19O306 ECONOMICS FOR ENGINEERS

UNIT 5 Money and Banking

By
R. Yashwanth
Assistant Professor
Department of Humanities
PSG College of Technology
Money:
Money is an officially-issued legal tender consisting of currency and coin.
It is the widely accepted circulating medium of exchange as defined by a
government.
Functions of money
1. Primary functions
a. Medium of exchange

As a medium of exchange money can be used for buying and selling of

goods and services and in payment of debts.

b. Common measure of value

 Money serves as a unit in terms of which the value of all goods and
services are expressed as ‘price’

 It is the pricing mechanism.

2. Secondary functions
a. Standard of deferred payments
 Money is used for immediate and future payments (buy goods now and pay later).

b. Store of value

 Money is stored for any desired period of time & the value of money remains the
same.

 Money is the most liquid asset.

c. Transfer of value

 Money can be transferred from one place to another and from one person to another.
3. Contingent functions

a. Distribution of social income

 Money facilitates the distribution of national income between the factors of

production.

b. Basis of credit system

 All credit is based on money.

c. Imparting a general form of capital

 Money can be used in production.

Fisher’s Quantity Theory of Money: The Cash Transactions Approach

 According to this theory, the value of money depends on the quantity of money in
circulation.

 The transaction version of the quantity theory explains that, other things remain
unchanged, the changes in money supply brings about a directly proportionate
change in the price level and hence an inversely proportionate change in the value of
money.
The Equation of Exchange

 Irving Fisher, presented the theory in terms of an equation called the equation of
exchange.

 Equation of exchange is given as:

 M represents the quantity of money in circulation, both coins and paper money but
excluding bank reserves and money held by the treasury.

 V stands for the velocity of money in circulation, i.e., the average number of times each
unit of money is spent for the purchase of goods and services during a given period.
 In a small economy, there is a farmer & a mechanic (with Rs. 50 between them).

 Farmer gives Rs. 50 to a mechanic for repairing his tractor.

 In turn, the mechanic buys corn worth Rs. 40 from the farmer.

 Again, the mechanic spends Rs. 10 to get a cat from the farmer.

 Now, Rs. 100 worth transactions have taken place, though there is only Rs. 50 in the
economy. It is possible because money was spent on new goods and services on an
average of twice a year; therefore, the velocity is 2/year.
 P represents the general price level.

 T refers to the aggregate volume of transactions for which money payments are made.

 Thus, MV → is the aggregate supply of money in a given period.

 And, PT → is the demand for money during a given period.

 MV=PT means supply of money = demand for money.

 The price level (P) is directly related to MV (supply of money) and inversely related to T.

 MV=PT; takes only notes and coins, but bank demand deposits and credit must be taken.
Extension of the original equation of exchange

 Fisher included the demand deposits of banks / bank money (M’) and the velocity of
circulation of bank money (V’).

 The extended equation of exchange is given as:

 (or)
 Demand for money

 Demand for money is the total amount of money that the

people in an economy want to hold.

 Motives for holding money are:

 Transactions motive
 Precautionary motive
 Speculative motive
 Supply of money
 Money supply is the total amount of money in the economy.
 Supply of money is the stock of money at a particular point of time.

Measures of money supply in India

 There are 4 measures of money supply introduced by RBI in April 1977 viz., M 1, M2, M3 and M4.
M1 (narrow money)
o Currency with the public which includes notes and coins of all denominations.
o Demand deposits with commercial and cooperative banks.
o ‘Other deposits’ with RBI which include current deposits of foreign central banks, financial
institutions etc.
M2
o M1 + post office savings
 M3 (broad money)

o M1 + Time deposits with commercial and cooperative banks.

 M4 (broadest measure of money supply)

o M3 + Total post office deposits

• Significance of M3

 Of the 4 measures of money supply, M3 is considered in

formulating macroeconomic objectives.
Central Banking

Central banks control and regulate the banking system.

