MONEY AND BANKING CHAPTER 3

MONEY-EVOLUTION
Barter system
Commodity money
Metallic money
Paper money
Bank money
Plastic money
E-money
BARTER SYSTEM
Commodities were exchanged for commodities-
c-c economy
Economic exchange of goods without the use of
money is known as barter system.
It’s a c-c economy or a commodity to commodity
exchange system.
DRAWBACKS OF THE BARTER SYSTEM AND THEIR
ELIMINATION
1. Double coincidence of wants
2. Lack of common unit or measure of value.
3. Lack of standard of future/deferred
payments(contractual payments)
4. difficulty in storing wealth or savings
5. Lack of divisibility
 MONEY-DEFINITION
Any thing which is commonly accepted as a medium of exchange is called
money.
‘money is what money does’. (Walker)
Though initially invented as a medium of exchange, gradually money found
its other uses as well:
Money is used as a store of value. Or, money is used as an instrument of
saving.
Money is used as a measure of value. Value of goods and services is
expressed in terms of money.
Money is used as a standard for deferred payments (deferred payments are
those payments which are made sometimes in the future).
Money is a matter of four functions-a medium, a measure, a standard and a
FORMS OF MONEY
1. Fiat money and fiduciary money
2. Full bodied money and credit money
 FIAT MONEY AND FIDUCIARY MONEY
Fiat money refers to that money which is issued by
order/authority of the government. It includes all notes and
coins which the people in a country are legally bound to
accept as a medium of exchange.
Fiduciary money is that money which is accepted as a
medium of exchange because of the trust between the
payer and the payee. Example: Cheques are fiduciary
money as these are accepted as a means of payment on
the basis of trust, not on the bases of any order of the
government.
FULL BODIED MONEY AND CREDIT MONEY
Full bodied money - Any unit of money, whose face value
and intrinsic value are equal, is known as, i.e. Money Value
= Commodity Value. For example, during the British period,
one rupee coin was made of silver and its value as money
was same as its value as a commodity.
Credit money refers to the money whose intrinsic value (as a
commodity) is much lower than its face value, i.e. Money
Value > Commodity Value. For example, face value of Rs.
100 note is Rs. 100, but we would get a much lower value
if we sell the note as a piece of paper. Credit cards, bank
deposits are other examples of credit money.
 SUPPLY OF MONEY
Supply of money refers to total stock of money (of all types) held by
the people of a country at a point of time.
Supply of money is stock concept.
Stock and flow variables
A stock variable is a quantity that is measured at a specific point in
time.
Eg. ………….
A flow variable is a quantity that is measured over a period of time.
It represents the rate at which something is changing or moving.
Eg. ………………………
Read the following statements carefully
Statement 1: Stock variables are measured at a point
of time.
Statement 2: Flow variables and stock variables are
same.
In light of the given statements, choose the correct
alternative from the following:
(a) Statement 1 is true and Statement 2 is false.
(b) Statement 1 is false and Statement 2 is true.
(c) Both Statements 1 and 2 are true.
(d) Both Statements 1 and 2 are false
Identify, flow variable from the following:(Choose
the correct alternative).
(a) Distance between Delhi and Amritsar
(b)Annual expenditure of a school
(c)Bank balance of Mr. Mukesh as on 31st March,
2022.
(d) Investments of Mr. Mohit as on 31St December,
202.
WHO ALL ARE THE SUPPLIERS OF MONEY IN A
COUNTRY?
1. the central bank (RBI)
2. the government
3. the banking system of a country(Commercial
banks)
The stock of money held by the suppliers of money is
never treated as a part of the supply of money in the
country.
In India, RBI issues currency on the basis of Minimum Reserve System.
In order to issue currency, the RBI is required to hold a certain amount of
reserves.
As of March 2021, the RBI's minimum reserves for issuing currency in India
are specified in the Reserve Bank of India Act, 1934. According to this
act, the RBI is required to maintain gold reserves and foreign currency
assets of not less than Rs. 200 crore (i.e., 2 billion rupees) of which gold
reserves should be a minimum of Rs. 115 crore.
In addition to gold and foreign currency reserves, the RBI also holds
domestic currency assets, including government securities and loans to
banks. These assets are used to ensure that the RBI has sufficient liquidity to
meet the currency demand in the economy.
It's important to note that the minimum reserve requirements for the RBI are
subject to change, depending on various economic factors and policy
decisions.
Ministry of Finance issues one rupee notes and all the coins in
India
Commercial banks are the second significant source of money
supply. Unlike the central bank, commercial banks do not have
the authority of issuing currency (notes and coins). Yet, they are
the suppliers of money as they create money by way of
demand deposits. These deposits serve as supply of money
because these are chequeable deposits. People can withdraw
or transfer money by writing cheques. Money created by the
commercial banks by way of demand deposits is called Bank
money

Supply of money refers to the stock of money held by those

who demand money not by those who supply money.
MEASUREMENT OF MONEY SUPPLY
In India, there are four alternative measures of money supply, popularly known as
M1, M2, M3 and M4.

