CHAPTER:-

MONEY AND
BANKING
Barter System
It is a system of exchange, where goods are exchange
for goods, also known as c-c economy. Where c stands
for commodity.
Drawbacks of Barter System of Exchange
Following are the drawbacks of barter system:
(i) Lack of Double Coincidence of Wants: The barter system
requires that a person who is willing to exchange his or her
goods should find another person who is not only willing to buy
the goods offered by the first person, but should also possess
what the first person wants in exchange. This is called double
coincidence of wants, which is hard to find.
(ii) Lack of Common Measure of Value: Different goods have
different values. There is no common unit of measuring value
under the barter system. It is difficult to decide in the
proportion in which the two goods are to be exchanged.
(iii) Lack of Standard of Deferred Payments: The barter system
lacks any satisfactory unit to engage in contracts involving the
deferred payments. It may be due to disagreement regarding
the specific good and its quality. Moreover, there is a risk of
increase or decrease in the value of the good overtime, thus
benefitting the lender or borrower of the good respectively.
(iv) Difficulty of Storage of Value: It is difficult to store wealth
for future use. Most of the goods like wheat, rice, cattle etc.
deteriorate with the passage of time or Involve heavy storage
cost.
(v) Difficulty of Transfer of Value: Under barter system, wealth
in the form of goods cannot be transferred from one place to
another. It is a difficult task as it requires a lot of time and
resources.

EVOLUTION OF MONEY
Money is a generally acceptable medium that can be
exchanged for goods and services, and can be used as a
measure and store of value.
Social institution money has undergone a process of
historical evolution spread a long period of time. During this
process of historical evolution, a variety of things had been
used as money. Commodities such as hides and skins of
animals, domestic animals such as cattle, sheep and goats and
agricultural products such as and wheat had been used as
money in different stages of economic evolution. In recent
times, metallic coins and paper currency have been used as a
medium of exchange. The new form of money today we are
having is plastic money (debit card, credit card etc) and the
latest form of money available is e-money.
Money

It is defined as a thing that is commonly accepted as a

medium of exchange. It is an intermediate good which
is acceptable to both the parties i.e. buyer and seller.

Definition of Money
(i) Legal definition of money: According to this
definition, money is anything which has the legal power
to act as a medium of exchange and to discharge debt.
(ii) Functional definition of money: According to this
definition, money is anything that is generally accepted
as a means of an exchange and at the same time, acts
as a measure and as a store of value.
Narrow vs Broad Definitions of Money
 Narrow definition of Money (M= C+DD):
It is based on 'medium of payment' function only. Thus, when
money is identified with medium of payment function only and
 its other functions are overlooked, it is said to be narrow
definition of money.
Accordingly, money (M) includes currency (C) and
demand deposits (DD) of banks, i.e., M=C+DD. (This is a
traditional approach to constituents of money supply.)

 Broad definition of Money (M=C+DD+ TD+ SD)

It is the broad definition of money when scope of money is
extended to include 'store of value' function in addition to
medium of exchange function. These have a high degree of
moneyness or liquidity and are widely used as store of value. In
addition to currency and demand deposits (i.e., narrow money),
it also includes time deposits (TD) and savings deposits (SD) at
banks and post offices. Thus, according to broad definition of
money M= C+DD+TD+SD.

Q) Distinguish between Money and Near Money.

MONEY NEAR MONEY

1)Money is anything which is
used as a medium of exchange
2)It has legal sanction of the
government.
3)It possesses 100% liquidity.
4) For instance, money in India
consists of coins and paper notes
1) Near money is a close substitute of money rather
than cash and currency It is as good as money but it is
not real money
2)it has no legal sanction as money. Assets which are
close substitutes of money are near money.
3)Near money cannot directly purchase goods and
services as cash or bank money, but it can be converted
into ready money easily within a short period of time.
4)Examples of near money are Bonds, Equity Shares,
National Saving Certificates, Commercial Bills, etc..
 Forms of Money
(i) Fiat money: The money issued by the legal authority of an economy, such as coins and
currency notes are termed as fiat money.
(ii) Fiduciary money :The form of money which is backed by the trust between the two
parties i.e. payer and payee, is termed as fiduciary money e.g. cheques issued by one party
to another, promissory notes, etc.
(iii) Full bodied money: The money in terms of coins whose commodity value is equal to
the monetary value, is termed as full bodied money.
(iv)Credit money : It refer to that money of which money value is more than commodity
value.

Legal Tender Money

1)Money that has a legal sanction by the government behind it,
is called legal tender or legal tender money.
2) It is the money issued by monetary authority or government
of which cannot be refused by any person in payment for
transactions
3) Everybody is bound to accept it in exchange for goods and
services and in discharge of debts.
4)For example, in India currency (notes) and coins are legal
tender money which cannot be refused in payment of
transactions.

