Narrow money

Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 12, Ch 3 "Money and Banking"

Meaning

Narrow money is the money that people can spend at once. In India it means the RBI's two most liquid measures of money supply, M1 and M2.

• M1 = Currency with the public + Net demand deposits of banks + Other deposits with RBI
• M2 = M1 + Post Office savings bank deposits

Narrow money shows how much ready spending power the public holds today. It is the part of money supply that is used for buying and selling. Broad money (M3 and M4) also includes savings that are locked in for a fixed time.

Explanation

Components of narrow money

• Currency with the public. These are the notes and coins held by people and firms.

• It does not include cash lying in banks' own safes. Money held by the government or the banking system is not part of money supply.

• Net demand deposits of banks. Demand deposits are savings and current accounts. You can withdraw this money at any time, or pay someone with a cheque, card or UPI.

• "Net" means deposits that one bank holds with another bank are left out. Only deposits owed to the public count.

• Other deposits with RBI. These are a small set of deposits kept with the RBI by bodies other than banks and the government.

• This item appears in both M0 and M1.

• Post Office savings bank deposits. These are added only in M2.

• They are a little less liquid than bank demand deposits. That is why M2 sits one step below M1.

Measure	What it adds	Type
M1	Currency with public + net demand deposits + other deposits with RBI	Narrow (most liquid)
M2	M1 + Post Office savings bank deposits	Narrow
M3	M1 + net time deposits of banks	Broad
M4	M3 + total Post Office savings deposits (excluding NSC)	Broad (least liquid)

• Liquidity means how easily money can be spent. It falls as you move from M1 to M4.
• Time deposits (fixed deposits) are locked for a period. So they belong to broad money, not narrow money.

How banks create narrow money: a worked example (CRR 20%)

• A demand deposit is money. So when a bank gives a loan that comes back as a new deposit, M1 rises.
• Example. Leela deposits ₹100. The bank keeps 20% as a reserve.
• The bank lends ₹80. The borrower spends it, and the money comes back to the bank as a deposit. Deposits are now ₹180.
• Required reserve = 20% of 180 = ₹36. The bank can lend ₹64 more.
• The series 100 + 80 + 64 + 51.2 + … has ratio r = 0.8.

• Sum = 100 × 1/(1 − 0.8) = ₹500.

• Result: M1 rises from ₹100 to ₹500. The money multiplier here is 1/CRR = 1/0.2 = 5.

• If CRR rises to 25%: the multiplier falls to 4, and deposits can reach only ₹400. Narrow money shrinks.

What makes narrow money rise or fall

• Credit creation. More bank lending creates more demand deposits, so M1 rises.
• The CRR. CRR (Cash Reserve Ratio) is the share of deposits a bank must keep with the RBI.

• Higher CRR:

  • banks can lend less;
  • fewer new deposits are created;
  • M1 grows more slowly.

• The public's cash habit (cdr). The currency deposit ratio (cdr) is the cash people hold divided by their bank deposits.

• If people keep more money in banks and less as cash:

  • cdr falls;
  • the multiplier m = (1 + cdr)/(cdr + rdr) rises;
  • more deposit money is created.

• Shift between demand and time deposits.

• If people move money from a fixed deposit to a savings account, M1 rises but M3 does not change. The money has only moved from time deposits to demand deposits, and both are already inside M3.

• Changes in high-powered money (M0). Banks build deposits on top of M0. When the RBI buys forex, lends to banks (repo) or lends to the government, M0 rises. This supports more narrow money.

In India

• Who measures it. The RBI publishes M1, M2, M3 and M4. It has compiled monetary statistics since July 1935 [3].

• It uses a balance-sheet approach. This means it combines the balance sheets of the RBI and the banks (commercial and co-operative) [3].

• The latest figures in our notes (2024-25).

• Currency with the public ≈ ₹36.3 lakh crore. This is the largest cash part of M1.

• Broad money M3 = ₹272.87 lakh crore. So narrow money is only one part of a much bigger total.

• Rules that shape it.

• CRR was cut to 4.0% of NDTL in December 2024 [4]. NDTL (net demand and time liabilities) means, roughly, a bank's deposits owed to the public.

• CRR now stands at 3.00% [2]. A lower CRR lets banks lend more, which can create more demand deposits.

• Committee link. The Working Group on Money Supply, chaired by Dr Y.V. Reddy, reported in June 1998. It proposed new aggregates NM1, NM2, NM3, based on residency and maturity, and liquidity aggregates L1, L2, L3 [3].

• Demonetisation (2016-17). Currency with the public fell sharply that year. This directly cut the cash part of narrow money.

Don't confuse with

• Broad money (M3, M4): Broad money includes time deposits (M3) and total Post Office savings (M4). Narrow money (M1, M2) leaves out bank time deposits. M3 is the one most used, and it is called "aggregate monetary resources".
• High-powered money (M0 / reserve money): M0 is the RBI's own liability. It includes cash held by banks and bankers' deposits with RBI. M1 counts only money held by the public, so bank reserves are not in M1.
• M2 vs M3 order: M2 adds Post Office savings to M1. M3 adds bank time deposits to M1, not to M2. Post Office deposits appear only in M2 and M4.
• NM1 / NM2 / NM3: These are the new aggregates proposed by the Y.V. Reddy Working Group (1998) [3]. They are not the same as the older M1–M4 measures.

Prelims Hooks

• Narrow money = M1 and M2. Broad money = M3 and M4. Liquidity falls from M1 to M4.
• M1 = Currency with the public + net demand deposits of banks + other deposits with RBI. It does not include time deposits or Post Office deposits.
• M2 = M1 + Post Office savings bank deposits. Trap: "M2 = M1 + time deposits of banks". This is false. That describes M3.
• "Other deposits with RBI" is found in both M0 and M1.
• Credit creation at CRR 20% turns ₹100 of deposits into ₹500 of M1. Simple multiplier = 1/CRR.
• The RBI has compiled money statistics since July 1935 using a balance-sheet approach. The Y.V. Reddy Working Group (June 1998) proposed NM1–NM3 and L1–L3 [3].

Mains Points

• Financial inclusion changes the mix of narrow money.
• Jan Dhan accounts and digital payments move money out of cash and into demand deposits.
• So cdr falls, the money multiplier rises, and more of M1 stays inside banks, where RBI policy signals can reach it.

• Demonetisation (2016-17) showed the other side: a sudden fall in currency with the public hit the cash part of narrow money.

• The RBI controls narrow money only partly.

• The RBI sets M0 and the CRR (cut to 4% in Dec 2024 [4], now 3% [2]).
• But demand deposits grow only if firms and households want to borrow, and if people choose to keep money in banks instead of as cash.

• So a CRR or repo rate cut may not raise money supply or spending much. This is useful for GS-III answers on how well monetary policy works.

• Narrow money vs broad money for policy.

• M1 tracks money that is ready to be spent. It gives a signal about spending in the near term.
• M3 also includes savings in time deposits. It shows the total money available for lending, which is why the RBI uses it most.
• Reading both together tells a policymaker whether people are holding money to spend it or to save it.

Related concepts

• Credit creation
• Bank balance sheet
• Bank reserves
• Money multiplier
• Currency deposit ratio
• Reserve deposit ratio
• Bank run
• High-powered money
• Currency in circulation
• Money supply

Read more

• Credit creation, high-powered money and the money supply