M1 measurement

M1=C+DD+OD
C: Currency held by public. Coins and currencies

DD: Demand Deposits

It includes savings account and current account deposits of people with
commercial banks.
These are chequeable deposits which can be withdrawn or transferred on
demand.
OD: other deposits
i. Demand deposits with RBI of public financial institutions like NABARD
(National Bank for Agricultural and Rural Development).
ii. Demand deposits with RBI of foreign central banks and of the foreign
governments.
iii. Demand deposits of international financial institutions like IMF and World
Bank.
OD does not include:
i. Deposits of the government of the country with RBI, and
ii. A deposit of the country’s banking system with RBI.

Gross Demand Deposits include inter-banking claims: claims

of one bank against the other. Net Demand Deposits do not
include inter-banking claims. Inter-banking claims are not a
part of demand deposits of the people. Only net demand
deposits are taken as a part of money supply.
TERM DEPOSITS AND DEMAND DEPOSITS
Term deposits are always for Demand deposits are not for
a specific period of time, like any specific period of money.
fixed deposits for a period of
Money in demand deposits
one year or two years.
can be withdrawn as and when
In term deposits, depositors needed.
cannot withdraw money as and Demand deposits are
when needed. chequeable deposits
Term deposits are not
chequeable deposits.
M2 MEASUREMENT
M2 = M1 + Deposits with post office saving bank
account
Besides all the components of M1, it also includes
savings of the people with the post offices.
M3 MEASUREMENT
M3 = M1 + Net time deposits with commercial bank
Besides all the components of M1, it also includes (net)
time deposits (or fixed deposits/term deposits) of the
people with the commercial banks.
M4 MEASUREMENT
M4 = M3 + Total deposits with post offices (other than
in the form of national saving certificate)
M4 concept of money supply is till broader even than
M3
Besides all the components of M3, it also includes total
deposits with the post offices (other than in the form of
National Saving Certificate).
 M1=C+DD+OD
M2 = M1 + Deposits with post office
saving bank account
M3 = M1 + Net time deposits with
commercial bank
M4 = M3 + Total deposits with post
offices (other than in the form of
national saving certificate)
NARROW AND BROAD MONEY
If M1 or M2 measures are used, then it is known as ‘narrow
money’ concept of money supply.
If M3 or M4 measures are used, then it is known as ‘broad
money’ concept of money supply