Legal Tender Money

Limited legal tender money
 It is the money which can be accepted
only up to a certain maximum limit fixed
by law. For instance, in India, coins are
limited legal tender because coins of Rs1,
Rs2, Rs5, Rs10 are accepted up to
maximum sum of Rs1000 as per
Unlimited legal tender money
 It is the money for which there
is no limit to the quantity of
money offered in a payment at
a time. For example, in India,
paper notes are unlimited legal
tender
Non Legal Tender Money
1)It refers to that form of money whose acceptance is optional.
2) For example, credit instruments like cheques, drafts, bills of
exchange are in use as money but they have no legal sanction
behind them.
3) It is accepted on the basis of trust that the issuer of money
commands.

Standard Money
Standard money refer to those coins whose
face (printed value) is to its intrinsic value.
Intrinsic value refers to the value of the metal
the coin is made of whereas face value refers to
the value marked on the face of the coin.
Token coins
It refers to money whose face value is much
greater than its intrinsic value. All Indian coins
like those of Rs10, Rs5, Rs2, Rs7 Rs1, etc. are
token coins because their value as money is far
above the value of metal contained in the coin.
Credit Money
Credit money refers to money whose intrinsic value is less than
its face value. Alternatively credit money is the money whose
face value as money is greater than intrinsic value (the
commodity value of the material from which the money is
made). Similarly, deposit money, token coins, currency notes
etc are other examples. Bank money is called credit money.

Fiat money
1)Fiat money is any money backed by the order
(fiat) of the government to act as money.
2)People have to accept it in exchange for
goods and services and in discharge of debt as
the government has ordered it to be money.
3)It is also called legal tender
4)For example coins and currency notes in India
are fiat money.
5) Fiat money is generally created and
circulated at the time of crisis like war or
emergency.
6) Since it is issued without any backing of gold,
silver or other reserves therefore; it is not
convertible into anything than itself.
Fiduciary Money
1)Fiduciary money is the money which is
accepted as money on the basis of trust that
the issuer commands
2)For example, cheques, drafts, bills of
exchange, etc. are fiduciary money.
3)It is also called non- legal tender (or money)
4)it is optional and voluntary.

High powered money

The total liability of the monetary authority of the country (RBI
in India) is called the monetary base or high powered money. It
consists of currency (notes coins in circulation with the public
and vault cash of the commercial banks) and deposits held by
the Government of India and commercial banks with RBI. High
powered money can be expressed with the help of the
following equation:
DD= Ne
H=CU + R
= cdr • DD + rdr •DD
= (cdr + rdr) DD
H = High powered money
cdr = Currency Deposit Ratio
rdr= Reserve Deposit Ratio

FUNCTIONS OF MONEY
Functions of money can be classified into Primary and
Secondary

(A)Primary/Basic functions:-
i) Medium of Exchange: It can be used in making payments for
all transactions of goods and services.
ii) Measure /Unit of value: - It helps in measuring the value of
goods and services. The value is usually called as price. After
knowing the value of goods in single unit (price) exchanges
become easy.
(B)Secondary functions:-
i)Standard of deferred payments: Deferred payments referred
to those payments which are to be made in near future.
Money acts as a standard deferred payment due to the
following reasons:
a) Value of money remains more or less constant compared
to other commodities.
b) Money has the merit of general acceptability.
c) Money is more durable compare to other commodity.

ii) Store of value: Money can be stored and does not lose value
Money acts as a store of value due to the following reasons:
a) It is easy and economical to store.
b) Money has the merit of general acceptability.
c) Value of money remains relatively constant

MONEY HAS OVERCOME THE DRAW BACKS OF

BARTER SYSTEM
1. Medium of Exchange: Money has removed the major difficulty of the
double coincidence of wants.

2. Measure of value: Money has become measuring rod to measure

the value of goods and services and is expressed in terms of price.

3. Store of value: It is very convenient, easy and economical to store

the value and has got general acceptability which was lacking in the
barter system

4. Standard of deferred payments: Money has simplified the borrowing

and lending of operations which were difficult under barter system. It
also encourages capital formation.

Demand for Money:

It is referred to as liquidity preference of an individual, i.e. the choice of
holding the money in liquid form (cash) or to earn interest rate or for
precaution purpose. (People generally holds money for three purposes
(according to keynes)
(i) Transactive purpose
(ii) Speculation purpose (for investment)
(iii) Precautionary purpose (for unforseen circumstances)

Concept of Supply of Money:

 The total stock of money in circulation among the public at a particular point of time is
called money supply.

