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CLASS XII MONEY AND BANKING CHAPTER-6

Money is defined as anything which is generally accepted as a medium of exchange, a store of value, a unit
of account and a standard of deferred payment.
MONEY SUPPLY: It is the total amount of money in circulation among the public at a particular point of
time .It is a stock variable and not a flow variable as it is measured at a point of time.
MEASURE OF MONEY
The basic measure of money supply includes those assets which can be directly used for transactions. It is
also called transactions money. It (M1) consists of:
a) Currency with the public(CU): Money supply includes only that currency and coins which are held
only by the public outside the banks. The RBI is the only institution in India which can issue
currency in India. However, only currency notes are issued by the RBI and coins are issued by the
Government of India.
● The currency issued by the Central Bank can be held by the public or by the commercial
banks and is called the HIGH-POWERED MONEY or ‘reserve money’ or ‘monetary base’
as it acts as a basis for credit creation.
● Currency notes and coins are called LEGAL TENDERS as they cannot be refused by any
citizen of the country for settlement of any transaction.
● Currency notes and coins are called FIAT MONEY because every country note bears on its
face a promise from the Governor of RBI that if someone produces the note to RBI or any
other commercial bank. RBI will be responsible for giving the person purchasing power equal
to the value printed on the note. The same is also true for coins.
b) Net Demand deposits by commercial banks (DD): Demand Deposits are the deposits which can be
drawn on demand by the depositors from Banks. Eg: Current account and savings account deposits.
● Demand deposits are created by the commercial banks and are called bank money.
● The word net implies that only deposits of the public held by the banks are to be included in
money supply. The inter-bank deposits, which a commercial bank holds in other commercial
banks are not to be regarded as a part of money supply.
NOTE:Cheques drawn on savings or current accounts can be refused by anyone as a mode of payment.
Hence, demand deposits are not legal tenders.
THIS BOX IS NOT IN SYLLABUS: ONLY FOR ENRICHMENT
2.M2= M1+Saving deposits with post office saving banks.
(Saving deposits of post offices are not a part of money supply as they do not serve as a medium of
exchange due to lack of cheque facility)
3.M3= M1+Net time deposits of banks.
4.M4= M3+Total deposits with post office saving organisation (excluding national savings Certificates
(NSC))
Note:
● M1 and M2 are called narrow money supply whereas M3 and M4 are called broad money.
● M3 is the most widely used measure of money supply. It is also used as aggregate monetary
resources
● Liquidity means the ability to convert an asset into money quickly and without loss of value. M1
being the most liquid and easiest for transaction and M4 being the least liquid.

DEMAND DEPOSITS FIXED DEPOSITS/TIME DEPOSITS

These are repayable by the banks on
demand.
They are chequable deposits
They carry a lower rate of interest than
fixed deposits.
The depositor can make any no. of
transactions for deposit/ withdrawal.
The amount is deposited with the bank for a
fixed period of time.
They are non-chequable deposits.
They carry interest which varies directly
with the period of time.
Depositors can make only 2 transactions i.e.
at the time of depositing money and
withdrawal of money on maturity.
MONETARY SYSTEM IN INDIA
RBI has the sole monopoly to issue currency notes. Coins are issued by the government of India. (The
Ministry of Financé used to issue the one rupee note. However the responsibility of putting all coins
and currency into circulation is the RBI.)

BANK: A bank is a financial institution whose demand deposits are widely accepted as money for making
payments and which has the power to create money.
TWO CHARACTERISTIC FUNCTIONS OF BANK
1) Bank deposits are chequable: Banks allow their depositors to withdraw their money without giving
any notice to the banks simply by writing cheques.
2) Banks create money: Banks demand deposits are a part of money supply. Banks lend money to the
borrowers by opening demand deposit accounts in their names. The borrowers are then free to use
this money by writing cheques.

CENTRAL BANK: It is a bank specially created by the government to serve as an apex bank to carry out
monetary policy of the country in public interest through the various functions assigned to it.
It was formed in 1935

FUNCTIONS OF CENTRAL BANK

1. Bank of issue/ Currency Authority: It means a bank which has legal right to issue currency notes.
It enjoys a complete monopoly of note issue as:
a) It brings about uniformity in the note circulation
b) It gives the central bank some direct control over money supply. Currency notes in circulation are
a part of the money supply.
The Central Govt of the country is authorised to borrow money from the Central Bank when its expenditure
exceeds its revenue and the government is unable to reduce its expenditure. This is done by selling treasury
bills to the RBI which creates new currency notes for this purpose. This is called deficit financing. The
government spends new currency and puts it into circulation to meet its expenditure.

