4.

MONEY AND BANKING

Learning objectives
To ;
• Describe the forms, function, and characteristics of money.
• Identify the motives for holding money.
• Inquire the functions of banks.
• Discuss the role and importance of central banks and commercial banks for
government, consumer, and producers.
• Describe demand for money and supply of money.
• To state the role of the central bank of India and the roles of a central bank in a
country in creating money.
• Evaluate the demand of money and different factors affecting it.
• Rationalize the relationship between interest rates and the demand for money.
• Outline the process of money creation by the commercial banking system.

Barter Exchange:

It implies the direct exchange of goods for goods without the use of money. Such exchange
exists in the C - C economy(commodity to commodity exchange economy). For example,
wheat may be exchanged for cloth, a teacher may be paid rice for her service etc.

Difficulties involved in the Barter Exchange:

1. Lack of a common measure of value.

2. Lack of double coincidence of wants.
3. Lack of standard of deferred(future) payments.
4. Lack of store of value.
5. Lack of divisibility.
6. Difficulty in exchange of services.
Money
Money may be defined as anything which is generally acceptable as a medium of exchange.

Functions of money

Primary Functions:

• Medium of Exchange: Money can be used to make payments for all transactions of
goods and services as money has the quality of general acceptability.
• Unit of value: It means that the value of all goods and services are measured in the
same standard unit money. The prices of different goods and services are expressed
in terms of money.

Secondary Functions:
 • Standard of deferred payment: Money is used to make future payments. If payment
to be made in future ,we know the amount to be paid.
• Transfer of value: Money is used as a convenient mode of transfer of value from one
person to another.
• Store of value: money serves as an excellent store of wealth for the future, as it can be
easily converted into other marketable assets such as land machinery plant etc. It
implies that money retains its value overtime

Forms of money

• Fiat money: It is the currency that a government declares to be legal tender(legally

bound to accept as a medium of exchange) but is not backed by a physical asset. The
value of fiat money is determined by the connection between supply and demand
rather than the worth of the commodity used to make the money .e.g., notes and coins
• Fiduciary money: Fiduciary money is that money which is accepted as a medium of
exchange because of the trust between the buyer and the payee. e.g., cheques
• Full bodied money: It refers to the money in terms of coins whose commodity value
is equal to the money value as and when these are issued. e.g., silver coins
• Credit money: It refers to the money of which the money value is more than its
commodity value. E.g., present coins.

Demand of Money: It is referred to as an individual’s liquidity preference, which is the

decision of holding money in liquid form, i.e., cash, in order to earn interest or as a
precaution.
➢ The Transaction Motive: The principal motive for holding money is to carry out
transactions. The transactions motive for demanding money arises from the fact that
most transactions involve an exchange of money. Because it is necessary to have
money available for transactions, money will be demanded.
➢ Precautionary motive: People often demand money as a precaution against an
uncertain future. Unexpected expenses, such as medical or car repair bills, often
require immediate payment. The need to have money available in such situations is
referred to as the precautionary motive for demanding money.
➢ Speculative motive: Money, like other stores of value, is an asset. The speculative
motive for demand for money arises when investing the money in some asset or bond
is considered riskier than simply holding the money.

Supply of Money

Total stock of money (currency notes, coins, and demand deposit of banks) in circulation
are held by the public at a given point of time.
Supply of money does not include cash balance held by central and state govt. and stock of
money held by banking system of country as they are not in actual circulation of the
country.

Features of money supply

• It includes money held by the public only: Does not include money creating sector
i.e., government, and banking system
• It is a stock concept: It is concerned with the particular point of time

Measures of Money Supply:

In a modern economy, money comprises cash and bank deposits.

M1: It is the first and basic measure of the money supply. It includes currency held by the public,
demand deposits of commercial banks, and other deposits with the Reserve Bank of India (RBI).
1 M1= Currency and coins with public (C) + Demand deposits of the public with the banks (DD) +
Other deposits (OD)
M2: It is also known as narrow money along with M1. It includes Savings deposits with Post Office saving
banks.
2 M2= M1 + Savings deposits with Post Office saving banks
M3: It also includes time deposits with a commercial bank and is known as broad money.
3 M3= M1 + Net time deposits with commercial banks
M4: It includes the total deposits excluding National Saving Certificates and is also known as broad
money along with M3.
4 M4= M3 + Total post office deposits excluding National Saving Certificates (NSC) Banking
Systems

Bank

Bank is a financial institution which accepts deposits from the people and gives
loan(credit)for the purpose of consumption or investment.