Indian Monetary System

In India, currency notes and coins are used for monetary transaction. Currency notes are
issued by the Reserve Bank of India (RBI), which is monetary authority in India. However,
coins are issued by the Government of India.

Components of Money Supply

(i) Currency held by public/people
(ii) Demand deposits of banks
(iii) Time deposits of banks
(iv) Savings account deposits
(v) Time and savings deposits with post offices
(vi) Other deposits of the RBI
(vii) National Savings Certificates (NSCs)

BANK
Commercial bank: - A commercial bank is a financial
institution which performs the functions of accepting deposits from the
general public and giving loans for investment with the aim of earning
profit.
Functions of Commercial bank
The two most distinctive features of a commercial bank are borrowing and
lending, i.e., acceptance of deposits and lending of money to projects to earn
interest (profit).

(A)Primary Functions:-

1. Acceptance of Deposits:-

(a) A commercial bank accepts deposits in the form of current, savings

and fixed deposit.

(b)It collects the surplus balances of the individuals, firms and finances
the temporary needs of commercial transactions. The first task is,
therefore, the collection of the savings of the public. The bank does this
by accepting deposits from its customers. Deposits are the lifeline of
banks.

Two traditional forms of deposits are demand deposit and term (or
time) deposit.

 Demand deposits: Deposits which can be withdrawn on demand

by depositors (or by writing cheques) are called demand deposits
 Time deposits: Time deposits, also called fixed deposits or term
deposits, are deposits which have fixed maturity, i.e., which are
payable only after the expiry of the specified period.

2. It Gives Loans and Advances

(a) The second major function of a commercial bank is to give loans and
advances particularly to businessmen and entrepreneurs and thereby
earn interests.
(b)A banks keeps a certain portion of the deposits with itself reserve
and gives (lends) the balance to the borrower as loans and advances in
the form of cash credit, demand loans, short-run loans, overdraft as
explained under.

(B)Secondary Functions:-

3. Discounting Bills of Exchange or Hundies

A bill of exchange represents a promise to pay a fixed amount of money

at a specific point of time in future. It can also be encashed earlier
through discounting process of a commercial bank.

4. Overdraft Facility

An overdraft is an advance given by allowing a customer keeping

current account to overdraw his current account up to an agreed limit.

5. Agency functions of the bank

(a) Transfer of fund

(b) Collection of funds

(c) Purchase and sale of shares and securities on behalf of the

customers

(d) Collection of dividend and interest

(e) Payment of bills and insurance premium on behalf of customers

(f) Acting as executor and trustee of will

(g) Acting as correspondent and representative of customer and
provide letter of credit to the customer

(Q) What do you mean by credit/money creation? Explain the process

of money creation by the commercial banks with the help of a
numerical example.

ANS) Money creation is a process in which a Commercial Bank creates

total deposits many times the initial deposits. The capacity of
Commercial Bank to create depends on two factors :

1. Amount of initial fresh deposit

2. Legal Reserve Ratio LRR

Money Creation = Initial Deposit x Money multiplier.

Working : Suppose (i) Initial Deposit Rs. 1000

(ii) LRR = 20%

As required, the bank keeps 20% i.e., Rs. 200 as cash reserve and lend
the remaining Rs. 800. Those who borrow use the money for making
payments. As assumed those who receive these payments put the
money back into their bank accounts. This creates a fresh deposit of Rs.
800. The bank again keep 20% i.e., Rs. 160 and lend Rs. 640. In this way
the money goes on multiplying leading to total money creation of Rs.
5000.

This way the deposits go on increasing round after round, but each time
80% of last round deposit. At the same time, cash reserves goes on
increasing each time, 80% of the last cash reserve. The deposit creation
comes to an end when total cash reserves become equal to initial
deposits (i.e. Rs 1000 in this case) . The total deposit creation comes to
Rs 5000 that is 5 times by the initial deposit as proven by the following
schedule. Deposits oblique money creation by commercial bank.

CENTRAL BANK
1) The Central Bank is the apex institution of monetary and banking
system of a country.

2) All institutions which deal in money constitute a monetary system.

3) Being an apex institution, it organizes, supervises, regulates and

develops the monetary system of the country.

4) In India, the name of the Central Bank is Reserve Bank India (RBI).

5) In India the Central Bank is known as Reserve Bank of India which

was established in 1935 and Nationalized on 1st January, 1949.

FUNCTIONS OF CENTRAL BANK

The Central Bank performs the, following important functions:

(1) Issue of Currency Authority

 The Central Bank is the sole authority for the issue of currency
in the country. Notes issued by it are circulated as legal tender
money.
 While issuing currency notes, a minimum fixed amount of
gold and foreign currencies is kept by the Central Bank
 The monopoly of issuing notes vested in the Central bank.

