The meaning of money supply

There are different meanings to money supply. It could refer to the legal tender which is the official money printed and issued by the monetary authority which everybody in the particular state is required to accept when proffered in settlement of a debt. A creditor in rupees can’t ask for the debt in Sri Lankan Rupees to be settled in a foreign currency unless the two parties agree beforehand at the time of the transaction. 

The debt of one party to the other may arise from the purchase of a good or service by one person from another. Or it may arise from a previous loan given by one party to the other on the promise of repayment with interest on a given date. 

Where a debt is incurred for the supply of a good or service, the debt is legally required to be settled only in Sri Lankan Rupees and the creditor cannot ask the debtor to settle it in any other currency unless agreed to at the time the debt is incurred and is permitted by the Law. The Exchange Control Law of a country may prohibit the incurring of such a debt in foreign currency except with the prior approval of the relevant governmental authority such as the Central Bank.

So to return to the matter of the definition of the money supply, it is considered to include only currency and bank deposits. The deposits in other financial institutions like the finance companies are not considered as money since these financial institution may not be able to honour such debt if it has become insolvent and the Central Bank or the Monetary Authority is not obliged to underwrite such debt.  So, the money supply of a State or country includes the currency and the bank deposits only. 

There is a risk that other financial institutions – other than the approved banks – may not be able to repay deposits on demand since they usually invest such moneys in other institutions and enterprises to obtain a higher return which would enable them to pay interest on the deposit made with them. How else would they be able to pay interest otherwise if they did not use the money to earn more? 

There are also time or savings deposits which are not included as money since they are not readily convertible to money until the period of the deposit has reached the end of the period for which it was deposited which is called the maturity period. So time and savings deposits are not considered as money until they have matured. So the money supply includes only currency and demand deposits with banks which can be freely transferred.

The quantum of the money supply is important since it affects the general price level. Even if the supply and demand for a particular good or service has not changed in real terms its price may change because the overall supply of money has increased and more money is available in the hands of the public in general for paying for the same volume of goods. So the prices of goods will be bid up and all those wanting to buy it will have to pay the higher prices which they can do since the money received for their own supplies and services have gone up accordingly. 

So the money supply – also called the narrow money supply – includes the currency and demand deposits in the banks which are engaged in deposit banking and not in savings banking deposits. But the deposits in savings deposits and even Fixed Deposits can be changed into immediate cash although a cash penalty will have to be paid by suffering the loss of the agreed interest in whole or in part. So these Savings Deposits and Fixed Deposits are included in what is called the broad money supply. 

– R.M.B. Senanayake