If money supply in the country is measured using M3 measure,

it is called ‘aggregate monetary resources’ of the country
QUESTIONS

1. Differentiate between high powered

money and bank money.
2. What are the contingent functions of
money?
3. What are the motives of money?
CALCULATE M1, M2, M3 AND M4.
Currency with the public-84,000
Demand deposits with banks-68,000
Other deposits with RBI-3612
Total deposits with post office-22500
Time deposits with banks-200555
Post office saving bank deposits-5528
 COMMERCIAL BANKS
Commercial banks are financial institutions which accepts
deposits from the general public and extends loans for
investment with the aim of earning profit.
The interest paid by the commercial banks to depositors is
lower than the rate charged from the borrowers. The
difference between these two interest rates is called the
‘spread’ and is the profit appropriated by the bank.
Two distinctive functions of commercial banks are borrowing
and lending, or in other words accepting deposits and
giving loans
 CREDIT CREATION/ DEPOSIT CREATION/ MONEY
CREATION BY COMMERCIAL BANKS
Commercial banks receive deposits from the public.
It cannot use the total deposits for giving loans.
It is legally compulsory for the banks to keep a certain minimum fraction
of net demand and time deposits as legal reserves. This fraction is
called Legal Reserve Ratio ( LRR).
LRR has two components – 1) Cash Reserve Ratio (CRR)
2) Statutory Liquidity Ratio(SLR)
 CREDIT CREATION
Credit creation is a process by which a commercial bank
creates total deposits which is number of times the initial
deposit.
Credit Multiplier(k) = 1
Cash Reserve Ratio (CRR)
Total credit creation = Initial deposit x 1
CRR
Credit creation is based on the following
assumptions
1) There is a single banking system in the
economy.
2) All transactions are routed through banks.
3) A depositor does not normally withdraw his
entire deposit at one time.
INITIAL DEPOSIT = RS.1000 & CRR = 20%
Rounds Deposits (Rs.) Loans (Rs.) Reserve (Rs.)
I 1000 800 200
II 800 640 160
III 640 512 128
IV ‘’ ‘’ ‘’
‘’ ‘’ ‘’
‘’ ‘’ ‘’
‘’ ‘’ ‘’
TOTAL 5000 4000 1000
Suppose a customer deposits Rs.1,000 in a bank and the
legal reserve ratio is 20% as proposed by RBI. The bank
will retain Rs.200 to meet customer obligation and
remaining Rs. 800 is lent to others. Those who borrow ,
will spend and the amount will come back to the bank as
deposits. Now bank retains 20% of Rs. 800,ie, Rs. 160
and the remaining Rs. 640 is available for lending. This
process continues till there is no further amount available
for lending. Money multiplier is 5 and when the initial
deposit is Rs. 1000, the total deposits in the banking
system will be Rs.5,000. This is how commercial banks
are able to create credit multiple times the initial
deposit.
 PRIMARY AND SECONDARY DEPOSTS
Banks receive cash Money is lent by the commercial
banks not in the form of cash, but in
deposits from the people. the form of credit entry in the
These are called ‘primary accounts of the borrowers. These
deposits’. credit entries are known as
Primary deposits shows secondary deposits (Derivative
savings of the people deposits)
Secondary deposits shows
borrowings of the of the depositors
from the banks.
TOTAL DEMAND DEPOSITS
=PRIMARY DEPOSITS OF COMMERCIAL BANKS
+ SECONDARY DEPOSITS OF COMMERCIAL BANKS
 CENTRAL BANK
Central bank is an apex body that controls,
operate regulates and directs the entire
banking and monetary structure of the
country. RBI is the central bank of India. RBI
was established in April 1, 1935 under
Reserve Bank of India Act passes in 1934. It
is the sole agency of note issuing and controls
the supply of money in the economy. It serves
as a banker to the government and manages
forex (foreign exchange) reserves of the
country.
FUNCTIONS OF CENTRAL BANK
1. Bank of issuing notes
Central bank has exclusive right of issuing
notes. This is called currency authority function
of the central bank. The notes issued by the
central bank are an unlimited legal tender
2. Banker to the government
Central bank is a banker, agent, and financial
advisor to the government.
As a banker to the government, it manages
accounts of the government.
As an agent to the government, it buys and
sells securities on behalf of the government.
As an advisor to the government, it frames
policies to regulate the money market.
3. Banker’s bank and supervisory role
As a banker’s bank, it has almost the same relation with other banks
in the country as a commercial bank has with its customers. Three
observations need to be noted in this context:
The central bank accepts deposits from the commercial banks, and
offers them loan.
The central bank provides ‘clearing house’ facility to the commercial
banks. It is a cheques clearing facility provided at one centre to all
the banks.
In its supervisory role, the central bank ensures that the commercial
banks show compliance to its directives, particularly relating to CRR
and SLR. The central bank changes CRR, SLR as and when required. It
ensures that the commercial banks show compliance to these changes
so that the desired targets are achieved.
4. Lender of the last resort
It means that if commercial banks fail to get
financial accommodation from anywhere, it
approaches the central bank as a last resort.
Central bank advances loan to such a bank against
approved securities. By offering loans to the
commercial banks in situations of emergency, the
central bank ensures:
(i) that the banking system of the country does not
suffer any set-back.
(ii) that money market remain stable.
 5. Custodian of foreign exchange
Central bank is the custodian of nation’s
foreign exchange reserves. It also exercises
‘managed floating’ to ensure stability of
exchange rate in the international money
market. Managed floating refers to the sale
and purchase of foreign exchange with a
view to achieving stability of exchange rate
for the domestic currency.
6. Clearing house functions
As central bank holds the cash reserves of all
the commercial banks, it becomes easier and
more convenient for it to act as their clearing
house. All commercial banks have their accounts
with the central bank. Therefore, the central
bank can easily settle claims of various
commercial banks against each other, by
making debit and credit entries in their
accounts.
7. Control of credit
The principal function of the central bank is to
control the supply of credit in the economy. It implies
increase or decrease in the supply of money in the
economy by regulating the creation of credit by the
commercial banks. The central bank needs to control
the supply of money to cope with the situations of
inflation and deflation. During inflation, the supply
of money is reduced and during deflation, it is
increased.
 CONTROL OF MONEY SUPPLY OR CREDIT SUPPLY BY
THE CENTRAL BANK (RBI IN INDIA)- MONETARY POLICY
The central bank adopts various measures to control
the supply of money in the economy. Largely, these
measures relate to credit supply by the commercial
banks. These are broadly classified as:
a) Quantitative instruments.
b) Qualitative instruments.
QUANTITATIVE INSTRUMENTS OF CREDIT CONTROL

