Components of Money Supply, the Central Bank and Commercial Banking

Unit 7 covers the institutions that create and manage money and credit. This chapter covers the components of money supply, the functions of a central bank, and the workings of commercial banking; the next chapter covers monetary policy instruments, non-banking financial institutions and the regulation of the capital market.

1. Components of Money Supply

Money supply measures form a hierarchy of decreasing LIQUIDITY: M1 (the narrowest and most liquid) comprises currency with the public plus demand deposits with banks plus other deposits with the central bank; M2 adds savings deposits with post office savings banks; M3 (the broadest measure most commonly targeted/monitored, also called aggregate monetary resources) adds time (fixed) deposits with banks to M1; M4 further adds total post office deposits. Each successive measure trades a little liquidity for a broader capture of what the public actually holds as a store of value, and central banks typically watch M3 as the headline monetary aggregate even while retaining M1 for its closer link to immediate transactions demand.

⚠️ M1 through M4 differ by liquidity, not by which is 'more real'
A common error treats a higher-numbered aggregate as somehow a different KIND of money rather than a progressively broader (and less liquid) count of the same underlying stock. NET frequently asks which specific item belongs in which aggregate — remembering that each successive M is built by adding one further, progressively less liquid, component onto the previous one is the reliable way to answer these rather than memorising four unconnected definitions.

2. Central Bank

A central bank performs five classic functions: it is the sole issuer of CURRENCY (the note-issuing monopoly), the BANKER TO THE GOVERNMENT (managing its accounts and public debt), the BANKER'S BANK and LENDER OF LAST RESORT (holding commercial banks' reserves and lending to solvent-but-illiquid banks in a crisis to prevent contagion), the custodian of FOREIGN EXCHANGE RESERVES, and the authority responsible for MONETARY POLICY and financial-system regulation. The lender-of-last-resort function is specifically about SOLVENT banks facing a temporary LIQUIDITY shortage (a run, or a temporary funding gap) — it is not meant to rescue an insolvent bank, and the classic Bagehot's Dictum states the principle precisely: lend freely, at a penalty rate, against good collateral.

3. Commercial Banking

Commercial banks perform financial INTERMEDIATION — accepting deposits and channelling them into loans and investments — and are precisely the institutions through which the credit-creation (money-multiplier) process from Unit 2 actually operates: a fresh deposit, minus the fraction retained as reserves, is re-lent, redeposited, re-lent again, and so on, multiplying the initial deposit into a larger expansion of bank money. Fractional-reserve banking is inherently exposed to a BANK RUN — if depositors simultaneously fear a bank cannot honour withdrawals and rush to withdraw at once, even a fundamentally solvent bank can be forced into failure purely from a self-fulfilling loss of confidence, since it holds only a fraction of deposits as liquid reserves at any moment.

Central bank versus commercial bank — the key functional difference
FeatureCentral bank
Note issueSole monopoly issuer of currency; commercial banks cannot issue legal-tender notes.
Profit motiveOperates for public-policy/monetary-stability objectives, not profit maximisation, unlike a commercial bank.
Customer relationshipDoes not deal directly with the general public — it deals with banks and the government, while commercial banks deal directly with households and firms.

4. Prudential Norms and Financial Stability

  • Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) — a CRR requires banks to keep a fraction of deposits as cash reserves with the central bank (earning no interest, directly shrinking the money multiplier when raised); an SLR requires banks to hold a fraction of deposits in specified liquid assets (often government securities) on their own books — both are direct levers over the money-creation process distinct from the interest-rate-based policy instruments covered in the next chapter.
  • Non-performing assets (NPAs) and capital adequacy — an NPA is a loan on which interest or principal payment has been overdue beyond a specified period, directly eroding a bank's capital base; capital-adequacy norms (e.g. Basel-style ratios) require banks to hold capital proportional to their risk-weighted assets, precisely to absorb losses from NPAs without failing.

Key takeaways

  • M1 through M4 form a hierarchy of decreasing liquidity, each successive measure adding a further, less liquid, component onto the previous one; M3 is the broadest commonly-watched aggregate.
  • The central bank's lender-of-last-resort function targets solvent-but-illiquid banks, not insolvent ones — Bagehot's Dictum: lend freely, at a penalty rate, against good collateral.
  • Commercial banks are the institutions through which fractional-reserve credit creation actually operates, which is also precisely why they are exposed to self-fulfilling bank runs.
  • A central bank issues currency, banks the government, banks the banks (and lends last-resort), holds forex reserves and conducts monetary policy — none of which a commercial bank does.
  • CRR/SLR are direct quantity levers over money creation, distinct from interest-rate instruments; NPAs erode bank capital, which capital-adequacy norms exist to buffer against.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

  1. M3, the broadest commonly-monitored monetary aggregate, is derived by adding to M1:

    1. Time (fixed) deposits with banks
    2. Only physical gold reserves
    3. Foreign currency held by tourists
    4. Stock market capitalisation
    Show answer

    Answer: A — Time (fixed) deposits with banks

    M3 = M1 + time deposits with banks; each successive monetary aggregate adds one further, progressively less liquid, component to the previous one.