• Reserve Bank of India (RBI)

 Reserve Bank of India is the central bank of India.

 RBI commenced its operations on 1st April 1935 in accordance with the provisions of
the Reserve Bank of India Act, 1934.

 After independence, RBI was nationalised on 1st January 1949.

 RBI is headquartered at Mumbai. It has 4 zonal offices at Kolkata, Chennai and New
Delhi (including Mumbai).
Structure of RBI

 The functions of RBI are governed by 21-member Central Board

of Directors
o Governor
o 4 Deputy Governors
o 2 Finance Ministry representatives
o 14 directors (10 government-nominated – 4 represent local
boards).
Functions of RBI

• 1. Bank of issue - Note issue

o RBI has the exclusive monopoly of note issue.

o RBI follows a minimum reserve system in the note issue (Rs. 200 crores = Rs.
115 crores worth of gold and Rs. 85 crores worth of foreign exchange reserves).
o The notes issued by RBI has unlimited legal tender throughout the country.
o Bank notes in India are currently issued in the denomination of Rs. 10, 20, 50,
100, 200, 500 and Rs. 2000.
o However, RBI cannot issue banknotes higher than Rs. 10,000 as per the current
provisions of the Reserve Bank of India Act, 1934.
Coins
o The government of India has the right to mint coins and issue one
rupee note (Coinage Act, 1906).
o Coins are manufactured in the government mints (but they are
circulated through RBI).
o Coins can be issued up to the denomination of Rs. 1000 as per The
Coinage Act, 2011.
2. Banker, agent, and adviser to the government

 Banker to the government

o RBI keeps the deposits of the central and state governments and makes payment on
behalf of the government.
o The central bank makes short-term loans to the government for a period not exceeding 90
days.

 Agent to the government

o It buys and sells foreign currencies on behalf of the government.

 Adviser to the government

o It advises the government on all monetary matters viz., in controlling inflation or deflation,
devaluation or revaluation of the currency, deficit financing, balance of payments etc.
3. Custodian of foreign balances of the country

 RBI buys and sells foreign currencies at international prices.

 It buys and sells gold.

 RBI fixes the exchange rates of the domestic currency in terms of foreign currencies.

 It tries to bring stability in foreign exchange rates.

4. Custodian of the cash reserves of commercial banks

 Commercial banks are required by law to keep certain minimum cash reserves with
the RBI (certain percentage of both time and demand deposits liabilities).

 It helps the RBI to extend financial assistance to the scheduled banks in times of
emergency. Hence RBI is the lender of last resort.
5. Lender of last resort

 By lender of the last resort, it is implied that the central bank meets the reasonable demands for
accommodation by commercial banks in times of difficulties and crisis.

6. Central clearance, settlement and transfer

 RBI keeps the cash balances of all commercial banks.

 Therefore, each commercial bank can settle their claims in the books of RBI.
o Eg: If Bank A has a cheque for Rs. 1000 on Bank B & Bank B has a cheque for
Rs. 1500 on Bank A.
o So, Bank A will give a cheque to Bank B for an amount of Rs. 500 & A’s account
will be debited by Rs. 500, while Bank B’s account will be credited by Rs. 500.
7. Controller of credit

 RBI controls credit to ensure internal price stability.

 It makes use of the quantitative (bank rate policy, open market operations, reserve
ratios) and qualitative techniques to control credit in the country.

8. Detection of fake currency

 RBI creates awareness about fake notes among the people.

 The website provides information about identifying fake currency.

9. Regulator and supervisor of the financial system

 RBI’s regulatory power relates to licensing of banks and their branches, supervises the
working of banks, amalgamation, reconstruction of loss making banks (change board
of directors), inspection of banks, auditing the accounts of commercial banks etc.

10. Miscellaneous functions

 RBI has set up Banker’s Training College to train the supervisory staff of commercial
banks.

