ECONOMIC & SOCIAL

DEVELOPMENT
(PRE-CUM-MAINS, 2020)

Under The Guidance Of

M K YADAV

Both Online & Offline Classes Available

BOOKLET # 1
MONETARY & CREDIT POLICY (PART I OF II)
INDEX
1 BASIC CONCEPTS OF MONEY: Features, Functions, & Types Of Money 1
2 MONEY SUPPLY & RELATED CONCEPTS: Types Of Deposits, Measures of Money Supply, 3
Credit Creation & Money Multiplier, & Velocity of Money
3 MONETARY POLICY: Objectives, Process, & Types 5

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 ECONOMIC & SOCIAL DEVELOPMENT: TARGET 2020
Under the Guidance of M K YADAV

UNIT 1: MONETARY AND CREDIT POLICY

1.1 BASIC CONCEPTS

1.1.1 MONEY
 Money is anything that is generally accepted as a means of payment in settlement of all transactions.
 It can be paper currency, coins, cheques, bank deposits, crypto currency etc.

1.1.2 FEATURES OF MONEY

 Acceptability: Everyone must be able to exchange the money for goods and services.
 Durability: Objects used as money must withstand physical wear and tear.
 Portability: People need to be able to take money with them as they go about their business.
 Divisibility: To be useful, money must be easily divided into smaller denominations, or units of value.
 Uniformity: Any two units of money must be uniform or same in the terms of what they will buy.
 Limited Supply: Money must be available only in limited quantities.

1.1.3 FUNCTIONS OF MONEY

 Primary Functions: Primary Functions are the most important functions of money, these are:
1. Medium of Exchange:
 Because of its general acceptability, money serves as a ‘common medium’ of exchange.
 It provides general purchasing power to the money holders ie. People can directly buy goods
and services from the market without having to convert money into anything else.
 This function has removed the major difficulty of lack of double coincidence of wants
associated with barter system.
 It allows purchase and sale to be conducted independently of each other.
2. Measure of Value (Unit of Account):
 Money serves as a common measure of value (or common denomination) in terms of which
values of all goods and services are expressed.
 This makes meaningful accounting systems possible by adding up values of wide varieties of
goods and services, whose physical quantities are measured in different units.
 This allows for direct comparison between prices of different commodities and determining
their exchange ratios.

 Secondary Functions: These functions are derived from primary functions and, therefore, they are also
known as ‘Derivative Functions’.
1. Standard of Deferred Payments:
 It serves as a standard or unit for the settlement of future monetary obligations.
 This applies to payment of interest, rent, salaries, pensions etc. It has simplified the borrowing
and lending operations.
 Money, through this function, helps in capital formation and economic development of the
economy.
2. Store of Value:
 Money is a way to store wealth i.e. money is an asset.
 Money can be used to transfer purchasing power from present to future.
 This function is derived from the use of money as a medium of exchange.

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1.1.4 TYPES OF MONEY

 Full bodied money:
- It is the type of money whose commodity value is equal to the money value.
- For example, the market value of the silver/copper contained in the coin being equal to the face
value of the coin.
 Token Money:
- It is the type of money whose money value is more than the commodity value.
- For example, paper note of Rs. 2000, its money value is far more than the cost of the paper used to
make the currency.
 Representative Full Bodied Money: It is a type of token money, issued against the backing of equivalent
value of bullion (precious metal) with the issuing authority.
 Fiat Money:
- It is the money which is issued by the order/authority of the government.
- This includes the money that people in a country are legally bound to accept.
 Fiduciary money:
- Fiduciary money is the money which is accepted as a medium of exchange because of the trust of
the payer and the payee.
- For example, Cheques or cryptocurrencies are accepted based on trust, rather than by order of the
government.
 Legal Tender Money:
- Legal tender is any official medium of payment, recognized by law, that can be used to meet a
financial obligation.
- It is the money which can’t be denied in the settlement of a monetary obligation.
- All coins issued under the authority of Section 6 of The Coinage Act, 1906, are be legal tender.
- All banknotes issued by RBI under RBI act, 1934 are legal tender.
- Limited legal tender: Compulsory to accept only up to certain extent e.g. In India, coins function as
limited legal tender. Therefore, 50 paise coins can be offered as legal tender for dues up to ₹10.
- Unlimited Legal Tender: Any amount of obligation can be discharged with it. In India, currency
notes are unlimited legal tender.
- Point to Note: Bitcoin is money (medium of exchange), but NOT legal tender.

