Money, Money Supply and the Reserve Bank of India

Functions and forms of money

Money serves four functions:

• medium of exchange, which removes the "double coincidence of wants" problem of barter;
• unit of account;
• store of value;
• standard of deferred payment.

Modern money is fiat money: it has value because the state declares it legal tender, not because it is backed by gold. India moved away from gold backing long ago. Under the minimum reserve system (since 1956–57), the RBI must hold gold and foreign assets worth at least ₹200 crore, of which gold is at least ₹115 crore, against currency issued.

Legal tender: RBI notes are legal tender throughout India. Coins are issued by the Government of India (Ministry of Finance) and distributed by the RBI. The ₹1 note is issued by the Ministry of Finance and bears the Finance Secretary's signature. All other notes bear the RBI Governor's signature.

Demonetisation (8 November 2016): the old ₹500 and ₹1,000 notes, about 86% of the currency by value, ceased to be legal tender. Stated aims were curbing black money, counterfeit currency and terror financing, and encouraging digital payments. The RBI later reported that almost all of the demonetised currency (about 99%) returned to banks. The ₹2,000 note introduced then was withdrawn from circulation in 2023 but remains legal tender.

Digital Rupee (e₹): the RBI's Central Bank Digital Currency pilots began in 2022 (wholesale in November, retail in December). The e₹ is a direct liability of the RBI, like cash, but digital.

Measures of money supply

M0 is also called high-powered money or the monetary base. M3 is the most commonly used measure of broad money. Liquidity measures (L1, L2, L3) were added following the Y.V. Reddy working group (1998).

Money multiplier = M3 ÷ M0. It depends on the public's currency–deposit ratio and banks' reserve ratio. When banks keep more reserves or people hold more cash, the multiplier falls.

Credit creation: banks lend out a part of deposits, and those loans become deposits elsewhere. In a simple model, an initial deposit can create deposits up to 1/(reserve ratio) times its value.

The Reserve Bank of India

History:

• Recommended by the Hilton Young Commission (Royal Commission on Indian Currency and Finance, 1926).
• Established on 1 April 1935 under the RBI Act 1934, as a shareholders' bank, with headquarters first in Calcutta. They moved to Mumbai in 1937.
• Nationalised on 1 January 1949.
• Its first Governor was Sir Osborne Smith; the first Indian Governor was C.D. Deshmukh (1943).

Governance:

• A Central Board of Directors appointed by the government: the Governor, up to four Deputy Governors and other directors.
• Section 7 of the RBI Act allows the government to give directions to the RBI after consultation, in the public interest. It was reportedly considered in 2018 but has never been formally used.

Functions:

1. Monetary authority: formulates and implements monetary policy (next lesson).
2. Issuer of currency (Section 22).
3. Banker to the government: for the Centre and, by agreement, the states. It manages public debt and provides Ways and Means Advances.
4. Banker's bank: holds banks' reserves and acts as lender of last resort.
5. Regulator and supervisor: of banks (under the Banking Regulation Act 1949), NBFCs, and payment systems (under the Payment and Settlement Systems Act 2007).
6. Manager of foreign exchange: under FEMA 1999. It manages the reserves and intervenes in the forex market.
7. Developmental role: priority sector lending, financial inclusion, financial literacy and institution-building. It helped create IDBI, NABARD, NHB and SIDBI.

RBI surplus transfer: the RBI transfers its surplus (dividend) to the government under Section 47. The Bimal Jalan Committee (2019) set the Economic Capital Framework, with a Contingent Risk Buffer of 5.5–6.5% of the balance sheet. A 2025 review widened the band to 4.5–7.5%. The RBI transferred ₹2.69 lakh crore for 2024–25, a record. Treat amounts as year-specific.

Inflation and money: the basic link

The quantity theory of money (MV = PY) suggests that, with velocity (V) and real output (Y) stable, faster money growth (M) raises prices (P). In practice, velocity changes, and India's inflation is driven by food and supply shocks as well as demand. That is why the RBI looks at many indicators, not only money supply.

Common prelims traps

• Coins are minted by the government at four mints (Mumbai, Kolkata, Hyderabad, Noida). Notes are printed at four presses: two run by the government's SPMCIL (Nashik, Dewas) and two by the RBI's BRBNMPL (Mysuru, Salboni).
• Demand deposits are in M1. Time deposits are added in M3.
• M3 includes time deposits of banks but not post office time deposits.
• The RBI is not a statutory regulator of insurance (IRDAI) or capital markets (SEBI).
• The RBI Governor is appointed by the Central Government.

Quick self-test

1. *What is high-powered money?* Reserve money (M0), the base on which banks create credit.
2. *Who issues ₹1 notes?* The Ministry of Finance.
3. *What does a fall in the money multiplier indicate?* People are holding more cash or banks are holding more reserves, so each rupee of base money supports less broad money.
4. *Under which Act does the RBI regulate payment systems?* The Payment and Settlement Systems Act 2007.

Practice: Mains question

*"The Reserve Bank of India performs multiple roles that may sometimes conflict." Discuss, with reference to its functions as monetary authority, banker to the government and banking regulator. (150 words)*

Hints: debt management vs inflation control (a separate debt agency was proposed); regulation of public sector banks under dual control; the surplus transfer debate. Conclude that institutional clarity and autonomy matter.

Common prelims traps

• M3 is broad money, and the RBI's main monetary aggregate. M1 is narrow money: currency with the public, demand deposits, and "other deposits" with the RBI.
• Reserve money (M0) includes bankers' deposits with the RBI. M1 does not, because those balances are not with the public.
• The money multiplier is M3 divided by M0. It falls when the CRR rises or when people hold more cash.
• Currency notes (other than ₹1) are issued by the RBI. Coins and ₹1 notes are issued by the Government of India under the Coinage Act 2011. The RBI only distributes them.
• The RBI follows a Minimum Reserve System (since 1957): it must hold ₹200 crore in gold and foreign exchange, of which at least ₹115 crore must be gold.

Analysis: independence of the central bank

The RBI Act gives the government power to issue directions under Section 7, after consultation, "in the public interest". This was reportedly discussed but never formally used, in 2018.

Points of tension:

• surplus transfers;
• the economic capital framework (the Bimal Jalan Committee, 2019);
• PCA norms;
• liquidity for NBFCs.

Why autonomy matters: an independent central bank makes inflation commitments credible.

The argument for accountability: the government must answer to Parliament, and statutory inflation targeting balances the two. The government sets the target; the MPC is accountable for meeting it.

Quick self-test

1. *Which is more liquid, M1 or M3?* M1.
2. *Who issues ₹1 notes?* The Ministry of Finance.
3. *What would a rise in the currency–deposit ratio do to the money multiplier?* Reduce it.