MONEY AND BANKING

Contents of the unit

Money - meaning and supply of money - Currency held by the public and net demand deposits held
by commercial banks. Money creation by the commercial banking system. Central bank and its
functions (example of the Reserve Bank of India): Bank of issue, Govt. Bank, Banker's Bank, Control
of Credit through Bank Rate, CRR, SLR, Repo Rate and Reverse Repo Rate, Open Market Operations,
Margin requirement

MEANING OF MONEY
Money may be defined as anything which is generally acceptable as a medium of exchange
and also acts as common measures of value, store of value and standard of deferred payment

MONEY IS THAT WHICH MONEY DOES.

Anything which is generally acceptable by the people in exchange of goods and services or in
repayment of debts is called money.

BARTER SYSTEM: MEANING AND ITS DRAWBACKS

Direct exchange of goods against goods without the use of money is called Barter exchange.
An economy based on barter exchange is called CC economy. Commodity for commodity
exchange economy.

Drawbacks of barter system

➢ Lack of double coincidence of wants: The simultaneous fulfillment of mutual wants by

buyers and sellers is known as double coincidence of wants.
➢ Lack of common measure of value
➢ Lack of standard for deferred payment:
➢ Lack of divisibility
➢ Lack of store of value

In order to overcome the disadvantage of barter system money was invented by the society.

Forms of money:

Legal definition of money: Legally money is anything proclaimed by law as a medium of

exchange

Functional definition of money: 1) Functional definition of money will include all things that
perform the 4functions of money i.e.
a) a unit of value
b) a medium of exchange
c) a standard of deferred payments
d) a store of value

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According to the definition money includes both notes and coins(currency)and chequable
deposits

Paper notes and coins is money as a matter of law. Nobody can refuse its acceptance as
medium of exchange. In other words, it is legal tender. It means people have to accept it
legally for different payments currency being legal tender is also called flat money

Fiat money
Fiat money Fiduciary money

1) It refers to money by order/ authority 1) It refers to money backed up by trust

of the government
2) It includes notes and coins
(currency)currency being legal tender is
called flat money because it serves as
money on the fiat (order) of the
government
between the payer and the payee
2) For example, cheques are fiduciary
money as these are accepted as means of
payment on the basis of trust NOT on the
basis of any order by the government

Narrow definition of money Broad definition of money

It is based upon its medium payments 1) Besides the money category it also
function includes some other things that have a high
degree of ‘moneyness and are widely used
as a store of value

2) It includes only currency (notes and
coins) and demand deposits. Functional
definition of money is narrow definition. In
other words, in its narrow definition,
money includes only those things which
function as money in terms ofa)
Medium of exchange
b) Unit of value
c) Standard of deferred payments
d) Store of value
2) Besides currency and demand deposits it
also includes- time deposits, savings
deposits at banks and post offices. These
financial assets have high degree of
‘moneyness’ or ‘liquidity’ but are not
generally acceptable in payment. These
deposits can be converted into demand
deposits or chequable deposits on a short
notice and are ‘near money’ assets. Thus
‘money assets’ and ‘near money assets’
make up the broad definition of money.

The primary functions of money are medium of exchange and measure of value. Standard of
deferred payment and store of value are secondary functions of money.

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 SUPPLY OF MONEY
MEANING OF MONEY SUPPLY
It refers to the total stock of money held by public at a particular point of time in an economy.

(Public means private individuals and business firms.) It excludes the government, the central
bank and the commercial bank

The money supply of the economy at any point of time is the total amount of money in
circulation.

There are 2 main components of money supply:

➢ Currency component: It consists of coins and currency (or paper) notes

➢ Deposit component: It consists of the bank deposits against which cheques are issued

Items Excluded from money supply

It does not include the money creating sector (Government and banking system) as cash
balances held by them do not come into actual circulation in the country.

The government and the banking system of a country are the suppliers or producers of
money. Hence money held by them is not a part of the stock of money held by the people.

Supply of money includes only that stock of money which is held by the people or those who
demand money.

COMPONENTS OF MONEY SUPPLY

➢ Currency: it consists of coins and paper currency

Coins: Coins are made of metal. The metallic coins are issued by the monetary authority
of the country, the central bank with the central government of the country

Paper currency: These are the most important part of money supply. The central bank in
every country has monopoly right of issuing currency notes.

➢ Deposit component: Demand deposits are also the most important component of money
supply. These are the money deposits made by the depositor or owner of the deposit to
the bank.

M 1 = Currency held by the public + Demand deposits + other deposits with the Reserve
Bank of India.