2. Banker to the government: Central Bank functions as a banker to the Central and State
governments in the following manner:
a) It carries out all the banking business of the government by keeping the cash balance of the
government in the current account
b) It accepts deposits from the government and makes payments on its behalf.
c) It gives loans and advances to the government against treasury bills.
d) It works as an agent of the government by managing public debt by undertaking payment of
interest on this debt .It advises the government on the quantum, timing and terms of such loans.
e) It gives advice to the government regarding money market, capital market, government loans and
on economic policy matters.
f) It works as an agent in matters of collection of taxes etc.
SIGNIFICANCE: This function signifies mutual and common interest of the Central Bank and Govt.

3. Banker’s Bank and Supervisor/ Lender of last resort: It acts as the Banker’s bank in the
following manner:
a) It fixes the percentage of cash reserves which the commercial banks are required to keep with the
Central Bank from their demand deposits called as CRR. The central Bank uses these reserves to
meet the emergency cash needs of individual commercial banks by granting them loans.
b) It also fixes the percentage of cash reserves which the commercial banks are required to keep
with them from their demand deposits called SLR. These reserves ensure that commercial Banks
have enough cash to meet the daily demand of their depositors.
c) It supervises the functioning of commercial Banks by making rules regarding licensing,
management, branch expansion etc and also undertakes periodic inspection.
d) It acts as the lender of the last resort by rediscounting their eligible securities and bills of
exchange and providing loans against them.
 e) It acts as a bank of central clearance,settlements and transfers.(It has a clearing house where
mutual indebtedness between banks is settled. The representatives of different banks meet daily
to settle interbank payments. These differences in payment are settled by transfer between their
respective accounts with the central bank.)
SIGNIFICANCE: It economises the use of money in the Banking Operations.

4. Controller of money supply and credit: Credit control is the most crucial function played by any central
bank in modern times. The central Bank can change the money supply and credit through a number of tools
and instruments which are as follows:

QUANTITATIVE CONTROL MEASURES QUALITATIVE CONTROL MEASURES

1. It determines the volume or quantity of It deals with allocation of credit between
the credit. alternative users.
2. Measures are : Measures are:
a) Bank Rate a) Margin requirement
b) Open market operations b) Moral Suasion
c) Varying Reserve requirements like c) Selective credit control
CRR and SLR.
d) Repo rate and Reverse repo rate
The main objective/ SIGNIFICANCE of credit control function is to stabilise the price level.This objective
is achieved by regulating the money supply and interest rate.

QUANTITATIVE CONTROL MEASURES

a) Repo Rate: It is the interest rate at which the commercial banks can borrow from the
central bank to meet their short term needs.
● When the Central Bank increases the repo rate, it forces the commercial bank to
raise the lending rates. It will make borrowings costlier to the general public.
People may borrow less. Thus, credit creation by banks declines and money
supply decreases in the economy.
● When the Central Bank decreases the repo rate, it forces the commercial bank to
lower the lending rates. It will make borrowing cheaper to the general public.
People may borrow more. Thus, credit creation by banks increases and money
supply increases in the economy.
(The Central Bank buys securities from the commercial bank with an agreement to
resell the same security to the commercial bank at a predetermined date and price of
resale. This type of agreement is called a repurchase agreement or repo. The interest
rate at which the money is lent in this way is called the repo rate.)
b) Reverse repo rate: It is the interest rate at which the commercial banks can deposit
their funds with the central bank. The central bank has the legal power to change it.
Raising the RRR gives incentives to the commercial banks to deposit their funds
with the central bank. This reduces liquidity with the commercial banks and has an
adverse effect on their credit creation capability. Borrowings from banks decline
which lowers the money supply in the economy and vice versa.
(The central bank may sell the securities through an agreement which has
a specification about the date and price at which it will be repurchased. This
type of agreement is called a reverse repurchase agreement or reverse
repo. The rate at which the money is withdrawn in this manner is called the
reverse repo rate.)
c) Bank Rate: Bank rate (also called discount rate) is the rate of interest at which the
Central Bank of the country lends money to the commercial bank of that country to
meet their long term needs.
 ● When the central Bank has to decrease the money supply during inflation, the
central bank raises its bank rate. The commercial banks are then forced to raise
their lending rates to the general public. As the lending rates rise the demand for
loans for loans is likely to fall. This leads to decrease in credit creation by banks
and thus reduces money supply in the hands of the general public.
● When the central Bank has to increase the money supply during a recession, the
central bank lowers its bank rate. The commercial banks are then forced to
lower their lending rates to the general public. As the lending rates fall, the
demand for loans for loans is likely to rise. This leads to increase in credit
creation by banks and thus increases money supply in the hands of the general
public.
● (The rate of interest charged by the commercial banks from the general public is
called the lending rate.)
Note: Repo rate mainly aims for short term effect and bank rate mainly aims for long term effect.
d) Open Market Operations:Open market operations refers to buying and selling of
bonds issued by the government to/from the public and the banks in the open
market, in order to influence the money supply in the country.
● When the central bank sells securities to the public, the public withdraws money
from the commercial banks and makes payment to the central bank. The money
flows out of commercial banks and into the central banks. This reduces deposits
of people with commercial banks; Reduction in deposits reduces lending power
of commercial banks, hence reduces the money supply in the hands of the
general public.
● When the central bank buys securities from the public, the central bank releases
liquidity in the economy since it pays for it by giving a cheque. The cheque
increases cash reserves with banks and thus increases bank’s ability to create
credit and increases the money supply in the hands of the general public.