Demonetization - When a currency ceases to be legal tender. Cases of demonetization in the past:
 In 1946, when the circulated Rs.1,000 and Rs.10,000 notes were demonetized
 In 1978, when Rs.1,000, Rs.5,000 and Rs.10,000 notes were demonetized.
 November, 2016, when Rs.500 and Rs.1000 notes were demonetized.

What were the objectives of Demonetization?

 Curbing corruption and accumulation of black money.
 Eradicating Counterfeit currency.
 Striking at the root of financing of terrorism and left wing extremism.
 Reducing cash in circulation and promote digitalization of payments to make India a less cash economy.
 Convert non-formal economy into a formal economy to expand tax base and employment.

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What Motivated Demonetisation?

 Increasing currency-GDP ratio – around 12% in 2014-15.
 In general, use of cash declines with development. However, India’s level of cash dependency was higher
than other countries in similar income group. It suggests that some of the cash holdings were not used for
legitimate transactions.
 Lesser soil rates for higher denomination notes indicated that they are less in circulation and hence stored
as Black money.

1.2 MONEY SUPPLY & RELATED CONCEPTS

1.2.1 MONEY SUPPLY
 Money Supply refers to the total stock of all types of money (currency and deposits in banks) held by
the public (including all economic entities except Government and Banks as they are the creators of
currency and deposits).
 Thus, it is the total money in circulation in an economy. It measures the total purchasing power in the
economy.

1.2.2 TYPES OF DEPOSITS

 Demand Deposits Vs. Time Deposits

Sno. DEMAND DEPOSITS TIME/TERM DEPOSITS

1 Payable on demand ie. Depositors can freely
withdraw any or all of the funds from account at
any time (through cheques).
2 Used as medium of exchange – ownership can
be transferred from one to another through
cheques.
3 Offer very high liquidity and ease of access.
4 For eg. All Current accounts, Demand liability
portion of Savings account.
Not payable on demand. Deposits made for a
predetermined period of time (fixed term).
Withdrawal only on maturity.
Cannot be used a medium of exchange.
Not liquid.
For eg. All Fixed accounts, Time liability portion of
savings account

 Current, Savings & Fixed Deposits

Sno. CURRENT ACCOUNT SAVINGS ACCOUNT FIXED DEPOSITS

1 Payable on demand through Payable on demand through Not payable on demand. No
cheques. cheques. cheqeuing facility.
2 Unlimited withdrawals allowed. Restrictions on number of A lumpsum amount is deposited
withdrawals and amount to be for a fixed term to maturity.
withdrawn. Combine features Premature withdrawal attracts a
of Current and Fixed Deposits. penalty.
3 No interest is paid and no Interest is paid on the Earn higher interest rates than
minimum balance is required to deposits. Minimum balance savings account.
be maintained. needs to be maintained with
bank.
4 Overdraft facility available Overdraft facility not available Loans can be taken against the
deposits by the depositor.

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5 Users/Account Holders – Users/Account Holders – Users/Account Holders - Mostly

usually Business firms etc. Mostly Households Households
Mainly used for transaction
purposes or ease of making
business payments

 Recurring Deposits:
- It is a special type of term/fixed deposit where an investor does not need to deposit a lump sum,
rather he/she has to deposit a fixed sum of money at regular intervals (for eg. Monthly) over an
agreed period of time (eg. 2-7 years).
- At maturity, the principal amount and interest is paid to the holder.
- Users/Account Holders – Usually salaried people who need to save regularly.

