Why this matters now
The monetary aggregates, money creation and the money multiplier are prelims-heavy concepts underpinning monetary policy and inflation.
Functions of money
Money serves four functions: a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. Modern money is mostly fiat (legal tender by government decree) and increasingly digital.
The monetary aggregates
The RBI measures money supply as: M0 (reserve/high-powered money) = currency in circulation + bankers’ deposits with RBI + other deposits; M1 (narrow money) = currency with public + demand deposits; M2 = M1 + savings deposits with post offices; M3 (broad money) = M1 + time deposits with banks (the most commonly used); M4 = M3 + post-office deposits.
Money creation & the multiplier
Banks create money through lending: a deposit is partly kept as reserves (CRR/SLR) and the rest lent out, which becomes new deposits, and so on. The money multiplier determines how much broad money is created from high-powered money (M0). The RBI controls money supply via its monetary-policy tools.
UPSC angle
Know the four functions of money, the aggregates (M0 reserve/high-powered; M1 narrow; M3 broad — most used), money creation by banks, and the money multiplier linking M0 to broad money.
Frequently asked questions
What are the functions of money?
A medium of exchange, a unit of account, a store of value and a standard of deferred payment.
What is M3?
Broad money — M1 (currency + demand deposits) plus time deposits with banks; the most commonly used aggregate.
What is high-powered money?
M0 or reserve money — currency in circulation plus banks’ deposits with the RBI and other deposits.
How do banks create money?
By lending out deposits (after keeping reserves), which become new deposits, multiplying the money supply.