The main reasons for granting power of issuing notes to central bank
are:-

a) Uniformity in note circulation

b) Better supervision and control

c) It is easy to control credit

d) Ensures public faith

e) Stabilization of internal and external value of currency

(2)Bankers to the government:-

The Central Bank acts as a banker to the government in various aspects:

 It accepts deposits from the government and gives loans to the

government.
 It maintains the accounts of the government and carries out all its
banking business.
 The Central Bank accepts receipts and makes payment for the
government and carries out exchange, remittance and other
banking operations .
 It provides short-term credit to the government.
 It provides foreign exchange to the government to repay external
debt.
 It manages public debt, i.e., to manage all new issues of
government loans.
 It advises the government on banking and financial.

(3)Banker's bank and supervisor

The Central Bank acts as a banker and supervisor to commercial
banks in various respects
 It provides financial assistance to banks by discounting
their bills and through loans and advances against
approved securities.
 The commercial banks are required to maintain a certain
percentage of liabilities with the Central Bank. The sole
aim of these reserves is to enable the Central Bank to
provide financial assistance in times of financial
emergency.
 It supervises, regulates and controls the activities of
commercial banks.
 It provides the commercial banks with centralized clearing
and remittance facility.
(4)The Central Bank performs the function of "controller of
credit"

 Supply of credit must be controlled so as to ensure the

smooth functioning of the economy.
 For this purpose, Central Bank adopts quantitative and
qualitative methods of credit control.
 Quantitative methods such as bank rate, open market
operations, variable reserve ratio aim at controlling cost
and availability of credit while the qualitative methods
such as margin requirements, direct action, rationing of
 credit and moral suasion influence the use and direction
of credit.

(5) Lender of Last Resort

In times of emergency when commercial banks fail to meet
obligations of their depositors due to liquidity crisis, they
approach Central Bank as a last resort for getting loans. As
lender of last resort, Central Bank guarantees solvency and
provides financial accommodation to commercial banks
 by rediscounting their eligible securities and bills of
exchange and
 by providing loans against their securities.
This saves banks from possible failure and banking system
from a possible breakdown. On the other hand, Central
Bank, by providing temporary financial accommodation,
saves the financial structure of the country from collapse.

(6)Custodian of Foreign Exchange Reserves (Forex)

 The Central Bank also functions as custodian of
country's foreign exchange reserves. Again it is the
responsibility of the Central Bank to stabilize the
external value of national currency.
  Therefore it keeps a certain minimum amount of gold
and foreign currency (like US dollars and British pounds)
against note issue and to meet emergency requirement
of foreign exchange.
 At the same time, in order to minimize fluctuations in
the foreign exchange rates, Central Bank buys or sells
foreign currencies in the market.
(7) Collection and Publication of Data
It has also been entrusted with the task of collection and
compilation of statistical information relating to banking and
other financial sectors of the economy.

(Q)What is money multiplier? How will you determine its

value? What ratio play an important role in the determination
of the value of the money multiplier?
Money multiplier/credit multiplier indicates the maximum
amount of additional money that the commercial banks can
legally create.
• It is determined by the formula:
where LRR is reserve requirement, as a percentage of demand
deposits of the commercial banks.
eg: If reserve requirement = 10% of deposits.

This implies that the commercial banks can create credit 10

times of their additional cash reserves.
Two ratios that play an important role in the determination of
the value of money multiplier are:
• Case Reserve Ratio (CRR)
• Cash Deposit Ratio (CDR)
Higher CRR lower the volume of credit creation and vice versa.
CDR tells us how much of additional cash be released by the RBI
and received by the public is actually deposited in the bank.

TOOLS OF CREDIT CONTROL BY CENTRAL BANK

AS RBI
 Cash Reserve Ratio (CRR): This refers to the proportion of
total deposit of the commercial bank which they must
keep as cash Reserves with Central Bank.
 Statutory Liquidity Ratio (SLR) : This refers to liquid assest
of the commercial banks which they must maintain (on
daily basis) as a minimum percentage of their total
deposits.
 Repo Rate : It is the rate of interest at which the Central
Bank gives short-period loan to the commercial banks. O
Reverse Repo Rate: It is the rate of interest at which the
central bank of a country borrows money from
commercial banks.
 Bank Rate : It is the rate of interest at which the central
Bank gives long-term loan to the commercial banks.
 Open Market Operations : Open market operations refer
to the sale and purchase of securities in the open market
by the central bank. By selling the securities (like, National
Saving Certificates- NSCS), the central bank soaks liquidity
(cash) from the economy. And, by buying the securities,
the central bank releases liquidity.
 Margin Requirement : The margin requirement refers to
the difference between the current value of the security
offered for loan (called collateral) and the value of loan
granted.