MACROECONOMICS

CHAPTER-2
(6MARKS)
MONEY AND BANKING
BY-VISHWAJEET SINGH ,PGT(ECO),K.V.(AFS), BAMRAULI,
PRAYAGRAJ
 TOPICS TO BE STUDIED
• BARTER SYSTEM OF EXCHANGE
• DIFFICULTIES OF BARTER SYSTEM
• MEANING OF MONEY AND ITS FUNCTIONS
• FORMS OF MONEY
• MONEY SUPPLY
• MEASURES OF MONEY SUPPLY
• COMMERCIAL BANKS AND THEIR FUNCTIONS
• CREDIT(MONEY) CREATION BY COMMERCIAL BANKS
• CENTRAL BANK AND ITS FUNCTIONS
• CONTROL OF CREDIT (MONEY SUPPLY) BY CENTRAL BANK
WITH THE HELP OF VARIOUS INSTRUMENTS OF MONETARY
POLICY
 BARTER SYSTEM OF EXCHANGE
It refers to that system of exchange where goods and
services were exchanged directly for other goods and
services.
This system of exchange existed prior to the
introduction of money.
DIFFICULTIES OF BARTER SYSTEM
• Lack of double coincidence of wants
• Lack of common unit for measure of value
• Problem in store of value
• Problem in transfer of value problem of future
payments
• Lack of divisibility
 MEANING OF MONEY
Anything which acts as medium of exchange is known
as money.
OR
Anything which is able to perform all the functions of
money, is money.
FUNCTIONS OF MONEY
• Medium of exchange
• Measure of value or unit of account
• Store of value
• Transfer of value
• Standard of future payments
 VARIOUS FORMS OF MONEY
Full bodied money
It is that money whose value as commodity (value of metal used/
intrinsic value) is equal to its value as money (face value).EX-Gold
coins, silver coins used in past.
Representative full bodied money (credit money)
It is that money whose value as money is greater than the value as
commodity.EX-All the paper notes used at present
Bank money
It refers to the demand deposits with banks.
High powered money
It refers to the currency held by public and cash reserves of banks.
H=C+R
H-High powered money, C-Currency with public, R-Cash reserves of
banks
 Legal tender money (Fiat money)
It is that money which serves as money on the order of government.
There are two types of Fiat money-
a) Limited legal tender money-It is that legal tender money which can be
used upto certain limit only for payments.EX-
COINS-Maximum payment limits in form of coins not lower than 1 rupees
is Rs.1000.
PAPER NOTES-Maximum payment limit in form of paper notes is
Rs.200000 per day.
b) Unlimited legal tender money-it is that legal tender money which can be
used upto any limit for payments.
Non legal tender money (fiduciary money/optional money)
It is is that money which is accepted as money on the basis of trust of
issuer.
EX-Cheque,draft, bill of exchange etc.
Near money
Anything which can be easily converted into cash is known as near money.
EX-Shares, bonds ,national saving certificate ,gold etc
 MONEY SUPPLY
It refers to total stock of money held by public at a given point of time.
NOTE-IT DOES NOT INCLUDE THE STOCK OF MONEY HELD BY MONEY
CREATING UNITS LIKE- GOVERNMENT, CENTRAL BANK AND
COMMERCIAL BANKS
Message of money supply
M1=C+DD+OD
Where, C-Currency(coins and paper notes) held by public

DD-Demand deposits with commercial banks

OD-Other deposits with RBI
i) Demand deposits with RBI of public financial institutions like
NABARD ,IDBI ,SIDBI
ii) Demand deposits with RBI of foreign Central banks and
governments
iii) Demand deposits with RBI of international financial
institutions like IMF, world Bank
M2=M1+Saving deposits with post office saving
bank

M3=M1+Net time deposits with commercial banks

M4=M3+Total deposits with post office saving

banks (Excluding national saving certificate)
NOTE-*M1 and M2 are considered as narrow
money.
*M3 is considered as broad money.
*M4 is considered as broader money.
 COMMERCIAL BANKS
Digital financial institutions which accept deposits from public and advance
loans to public with the aim of making profit.Like-SBI,UBI,PNB,ICICI,HDFC

Functions of commercial banks

A) Primary functions
1) Accepting deposits-
Current account deposit Saving account deposit Fixed account deposit(Time
(demand deposit) deposit)
These deposits can be These deposits can be These deposits can be
withdrawn at any time by withdrawn at any time by withdrawn after fixed
the depositor. the depositor with some period of time
restrictions on number of
withdrawals.
Cheque book is issued and Cheque book is issued but Cheque book is issued
there is no restriction on the there is a restriction on the
number of cheques issued number of cheques issued