Currency held by the public has the merit of general acceptability for making transactions.
It is one of the most important constituent of money supply.

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➢ Demand Deposits held by public with the commercial banks are considered money
because they are readily accepted as means of payment. Both currency and demand
deposits are the most liquid assets that form money supply defined in the narrow sense.

➢ Other deposits with the Reserve Bank of India: These include demand deposits of
public financial institutions, foreign central banks, foreign governments, international
financial organization like World Bank. However, it does not include deposits of the
Indian Government and commercial bank with RBI

➢ M2 = M1 + saving deposits with the post office savings bank

➢ It is a broader concept of supply of money compared to M1. It also includes savings of
the people with the post offices.
➢ As post office savings deposits are not withdrawals by cheque they could not be placed
in the same category as bank savings deposits.

M 3 MEASUREMENT:
It is also a broader concept of money as compared to M1. Besides all the components of M1
it includes net time deposits (or fixed deposits/term deposits) of the people with the
commercial banks.

M 3 = M1 + Net Time Deposits with the Commercial Banks

M 4 MEASUREMENT:
It is a still broader concept of money than M 3. Besides all the components of M 3 it also
includes the total deposits with the post offices (other than in the form of National Saving
Certificate)

M 4 = M 3 + Total Deposits with the Post Offices (other than in the form of National Saving
Certificate

Flow chart summarizing the components of money supply

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MONEY CREATION
➢ The basic measure of money supply has two components.
Currency with public and demand deposits in commercial banks. The currency created by
the RBI is called High powered money and demand deposits created by the commercial
bank is called the bank money

Money is anything usable for undertaking transactions i.e. receipts and payments. The
stock of such money in an economy is called money supply

➢ Money creation is also called deposit creation or credit creation.

Commercial banks receive deposits from the public. The depositors are free to withdraw,
in part or in full, their deposit amounts by writing cheques. The banks use the money in
these deposits to give loans. These functions of the commercial banking system are the
basis of deposit creation. How much are the deposits created is determined by the
amount of initial deposits by the public and the Legal Reserve Ratio. The quantitative
outcome is called money multiplier. Let us explain the process of money creation and
the measure of money multiplier. Note that money creation is also called ‘deposit
creation’ or ‘credit creation’.

The Process of Money Creation

Let us assume that the entire commercial banking system is one unit. Let us call this one unit
simply ‘’banks’. Let us also assume that all receipts and payments in the economy are routed
through the banks. One who makes payment does it by writing cheque. The one who receives
payment deposits the same in his deposit account.

Suppose initially people deposit Rs. 100. The banks use this money for giving loans. But the
banks cannot use the whole of deposit for this purpose. It is legally compulsory for the banks
to keep a certain minimum fraction of these deposits as cash. The fraction is called the Legal
Reserve Ratio (LRR). The LRR is fixed by the central bank. It with the central bank, and this
part ratio is called the Cash Reserve Ratio. The other part is kept by the banks themselves and
is called the Statutory Liquidity Ratio.

Why are the banks required to keep only a fraction of deposits as cash reserves? What will
banks do if the demand for cash withdrawn is more than cash reserves at some point of time?
There are two reasons.

➢ First the banking experience has revealed that not all depositors approach the banks for
withdrawal of money at the same time, and also that normally they withdraw a fraction
of deposits.

➢ Secondly, there is a constant flow of new deposits for withdrawal of cash, it is sufficient
for banks to keep only a fraction of deposits as cash reserve.

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 Let us now explain the process. Suppose the initial deposits in banks is Rs. 100 and the
LRR is 20 percent. Further suppose that banks keep only the minimum required i.e. Rs. 20
as cash reserve, no more no less – Banks are now free to lend the remainder Rs. 80.
Suppose they lend Rs. 80. What banks do is to open deposit accounts in the names of the
borrowers who are free to withdraw the amount whenever they like. Suppose they
withdraw the whole of amount for making payments.

Now, since all the transactions are routed through the banks, the money spent by the
borrowers comes back into the banks into the deposit accounts of those who have
received this payment. This increase demand deposits in banks by Rs. 80. It is 80 percent
of the initial deposit. These deposits of Rs. 80 have resulted on account of loans given by
the banks. In this sense the banks are responsible for money creation. With this round
increase in total deposits is now Rs. 180 (=100+80).

When banks receive new deposit of Rs. 80, they keep 20 percent of it as cash reserves and
use the remaining Rs. 64 for giving loans. The borrowers use these loans for making
payments. The money comes back into the accounts of those who have received the
payments. Bank deposits again rise, but by a smaller amount of Rs. 64. It is 80 percent of
the last deposit creation. The Total deposits now increase to Rs. 244 (=100+80+64). The
process does not end here.

