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MONEY AND
BANKING
 DEFINITION OF MONEY

The term ‘Money’ is used to cover all such

Money is anything which is generally
things like coins, currency notes, cheques
accepted as a medium of exchange,
etc., which are used to conduct business
measure of value, store of value and means
transactions and settlement of business
for standard of deferred payment
claims.

 Store of value – Money is used as an

instrument of saving
 Measure of value – Value of goods and
services is expressed in terms of money
 Standard of deferred payments – Money is
used to make those payments which are to be
made in future.
 EVOLUTION OF MONEY
Some of the major stages through which money has evolved are as follows: (i)
Commodity Money (ii) Metallic Money (iii) Paper Money (iv) Credit Money (v)
Plastic Money.
Money has evolved through different stages according to the time, place and
circumstances.

(i) Commodity Money:

In the earliest period of human civilization, any commodity that was generally
demanded and chosen by common consent was used as money.
Goods like furs, skins, salt, rice, wheat, utensils, weapons etc. were commonly
used as money. Such exchange of goods for goods was known as ‘Barter
Exchange’.
(ii) Metallic Money:
With progress of human civilization, commodity money changed into metallic
money. Metals like gold, silver, copper, etc. were used as they could be easily
handled and their quantity can be easily ascertained. It was the main form of
(iii) Paper Money:
It was found inconvenient as well as dangerous to carry gold and
silver coins from place to place. So, invention of paper money
marked a very important stage in the development of money. Paper
money is regulated and controlled by Central bank of the country
(RBI in India). At present, a very large part of money consists
mainly of currency notes or paper money issued by the central
bank.
(iv) Credit Money:
Emergence of credit money took place almost side by side with
that of paper money. People keep a part of their cash as deposits
with banks, which they can withdraw at their convenience through
cheques. The cheque (known as credit money or bank money),
itself, is not money, but it performs the same functions as money.
(v) Plastic Money:
The latest type of money is plastic money in the form of Credit
cards and Debit cards. They aim at removing the need for carrying
cash to make transactions.
Prior to money, goods were exchanged for goods to satisfy the needs of individuals.
This-exchange of goods for goods is known as the barter system of exchange.
According to Chandler,
“The direct exchange of economic goods for one another is called barter.”
However, the barter system was not sufficient to serve the ever-increasing needs and wants of
individuals.
Following are some of the DRAWBACKS OF THE BARTER SYSTEM:
(A) Double Coincidence of Wants:
Refers to one of the assumption of barter system that led to its failure. The double coincidence of wants
implies that the exchange of goods and services between two individuals would take place only when
both the individuals require each other’s goods.
(B) Common Measure of Value:
In barter system, there is no common measure of value; therefore, it is difficult to find out any fixed
ratio for exchanging goods and services.
(c) Indivisibility of Goods:
The barter system of exchange was not applicable in case of goods that lose their utility if divided into
parts. For example, the value of one camel is equal to two horses.
D) Lack of store of value:
 (D) STORE OF VALUE:
Refers to one of the reason FORMS forOF theMONEY
failure of the barter system.
According SOME IMPORTANT
to the barterFORMS
system,OF MONEY
valueAREisDESCRIBED
stored in ASthe
UNDER-
form of
1) FIAT MONEY AND FIDUCIARY MONEY- Fiat money refers to that money which is issued by
commodities,order/authority
such as cereal grains and
of the government. E.g.cattle.
all notes and coins.
(E) DEFERRED
Fiduciary money-It is thatPAYMENTS:
money which is accepted as a medium of exchange because of the
Refer to one of trust
thebetween
mostthe payer and the
important payee. E.g. cheques
drawback of the barter
2 FULL BODIED MONEY AND CREDIT MONEY- Full bodied money refers to money in terms of
system.
coins whoseDeferred payments
commodity value is equal toinvolve those
money value payments
as when that are
these are issued. E.g. silver
made sometime in future. For example, coin interests, rents, loans,
Credit insurance
and money- It refers to that money
premium. Inofthe
which moneysystem,
barter value is more than commodityare
commodities value.
E.g. 1 rupee coin
used as a medium of exchange; therefore, it is very difficult to
make deferred payments.
 FUNCTIONS OF MONEY

SECONDARY/
PRIMARY
SUBSIDIARY FUNCTIONS
FUNCTIONS

1. STANDARD OF DEFERRED PAYMENTS

1. MEDIUM OF EXCHANGE

2. STORE OF VALUE
2. MEASURE/UNIT OF VALUE

3. TRANSFER OF VALUE
 PRIMARY
FUNCTIONS

1. MEDIUM OF EXCHANGE: Money acts as a medium for the sale and purchase of goods and services. In the
absence of money, goods were exchanged for goods. This required double coincidence of wants. Implying that,
exchange was difficult, and therefore, limited. Introduction of money has separated the acts of sale and
purchase: double coincidence of wants is no longer a limitation. Expansion of exchange leads to expansion of
value addition for GDP growth.

