CH-3 MONEY AND

BANKING
 Topics included in the syllabus
• Money – meaning and functions
• 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, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Repo
Rate and Reverse Repo Rate, Open Market Operations, Margin
requirement.
Money
•Money is the most often used means of
exchange. It is an economic unit that serves as
a universally accepted means of exchange in a
transactional economy.
•Money offers the benefit of lowering transaction
costs, particularly the double coincidence of
wants. There can be no exchange of
commodities and thus no role for money in an
economy consisting of only one person.
Barter Exchange
• It
is a trade in which one product or service is exchanged
for another. It is the oldest form of commerce. Individuals
and businesses exchange goods and services based on
equivalent prices and good estimates. Individuals and
businesses barter goods and services with one another
based on similar pricing and quality assessments.
• Bartering, on a larger scale, can result in the most
efficient use of resources by exchanging items in
quantities that have equivalent values. Bartering can also
assist economies in reaching equilibrium, which happens
when supply and demand are equal.
Disadvantages of Barter
Exchange
•1. A lack of a standardized means of
measuring value.
•2. There is a lack of desire for duplication.
•3. A scarcity of common value measures.
•4. Inadequate store of value.
•5. Deferred payment standards are lacking.
6. Inability to divide
 Functions of Money
•1. Primary functions.
• i. A mode of exchange.
• ii. A common measure of value or a common unit of
value.

•2. Secondary functions:

• i. Value storage.
• ii. Value transfer.
•iii. Deferred payment standard.
Characteristics of Money
• Money needs to be all of the following:
• Acceptable
• Durable
• Portable
• Divisible
• Standardized, easily recognized but not easily
copied
• Controlled by central authority
Different Kinds of Money

• Commodity money
• Gold and other precious metals
• Coins
• Paper money
• Chequebook money (deposits)
 Demand of Money
•Itis referred to as an individual's liquidity preference,
which is the decision to hold money in liquid form, i.e.,
cash, to earn interest or as a precaution.
•Money demand is impacted by several factors such as
inflation, income, interest rates, and future
uncertainty.
•The two important motives for the demand of money:
transaction, and speculative motives, are commonly
used to describe how these elements affect money
demand
 MOTIVES OF DEMAND
• i.
Transaction Motive: The drive to hold cash amounts is referred
to as the transaction's motive. The fact that most transactions
involve an exchange of money is the transaction motive for
demanding money. Money will be demanded because it is necessary
to have money available for transactions. The aggregate quantity of
transactions in an economy tends to increase as income grows.
• As a result, as income or GDP rises, so does the demand for money
in transactions.
• ii.Speculative Motive: It refers to funds retained by investors to
capitalise on potential investment opportunities in the economy.
When retaining money is thought to be less hazardous than lending
it or investing it in another asset, the speculative motive for
demanding money emerges.
 Aggregate Money Demand
• Inan economy, the entire demand for money is made up of
transaction demand and speculative demand. The former is
proportionate to real GDP and the price level, whereas the latter
is inversely related to the market interest rate.
 Fiat money
•Itis the currency
that a
government
declares to be
legal tender but
is not backed by
a physical asset.
Supply of Money:
•It
refers to the total money held by the
public at a particular point in time in an
economy. The supply of money does not
include the cash balances held by the
national and state governments, as well
as the stock of money held by the
country's banking system, because these
are not in active circulation in the country.
Measures of Money Supply:
• i.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).
• M1= Currency and coins with public( C) + D 1 emand
deposits of the public with the banks(DD) Other deposits
(OD)
• ii.
M2 : It is also known as narrow money along with M1. It
includes Savings deposits with Post Office saving banks.
• M2=M1+ Savings deposits with Post Office sav 2 1 = + ing
banks
 M1 Definition M2 Definition
• Includes all of M1 plus all notice
• Simplest, most basic definition deposits (savings accounts on
• Includes currency in circulation (coins and deposit for an undefined length of
paper bank notes) plus demand deposits in the time) and what are called personal
chequing accounts of all commercial banks. term deposits, which are on deposit
• The word demand in demand deposits for a specific term, such as six
refers to the fact that depositors can months.
demand their deposits in cash at any time. • The money supply (in $ billions) in
• The money supply (in $ billions) in Canada in Canada in November 2007 was:
November 2007 was: • M2 = M1 plus notice deposits and
• M1 = currency plus demand deposits personal term deposits
• 189 = 49 + 140 • 769 = 189 + 580
• (26% ) (74%) • (25% ) (75%)
M3 Definition