The deposit creation continues in the above manner. The deposits go on increasing round
after round but each time only 80 percent of the last round deposits. At the same time
cash reserves go on increasing, each time 80 percent of the last cash reserve. The deposit
creation comes to end when total cash reserves become equal to the initial deposit. The
total deposit creation comes to Rs. 500, five times the initial deposit as shown in the table
below

Deposits Loans Cash Reserves

(Rs) (Rs) LRR =0.2
Initial 100 80 20
Round 1 80 64 16
Round 2 64 51.2 12.80
- - - -
- - - -
Total 500 400 100

Money Multiplier

How many times the total deposits would be of the initial deposit is determined by the LRR.
The multiple called the money or deposit multiplier, is:
Money multiplier =
1 /LRR In our above illustration the LRR is 0.2 therefore,
Money multiplier =
1/ 0.2 = 5
The total money creation is thus:
Money creation = initial deposit x 1/ LRR = 100 x 1/0.2 = 500

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Note that lower the LRR, higher the money multiplier and more the money creation. If the
LRR = 0.1, the money multiplier is 10(=1/0.1). If the LRR is 0.4, the money multiplier is
2.5(1/0.4)

BANKING
FUNCTIONS OF THE CENTRAL BANK

1. BANKER TO THE GOVERNMENT

The Central Bank acts as a banker to the government - both Central as well as State
governments.

As a banker to the government it performs the following functions:

a) It receives deposits from the government and collects cheques and drafts
deposited in the government account
b) It provides cash to the government as required for payments of salaries and wages
to their staff and other cash disbursements
c) It makes payment on behalf of the government to meet the budget deficit
d) It advances loans to the government
e) It supplies foreign exchange to the government for repaying external debt or
making other payments.
f) It advises the government on banking and financial matters

As a fiscal agent

a) It manages public debt

b) It collects taxes and other payments on behalf of the government
c) It represents the government in the international financial institutions like the
World Bank international monetary fund etc.
d) The government borrows money by selling treasury bills to the Central Bank. The
government carries on short term borrowings by selling ad-hoc treasury bills to
the Central Bank.

As adviser

a) The central bank also acts as a financial adviser to the government.it gives advice
to the government on all financial and economic matters such as deficit financing,
devaluation of currency, trade policy, foreign exchange policy etc.

2. CURRENCY AUTHORITY /BANK OF ISSUE

The Central Bank is the sole authority for the issue of currency in the country. It
promotes efficiency in the financial system.

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 ➢ Firstly, because this leads to uniformity in the issue of currency.

➢ Secondly, because it gives Central Bank direct control over money supply

➢ The central bank is the sole authority for the issue of currency in the country. All
currency issued by central bank is its monetary liability. This means that the central
bank is obliged to back the currency with assets of equal value. These assets usually
consist of gold coins, foreign securities and domestic governments local currency
securities.

➢ The country’s central government is usually authorized to borrow money from the
central bank. The government does this by selling local currency securities to the
central bank. When the central bank acquires these securities, it issues currency.
This authority of the government gives it flexibility to monetize its debt. Monetizing
the government debt (public debt) is the process of converting its debt (whether
existing or new) which is a non- monetary liability, into Central bank currency which
is monetary liability

3. BANKERS BANK AND SUPERVISOR

As the banker to banks, the Central Bank holds a part of the cash reserves of banks,
lends them short-term funds and provides them with centralized clearing and
remittance facilities

➢ The banks are required to deposit a stipulated ratio of their net total liabilities (the
CRR) with the Central Bank.

➢ The purpose of this stipulation is to use these reserves as an instrument of

monetary and credit control.

➢ In addition to this the bank holds excess reserves with the Central Bank to meet any
unexpected crisis arising in the commercial banks. The pool of funds with the
Central Bank serves as a source from which it can make advances to banks
temporarily in need of funds, acting in its capacity as lender of last resort.

➢ The Central Bank supervises, regulates and controls the commercial banks. The
Central Bank supervises, regulates and controls the commercial banks.

➢ The regulation of banks may be related to their licensing, branch expansion, liquidity
of assets, management, amalgamation (merging of banks) and liquidation (the
winding up of banks). The control is exercised by periodic inspection of banks and
the returns filed by them

4. LENDER OF THE LAST RESORT

➢ It means that if a commercial bank fails to get financial accommodation from

anywhere, it approaches the central bank as a resort.