 Post Office Deposits:

Sno. PO SAVINGS DEPOSITS PO TIME DEPOSITS

1 Payable on Demand through withdrawal slips Not payable on demand.
2 Restrictions on number of withdrawals and Withdrawal only on maturity.
amount to be withdrawn.
3 Cannot be used as medium of exchange. Lack Cannot be used a medium of exchange.
cheqeuing facility.
4 Less liquid than demand Deposits Not liquid.

 Post offices offer a wide range of saving options - Time Deposit Account, Recurring Deposit Account,
Savings account etc. These help in financial inclusion.
 Saving schemes offered buy Post offices are: Public Provident Fund (PPF), Kisan Vikas Patra (KVP),
National Saving Certificate (NSC), etc.

1.2.3 MEASURES OF MONEY SUPPLY

a) M0 or Reserve Money or Base Money or High Powered Money (H)
 M0 = Currency in Circulation + Bankers’ Deposits with RBI + Other deposits with RBI
 It is the monetary base of economy.
 It takes into account Producers of Money.
 Money produced by RBI and Government and held by public and banks

b) M1 = C + DD + OD
 C, Currency held by the Public.
 DD, Demand deposits of the people with commercial banks.
 OD, Demand deposits of public financial institutions, foreign central banks, international financial
institutions with RBI.
 M1 is called narrow money because it is the most liquid measure of money supply.
 M1 excludes
- Deposits of Commercial Banks with RBI
- Deposits of Government with RBI
- Inter-bank deposits

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c) M2 = M1 + Savings Deposits with post office saving bank

d) M3 or Aggregate Monetary Resource (AMR) or broad measure of money = M1 + Net Time deposits
with banks
e) M4 = M3 + Total deposits (Saving + Time) with post offices (excluding National Savings Certificates)
 M4 is the broadest measure of money supply

In terms of liquidity  M1 (most liquid) > M2 > M3 > M4 (least liquid)

1.2.4 MONEY SUPPLY & CREDIT CREATION

 Money supply = M0*m, where ‘M0’ is the monetary base and ‘m’ is the money multiplier.
 Money multiplier is the credit creation capacity of banks.
 Determinants of credit creation
1. Currency Deposit ratio (c) = Currency with Public (C) / Deposits with Banks (D)
- Inverse relation  Lower the ratio, greater the credit creation capacity and vice versa.
2. Time deposit ratio (t) = Time deposits (TD) / Demand deposits (DD)
- Direct relation  Higher the ratio, greater the credit creation capacity and vice versa.
3. Reserves Deposit Ratio (r): Reserves with Banks (R) / Deposits with Banks (D)
- Inverse relation  Lower the ratio, greater the credit creation capacity and vice versa.

1.2.5 VELOCITY OF MONEY

 It refers to the average number of times a single unit of money changes hands or is used in an economy,
during a given period of time ie. The rate of circulation of the currency.
 Simply put, it's the rate at which people spend money.
 Thus, a higher velocity is a sign that the same amount of money is being used for a number of
transactions.
 It is also indicative of how much economic activity occurs or is possible at a certain level of money supply.
 It is calculated as, M*V = P*Q (Fisher’s equation)
- M*V = Supply of Money ( M, quantity of money in existence and V, Velocity of Money )
- P*Q = Demand of Money ( P, current price level and Q, real value of output)

1.3 MONETARY POLICY

1.3.1 MONETARY POLICY
 It is the use of instruments under the control of the Central Bank (RBI) to regulate the availability, cost
and use of money and credit in an economy to achieve specified goals/objectives.
 Monetary policy operates through changes in money supply, which influences the aggregate demand
for output in money terms (directly or indirectly).

1.3.2 OBJECTIVES OF MONETARY POLICY

 Through an amendment to the Reserve Bank of India (RBI) Act, 1934 in 2016, it was written into the
preamble of the RBI Act that the primary objective of the monetary policy in India is to maintain price
stability, while keeping in mind the objective of growth.

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1.3.3 WHO OPERATES MONETARY POLICY?

