 and 5 also.
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Technically speaking, one rupee note is also a coin in India. Coins are of two kinds—standard and token. The face value of token coin is more than their intrinsic value but the face value of standard coin is equal to their intrinsic value. Standard coins are hardly found anywhere in the world, these days.
(ii) Notes or Paper Currency:
These days, paper currency is the main part of legal tender money in every country. Paper money includes currency notes of various denominations such as the currency notes of the value of Rs. 2, 5, 10, 20, 50 and 100 circulating in India. The currency notes are generally issued by the Central Bank of the country. Behind the issuance of currency notes, a reserve fund is kept in the form of gold, silver and foreign exchange.
In what proportion the value of currency notes issued, should be kept in reserve fund differs from country to country. In India, at present, there is a backing of Rs. 200 crores in the form of reserve funds consisting of gold and foreign exchange.
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(iii) Demand Deposits:
Demand deposits are also included in the money supply. These deposits are as good as coins and notes, as medium of exchange. By way of definition, these deposits can be withdrawn from the banks on demand.
Time deposits such as fixed deposits are not included in the money supply from the point of view of narrow approach for these deposits cannot be withdrawn from the banks before the expiry of the stipulated time for which they are deposited and hence, they cannot be used as a medium of exchange at all times.
Meaning and’ measurement of money supply on the basis of money as a medium of exchange has been regarded as narrow approach of money supply. This is based on money as a medium of exchange and does not take into view another important functions namely money as a store of value.
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2. Money supply on the Basis of Money as a Medium of Exchange and Store of Value:
Many economists have suggested the broad measure of money supply and notable amongst them is Milton Fricdman. According to them, the store of value function of money is as important as the medium of exchange function. According to them, savings and time deposits can be conveniently converted into demand deposits. Therefore, according to the broad approach point of view, besides M1 time and saving deposits should also be included in the money supply. This measure of money supply is called as M2. In this way:
M2 = M1 + Time deposits.
According to Friedman, this measure of money supply is the best. Time deposits include fixed deposits and saving deposits.
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M2 is the broad measure of money supply because besides M1 it also includes time deposits which indicate the store of value Junction of money. Time deposits (such as fixed deposits) cannot be withdrawn before the expiry of the stipulated time for which deposits have been made.