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 ➢ Central bank helps these banks through discounting of approved securities and bills
of exchange.
➢ The central bank ensures:
o that banking system of the country does not suffer any set back; and
o that money market remains stable.

5. CUSTODIAN OF FOREIGN EXCHANGE:

It is the custodian of nation foreign exchange reserve.

a) The central bank maintains foreign exchange reserve in order to promote

international trade and stabilize exchange rate.
b) It is a source of great strength to the banking system of the country.
c) The centralized cash reserves can be used most effectively during periods of
seasonal strains and in financial crisis or emergencies.
d) The central bank provides funds to the commercial banks to overcome the
financial difficulties.

6. CLEARING HOUSE FUNCTION;

➢ As a custodian of the cash reserves of the commercial banks, the central bank acts
as the clearing house for these banks.

➢ For example, Bank A receives a cheque of Rs 10000 drawn on Bank B. Bank B

receives a cheque drawn on Bank A both banks A and B have their accounts with the
central bank. The cheques of both the banks are cleared through their accounts with
the central bank. This is how the central bank acts as a clearing house.

➢ Since all banks have their accounts with the central bank, the central bank can easily
settle the claims of various banks against each other simply by book entries or
transfers from and to their accounts. This method of settling accounts is called
clearing house function of the central bank

➢ The significance of this function is that it economizes the use of money in the
banking operations.

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QUANTITATIVE MEASURES OF CREDIT CONTROL

4. Statutory liquidity ratio: Banks are also required to maintain a specified percentage
of their net total demand and time deposits in the form of designated liquid assets
with themselves.

This specific percentage is called Statutory Liquidity Ratio (SLR). Increasing the SLR
reduces the ability of banks to give credit and vice versa.

5. Repo Rate: When the commercial banks are in need of funds for a short period,
they can borrow from the Central Bank. The rate of interest charged by the Central
Bank on such lending’s is called Repo Rate. Raising Repo Rate makes such borrowings
by the commercial banks costly. As such when Repo Rate is raised, banks are also
forced to raise their lending rates. This has a negative effect on demand for
borrowings from the commercial banks. Lowering Repo Rate has the opposite effect.

6. Reverse Repo Rate: When the commercial banks have surplus funds they can
deposit the same with the central bank and earn interest. The rate of interest paid
by the Central Bank on such deposits is called Reverse Repo Rate. When this rate is
raised, it encourages the commercial banks to park their funds with the central bank.
This has the negative effect on the lending capability of the commercial banks.
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Lowering Reverse Repo Rate has the opposite effect which raises demand for
borrowings from the commercial banks.
QUALITATIVE METHODS OF CREDIT CONTROL

Qualitative methods or selective methods are those methods which are used by the Central
bank to regulate the flow of credit into particular directions of the economy.

Unlike Quantitative methods, these methods affect the type of credit given by the commercial
banks. It is because of this specific use of credit that they are called ‘selective controls’

The important qualitative methods of credit control are:

1) Imposing Margin Requirements on secured loans

2) Moral Suasion

3) Selective Credit Controls

1. Margin requirement

➢ A margin is the difference between the amount of the loan and market value of the
security offered by the borrower against the loan.
➢ If the margin imposed by the Central Bank is 40%, then the bank is allowed to give a
loan only up to 60% of the value of the security.
➢ By altering the margin requirements, the Central Bank can alter the amount of loans
made against securities by the banks.

2. Moral Suasion

➢ This is a combination of persuasion and pressure that the Central bank applies on
the other banks in order to get them fall in line with its policy.
➢ This is exercised through discussions, letters, speeches and hints to the banks
➢ The Central bank frequently announces its policy position and urges the banks to fall
in line.
➢ Moral Suasion can be used both for quantitative as well as qualitative credit control

3. Selective Credit Control

➢ This can be applied both in positive as well as negative manner

➢ Application in a positive manner would mean using measures to channel credit to
particular sectors, usually the priority sectors.
➢ Application in a negative manner would mean using measures to restrict the flow of
credit to particular sectors.