No interest is given Very low interest rate is High interest rate is given
given
Generally used by business Generally used by Used by both households
units. households. and business units
.
2)Advancing loans-
Cash credit Demand loan Short term, medium
term and long term
loans
Under this loan This loan is to be repaid on Short term loans are given
arrangement an eligible demand of bank. for a period less than of 2
borrowers first sanctioned years.
credit limit upto which he Medium term loans are
may borrow from the bank. given for a period of 2
years to 5 years
Generally used by business Long term loans are given
units. for a period more than of 5
years
Check book issued No check book issued No check book issued

Interest is recharged on Interest charged on whole Interest charged on whole

amount actually used. amount of loan amount of loan

No stated maturity No stated maturity. Stated maturity.

B)Secondary functions-
1) Overdraft facilities
2) Investment of funds
3) Locker facilities
4)Sale and purchase of shares and bonds for their
customers
 CREDIT(MONEY) CREATION BY
COMMERCIAL BANKS
Suppose there is an individual who is depositing(Primary/Initial
deposit) Rs 1000 in a commercial bank and bank has estimated
that Required Reserve (Legal Reserve Ratio) is 20%.Then-
TOTAL CREDIT CREATION BY COMMERCIAL BANK
=PRIMARY DEPOSIT × CREDIT MULTIPLIER
=PRIMARY DEPOSIT × 1/REQUIRED RESERVE(LRR)
=1000×1/20%
=1000×1/0.2
CREDIT MULTIPLIER
=1000×5 =1/REQUIRED RESERVE(LRR)
=Rs 5000
This process can be understood with the help of the table given
on next slide-
. ROUNDS DEPOSITS/CASH RR(LRR)=20% EXCESS
CREDIT(Rs) RESERVE(ER)=80%
FIRST 1000(primary 200 800
deposit)

SECOND 800(secondary 160 640

deposit)

THIRD 640(secondary 128 512

deposit)

FOURTH 512(secondary 102.4 409.6

deposit)

FIFTH 409.6(secondary 81.92 327.68

deposit)
-------- ------- -------- --------

-------- ------- -------- ---------

--------- ------- --------- ----------

TOTAL 5000 1000 4000
 CREDIT(MONEY) CREATION BY
COMMERCIAL BANKS
Suppose there is an individual who is depositing(Primary/Initial
deposit) Rs 2000 in a commercial bank and bank has estimated
that Required Reserve (Legal Reserve Ratio) is 10%.Then-
TOTAL CREDIT CREATION BY COMMERCIAL BANK
=PRIMARY DEPOSIT × CREDIT MULTIPLIER
=PRIMARY DEPOSIT × 1/REQUIRED RESERVE(LRR)
=2000×1/10%
=2000×1/0.1
CREDIT MULTIPLIER
=2000×10 =1/REQUIRED RESERVE(LRR)
=Rs 20000
This process can be understood with the help of the table given on
next slide-
.
ROUNDS DEPOSITS/CASH RR(LRR)=10% EXCESS
. CREDIT(Rs) RESERVE(ER)=90%
FIRST 2000(primary 200 1800
deposit)

SECOND 1800(secondary 180 1620

deposit)

THIRD 1620(secondary 162 1458

deposit)

FOURTH 1458(secondary 145.8 1312.2

deposit)

