Money Supply & Inflation: Definitions and Measurement

Posted on Jul 18, 2025 in Economy

Concept of Money Supply

Money supply refers to the amount of money in circulation within an economy at any given time. It is the total stock of money held by the people, including individuals, firms, and state constituent bodies, excluding the State Treasury, Central Bank, and Commercial Banks. Cash balances held by federal and federating governments with the Central Bank and in treasuries are not considered part of the money supply because they are created through administrative and non-commercial government operations.

Furthermore, money supply refers to the disposable stock of money. Therefore, money supply is the stock of money in circulation. Money supply can be viewed from two perspectives: as a stock and as a flow. Thus, at a given point in time, the total stock of money and the total supply of money are different. Money supply viewed at a specific point in time is the stock of money held by the people on a given day, whereas money supply viewed over time is considered a flow. Units of money are spent and re-spent several times during a given period. The average number of times a unit of money circulates among the people in a given year is known as the Velocity of Circulation of Money.

Constituents of Money Supply

Traditional Approach

According to the traditional approach, the money supply consists of currency money (coins and notes) and bank money (checkable demand deposits with commercial banks). Currency money is considered high-powered money due to the legal backing of the state. The Central Bank of a country issues currency notes and coins because it holds the monopoly on note and coin issuance. The supply of money in a country depends on the system of note issuance adopted.

For instance, India adopted the Minimum Reserve System in 1957. Under this system, the Reserve Bank of India (RBI) must maintain a minimum reserve of ₹200 Crores, consisting of gold and foreign securities. Of this, the value of gold should not be less than ₹115 Crores. With this reserve, the Reserve Bank of India has the power to issue an unlimited amount of currency in the country.

Modern Approach

According to the modern approach, money supply includes currency money and near money. Money supply, therefore, consists of:

• Coins
• Currency notes
• Demand deposits of commercial banks
• Time deposits of commercial banks
• Financial assets
• Treasury bills and commercial bills of exchange
• Bonds and equities

Meaning of Inflation

A sustained rise in the general price level over a period of time is known as inflation. Conversely, a sustained fall in the general price level would be known as deflation. Inflation is measured using a price index. For instance, in India, we have the Wholesale Price Index (WPI) and the Consumer Price Index (CPI). The price index is based on a basket of goods and services. Within a given basket, the prices of some goods and services may rise or fall. However, when there is a net increase in the price of the basket, it is called inflation.

Inflation is a rate of change in the price level. The rate of change is measured with reference to a base year to obtain a long-term perspective on price increases. For all practical purposes, the inflation rate is measured on a yearly basis. However, in recent years, the inflation rate is also measured on a monthly and weekly basis. The rate of inflation can be measured as: P = [(P1 – P0) / P0] × 100.

For example, the price index based on Wholesale Prices in India for the year 2003-04 was 180.3, and in 2004-05, it was 189.5. The rate of inflation for the year 2004-05 was 5.1 percent.

Inflation Rate based on Wholesale Price Index (WPI)

in India for the period 2005-06 to 2012-13.