Central Bank

The central Bank is the apex institution of monetary and financial system of a country ,which
controls, operates ,regulates, and directs the entire banking and monetary structure of the
country. Almost every country has one central bank. India’s central bank is the ‘Reserve Bank
of India’ which was established on April 1st, 1935, under Reserve Bank of India act 1934. It
makes monetary policy of the country in public interest. It manages, supervises, and
facilitates the banking system of the country.

Functions of Central Bank

Central bank has several important functions.

1. Bank of Issue(currency authority): In India Reserve Bank of India has the sole right of
issuing paper currency notes and the coins(except ₹1.00 notes and coins which are issued
by Ministry of Finance)

2. Banker to the Government: As a banker to the government, it carries out all banking
business of the government. It maintains a current account for keeping their cash balances
and accepts receipts and make payments for the government, carry out exchange,
remittance, and other banking operations. It also gives loans and advances to the
government for temporary periods. The government borrows money by selling treasury
bills to the central bank. As an agent, the central bank also has the responsibility of
managing the public debt. The central bank advises the government from time to time on
economic, financial, and monetary matters(financial advisor).

3. Banker’s Bank and Supervisor: The central bank acts as the banker to other banks. It
regulate controls and supervise the commercial banks. It keeps a certain portion of the
deposits of all commercial banks as reserves(CRR). In this way central bank act as a
CUSTODIAN OF CASH RESERVES of commercial banks. When commercial banks fail to
meet their financial requirements from other sources, they approach the central bank to
get loans and advances. Central bank assists the banks through discounting of approved
securities and bill of exchange i.e., LENDER OF LAST RESORT.

4. Custodian of foreign exchange reserves: Commercial banks are required to keep a certain
proportion of their deposits (CRR)with the central bank. RBI fixes the rate of percentage of
CRR and SLR and modify, if necessary.

5. Controller of money supply and credit: RBI controls the money supply and credit in the
best interests of the economy and solves the problem of inflation and deflation.
The RBI controls the money supply in the economy in various ways. The tools used by the
Central bank to control money supply can be quantitative or qualitative.

QUANTITATIVE MEASURES TO CONTROL MONEY SUPPLY

Bank Rate: Bank rate is the interest rate charged by a nation’s central bank to its domestic
banks in order for them to borrow money. The RBI can influence money supply by
changing the rate at which it gives loans to the commercial banks.

Open Market Operations : It refers to buying and selling of bonds issued by the
Government in the open market. This purchase and sale is entrusted to the Central bank on
behalf of the Government. When RBI buys a Government bond in the open market, it pays
for it by giving a cheque. Thus, the total amount of reserves and the money supply in the
economy increases. Selling of a bond by RBI (to private individuals or institutions) leads to
reduction in quantity of reserves and hence the money supply.

There are two types of open market operations:

1) Outright : Outright open market operations are permanent in

nature, when the central bank buys these securities (thus injecting
money into the system), it is without any promise to sell them
later. Similarly, when the central bank sells these securities (thus
withdrawing money from the system), it is without any promise to
buy them later.
2) Repo and Reverse repo
o Repo : when the central bank buys the security, this
agreement of purchase also has specification about date
and price of resale of this security. This type of agreement
is called a repurchase agreement or repo. The interest
rate at which the central bank of a country lends money to
commercial banks in the event of any shortfall of funds by
buying the securities is called the repo rate.
o Reverse repo: Central bank sell the securities through an
agreement which has a specification about the date and
price at which it will be repurchased. This type of
agreement is called a reverse repurchase agreement or
reverse repo. The rate at which the money is withdrawn in
this manner, from commercial banks within the country is
called the reverse repo rate.

LRR: RBI controls the money supply the extent of money supply by changing the LRR
percentage.
Legal Reserve Ratio(LRR)/ Legal Reserve Requirements:- It is fixed by the central bank
of a country, and it is the minimum ratio of deposit legally required to be kept as cash by
banks.
Cash Reserve Ratio(CRR):- It is a part of LRR which is to be kept with the central
bank.(Approx.4.5 %)
Statutory Liquidity Ratio(SLR):- It is a part of LRR which is to be kept with the bank
themselves. (Approx.8%)

SLR+CRR=LRR

QUALITATIVE MEASURES TO CONTROL MONEY SUPPLY

Margin requirements: Margin is the difference between the amount of loan and the
market value of the security offered by the borrower against the loan.
e.g., If the margin fixed by the central bank is 40 %, the commercial banks are allowed to
give a loan only up to 60% of the value of the security.

