MONEY SUPPLY

The term ‘money supply’ refers to the number of rupees held by the public and the central bank controls the supply of money by varying the number of rupees in circulation through open market operations or by increasing or decreasing the reserve ratios of member banks.  

Money supply plays a crucial role in the determination of price level and interest rate. So it is important to identify what determines the money supply in an economy. 
The money supply is determined by the policy of Central Bank of a country and the Government. In addition to Central Bank and the Government, the public and commercial banks also play a crucial role. There are different measures of money supply depending upon which types of deposits of banks and other financial institutions are included in it.
Growth of money supply is an important factor not only for the acceleration of process of economic development but also for the achievement of price stability in the economy. What constitutes the money supply and what factors causes variation and growth in money supply if the objective of development with stability is to be achieved. 
Further, the banking system also plays a significant role in determining the money supply. The central bank provides the monetary base (bank reserves and currency) upon which the money supply (currency and deposits) is built. Commercial banks act as creators or destroyers of money in a modern economy due to the existence of present fractional reserve system. The money supply is sensitive to changes in the rate of interest.
The money supply is measured in the form of four types of money. 
M₁:  is the transactions demand for money.  It is the sum of coins and paper currency in circulation outside the bank plus deposits that can be withdrawn by checks.  Coins and paper currency are called fiat money (legal tender).  Thus, money supply is determined not only by the monetary policy of the central bank, but also by the behavior of the households and of banks. In India, the money supply, in a narrow sense, includes both currencies with the public and deposits at banks that can be used on demand by the households for the purposes of transaction. Thus, M = C + D Where, M = money supply, C= currency, D = Demand deposits
 M2: This is broad money  is equal to M₁ + near monies – such as savings and small denominations of time deposit and non-institutional holdings of money market mutual funds.  All of the assets in M₂ earn much lower interest rates than the liquid assets such as certificates of deposits and are much more liquid.  So there is a natural separation between M₂ as a liquid asset generally acceptable as a means of payments and earns low or no interest. Within M₂, the deposits in M₁ are most liquid and earn the lowest return. The broader definition M₂ adds money market funds, saving deposits and small denomination time deposits to M₁.

M3: M₃ contains M₂ and other assets such as large denomination time deposits, MMMFs held by institutions and repurchase agreements. In a repo agreement as bank borrows from a non-bank customer by selling a security, such as a government bond, to the customer and promising to buy the security back. Several of the assets included in M₂ and M₃ are not money in the strict sense of being directly acceptable in payment. For example, repo agreements, which are part of M_3, cannot be used directly for making purchases. However, because these assets can be quickly and cheaply converted into currency or chequable deposits, they are included in the broader measures of money.

M4: The measure M4 of money supply includes not only all the items of M3 but also the total deposits with the post office savings organization. However, this excludes contribution made by the public to the national saving certificates. Thus, M4 = M3 + Total Deposits with Post Office Savings Organization.
Thus the total amount of money in circulation can be measured in terms of M1, M2,M3 and M4.