2. MEASURE OR UNIT OF VALUE: Unit of account means that the value of each good or service is measured in the
monetary unit. Measurement of value was very difficult in the barter system: one good was valued in terms of the other.
There was no common unit of value Introduction of money has removed this difficulty .
It is because of the existence of money as a common unit of value that we are now able to construct consumer price index
and wholesale price index. Common unit of value (in terms of money) has facilitated comparison of market value of
different assets. Expansion of market has led to expansion of investment in the economy. Common unit of value has
facilitated the estimation of national income and related aggregates.
 SECONDARY
FUNCTIONS

1. STORE OF VALUE: Store of value implies store of wealth. Storing wealth has become considerably easy
with the introduction of money. Wealth can be stored just in terms of paper titles like FDR (fixed deposit
receipt). It was not convenient to store value in the barter system of exchange. Because, goods tend to wear-
out or perish. (a) Stored wealth is a source of future investment, and investment is the principal determinant
of GDP growth. Saving is a virtue when converted into investment. However, it may be noted that idle saving
leads to the deficiency of demand. It hinders the process of GDP growth.

2. TRANSFER OF VALUE: Money serves as a convenient mode of transfer of value (wealth). Money value can be
conveniently transferred (or can be e-transferred) to any part of the world. It is the transfer of value, which has led to the
emergence of MNCs (Multinational Corporations). Accordingly, the concept of global economy has come into existence. It
has led to the emergence of Global Financial Market. Transfer of value has encouraged the growth of multinational
corporations. This has raised the level of global economic activity. Transfer of value has facilitated Direct Foreign
Investment. This has accelerated the process of growth in less developed economies. Accordingly. balanced regional
growth has become an achievable target.
 MONEY AND MONEY SUPPLY
MONEY – It refers to anything that is accepted as a medium
of exchange, measure of value, store of value and means for
standard of deferred payments.

MONEY SUPPLY – It refers to the total volume of money held

by public
at a particular point of time in an economy.
• It includes money held bypublic only. That
means individual and business firms.
• It doesn’t include money creating sector, government and
banking sector.
• It is a stock concept.
MEASURES OF MONEY SUPPLY
M4 -
M3 -
M2 - M3 + total
deposits with post
M1 + net time
M1 - M1 + savings deposits of office savings
deposits with post commercial banks. organization.
C + DD + OD office savings bank.

1. Currency held by the public (CC) – Money supply consists of currency notes and coins held by
the public outside the banks.
2. Net demand deposits held by commercial banks (DD) – Demand deposits are the deposits which
can be withdrawn from banks on demand by writing cheques or through debit cards, etc. For
example, current account deposits and savings account deposits. The word net implies that only
deposits of the public held by the banks are to be included in money supply. The interbank deposits
which a commercial banks holds in other banks are not to be a part of money supply.
3. Other deposits with RBI (OD) – This includes demand deposits of public financial institutions,
demand deposits of foreign central banks and international financial institutions like IMF, World bank
etc.
 IMPORTANT TERMS
High powered money or Bank money
monetary base
It refers to demand deposits or
The currency issued by central chequeable deposits of the
bank can be held by the public people of the commercial
or by the commercial banks. banks.

Demand Term deposit

deposits
These are for a period of time,
These are chequable deposits which like fixed deposits for a period of
can be transferred or withdrawn on
one year or two years..
demand..

1. Gross demand deposits- These BUY

include inter banking claims. SELL
2. Net demand deposits- These don’t
include inter banking claims.
ONLY NET DEMAND DEPOSITS ARE
TAKEN AS A PART OF MONEY SUPPLY.
 LET’S
RECA Q1. Supply of money refers to quantity of
P money
1. As on 31. st March
2. During any specified period of time
3. As on any point of time
4. During a fiscal year

Q2. Which of the following is not included in

money supply?
5. High powered money
6. Bank money
7. Time deposits
8. Inter bank deposits

II. FILL IN THE BLANKS:

9. In INDIA, main source of money supply is

.
2. measure of money supply refers to the sum of
currency, demand deposits in banks and other deposits
in RBI.
 BANKING
BANK means an institution which receives
funds from the public and gives loans and
advances to those who need them.

