Money and Banking

What is money: anything which is generally acceptable as medium of exchange is known as money.
Normally money is a legal tender and it must be limited in quantity to function properly. Briefly, money is
what money does.

Functions of Money

Money is often defined in terms of the three functions or services that it provides. Money serves as a
medium of exchange, as a store of value, and as a unit of account and as Standard of Deferred
Payment.

Money as a Medium of exchange: Money's most important function is as a medium of exchange to

facilitate transactions. Without money, all transactions would have to be conducted by barter, which involves
direct exchange of one good or service for another. The difficulty with a barter system is that in order to
obtain a particular good or service from a supplier, one has to possess a good or service of equal value,
which the supplier also desires.

In other words, in a barter system, exchange can take place only if there is a double coincidence of wants
between two transacting parties. The likelihood of a double coincidence of wants, however, is small and
makes the exchange of goods and services rather difficult. Money effectively eliminates the double
coincidence of wants problem by serving as a medium of exchange that is accepted in all transactions, by all
parties, regardless of whether they desire each others' goods and services.

Money as a Store of value: In order to be a medium of exchange, money must hold its value over time; that
is, it must be a store of value. If money could not be stored for some period of time and still remain valuable
in exchange, it would not solve the double coincidence of wants problem and therefore would not be adopted
as a medium of exchange. As a store of value, money is not unique; many other stores of value exist, such as
land, works of art, and even baseball cards and stamps.

Money may not even be the best store of value because it depreciates with inflation. However, money is
more liquid than most other stores of value because as a medium of exchange, it is readily accepted
everywhere. Furthermore, money is an easily transported store of value that is available in a number of
convenient denominations.

Money as a Unit of account/ money as a measure of value: Money also functions as a unit of account,
providing a common measure of the value of goods and services being exchanged. Knowing the value or
price of a good, in terms of money, enables both the supplier and the purchaser of the good to make
decisions about how much of the good to supply and how much of the good to purchase.

Money as a Standard of Deferred Payment: Another function of money it that it serves as a standard for
deferred payments. Deferred payments mean those payments which are to be made in the future. If a loan is
taken today, it would be paid back after a period of time. The amount of loan is measured in terms of money
and it is paid back in money. A large number of credit transactions involving huge future payments are made
daily. Money performs this function of standard for deferred payments because its value remains more or
less stable.

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Features (Characteristics) of Good Money

General Acceptability: The main quality of good money is its general acceptability. It should be commonly
acceptable for the sale and purchase of goods and services. Anything, which is acceptable in a certain
payment but not generally acceptable, cannot/be regard as good money. If people lose confidence in money
and refuse to accept it in payments, it will not work as money any further. It practically happened in Kuwait
during the gulf war, when people refused to accept Kuwaiti Dinars in payments.

Stability of Value: Good money is that whose value is fairly stable. Frequent changes in the value of money
will inject the element of instability in economy and people lose confidence in it. Moreover, money is a
standard for measuring the values of other goods and services.

Portability: Good money should have the quality of portability. It is possible only if it contains huge value
in small bulk. This quality of money makes best use of money possible. Paper money is considered good
money as it can be shifted easily from one place to another.

Divisibility:  Another quality of good money is that it should be capable of making small purchases. It is
possible only if the money is divisible into small units. When money is divisible into small units, the
consumer will get maximum satisfaction with his limited income by equating the marginal utility of all the
purchased commodities. Paper money possesses this quality. A thousand rupee note can be changed into the
notes of small denominations. It enables a person to make small purchases.

Durability: Good money is that which is durable and long lasting. It should not deteriorate rapidly with the
passage of time. Gold and silver coins are more durable as compared to paper money. A paper can last only
for few months if it remains in circulation and a coin can work as a medium of exchange for many years.

Scarcity: it must be limited in supply so that someone has it and others do not and in this way we can make
the exchange possible.

Inflation and functions of money 

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Commercial banks

A commercial bank is a financial institution that is authorized by law to receive money from businesses and
individuals and lend money to them. Commercial banks are open to the public and serve individuals,
institutions, and businesses. A commercial bank provides services directly to individuals and businesses.

Banks are regulated by federal and state laws and also monitored through the central bank.

Functions of Commercial Banks

Accepting Deposits:

The most important function of commercial banks is to accept deposits from the public. Various sections of
society, according to their needs and economic condition, deposit their savings with the banks.

