A simple guide to how money circulates in the Indian economy

Nothing is constant.
Nothing is constant.
Image: Reuters/Adnan Abidi
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When money is released by the RBI (Reserve Bank of India) into the economy, it goes into circulation through transactions. The government may pay the people it employs, buy goods and services, give subsidies, and so on. Part of this money is kept by the recipients and the rest goes back into bank accounts. A government servant who receives a salary keeps a fraction of it at home and puts the rest in his bank account to earn some interest. The businessmen who sell their goods or services to the government and get money in their bank accounts use only a part of that to carry on their business, while the rest stays in the bank.

One can see that most of the money released into the economy keeps going in and out of the commercial banking system where businesses and households maintain their accounts. The banks have to pay the depositors some interest for keeping their money with them. They too now need to earn some income to pay this interest. They do so by lending the money they get to those who need it for various purposes. I may be setting up a plant to produce some item and may need long-term capital. I may need to set up an office to provide services. I may need capital to pay wages to my workers and also to buy raw material. A part of the profit earned by my business is paid to the banks as interest for the loan I have taken. What this means is that a bank does not have the money that its depositors deposited with it. If all the depositors come to a bank and want to withdraw their deposits, the bank would not be able to pay them. This is called a “run” on a bank, and such a bank fails. This is where the RBI plays the role of a banker to the banks, giving money to the banks.

Each bank is required to deposit a certain amount of its deposits with the RBI. This is called the cash reserve ratio (CRR). If a bank gets Rs100 in deposits and the CRR is 10%, then it has to deposit Rs10 with the RBI. It now has Rs90 to lend. This Rs90 is then given to a borrower, who pays it to someone else who puts it in their bank. That bank then has to deposit Rs9 with the RBI and can now lend Rs81. This amount may be lent and may make its way to a third bank, which then has to deposit Rs8.1 with the RBI.

This chain can continue, now looping in another bank which has to pay the RBI Rs7.29. The banks get Rs100+90+81+72.9…and the RBI gets Rs10+9+8.1+7.29+…What the banks are getting is also going out to the public and is being used as money. As the chain of deposits and withdrawals is completed over time, the Rs100 deposit leads to the system getting Rs1,000 and the RBI Rs100. You can see that the banking system, along with the RBI, has created 10 times the money that the RBI released to begin with. This is called the money multiplier.


The RBI, the lender of last resort

The advantage of this system is that if a bank is in trouble and does not have the funds to return to its depositors, it can borrow from the RBI. So, the RBI is a guarantor of the banking system. For performing this role, the RBI is also a regulator of the banks and tries to make sure that no bank goes too much out of line with the prudential norms. When would a bank be in trouble? When it has lent out money to insolvent borrowers who are not paying back the interest on the loans they have taken and are not in a position to return the capital they have borrowed. This becomes a bad debt for the bank. If this debt is large in relation to the total lending of the bank, then the bank is in trouble since it does not have the money to pay interest to its depositors or return their deposits. In India, this problem has manifested itself recently as the problem of NPAs (non-performing assets) in banks. The RBI has been trying to deal with this situation.

Different forms of money, liquidity

What has been said above also illustrates that it is not just the cash that the RBI releases into the system that constitutes money, but also the bank deposits that are used as a means of carrying on transactions. In the simplified example above, there was only one form of bank deposit, but there are many kinds of bank deposits, with varying functions. There are current accounts, largely maintained by businesses, which can be used to make payments. There are savings accounts with households, whose members can write cheques to make payments. Then there are the fixed deposits, which cannot be used to make immediate payments but can be used with some delay to make payments. In India, there are also post office accounts that can be used to make payments. All these instruments constitute different forms of money. This brings in the concept of liquidity. Cash is the most liquid form of money, followed by the current account. The least liquid is the fixed deposit. Correspondingly, there are different forms of money that the experts talk of cash, M0, M3, and so on. Each of these measures of money has different significance for different sections of society. If people have no access to banks, then cash is relevant, and not M1 (see explanation below). There is another complication. The cash issued by the RBI is called ‘base money’ or ‘reserve money’ (M0). A part of this comes back to the RBI as CRR. Therefore the entire amount of cash released by the RBI is not available outside. That portion of the cash which is outside the RBI is the “currency in circulation.”

The banks themselves hold some money in their ATMs and vaults for their daily requirements, and this money is not with the public. So, the “currency with the public’” is the currency in circulation minus the currency that is held by the banks. The public can also use its savings accounts and current accounts to make payments, and this is another measure of money available to the public, called M1. This is the sum of the currency with the public and the deposits of the public in banks. The public also has deposits with the post offices, and if that is added to M1, one gets M2. If to M1 the time deposits (fixed deposits of tenure longer than one year) with the banks are added, we get M3. And if to M3 the total post office deposits (fixed deposits) are added, then we get M4.

To sum it up:

1. Currency with public = currency in circulation – cash on hand with banks

2. M0 (reserve money) = currency with public + cash on hand with banks + “other” deposits with RBI + bankers’ deposits with RBI

3. M1 (high-powered money) = currency with public + deposit money of public; where, deposit money of public = demand deposits with banks + “other” deposits with Reserve Bank

4. M2 = M1 + post office savings deposits

5. M3 = M1 + time deposits with banks

6. M4 = M3 + total post office deposits.

Excerpted with the permission of Penguin Random House from Demonetization and the Black Economy by Arun Kumar.