--------- ------ --------- --------

-------- ------- -------- --------

-------- ------- -------- ---------

--------- ------- --------- ----------

TOTAL 20000 2000 18000
 CENTRAL BANK AND ITS
FUNCTIONS
Central Bank
central bank is an Apex institution of a country that
controls and regulates the entire monetary and financial
system of the country.
In India Reserve Bank of India (RBI)operates as Central
Bank.
RBI was setup on 1 April 1935.
Functions of RBI/Central bank
1)Currency authority (bank of issue)-Central bank of a
country has the legal right to issue all the currencies.In
India RBI has exclusive right to issue all the
currences(except one rupee notes and all the coins.)
2) Banker to the government
As a banker to government Central Bank of a country
performs following functions-
a) It accepts deposits and grant loans to government.
b) it sells and purchases government securities on
behalf of government.
c) it acts as financial advisor to the government.
3) Bankers Bank-Central Bank of a country is Bank of all
the commercial banks.it means it accepts the deposits
from commercial banks as well as advances loans to
commercial banks also.
4) Supervision of commercial banks-Central Bank
supervises the licensing,merger and expansion of
commercial banks.
5) Lender of last resort-If a commercial bank is facing
the the problem of financial crisis then central bank
provides the financial assistance (financial
accommodation)to the commerce bank as a lender of
last resort.
6) Custodian of foreign exchanger reserve-Only central
bank maintains the stock of Foreign currencies to
promote the international trade.
7) Control of money supply(credit)-To solve the
problems of inflation and depression RBI decreases an
increases the money supply in the economy with the
help of various instruments of monetary policy.
 CONTROL OF MONEY SUPPLY(CREDIT) BY
CENTRAL BANK/RBI
To control the money supply RBI uses the various
instruments of monetary policy.
A) QUANTITATIVE INSTRUMENT
B) QUALITATIVE INSTRUMENTS
A)QUANTITATIVE INSTRUMENT
These instruments are used to increase or decrease the over all
money supply in the economy. Followings are the quantitative to
instrument-
1) Bank rate-It is that rate of interest at which RBI provide
long-term loans to commercial bank. At present it is 4.65%
# In case of inflation-To solve the problem of inflation bank rate
is increased so that money supply can be decreased.
# In case of deflation-To solve the problem of deflation bank rate
is decreased so that money supply can be increased.
2) Repo rate-It is that rate of interest at which RBI gives
short term loans to commercial banks. At present it is 4%.
# In case of inflation-To solve the problem of inflation, repo
rate is increased so that money supply can be decreased.
# In case of deflation-To solve the problem of deflation,
repo rate is decreased so that money supply can be
increased
3) Reverse repo rate-it is that rate of interest which is
given by RBI to commercial banks against their short term
deposits with RBI.At present it is 3.35%.
# In case of inflation-To solve the problem of inflation,
reverse repo rate is increased so that money supply can be
decreased.
# In case of deflation-To solve the problem of deflation,
reverse repo rate is decreased so that money supply can be
increased.
4) Cash Reserve Ratio (CRR)-It is that proportion of
total bank's deposit which each and every commercial bank
has to keep with RBI. At present it is 3%.
# In case of inflation-To solve the problem of inflation, CRR is
increased so that money supply can be decreased.
# In case of deflation-To solve the problem of deflation, CRR is
decreased so that money supply can be increased.
5) Statutory Liquidity Ratio(SLR)-It is that proportion
of total bank's deposit which each and every commercial bank
has to keep with itself in form of liquid assets. At present it is
18.5%.
# In case of inflation-To solve the problem of inflation, SLR is
increased so that money supply can be decreased.
# In case of deflation-To solve the problem of deflation, SLR is
decreased so that money supply can be increased.
 .
6) Open market operations-Under open market
operations RBI sells and purchases the government
securities in open market.
# In case of inflation-To solve the problem of inflation,
government securities are sold by RBI ,so that money
supply can be decreased.
# In case of deflation-To solve the problem of deflation,
government securities are purchaseed by RBI ,so that
money supply can be increased.
B) Qualitative instruments
These instruments are used to increase or decrease the
money supply in particular sectors of economy.
Followings a the qualitative instruments of monetary
policy.
 .
1) Margin requirement-It is the difference between the
value of security offered for loan and the amount of loan
granted against that security.
# In case of inflation-To solve the problem of inflation, margin
requirement is increased ,so that money supply can be
decreased.
# In case of deflation-To solve the problem of deflation, margin
requirement is decreased ,so that money supply can be
increased.
2) Rationing of credit-It refers to to the fixation of
maximum amount of loan that can be granted by commercial
banks to a particular sector.
# In case of inflation-To solve the problem of inflation,
maximum limit of loan is decreased so that money supply can
be decreased.
# In case of deflation-To solve the problem of deflation,
maximum limit of loan is increased so that money supply can be
increased.
3) Direct action-RBI may take direct action against
those commercial banks which do not follow its
policies regarding control of money supply.
4) Moral suasion-It refers to oral or written appeal
made by RBI to commercial banks to follow its policies
regarding control of money supply.
 DIFFERENCES BETWEEN CENTRAL
BANK AND COMMERCIAL BANKS
. CENTRAL BANK COMMERCIAL BANKS

Definition Definition

It is a non-profit making institution. Their main objective is to earn profit

It is a public sector institution. These are owned by both public sector

as well as private sector.
There is only one Central Bank in a There are many commercial banks in a
country. country.
It does not deal with public. These banks deal with public.

Example-RBI Example-SBI,UBI,PNB,ICICI,HDFC