 RBI collects and publishes statistical information relating to banking, finance, currency
etc.
Commercial banks

 Banks mobilise funds and lend it for productive purposes.

 A commercial bank is a type of bank / financial institution that provides services such
as accepting deposits (at lower interest rate), advancing loans (at higher interest rate)
and providing agency services to its customers.

 Banks conduct business purely on profit motive (difference between lending and
deposit rates).
Functions of commercial banks

(1) Accepting deposits

 This is the most important function of commercial banks.

 The main kinds of deposits are:

(i) Current account deposits or demand deposits

 Such deposits are maintained by businessmen (opened in the name of firm).

 They are the demand liabilities of the bank.

o These are repayable on demand (withdrawals using cheque) subject to a
minimum required balance.
 The customer can overdraw from the account (by paying interest).

 Banks do not pay interest on these accounts. Rather, they impose service charges for
running these accounts.

 There are no limits for the number of transactions or the amount of transactions in a
day.
ii. Fixed deposits or time deposits

 Fixed deposits refer to those deposits, in which the amount is deposited with the
bank for a fixed period of time (7 days to 10 years).

 If the amount is withdrawn early, some banks impose penalty.

 They are known as the time liabilities of the bank.

 Such deposits do not enjoy cheque facility (non-chequable deposit).

 These deposits carry a high rate of interest.

(iii) Saving deposits

 They are popular for individual accounts. It is for saving money.

 It is an interest yielding account.

 Saving bank account-holder is required to maintain a minimum balance in the account

to avail cheque facilities.

 These deposits carry a lower rate of interest (less than fixed deposits).

(iv) Recurring deposits

 In RD, people can save small amount every month (a minimum of Rs. 100 p.m).
(2) Advancing of loans (creation of credit)

 The other major function of a commercial bank is to make loans and

advances.

 The deposit money does not remain idle with the banks; it is lent out as
loans (for interest).

Types of loans and advances

(a) Money at call

o Loans are given for very short period.
o These are repayable at call or a short notice of a fortnight or less.
(b) Overdraft facilities

o OD is provided to current account holders up to an agreed limit.

(c) Direct loans

o It is given against collateral securities.

(d) Discounting of bills

o Banks purchase bills before the maturity and provide funds to the seller at a discount.

(e) Loans against share / securities (of reputed companies)

o Banks provide loans against security of shares / debentures of reputed companies.

(f) Loans against savings certificates

o Commercial banks provide loans up to certain value of savings certificates like

National savings certificate, fixed deposit receipt, Kisan Vikas Patra etc.

(g) Consumer loans and advances

o Banks finance the purchase of consumer durables like Car, vehicles etc.
Banks may give loans in the following ways:

 Home loans (construction, renovation, buying property or land)

 Personal loans (based on income; no collateral is required; repayment 12-60 months)

 Business loan (for existing/new)

 Education loan (to pursue education in India/abroad)

 Gold loan (it is given against gold as security)

 Vehicle/car loan
3. Credit creation (most important function of commercial banks)

 When a bank advances a loan, it opens an account in the name of the borrower and
does not pay him in cash but allows him to draw money by cheque according to his
needs.

 By granting a loan, the bank creates credit or deposit.

4. Financing foreign trade

 A commercial bank finances foreign trade of its customers.

 They buy and sell foreign currencies.

5. Agency services

 A commercial bank performs certain functions as an agent for its customers.

 Some of these functions relate to:

o Collection and payment of cheques, bills of exchange, drafts, dividends
etc.
o Buys and sells shares, securities, debentures.
o Pays subscriptions, insurance premium, rent, electric and water bills on
standing orders (pay in regular intervals).