  2. Bagehot's Dictum on the central bank's lender-of-last-resort role advises lending:

    1. Freely, at a penalty rate, against good collateral
    2. Only to insolvent banks with no collateral required
    3. Never, under any circumstances
    4. Only to foreign governments
    Show answer

    Answer: A — Freely, at a penalty rate, against good collateral

    Bagehot's principle targets SOLVENT but illiquid banks, lending generously but at a penalty rate against sound collateral — precisely to prevent contagion without bailing out genuinely insolvent institutions.

  3. A key functional difference between a central bank and a commercial bank is that the central bank:

    1. Does not deal directly with the general public and is not driven by profit maximisation
    2. Accepts deposits from households directly
    3. Competes with commercial banks for retail customers
    4. Is legally identical to a commercial bank
    Show answer

    Answer: A — Does not deal directly with the general public and is not driven by profit maximisation

    A central bank deals with banks and the government, not the public directly, and pursues monetary-stability objectives rather than profit — a commercial bank does exactly the opposite on both counts.

  4. A bank run can force even a fundamentally solvent bank into failure because:

    1. Fractional-reserve banking means only a fraction of deposits are held as liquid reserves at any moment
    2. Banks always hold 100% of deposits in cash
    3. Deposits earn no interest anywhere
    4. Central banks always refuse to intervene
    Show answer

    Answer: A — Fractional-reserve banking means only a fraction of deposits are held as liquid reserves at any moment

    Because banks re-lend most of what they receive as deposits, holding only a fraction as reserves, a simultaneous rush to withdraw can exhaust liquid reserves even at a bank whose underlying loan book is perfectly sound — a self-fulfilling confidence failure.

  5. A rise in the Cash Reserve Ratio (CRR) tends to:

    1. Shrink the money multiplier and hence money supply
    2. Expand money supply indefinitely
    3. Have no effect on bank lending capacity
    4. Directly set the exchange rate
    Show answer

    Answer: A — Shrink the money multiplier and hence money supply

    A higher CRR forces banks to keep a larger, non-interest-earning share of deposits idle with the central bank, directly reducing the reserve-deposit ratio's complement available for lending and shrinking the money multiplier.

  6. A non-performing asset (NPA) is defined as a loan on which:

    1. Interest or principal payment has been overdue beyond a specified period
    2. The interest rate is exactly zero
    3. The borrower is a government entity
    4. The loan has been fully repaid
    Show answer

    Answer: A — Interest or principal payment has been overdue beyond a specified period

    An NPA is specifically a loan whose interest or principal is overdue past a defined threshold, which directly erodes the lending bank's capital base and is what capital-adequacy norms are designed to buffer against.

  7. The Statutory Liquidity Ratio (SLR) requires banks to hold a fraction of deposits in:

    1. Specified liquid assets (often government securities) on their own books
    2. Foreign real estate only
    3. Cryptocurrency
    4. Cash reserves with the central bank only, identical to CRR
    Show answer

    Answer: A — Specified liquid assets (often government securities) on their own books

    SLR is distinct from CRR: SLR assets are held on the bank's OWN books (typically government securities), while CRR is specifically cash held with the central bank — the two are separate, complementary liquidity/quantity levers.

  8. Which of the following are classic functions of a central bank?

    1. Sole issuer of currency
    2. Banker to the government
    3. Lender of last resort to the banking system
    4. Accepting retail deposits directly from the general public
    Show answer

    Answer: A — Sole issuer of currency; B — Banker to the government; C — Lender of last resort to the banking system

    The first three are classic central bank functions; accepting retail deposits directly from the public is precisely a commercial bank's role, not the central bank's.

  9. Name the narrowest, most liquid measure of money supply — currency with the public plus demand deposits with banks plus other deposits with the central bank.

    Numerical answer — type the value.

    Show answer

    Answer: M1

    M1 is the standard name for this narrowest measure; each successive aggregate (M2, M3, M4) adds a progressively less liquid component on top of M1.