• Includes M2 but adds to it term deposits of

businesses (known as certificates of deposits), which
are easily convertible into chequable deposits.
• The money supply (in $ billions) in Canada in
November 2007 was:
• M3 = M2 plus certificates of deposits
• 1191 = 769 + 422
 Banking Systems
• 1. Commercial Bank: • 2. Central Bank:
•A commercial bank is a type of • In the banking system, the
financial organization that handles
all transactions involving the central bank is recognized as the
deposit and withdrawal of money for highest financial institution. It is
the public, as well as the provision seen as an essential component
of loans for investment purposes of a country's economic and
and other similar activities. financial system.
• These banks are profit-making
enterprises that conduct business • The central bank is an
only to make a profit. State Bank of independent authority in charge
India and Canara Bank are some of supervising, regulating, and
examples. stabilizing the country's
monetary and banking structures
 COMMERCIAL BANK
• A Commercial bank is a financial institution which performs the
functions of accepting deposits from the public and advancing
loans. The Bank acts as an intermediary between those who have
surplus money and those who are in need of money.

•
 Types of deposits held by the Commercial Banks

A) Current account deposits: • c) Fixed or Time Deposits:

The depositor can withdraw his money at any • Money is deposited for a fixed period of time.
time. Cheque facility is provided to the The depositor can withdraw money only after
depositor. The Bank does not pay any interest. completing that term. Interest rate is high.
•
b) Saving Account deposits: • d) Recurring Deposit:
• The depositor can withdraw his money at any • It aims at encouraging regular savings by the
time. However, the bank may impose some people. The depositor can deposit money in
restrictions on withdrawal. Interest rate is low installments for a given period of time.
when compared to time deposits. The purpose Withdrawal can be done only after completing
of this deposit is to encourage small savings. the term.
 CREDIT CREATION BY COMMERCIAL BANKS
• Assumptions:
• Banking system is considered as one unit, namely Banks..
• All receipts and payments in the economy are through the banks.
• All payments are through cheques.
• The one who receives payment deposits the same in his account.

Suppose, Bank receives a deposit of Rs 1000. A part of this deposit Bank keeps as Statutory
Liquidity Ratio (CRR and SLR). Suppose LRR is 20%.
• The Bank keeps Rs.200 as reserve and gives Rs. 800 as loans. The borrower is asked to open an
account with the Bank and the loan amount is credited in his account. So, Bank receives a
deposit of Rs. 800.
• Suppose, the man who takes loan withdraws the money, he pays it to another man and the
other person will deposit that amount in the Bank. Every loan creates a deposit.
 CREDIT CREATION BY COMMERCIAL
BANKS
• Now the Bank has Rs. 800 as deposit, it can keep 20% of the amount as reserve and lend
the remaining Rs. 640. The deposit creation continues in the above manner. So, Bank can
lend several times more than the amount that it receives as deposit.
• How many times more than the initial deposit can the Bank lend? It depends on the LRR.
•
• Money Multiplier =
• Money Created = Initial deposit x Multiplier
• = 1000 x
• = 5000
 Money Creation by Banks:
• Banks are in the business to make money.
• Major source of profit comes from using any excess deposits productivity be
lending them out.
• Profit comes from the spread – the difference between the interest rate a
bank charges to borrowers and the interest rate it pays to depositors.
• Not much difference in spread between different banks.
• Total profits come from total volume rather than differences in spreads.
• Banks do not carry excess inventory (money).
• No return on idle money balances
• Reserves kept to a minimum
• Cash reserve ratio is the proportion of demand deposits that a bank
wants to hold in the form of cash.
 CENTRAL BANK
• Central Bank is the monetary authority of a country
• It controls, regulates and supervises all the monetary institutions.
• The name of the Central bank in India is Reserve Bank of India (RBI). It was established
in 1935.
 Functions of the Central Bank (RBI)

• i) Issue of currency • (ii) Banker to the government

• The Central Bank receives and makes all
• The Central Bank alone
can issue currency notes in India. the payments on behalf of the government.
It is called “the ways and means loans”.
• Coins and one-rupee notes are printed by
• The Central Bank manages public debt. The
the Government. The RBI will put them
into circulation. All other currency notes Central bank has to manage all issues
are printed and issued by RBI. connected with public debt.
• The Central Bank advises the government
• India follows minimum reserve system.
on banking and financial matters.
RBI has to maintain gold and foreign
• The government keeps its balances in the
exchange reserves of `200 crores out of
which ` 115 crores should be gold. current account of the RBI.
 Functions of the Central Bank (RBI)

• iii) Bankers’ Bank and supervisor:

• Iv)Lender of the Last Resort:-
• All the commercial banks have to keep some
percentage of their deposits with the RBI.
This is called Cash Reserve Ratio (CRR).
• The central Bank gives licences to start • When the Commercial Banks are in
commercial banks, inspects the work of financial difficulties, they can get
commercial banks periodically and loans from the RBI. They can
sometimes asks the banks to wind up. approach the RBI with discounted
• Every commercial bank is required to
bills. RBI will rediscount them and
maintain a fixed percentage of its deposits in
the form of cash with itself. This is called
advance loans.
Statutory Liquidity Ratio. RBI fixes SLR.
 Functions of the Central Bank (RBI)

• (v) Clearing house function • vi)Custodian of foreign

• Representatives from different exchange reserves
banks in a city meet at the clearing
house office of the central bank.
• The Central Bank
Wherever RBI is not there SBI office buys and sells foreign
will have the clearing facility. currencies in the market. So,
• Payments from one bank to another we say central bank is the
are adjusted in the accounts custodian of foreign exchange
maintained by the commercial banks
with the RBI or SBI.
reserves.
vii)Control of credit

•
Commercial banks create credit where as central
bank controls credit. The central bank has two
weapons to control credit in the country. They are:
• (A) Quantitative credit control measures.
•(B) Qualitative credit control measures.
 a. Quantitative measures :-

•Bank Rate
•Repo Rate
•Reverse Repo Rate
•Open Market operations
•Cash Reserve Ratio (CRR)
•Statutory Liquidity Ratio (SLR)
 a. Quantitative measures :-

• 1. Bank Rate:
• Commercial Banks may take loans to meet their long term credit needs from the Central Bank. The interest charged on
these loans is called Bank Rate.
• During Inflation Bank Rate will be increased. The lending capacity of commercial banks will fall. They will advance less
loans with high interest rate . Money supply will fall. Aggregate Demand will fall. Inflation will be reduced
• During deflation, bank rate will be decreased. Lending power of banks will increase. They will advance more loans.
Demand will increase . Deflation will be reduced.

2. Repo Rate:
Commercial Banks may take loans to meet their short term credit needs from the Central Bank. The interest charged on
these loans is called Repo Rate.
• During Inflation Repo Rate will be increased. The lending capacity of commercial banks will fall. They will advance less
loans with high interest rate . Money supply will fall. Aggregate Demand will fall. Inflation will be reduced
• During deflation, Repo Rate will be decreased. Lending power of banks will increase. They will advance more loans.
Demand will increase . Deflation will be reduced
 a. Quantitative measures :-

• 3. Reverse Repo Rate

• Reverse Repo Rate: Sometimes, the Central Bank may borrow money from Commercial Banks.
This interest paid for these loans is called Reverse Repo Rate. During Inflation, the Reverse
Repo rate will be increased. The Commercial Banks will lend more money to Central bank. They
will lend less to public. Money supply and Aggregate Demand will fall.
• During deflation reverse repo rate will be reduced. Banks will lend less to RBI and more to
public. Money supply will increase. Deflation will be controlled

4. Open Market Operations:

• During Inflation, the Central Bank will sell securities to the public and get money. Money supply
will decrease and inflation will be controlled.
• During deflation, the Central Bank will buy back securities and give money to public. Money
supply will increase. Deflation will be controlled.
a. Quantitative measures :-

• 5. Legal Reserve Ratio

Cash Reserve Ratio Statutory Liquidity Ratio

LRR will be increased during inflation and reduced during deflation

 Qualitative credit control measures
(or)
Selective credit control measures:-
•Margin Requirement: This can be explained with an example. A person
gives a collateral security worth Rs 100 to a commercial bank and the bank
may give him loan of Rs 80. This means the margin is 20%. During Inflation
bank will increase margin requirement. During deflation margin
requirement will be reduced.
Rationing of credit: Rationing of credit refers to the fixation of credit quotes
for different business activities. Rationing of credit is introduced when the
flow of credit is to be checked particularly for speculative activities in the
economy. The central bank fixes credit quota for different activities,
commercial banks can not exceed the quota limits while granting loans.
 Qualitative credit control measures
(or)
Selective credit control measures:-
Direct Action:-The central bank may initiate direct action against the
member banks in case do not comply with its directives. Direct action
includes derecognizing of a commercial bank as a member of country's
banking system.

Moral Suasion:-Some times the central bank makes the member

banks agree through persuasion or pressure to follow its directives
with a view to controlling the flow of credit. The central bank has its
control overall commercial banks. Therefore, these banks generally
care for the advice of the central bank for expanding or contracting the
flow of credit