BANKING has been defined as accepting,

for the purpose of lending or investment,
deposits of money from the public which
are payable on demand or with-drawable
by cheque, draft, order or otherwise.

A commercial bank is that financial

institution which accpets deposits from
the people, gives for
purposes loan various
and functions. performs various other
PRIMARY FUNCTIONS OF COMMERCIAL BANK
ACCEPTING DEPOSITS

Bank accept deposits in several forms according to the requirement of different sections of the society.
CURRENT ACCOUNT DEPOSIT OR DEMAND DEPOSIT which are repayable by bank on demand.
FIXED DEPOSITS OR TIME DEPOSITS in which the amount is deposited with the bank for a fixed
period.
A D VA N C I N G LOANS
MONEY CREATION BY COMMERCIAL BANKING
SYSTEM
MONEY CREATION is the process by which the money supply of a
country or of an economic region is increased. The commercial bank is
responsible for putting currency in circulation through the process of
credit creation.
LEGAL RESERVE RATIO
It is legally compulsory for the banks to keep a certain minimum fraction
of net total demand and time deposits as cash reserves. This LRR is
fixed by the central bank.
i. Cash reserve ratio – It is the fraction of net total demand and time
deposits that commercial banks must keep as cash reserves with the
central bank.
ii. Statutory liquidity ratio – It is the fraction of net total demand and
time deposits that commercial banks must keep with themselves in
the form of specified liquid assets.

How much are the deposits created is determined by:

• The amount of initial deposit
• The legal reserve ratio
 • Money multiplier refers to the process of creation of
credit by the commercial banks, with the help of initial
deposits made by the public and legal reserve ratio.
$ $ $ $ $ $ $ • Money multiplier – 1/LRR
• Value of money multiplier is always greater than 1
since LRR is less than 100%
• Lower the LRR, higher will be the value of money
multiplier and hence, more the money creation.

$ $ $ $ $ $ $ $ $ MORE LESS

$ $ $
$ $ $ $ $ $ $

MONEY MULTIPLIER
 MONEY MULTIPLIER NUMERICAL ILLUSTRATION
• Let us assume that there is only one bank in the economy.
• All receipts and payments in the economy are routed through
that bank.
• Suppose customer deposits Rs. 10000 in bank and the LRR
proposed by the central bank is 20%.
• Since LRR is 20%, the bank will keep 20% of deposits as
reserves, i.e., Rs. 2000 and will lend the remaining 80%, i.e.,
Rs. 8000. Those who borrow will spend this money and same
Rs. 8000 will come back to the bank in the form of deposits.
This raises the total deposits to Rs. 18000 now. Bank again
keeps 20% of 8000, i.e., Rs. 1600 as reserves and lend Rs.
6400 to those in need. This will further raise the deposits with
banks. In this way, deposits will go on increasing @ 80% of
the last deposit.
 Deposits creation by commercial banks
ROUNDS INITIAL FINAL LOANS RESERVES
DEPOSIT DEPOSIT
ROUND 1 10,000 10,000 8000 2000
(10,000 * 0.8)
ROUND 2 8000 6400 1600
(8000 * 0.8)
ROUND 3 6400 5120 1280
(6400 * 0.8)
∞ ∞ ∞ ∞ ∞

TOTAL 50,000 40000 10000

 The deposits creation comes to an end when total reserves becomes equal to the initial deposit, i.e., Rs.
10000.
The number of times the total deposits will become, is determined by money multiplier, i.e., 1/LRR.
Money multiplier = 1/LRR
= 1/0.2 = 5 times.
Total credit creation = initial deposit * 1/LRR
= 10000 * 5 = Rs. 50,000.
 TEST 1. Deposit creation by banks comes to an end when .
YOURSEL a) Fresh deposits with banks become zero
F b) Legal reserve ratio becomes zero
c) Money multiplier becomes zero
d) Total reserves = initial deposits

2. Initial deposits made by the people in th banks from their

resources are called-
own
A) Time Deposits C) Primary deposits
B) Secondary deposits D) None of these

3. State giving reasons whether the following statements are true

or false.
a) Currency created by central bank is called bank money
b) Higher the legal reserve ratio, greater would be the money
creation in the economy
c) Money supply is a stock variable
CENTRAL BANK

Central bank is an apex institution

which operates, control, directs and
regulates the monetary and banking
structure of a country. INDIA’s central
bank is RESERVE BANK OF INDIA.
 #1 ISSUE OF CURRENCY