f) Varying Legal Reserve requirements: Legal reserve ratio refers to the minimum percentage of
deposits which the commercial banks are required to keep with themselves and with the
central bank. It has 2 components:
a) SLR is the minimum percentage of deposits to be kept by a commercial bank with
itself. It is kept in the form of cash, gold and government securities.
b) CRR is the minimum percentage of deposits to be kept by a commercial bank with the
central bank. It is also called the reserve ratio or required reserve ratio.

● If the central bank raises the amount of legal reserves i.e SLR and CRR, the amount of
effective deposits left with commercial banks is reduced. This reduces the capacity of
commercial banks to create credit. Lending falls and so falls the money supply in the
economy.
● When the Central Bank reduces CRR or SLR or both, more money is left with
commercial banks for lending. As lending increases, the money creation increases and
money supply in the economy increases.

QUALITATIVE CONTROL MEASURES

a) Margin requirement refers to the difference between the current value of the
security offered for loan (called collateral) and the value of loan granted.Thus, if
 the margin imposed is 40%, then the bank is allowed to give a loan up to 60% of
the value of the security.
● When the central bank raises the limit of margin requirements, it discourages
borrowing as it makes traders get less credit against their securities.The higher
the margin requirement, less is the amount that can be lent to the borrowers.
This adversely affects money supply in the economy.
● Lowering margin requirements forces borrowers to secure larger amounts of
funds from the banks, thereby increasing money supply in the economy .
b) Moral Suasion is a combination of persuasion and pressure that the central bank
applies on commercial banks to follow its policies. This is done through
discussions, speeches, letters and hints to banks. To reduce the money supply, the
central bank appeals to the commercial banks to discourage lending. This reduces
the availability of credit.

c) Selective Credit Controls (Introduce Credit Rationing): SCCs refers to a

method in which the central bank gives directions to other banks to give or not to
give credit for certain purposes to particular/priority sectors. To reduce money
supply, the central bank introduces rationing of credit in order to prevent excessive
flow of credit, particularly for speculative activities. It helps to wipe off the excess
demand.

(Note: Open market operations, CRR, SLR and reverse repo rate together determine the credit creation
capacity of commercial banks while Repo rate, Bank rate and margin requirements determine demand for
loans from banks.)

Commercial Banks are financial institutions which accept demand deposits from the general public,
transfer funds from one bank to another and create money. They accept deposits from the public and lend
out part of these funds to those who want to borrow. The interest rate paid by the banks to depositors is
lower than the rate charged from the borrowers. This difference between these two types of interest rates,
called the ‘spread’ is the profit appropriated by the bank.