 For some of these services, the bank may charge its clients.
6. General utility services

 A commercial bank performs certain general utility services such as:

o Locker facility

 Commercial banks provide safety vaults or lockers to keep

valuable articles in safe custody (jewellery, important
documents).
o Issue of cheques, drafts, travellers’ cheques etc.
o Issue of letter of credit
7. Modern functions / Technology in banking

 Issue of debit and credit cards

 Point of sale (POS) terminals

 Providing ATM facility

 Net banking

 Mobile banking

 Selling of insurance products (Bancassurance)

 Telebanking

 SMS alerts

 Rail/Air ticket reservation

Electronic transfer of funds (NEFT, RTGS, IMPS).
o National Electronic Fund Transfer (waiting time is there; it results in
time lag)
o Real Time Gross Settlement (no waiting time)
o Immediate Payment Service (it is an instant 24X7 interbank electronic
fund transfer service)
National income – Meaning and definition

 National income is the aggregate money value of all goods and services produced in a
country during one year.

 National Income Committee defines national income as, “the value of commodities
and services produced in an economy during a given period, counted without
duplication”.

 National income estimates are prepared by Central Statistics Office (CSO).

 Concepts of National Income
• 1. Gross Domestic Product (GDP) at Market Price

 Dernberg defines GDP at market price as, “the market value of the output
of final goods and services produced in the domestic territory of a
country during an accounting year”.

• 2. GDP at Factor Cost

GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies

• 3. Net Domestic Product (NDP) at Factor Cost

 NDPFC = GDP at Factor Cost – Depreciation

4. Gross National Product (GNP) at Market Price

 GNP at Market Prices = GDP at Market Prices + Net Income from abroad

Points to be remembered

 Final value of goods and services is taken.

 Goods and services rendered free of charge is not taken.

 Purchase and sale of old goods are not considered.

 Incomes received under social security schemes.

 Income earned through illegal activities

5. GNP at Factor Cost
 GNP at Factor Cost = GNP at Market Price – Indirect Taxes +
Subsidies

6. NNP at Market Prices

 NNP at Market Prices = GNP at Market Prices - Depreciation

7. NNP at Factor Cost (National Income)

NNP at Factor Cost = GNP at Factor Cost – Depreciation
8. Personal Income

 Personal income is the total income received by the individuals of a

country from all sources before payment of direct taxes in one year.

9. Disposable Personal Income

 Disposable income = Personal income – Direct taxes

10. Disposable Personal Outlay

 Disposable outlay = Disposable income – Savings
11. Nominal GDP

 When GDP is measured at current price, it is called GDP at

current prices or nominal GDP.

 Real GDP

Nominal GDP can change due to 2 reasons:

Changes in the volume of output
Changes in the prices
 If the nominal GDP changes due to prices, then nominal GDP does not show the real
state of the economy.

 Increase in prices - value of GDP increases; decrease in prices – value of output

decreases.

 Real GDP is the value of economic output adjusted for price changes i.e., evaluated at
base year prices (adjusted for inflation and deflation).

 Real GDP shows changes in volume of output.

 Base year nominal GDP = Real GDP in base year

• GDP deflator

 The GDP deflator, also called implicit price deflator, is a measure of inflation.

 GDP deflator is a measure of price inflation/deflation with respect to a specific base

year. (GDP deflator of the base year is equal to 100).

 GDP deflator is used to convert nominal GDP into real GDP.

 *100
 Methods of measuring national income

 There are 3 methods of measuring national income. They are:

Product method
Income method
Expenditure method
1. Product method

 This method is also called as output method or value added method.