• The central bank has the sole authority for the issue of currency in the country. All the currency
issued by the central bank is its monetary liability.
• It has to keep a reserve in the form of foreign currencies, government securities, other
securities and metallic reserves (gold etc.) as per statutory rules against the notes issued by it.
• By having monopoly of the issue of notes, the central bank can restrict or expand the supply
of money according to the requirements of the countries.
• With its monopoly of notes issue, the central bank can maintain stability in the internal and the
external value of external value of home currency.
 #2 BANKER TO THE
GOVERNMENT
• Central bank acts as a banker, agent and financial
advisor of the government like commercial to the
public.
• As a banker to the government central bank accepts
receipts and make payments for the government,
and carries out exchange and remittances and other
banking operations. It provides short-term credit to the
government in time of difficulties.
• As a government banker and agent, the central bank
conducts sale and purchase of the government
securities and also manages their public debt
(national debt) and foreign debt.
• The central bank also act as advisor to the
government on monetary, banking and
financial matters.
#4 CLEARING HOUSE FUNCTION
• The central bank acts as a clearing house
for transfer and settlement of mutual
claims of commercial banks.
• Since the central bank holds reserves of
commercial banks, it transfers funds from #5 LENDER OF
one bank to other banks to facilitate
clearing of checks. LAST
RESORT
• The central bank acts as a lender of the
last resort for commercial banks.
Whenever banks are short of funds, they
can take loans from central bank.
• As commercial banks lend to individuals,
the central bank lends to the commercial
banks in times of emergency. Thus the
central bank assumes the responsibility
of meeting directly or indirectly all the
reasonable demand for funds at the time
of crisis. .
#6 CUSTODIAN OF NATION’S RESERVES OF FOREIGN
EXCHANGE.

SELL

BUY

SELL • The central bank is the custodian of the nation’s

gold and foreign exchange reserves.
• These reserves are regulated to
stabilize
exchange rate in the international money market.
BUY • If there are fluctuations in the money market in the
foreign exchange rate, the central bank, in order
to minimize them, may have to sell and buy
foreign currencies in the market.
 #7 CONTROLLER OF CREDIT AND MONEY
SUPPLY
Central banks are supposed to control and regulate the volume and direction of credit by using its monetary
policies. Monetary policies are further classified into quantitative measure and qualitative measures.

QUANTITATIVE MEASURES QUALITATIVE MEASURES

Methods which regulate the volume of Methods which regulate the flow and
credit in the entire economy. direction of credit in selective
sectors of the economy.
Non-discriminatory in nature Discriminatory in nature
Affect the entire economy. Affect traders and businesses only
Types of quantitative methods are Types of qualitative methods are
Bank rate, Open market operations margin requirements, moral suasion
etc. etc.
 RECAP
I. MATCH THE FOLLOWING

Match the terms in column 1 with the relevant function in column 2.

COLUMN 1 COLUMN 2

a) Money i. Issue of currency

a) Commercial banks i. Fixed by central bank

a) Central banks i. Medium of exchange

a) Legal reserve ratio i. Credit creation

2. Which of the following systems is followed by RBI for issuing currency?

a) Simple deposit system
b) Minimum reserve system
c) Proportionate system
d) Fixed fiduciary issue system
 CASH
CASH RESERVE
RESERVE
BANK
BANK RATE
RATE RATIO
RATIO

QUANTITATIV
E STATUTOR
OPEN MARKET Y
MEASURES
OPERATIONS LIQUIDITY
RATIO

REPO &
REVERSE
REPO RATE
OPEN MARKET OPERATIONS
Open market operations refers to buying and selling of government
securities and bonds by the central bank, from and to the general
public and banks. This is done to influence money supply in an
economy.
• Sale of securities -During excess demand or inflation the central
bank start selling of government securities in the market which
reduces the money supply.
• Purchase of securities- During deficient demand or deflation the
central bank starts purchasing or buying of government securities
from the market ,which increases the money supply in the
economy.
 BUY BANK RATE
Bank rate is a rate of interest at which
Central Bank lends funds to commercial
banks.
Increase in bank rate during excess
money supply or inflation. Central Bank
increases the bank rate, high bank rate
forces the commercial banks to raise the
SELL rate of interest which makes the credit
costly or dear. As a result demand for
loans and other purposes falls and
money supply reduces.
Decrease in bank rate- During deficient
money supply or deflation, Central Bank
decreases the bank rate, lower bank rate
forces the commercial banks to reduce
the rate of interest ,which makes credit
cheap .As a result demand for loans and
other purposes increases. Thus credit
creation or money supply increases.
CASH RESERVE RATIO
Cash reserve ratio : The banks are required to
deposit with the central bank a percentage of their net
deposits and time deposits. The minimum percentage
is fixed by the central bank is called cash reserve ratio.
Increase in cash reserve ratio : During excess
demand the central bank increases the cash reserve
ratio. An increase in CRR has the effect of reducing
the bank excess reserves and thus reduced their
ability to give credit. The volume of aggregate
demand and investment will decrease.
Decrease in cash reserve ratio : During deficient
demand or deflation the central bank decreases the
cash reserve ratio, A decrease in cash reserve ratio
has the effect of increasing the banks reserves and
thus increase their ability to give credit. The volume of
aggregate demand and investment will increase.
 STATUTORY LIQUIDITY RATIO

