Question

1) Define M0, M1, M2 and M3 and answer the following parts:

a) What is the reason for using these different measures of money supply?

b) Is there a measure of money supply that is NOT affected by the banking multiplier, i.e. that is determined solely by the actions of the Central Bank?

c) Which nominal interest rate is controlled by the Central Bank? How?

d) Under which assumptions about the determinants of the Term Structure of Interest Rates could you claim that the Central Bank is able to set every nominal interest rate, from the shortest term to the longest?

Answer 1

1. M0 is the narrowest money. It includes only banknotes and coins in circulation. M1 includes M0 and demand deposits. M2 includes M1, small savings and term savings. M3 is called as broad money. It includes M2, large time deposits, institutional money market funds, short term repurchase agreements along with other large liquid assets. These are the four measures of the money supply.

a. It helps to control the money supply at a different level. Suppose if the central bank wants to control money circulation at the hands of the people, then they consider only M0. It also helps to implement policies to increase or decrease money circulation at a different level. For e.g, if the central bank wants to increase small savings, then it will consider the M2 measure of money supply alone.

b. No. In one way or another, they all are affected by actions of the central bank. E.g demonstration will affect even M0 money also.

C. Base rate, repo rate, cash reserve ratio and other in5erest rates which are short term are the nominal interest rates set by the central bank. The nominal interest rates are not adjusted with inflation. Central bank keeps low nominal rates to increase spending and borrowing of the consumers. This will increase economic activity in the country.