CREDIT CREATION OR MONEY CREATION BY A COMMERCIAL BANK:

All commercial banks can create deposits or credit which is much larger than their initial deposit. When a
Bank gives a loan to a customer and that customer deposits the loan amount in the bank itself, then total
bank deposits and therefore total money supply will rise. There is a limit to money or credit creation by
banks and this is determined by the Central bank (RBI). The RBI decides a certain percentage of deposits
which every bank must keep as reserves. This is done to ensure that no bank is ‘over lending’. This is a legal
requirement and is binding on the banks. This is called the ‘Required Reserve Ratio’ or the ‘Reserve Ratio’
or ‘Cash Reserve Ratio’ (CRR).

Cash Reserve Ratio (CRR) = Percentage of deposits which a bank must keep as cash reserves with the bank.

Apart from the CRR, banks are also required to keep some reserves in liquid form in the short term. This
ratio is called Statutory Liquidity Ratio or SLR. The statutory requirement of the reserve ratio acts as a limit
to the amount of credit that banks can create.

Thus, the total deposits that are created depend upon 2 factors:
● Amount of initial deposits
● Legal Reserve Ratio(LRR)/CRR
Suppose a new deposit of Rs 1000 is made in the bank. Let LRR be 10% then the bank would keep 10% i.e.
Rs 100 as the reserve and can advance loan upto Rs 900. This is the first round of credit creation.
Suppose the borrowers withdraw the entire amount of loan and spend the same on the goods and services
needed for investment and consumption. It means that the sellers of these goods and services receive Rs 900
of revenue and deposit the same in their respective bank accounts. The Banks get new deposits. Again they
keep 10% of these deposits i.e Rs 90 as cash and lend the remaining 810 RS. This is the second round.
In the same manner as above, the third round creation of deposits would mean cash reserve of Rs 81 and
loan of Rs 729.

Likewise, in each successive round, deposits would be created but they would become smaller and smaller
and ultimately virtually become zero. The sum total of all deposits would be equal to the money created.

Thus, Money creation = (1/ LRR ) * initial deposit (Money creation = (1/ CRR ) * initial deposit)

1/LRR is called the deposit multiplier or money multiplier. The multiple by which deposits can increase due
to an initial deposit is called money multiplier.
This way we can see that if LRR is 10% and initial deposit is Rs 1000, a commercial bank is able to create
10000 Rs worth of deposits. Deposit creation comes to end when total cash reserves become equal to the initial
deposit.
Round Deposits Loans Cash reserve
I 1000 900 100
II 900 810 90
III 810 729 81
ː ː ː
ː ː ː
Total 10000 9000 1000

M1= Currency + deposits= 0+10000= 10000

Thus, money supply increase from Rs 1000 to Rs 10000

DIFFERENCE:
CENTRAL BANK COMMERCIAL BANK
It is governed by the people connected with It can be governed by both government and
the government. private sectors
The primary objective of central bank is Its primary objective is maximisation of
monetary management of the economy profits.
It does not undertake ordinary banking It undertakes ordinary banking business with
business with the general public and deals the general public.
with the government only.
It adds to the money supply by printing new It adds to the money supply by creating
currency notes. demand deposits.
There is only one central bank in the economy. There can be many commercial banks in the
country.
ADDITIONAL READING...NCERT
Assume that there is only one bank in the country. Let us construct a fictional balance sheet for this bank.
Balance sheet is a record of assets and liabilities of any firm. Conventionally, the assets of the firm are
recorded on the left hand side and liabilities on the right hand side. Accounting rules say that both sides of
the balance sheet must be equal or total assets must be equal to the total liabilities.
Assets are things a firm owns or what a firm can claim from others. In the case of a bank, apart from
buildings, furniture, etc., its assets are loans given to the public. When the bank gives out a loan of Rs 100 to
a person, this is the bank’s claim on that person for Rs 100. Another asset that a bank has is reserves.
Reserves are deposits which commercial banks keep with the Central bank, Reserve Bank of India (RBI)
and its cash. These reserves are kept partly as cash and partly in the form of financial instruments (bonds and
treasury bills) issued by the RBI. Reserves are similar to deposits we keep with banks. We keep deposits and
these deposits are our assets, they can be withdrawn by us. Similarly, commercial banks like State Bank of
India (SBI) keep their deposits with RBI and these are called Reserves.
Assets = Reserves + Loans
Liabilities for any firm are its debts or what it owes to others. For a bank, the main liability is the deposits
which people keep with it.
Liabilities = Deposits
The accounting rule states that both sides of the account must balance. Hence if assets are greater than
liabilities, they are recorded on the right hand side as Net Worth.
Net Worth = Assets – Liabilities

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