 Value added by all industries in the economy gives GNP by value

added method.
 GNP = Gross value added + Net income from abroad

Value added means, the value added to the product at every stage in
the production process (difference between value of output and input
is called value added).
 Firm Stage of production Purchasing price Selling price Value added
Landowner sells trees to
A - 100 100
sawmill owner
Sawmill owner makes
B timber sheets to sell it to 100 180 80
furniture manufacturer
Furniture manufacturer
turns timber sheets into
C 180 290 110
furniture and sells to
retailer
Retailer sells furniture to
D 290 420 130
final consumer
Total value 570 990 420

Total value added = Total value of sales – cost of intermediate goods = 990 – 570 = 420
 Only the value of final goods is taken.
2. Income method
 GNP = Wages and salaries + Rents + Interest + Dividends +
Undistributed corporate profits + Mixed incomes + Direct
taxes + Indirect taxes + Depreciation + Net income earned
from abroad
3. Expenditure method (outlay method)

 GNP = C + I + G + (X-M)
 C is private consumption expenditure (on durable and non-durable
goods).
 I is private investment (on new investment and on replacement of
old capital).
 G is government expenditure (on goods and services, employees,
police, PSUs, stationeries, furnitures, vehicles, etc).
 X-M is net exports (X is exports; M is imports).
Problems in measuring national income

• 1. Difficulty in estimating non-monetised sector

• 2. Non-availability of reliable statistics

• 3. Lack of accounting habit

• 4. Lack of occupational specification

• 5. Lack of uniformity

• 6. Earning through illegal activities

• 7. Double counting

• 8. Inability to value the services

Inflation

 Inflation is the rate at which the prices for goods and services are rising and, consequently,
the purchasing power of currency is falling.

 Shapiro defines it as, “a persistent and appreciable rise in the general level of prices”.

Types of inflation

• 1. Creeping Inflation (less than 3 per cent per annum)

• 2. Walking Inflation or Trotting Inflation (3 to 7% per annum)

• 3. Moderate Inflation (less than 10% per annum)

• 4. Running Inflation (10 to 20% per annum)

• 5. Hyperinflation (more than 20 to 100% per annum)

Causes of Inflation

 There are 2 theories which state the cause of inflation. They are:

1. Demand-Pull inflation

2. Cost-Push inflation

1. Demand-Pull inflation

 This theory can be summarized as “too much money chasing too few goods”.

 According to this theory, inflation is caused when aggregate demand exceeds

aggregate supply of goods and services.
Factors affecting demand

• i. Increase in money supply

• ii. Increase in disposable income

• iii. Increase in public expenditure

• iv. Increase in consumer spending

• v. Cheap monetary policy

• vi. Expansion of the private sector

• vii. Black money

Factors affecting supply

• i. Shortage of factors of production

• ii. Industrial disputes

• iii. Natural calamities

• iv. Artificial scarcities

• v. Increase in exports
2. Cost-Push inflation

 Caused by wage-push and profit-push to prices.

 Cost-push inflation is the rise in money wages than the productivity of labour (due to
pressure from trade unions; because of rise in cost of living index).

 It increases the cost of production.

 Employers in turn raise the price of products (to increase their profits).
Methods to control inflation

 When D>S, prices rise and it leads to inflation.

o So, supply has to be increased to match demand (or)
o Reduce money incomes to reduce demand.

The methods of controlling inflation are:

 Monetary measures

 Fiscal measures

 Other measures
1. Monetary measures (reducing money incomes)

(a) Credit control

 The central bank adopts quantitative and qualitative measures

of credit control.

 Quantitative credit control measures include raising the Bank

rates, Open market operations, Cash Reserve Ratio (CRR),
Statutory Liquidity Ratio (SLR), Repo rate, Reverse repo rate.
 Qualitative credit control measures include Margin requirements, Moral suasion.

(b) Demonetization of currency

 One of the monetary measures is to demonetize currency of higher denominations.

 Such a measure is usually adopted when there is abundance of black money in the
country.
2. Fiscal measures

• (a) Reduction in unnecessary expenditure

• (b) Increase in taxes

• (c) Public debt

• (d) Surplus budgets (anti-inflationary budgetary policy)

3. Other measures

• (a) To increase production

• (b) Price control

• (c) Rationing

Deflation

 It is “state in which the value of money is rising i.e., prices are falling”.

 Deflation is a situation when prices fall along with reduction in output and
employment.
Thank You