Quantitative instruments are those instruments

of credit control which focus on the overall
supply of money in the economy. Supply of
money is lowered to tackle inflation, and it is
raised to tackle deflation.
QUANTITATIVE INSTRUMENTS
1.Bank Rate
2.Open market Operations
3.Repo Rate
4.Reverse Repo Rate
5. Cash Reserve Ratio
6.Statutory Liquidity Ratio
QUALITATIVE INSTRUMENTS

1.Margin requirement
2.Rationing of credit
3.Moral Suasion
 BANK RATE
Bank rate refers to the rate at which the RBI lends money to the commercial
banks. It refers to immediate loan requirement of the commercial banks.
The increase or decrease in bank rate is often followed by increase or
decrease in the market rate of interest (the interest rate charged by the
commercial banks from the general public). Accordingly, the cost of credit
changes in the market. When bank rate is increased, market rate of
interest is also increased. Then the cost of capital increases. This lowers the
demand for credit and therefore, the supply of money tends to fall.
Accordingly, inflation is corrected. On the other hand, when bank rate is
decreased, market rate of interest is also decreased. The cost of capital
decreases. This increases demand for credit and therefore, supply of
money tends to rise. Accordingly, deflation is corrected.
 OPEN MARKET OPERATIONS
Open market operations refer to the sale and purchase of securities
in the open market by the RBI on behalf of the government. By selling
the securities (like, National Saving Certificates) in the open market,
the RBI soaks liquidity (cash) from the economy. And, by buying the
securities, the RBI releases liquidity. While liquidity is soaked (as
during inflation), cash reserves of the commercial banks are
squeezed, implying a cut in their credit creation capacity. On the
other hand, when liquidity is released (as during recession/deflation),
cash reserves of the banks tend to rise, implying a rise in credit
creation capacity of the commercial banks. Thus, inflation is corrected
by selling the securities and soaking liquidity, while deflation is
corrected by buying the securities and releasing liquidity.
 REPO RATE
Repo rate is the rate at which the central bank of a country
lends money to commercial banks to meet their short-term needs.
The central bank advances loans against approved securities or
eligible bills of exchange. During inflation, an increase in repo
rate increases the cost of borrowings from the central bank. It
forces the commercial banks to increase their lending rate, which
discourages borrowers from taking loans. It reduces the ability
of commercial banks to create credit. A decrease in the repo
rate will have the opposite effect (Deflation)
 RESERVE REPO RATE
Reverse Repo Rate is a mechanism to absorb the liquidity in
the market, thus restricting the borrowing power of investors.
Reverse Repo Rate is when the RBI borrows money from banks
when there is excess liquidity in the market. The banks benefit
out of it by receiving interest for their holdings with the central
bank. During high levels of inflation in the economy, the RBI
increases the reverse repo. It encourages the banks to park
more funds with the RBI to earn higher returns on excess funds.
Banks are left with lesser funds to extend loans and
borrowings to consumers.
 CASH RESERVE RATIO (CRR)
It refers to the minimum percentage of bank’s total
deposits required to be kept with the RBI. A change
in CRR affects the ability of commercial banks to
create the credit. For example, an increase in CRR
reduces the excess reserves of commercial banks
and limits their credit creating power and vice
versa
 STATUTORY LIQUIDITY RATIO (SLR)
Every bank is required to maintain a fixed percentage of its
assets in the form of liquid assets, called SLR. The liquid assets
include: (i) cash, (ii) gold, and (iii) unencumbered approved
securities. The rate of SLR is fixed by the RBI and is varied from
time to time. To decrease the supply of money (as during
inflation), the central bank increases the SLR. Accordingly, funds
available for CRR deposits (for the creation of credit) are
reduced. Conversely, SLR is reduced to increase the supply of
money (as during deflation) in the economy. Accordingly, funds
available for CRR deposits (for the creation of credit) are
increased
QUALITATIVE INSTRUMENT OF CREDIT CONTROL

Qualitative instruments are those instruments

of credit control which focus on select sectors
of the economy. These instruments are used to
increase or decrease the supply of money to
select sectors of the economy.
 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. If
margin fixed by the central bank is 40%, then
commercial banks are allowed to give a loan only up to
60% of the value of security. An increase in margin
(inflation) reduces the borrowing capacity and money
supply. A fall in margin (deflation) encourages the
people to borrow more.
 RATIONING OF CREDIT
Rationing of credit refers to fixation of credit quotas for
different business activities. Rationing of credit is
introduced when the supply of credit is to be checked
particularly for speculative activities in the economy. RBI
fixes credit quota for different business activities. The
commercial banks cannot exceed the quota limits while
granting loans. This restricts the supply of money in the
economy, and inflation is controlled. One the other hand,
rationing of credit is withdrawn to increase the supply of
money. This controls deflation.
 MORAL SUASION

It is like rendering an advice to the

commercial banks by the RBI to follow its
directives. The banks are advised to
restrict loans during inflation, and be
liberal in lending during deflation.