 The RBI is vested with the responsibility of conducting monetary policy under the Reserve Bank of India
Act, 1934. It is announced bimonthly.
 In 2015, The RBI and Government of India (GoI) signed the Monetary Policy Framework Agreement
(MPFA), which made achieving price stability and inflation targeting the responsibilities of RBI.
 In 2016, an amendment to the RBI Act, 1934 gave a statutory backing to the aforementioned Monetary
Policy Framework Agreement and for implementation of the inflation targeting framework.

Inflation Targeting
 It is a monetary policy strategy used by Central Banks for maintaining price level at a certain level or
within a range.
 As per the Monetary Policy Framework Agreement, the RBI will be responsible for containing inflation
targets at 4%, with a band of (+/-) 2%, of Consumer Price Index (CPI).
 The RBI is also solely responsible for deciding Policy Rates to meet inflation target.
 If the RBI fails to achieve the target, it shall send out a report to the Central Government the reasons for
failure to meet targets, remedial measures proposed to be taken, & time bound achievement of target.
 The RBI will also be required to bring a document every 6 months to explain the sources of inflation and
forecast for inflation for next 6-18 months.
 The inflation target is set by the GoI, in consultation with the RBI, once in every 5 years.

1.3.4 THE MONETARY POLICY PROCESS Open and Transparent Monetary

 The amendment to the RBI Act, 1934 also provided for setting up Policy Making
of Monetary Policy Committee (MPC).  MPC is required to meet at least 4
 The MPC determines the policy interest rate required to achieve times in a year.
 Minimum quorum for meeting - 4
the inflation target.
members.
 It was setup in line with Urjit Patel committee recommendations.  Each member of the MPC has one
 The Central Government constituted the MPC, in 2016, through vote, and in the event of an
a notification in the Official Gazette. equality of votes, the Governor
 The MPC replaced the earlier system where the RBI governor had has a second or casting vote.
complete control over monetary policy decisions. The present Decision made by majority vote.
Committee-based approach adds value and transparency to  Resolution adopted by the MPC is
published after conclusion of
monetary policy decisions.
every meeting of the MPC.
 Composition of MPC (6 members)  On the 14th day, the minutes of
- RBI Governor (Chairperson) the proceedings of the MPC are
- RBI Deputy Governor in charge of monetary policy published.
- One official nominated by the RBI Board.  Once in every 6 months, RBI is
- 3 members - nominees, appointed by the Central required to publish a document
Government based on the recommendations of a search- called the Monetary Policy
Report.
cum-selection committee.

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Urjit Patel Committee Recommendations

 Inflation Targeting: RBI used to have “Multiple Indicator Approach” for monetary policy such as
employment, growth, foreign exchange rate, inflation etc. These were often conflicting, hence, the
committee recommended inflation targeting as primary objective of RBI.
 Use of CPI (combined) in place of WPI for deciding about monetary policy. Inflation target to be 4% (with
a standard deviation of 2%) of Consumer Price Index (CPI) (nominal anchor).
 Monetary Policy Committee should be created rather than the RBI governor solely deciding the Monetary
Policy. Members should be both from within and outside the RBI. RBI should give a public statement if it
fails to meet the inflation target.
 Repo rate should be more than inflation.
 Effective Coordination between Fiscal and Monetary policy must be maintained.
 Decrease SLR as per the Basel Norms and remove interest subvention scheme and Market Stabilisation
Scheme (MSS).
 Government obligations:
- The Central Government needs to reduce the fiscal deficit to 3% of GDP by 2016-17.
- Administered prices, wages and interest rates are impediments to transmission of monetary policy
and should be eliminated.
 Government debt management should be under a separate body like PDMA (Public Debt Management
Agency)

1.3.5 TYPES OF MONETARY POLICY

a) Contractionary Monetary Policy
 It seeks to decrease the money supply in the economy
 It usually checks the inflation
 It is also called “Dear money policy”
b) Expansionary Monetary Policy
 It seeks to increase the money supply in the economy
 It is pursued to check recession
 It is also called “Cheap money policy”

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