For example, fixed and low income group people deposit their savings in small amounts from the points of
view of security, income and saving promotion. On the other hand, traders and businessmen deposit their
savings in the banks for the convenience of payment.

Therefore, keeping the needs and interests of various sections of society, banks formulate various deposit
schemes. Generally, there ire three types of deposits which are as follows:

(i) Current Deposits: The depositors of such deposits can withdraw and deposit money whenever they
desire. Since banks have to keep the deposited amount of such accounts in cash always, they carry either no
interest or very low rate of interest. These deposits are called as Demand Deposits because these can be
demanded or withdrawn by the depositors at any time they want.

Such deposit accounts are highly useful for traders and big business firms because they have to make
payments and accept payments many times in a day.

(ii) Fixed Deposits: These are the deposits which are deposited for a definite period of time. This period is
generally not less than one year and, therefore, these are called as long term deposits. These deposits cannot
be withdrawn before the expiry of the stipulated time and, therefore, these are also called as time deposits.

These deposits generally carry a higher rate of interest because banks can use these deposits for a definite
time without having the fear of being withdrawn.

(iii) Saving Deposits: In such deposits, money up to a certain limit can be deposited and withdrawn once or
twice in a week. On such deposits, the rate of interest is very less. As is evident from the name of such
deposits their main objective is to mobilize small savings in the form of deposits. These deposits are
generally done by salaried people and the people who have fixed and less income.

Advancing (giving) Loans:

The second important function of commercial banks is to advance loans to its customers. Banks charge
interest from the borrowers and this is the main source of their income.

Banks advance loans not only on the basis of the deposits of the public rather they also advance loans on the
basis of depositing the money in the accounts of borrowers. In other words, they create loans out of deposits
and deposits out of loans. This is called as credit creation by commercial banks.

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Modern banks give mostly secured loans for productive purposes. In other words, at the time of advancing
loans, they demand proper security or collateral. Generally, the value of security or collateral is equal to the
amount of loan. This is done mainly with a view to recover the loan money by selling the security in the
event of non-refund of the loan.

At limes, banks give loan on the basis of personal security also. Therefore, such loans are called as unsecured
loan. Banks generally give following types of loans and advances:

(i) Cash Credit: In this type of credit scheme, banks advance loans to its customers on the basis of bonds,
inventories and other approved securities. Under this scheme, banks enter into an agreement with its
customers to which money can be withdrawn many times during a year. Under this set up banks open
accounts of their customers and deposit the loan money. With this type of loan, credit is created.

(ii) Demand loans: These are such loans that can be recalled on demand by the banks. The entire loan
amount is paid in lump sum by crediting it to the loan account of the borrower, and thus entire loan becomes
chargeable to interest with immediate effect.

(iii) Short-term loan: These loans may be given as personal loans, loans to finance working capital or as
priority sector advances. These are made against some security and entire loan amount is transferred to the
loan account of the borrower.

(iv) Over-Draft: Banks advance loans to its customer’s upto a certain amount through over-drafts, if there
are no deposits in the current account. For this banks demand a security from the customers and charge very
high rate of interest.

Discounting of Bills of Exchange

This is the most prevalent and important method of advancing loans to the traders for short-term purposes.
Under this system, banks advance loans to the traders and business firms by discounting their bills. In this
way, businessmen get loans on the basis of their bills of exchange before the time of their maturity.

Investment of Funds

The banks invest their surplus funds in three types of securities—Government securities, other approved
securities and other securities. Government securities include both, central and state governments, such as
treasury bills, national savings certificate etc.

Other securities include securities of state associated bodies like electricity boards, housing boards,
debentures of Land Development Banks units of UTI, shares of Regional Rural banks etc.

Agency Functions

Banks function in the form of agents and representatives of their customers. Customers give their consent for
performing such functions. The important functions of these types are as follows:

(i) Banks collect cheques, drafts, bills of exchange and dividends of the shares for their customers.

(ii) Banks make payment for their clients and at times accept the bills of exchange: of their customers for
which payment is made at the fixed time.

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(iii) Banks pay insurance premium of their customers. Besides this, they also deposit loan installments,
income-tax, interest etc. as per directions.

(iv) Banks purchase and sell securities, shares and debentures on behalf of their customers.

(v) Banks arrange to send money from one place to another for the convenience of their customers.