Statutory liquidity ratio- Banks are required to maintain a specified fixed percentage of their net demand and time
deposits in the form of cash or other liquid assets with themselves. It is called statutory liquidity ratio.
• Increase in SLR: During excess demand or inflation the central bank increases the SLR ratio. An increase in
SLR has the effect of reducing the banks reserve and does reduce their ability to give credit. The volume of
aggregate demand and investment will decrease.
• Decrease in SLR: During deficient demand or deflation the central bank decreases the SLR. A decrease in
SLR has the effect of increasing the bank's reserves and does increase their ability to give credit. The volume
of aggregate demand and investment will increase.
 REPO RATE AND REVERSE
REPO RATE
• Repo rate- Repo rate or repurchase rate is the rate at which
Commercial Banks borrow money from the Central bank for a
short period by selling their financial securities to them.
• Raising repo rate make such borrowings by the
commercial banks costly therefore commercial banks are
also forced to raise their lending rates. It makes borrowing
costly. People borrow less. Thus credit creation by
commercial bank decline. Hence, money supply will
decrease in the economy.
• Reducing repo rate has the opposite effect i.e. money
supply will increase in the economy.
• Reverse repo rate- When the commercial banks have surplus
funds they can deposit the same with RBI and can earn interest.
The rate of interest paid by central bank on such deposits is
known as reverse repo rate. An increase in Reverse Repo rate
can cause the commercial bank to transfer more funds to
Central Bank. Due to attractive interest rates this has negative
impact on the lending capacities of the commercial banks and
vice versa.
 MORAL
MARGIN REQUIREMENT
SUASION

QUALITATIV
SELECTIVE CREDIT E
CONTROL MEASURES
 QUALITATIVE MEASURES

1
SELECTIVE CREDIT CONTROL MORAL SUATION
Under the selective or qualitative credit Moral suasion -This is a combination of

2
control methods, the RBI encourages flow persuasion and pressure that the central bank
of credit only to certain types of industries applies on the other banks in order to get
and discourages the use of bank credit for them to fall in line with its policy. This is
certain other purposes. Under this method, exercise through discussions latest speeches
extension of credit to essential purposes is and hints to banks. The central bank
encouraged and to non-essential frequently announces its policy position and
purposes is discouraged. urges the banks to fall in line.
MARGIN REQUIREMENT
Margin requirement - A margin is the difference between
the amount of the loan and market value of the security
3 offered by the borrower against the loan. During inflation
margin requirement is increased so that credit creation
is less and During deflation margin requirement is
decreased so that credit creation is more
DIFFERENCE BETWEEN CENTRAL
BANK AND COMMERCIAL BANK.
CENTRAL BANK COMMERCIAL BANKS
The central bank is the apex bank engaged in Commercial banks are financial institutions that
regulating commercial banks. It is the apex perform the functions of accepting demand
institution of a country’s monetary system. The and time deposits from the public and giving
design and the control of the country’s loans to the public out of this money to
monetary policy is its main responsibility. interest earning investment projects.

There is only one central bank in a country. There is a large number of commercial banks
India’s central bank is the Reserve Bank in a country, eg, state bank of INDIA, ICICI
of INDIA. bank etc.

The central bank is owned and governed by the Commercial banks may be owned by the
central government. government or by the private sector.

The central banks works in public interest. Commercial banks work with profit motive.
 1. Which of the following is not a quantitative
TEST method of credit control?
YOURSELF a) Open market operation b) Margin requirements
c) Variable reserve ratio d) Bank rate policy

2. Who regulates money supply?

a) Government of India b) RBI
c) Commercial Banks d) Planning commission

3. If an economy is to control recession, which of the

following can be appropriate?
a) Reducing repo rate b) Reducing CRR
c) Both a and b d) none of the
above
4. State giving reasons whether the following
statements are true or false.
a) To increase the money supply in the economy,
central bank reduces the margin
requirements
b) Statutory liquidity ratio is the ratio of demand
deposits of a commercial bank which it has to
keep in the form of specified liquid assets.
Thank You