Moral suasion and direct action: This is a combination of persuasion and pressure that
central banks are placed on other banks in order to get them act, in a manner or in line
with its policy. it is exercised through discussions, letters etc. RBI can take direct action
against the commercial banks which are not obeying its rules and regulations.

Selective credit control: RBI gives directions to other banks to give or not to give credit
for certain purposes or to particular sectors. The priority sectors include small scale
industry ,agriculture etc.

Rationing of credit :It is a method by which the Central Bank seeks to limit the maximum
amount of loans and advances and, also in certain cases, fix ceiling for specific categories of
loans and advances.

To control inflation To control deflation

RBI Increases bank rate RBI Decreases bank rate
RBI Increases repo rate RBI Decreases repo rate.
RBI Increases reverse repo rate RBI Decreases reverse repo rate
RBI Increases CRR and SLR RBI Decreases CRR and SLR
RBI Increases Margin requirement RBI Decreases Margin requirement
RBI Advices commercial banks to control credit, RBI Advices commercial banks to give more
to give credit only to some priority sectors and to credit, to give credit for all sectors/purpose and
fix a limit for credit amount not to fix a limit for credit amount

Commercial Banks

Commercial banks are the financial institutions which are a part of the money-creating
system of the economy.
Functions of Commercial Banks
1.Primary functions:-

(a) Accepting deposits

(b) Advancing loans
(c) Discounting bill of exchange.

Secondary functions:-

1.Agency function

(a) Transfer of fund

(b) Collection of funds
(c) Purchase and sale of shares and securities on behalf of the customers
(d) Collection of dividend and interest
(e) Payment of bills and insurance premium on behalf of customers
(f) Acting as executor and trustee of will
(g) Acting as correspondent and representative of customer and provide letter of credit to the customer.

2. General utility function

(a) Purchase and sell of foreign exchange.

(b) Issuance of traveler’s cheque.
(c) Safe custody of valuable goods in lockers.
(d) Underwriting of securities.

Different types of accounts

➢ Current account deposits or demand deposits: These deposits refers to the deposits which are
repayable by the banks on demand. Such deposits are generally maintained by businessman.
They can be drawn upon by a check without any restriction. Banks do not pay any interest on
these accounts rather banks impose service charges for running these accounts.
➢ Saving deposits: These deposits combine features of both current account deposits and fixed
deposits. The deposits are given cheque facility to withdraw money from their account. But
some restrictions are imposed on the amount and the number of withdrawals in order to
discourage frequent use of saving deposits. They carry a rate of interest which is less than the
interest rate on fixed it deposits.
➢ Fixed deposit or time deposit: Fixed deposit refers to the deposit in which the amount is
deposited with the bank for a fixed period of time. Such deposits do not enjoy cheque facility.
These deposits carry a high rate of interest.

Difference between fixed deposits and demand deposits

MONEY CREATION OR CREDIT CREATION BY COMMERCIAL BANKS

The capacity of banks to create money or credit depends on (i) Amount of primary deposits
and (ii) Legal reserve ratio(LRR).

Commercial bank’s demand deposits are a part of money supply. Commercial banks lend
money to the borrowers by opening demand deposit account in their names. The
borrowers are free to use this money by writing cheques. According to definition demand
deposits are a part of money supply. Therefore, by creating additional demand deposits
banks create money. The deposit creation comes to an end when total cash reserves
become equal to the initial deposit.

Money creation depends upon two factor: 1)Primary deposits and 2)Legal Reserve Ratio
(LRR).

Money multiplier

The money multiplier or deposit multiplier measures the amount of money that the banks
are able to create in the form of deposits with every unit of money it keep as reserves.

Deposit Multiplier/ money multiplier = 1/LRR

Total Deposit creation = Initial deposit * 1/LRR

The value of money multiplayer is determined by LRR. Higher the value of LRR, lower is the
value of money multiplier and less money is created by the banking system and vice versa.

(QUESTIONS)