1.6. Factors affecting Money Supply in India

Money supply with the public is influenced mainly by the central bank of country and its commercial banks, which in turn changes the preference of the public for holding cash balances vis-a-vis deposits in the banks. These influences on money supply can be summarized by the following key ratios:

The currency deposit ratio: The ratio of money held by the public in currency to that they hold in bank deposits. It reflects people’s preference of liquidity. It is a purely behavioural parameter which depends, among other things, on the seasonal pattern of expenditure. For example, cdr increases during the festive season as people convert deposits to cash balance for meeting extra expenditure during such periods.

The Reserve deposit ratio: Banks hold a part of the money people keep in their bank deposits as reserve money and loan out the rest to various investment projects. Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI. Banks use this reserve to meet the demand for cash by account holders. Reserve deposit ratio (rdr) is the proportion of the total deposits, commercial banks keep as reserves. Keeping reserves is costly for banks, as, otherwise, they could lend this balance to interest earning investment projects. However, RBI requires commercial banks to keep reserves in order to ensure that banks have a safe cushion of assets to draw on when account holders want to be paid.

RBI uses various policy instruments to bring forth a healthy rdr in commercial banks. The first instrument is the Cash Reserve Ratio which specifies the fraction of their deposits that banks must keep with RBI. There is another tool called Statutory Liquidity Ratio which requires the banks to maintain a given fraction of their total demand and time deposits in the form of specified liquid assets. Apart from these ratios RBI uses a certain interest rate called the Bank Rate to control the value of rdr. Commercial banks can borrow money from RBI at the bank rate when they run short of reserves. A high bank rate makes such borrowing from RBI costly and, in effect, encourages the commercial banks to maintain a healthy rdr.

Through its fiscal policy, the government also fleets, some extent, the supply of money. Finer details of this aspect have been dealt with in the document on monetary policy.