Miscellaneous Functions

Besides the functions mentioned above, banks perform many other functions of general utility which are as
follows:

(i) Banks make arrangement of lockers for the safe custody of valuable assets of their customers such as
gold, silver, legal documents etc.

(ii) Banks give reference for their customers.

(iii) Banks collect necessary and useful statistics relating to trade and industry.

(iv) For facilitating foreign trade, banks undertake to sell and purchase foreign exchange.

(v) Banks advise their clients relating to investment decisions as specialist

Central Bank

It is bank that operates to establish monetary and fiscal policy and to control the money supply and interest
rate. It is normally a nonprofit making state owned bank. State Bank of Pakistan, bank of
England is examples of central banks.

Functions of a Central Bank

Regulator of Currency: The central bank is the bank of issue. It has the monopoly of note issue. Notes
issued by it circulate as legal tender money. It has its issue department which issues notes and coins to
commercial banks. Coins are manufactured in the government mint but they are put into circulation through
the central bank.

The monopoly of issuing notes vested in the central bank ensures uniformity in the notes issued which helps
in facilitating exchange and trade within the country. It brings stability in the monetary system and creates
confidence among the public. The central bank can restrict or expand the supply of cash according to the
requirements of the economy. Thus it provides elasticity to the monetary system. By having a monopoly of
note issue, the central bank also controls the banking system by being the ultimate source of cash. Last but
not the least, by entrusting the monopoly of note issue to the central bank, the government is able to earn
profits from printing notes whose cost is very low as compared with their face value.

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2. Banker, Fiscal Agent and Adviser to the Government: Central banks everywhere act as bankers, fiscal
agents and advisers to their respective governments. As banker to the government, the central bank keeps the
deposits of the central and state governments and makes payments on behalf of governments. But it does not
pay interest on governments deposits. It buys and sells foreign currencies on behalf of the government.

3. Custodian of Cash Reserves of Commercial Banks: Commercial banks are required by law to keep
reserves equal to a certain percentage of both time and demand deposits liabilities with the central banks. It is
on the basis of these reserves that the central bank transfers funds from one bank to another to facilitate the
clearing of cheques.

4. Custody and Management of Foreign Exchange Reserves: The central bank keeps and manages the
foreign exchange reserves of the country. It is an official reservoir of gold and foreign currencies. It sells
gold at fixed prices to the monetary authorities of other countries. It also buys and sells foreign currencies at
international prices. Further, it fixes the exchange rates of the domestic currency in terms of foreign
currencies.

5. Lender of the Last Resort: The central bank lends to such institutions in order to help them in times of
stress so as to save the financial structure of the country from collapse. It acts as lender of the last resort
through discount house on the basis of treasury bills, government securities and bonds at “the front door”. By
granting accommodation in the form of re-discounts and collateral advances to commercial banks, bill
brokers and dealers, or other financial institutions, the central bank acts as the lender of the last resort.

6. Clearing House for Transfer and Settlement: As bankers’ bank, the central bank acts as a clearing
house for transfer and settlement of mutual claims of commercial banks. Since the central bank holds
reserves of commercial banks, it transfers funds from one bank to other banks to facilitate clearing of
cheques. This is done by making transfer entries in their accounts on the principle of book-keeping. To
transfer and settle claims of one bank upon others, the central bank operates a separate department in big
cities and trade centres. This department is known as the “clearing house” and it renders the service free to
commercial banks.

7. Controller of Credit: The most important function of the central bank is to control the credit creation
power of commercial bank in order to control inflationary and deflationary pressures within this economy.
For this purpose, it adopts quantitative methods and qualitative methods. Quantitative methods aim at
controlling the cost and quantity of credit by adopting bank rate policy, open market operations, and by
variations in reserve ratios of commercial banks.

Accordingly, the central banks possess some additional powers of supervision and control over the
commercial banks. They are the issuing of licences; the regulation of branch expansion; to see that every
bank maintains the minimum paid up capital and reserves as provided by law; inspecting or auditing the
accounts of banks; to approve the appointment of chairmen and directors of such banks in accordance with
the rules and qualifications; to control and recommend merger of weak banks in order to avoid their failures
and to protect the interest of depositors; to recommend nationalisation of certain banks to the government in
public interest; to publish periodical reports relating to different aspects of monetary and economic policies
for the benefit of banks and the public; and to engage in research and train banking personnel etc..

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 An insight to Economics
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