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Differentiate between Demand Deposits and Fixed Deposits –

Demand Deposits Fixed Deposits

Demand Deposits can be withdrawn by their These deposits can be withdrawn only
depositors at any time without notice after the expiry of a certain fixed period
They are chequable i.e. they can be withdrawn They are not chequable
through cheques
No interest is paid on these deposits. Rather These deposits carry high rates of interest
depositors have to pay something to the bank
for its services
These deposits constitute a part of money They fall under the category of near
supply money

Bank rate Repo rate

It is the rate at which the central bank lends
funds as a lendor of last resort to the banks,
against approved securities or eligible bills
of exchange
It is the repurchase rate at which banks
borrow money from the central bank (RBI)
for short period of time by selling their
financial securities to the central bank with
an agreement to repurchase it at a future
date at a predetermined price

Bank rate relates to borrowings by the Repo rate relates to short term borrowing by
commercial banks to cope with their the commercial banks
immediate cash-crunch

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RECAP OF THE UNIT

Money is defined as anything that is accepted as medium of exchange, a store of value, unit
of account and a standard of deferred payment

Money supply of a country is stock of money on a specific day

Cash with public and demand deposits are parts of money supply because these can directly
be used for making payments

Measure of money supply is the total amount of coins and currency held outside the banks
and the total amount in demand deposits on a specific day.

Currency includes coins and currency notes.

Currency is also called fiat money and defined as the money which under law must be
accepted for all debts.

A demand deposit is any deposit account on which a cheque can be written.

Bank is a financial institution whose deposits are widely accepted as money for making
payments, and which has the power to create money.

Banking system is a two-tier structure. A central bank and a commercial bank

A commercial bank is a financial institution who accepts deposits from general public and
transfer funds to other banks and creates money.

Banks create money by giving loans

Legal reserve ratio is that fraction of demand deposits which is legally compulsory for the
banks to keep as reserves.

Total deposit creation by banks is 1/LRR times the initial deposit

A central bank is bank especially created by the government to serve as an apex bank to carry
out monetary policy of the country in public interest through various functions assigned to it.

Main traditional functions of a central bank are

Bank of issue ie legal right to issue currency notes

Government banker agent and advisor

Bankers bank and supervisor

Controller of credit

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The main instruments used by the central bank in performing its controller of credit functions
are

a) Open market operation CRR, SLR, Repo rate, Reverse Repo rate, and
margin requirements.

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BOARD QUESTIONS

1. Give the meaning of money supply and state its components

2. What is commercial bank?
3. What is meant by cash reserve ratio?
4. What is a central bank?
5. Define bank rate
6. What are time deposits in banks?
7. Explain currency authority function of the central bank?
8. Explain banker to the government function of the central bank?
9. Explain the lender of last resort function of the central bank?
10. Explain clearing house function of central bank
11. Explain the process of credit creation by commercial banks
12. What is legal reserve ratio? State its components
13. Differentiate between cash reserve ratio and statutory liquidity ratio
14. What is bank rate? How does it work as method of credit control?
15. Explain the open market operation method of credit control used by the central bank?
16. Explain the role of cash reserve ratio in controlling credit creation.

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HOTS
Currency is issued by the central bank yet we say that the commercial banks create money.
Explain. How is this money creation by commercial banks likely to affect the national income?

Ans. Money supply has two components currency and demand deposits with commercial
banks. Currency is issued by the central bank while demand deposits are created by the
commercial banks by lending money to the people. In this way commercial banks create
money.

Commercial banks lend money mainly to investors. The rise in investment in the economy
leads to rise in national income through the multiplier effect.

MCQ
1. Reverse repo rate is the rate at which Central bank
a) Gives loans to commercial banks for long term
b) Gives loans to commercial banks for short term
c) Borrows money from commercial banks
d) None of these

2. With an increase in margin requirement the availability of credit in the economy will
a) Increase
b) Decrease
c) Unchanged
d) None of these.

3. Higher the legal reserve ratio ----- will be the credit creation.
a) Higher
b) Lower
c) Constant
d) None of these

4. Quantitative instrument of RBI can be

a) Bank rate policy
b) Cash reserve ratio
c) Statutory liquidity ratio
d) All of the above

5. Demand deposits include

a) Saving account deposits and fixed deposits
b) Saving account deposits and current account deposits
c) Current account deposits and fixed deposits
d) All types of deposits

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6. Which of the following interest rate is applicable to short period lending?
a) Repo rate
b) Bank rate
c) Reverse repo rate
d) Both a and c

7. Lowering of CRR by the central bank has the following impact on the credit creation
capacity of the commercial banks
a) Fall
b) Increase
c) Can be fall or can be increased
d) No effect.

8. Raising reverse repo rate by the central bank is likely to have the following impact on
the money supply in the economy
a) Money supply will increase
b) Money supply will decrease
c) May rise or fall
d) No effect

9. Which of the following will increase the money supply?

a) Fall in repo rate
b) Purchase of securities in open market
c) Decrease in CRR
d) All of these.

10. The rate at which the central bank lends money to commercial banks as a lender of the
last resort is known as
a) Repo rate
b) Reverse repo rate
c) Bank rate
d) Lending rate

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