Chapter 3. Money and Banking

• Money is most important discovery of modern times. This is foundation stone around which all economic activities resolve. This is very difficult to imagine modern economic life without money. This is basic necessity of all economies.
• Money is anything which is usually accepted as a medium of exchange, measures of value, store of value and means for standard of deferred payment. This is commonly accepted medium of exchange.
• In an economy that consists of only one individual there cannot be any exchange of commodities and hence there is no role for money. This is not perishable. It can act as a store of value for individuals.

Functions of Money
• functions of money can be broadly categorized under two heads: [i] Primary Functions, and [ii] Secondary Functions.
• Money, as a medium of exchange, means that it can be used to make payments for all transactions of goods and services.
• Money as a measure of value means that money works as a common denomination in which values of all goods and services are expressed.
• Money acts as a standard of deferred payments, which are to be made in future.
• Money is a way to store wealth. Money can be used to transfer purchasing power from present to future.
• value of all goods and services can be expressed in monetary units.

Barter System
• Barter Exchange refers to exchange of goods for goods. An economy, where there is a direct barter of goods and services, is known as a Barter Economy or C-C Economy.
• A barter system has other deficiencies. This is difficult to carry forward one’s wealth under barter system.
• Barter system can work only when both buyer and seller are ready to exchange each other’s good.
• Economic exchanges without mediation of money are referred to as barter exchanges.

Cashless Economy
• Some countries have made an attempt to move towards an economy which uses less of cash and more of digital transactions.
• A cashless society describes an economic state whereby financial transactions are not connected with money in form of physical bank notes or coins but rather through transfer of digital information between transacting parties.

Reforms related to Cashless Economy
• In India, government has been consistently investing in various reforms for greater financial inclusion. During last few years, initiatives such as:
(1) Jan Dhan accounts, (2) Aadhar enabled payment systems, (3) e –Wallets, (4) National Financial Switch [NFS], and others. They have strengthened government’s resolve to go cashless.
• Today, financial inclusion is seen as a realistic dream because of mobile and smart phone penetration across country.

Demand for Money
• demand for money tells us what makes people desire a certain amount of money.
• A rise in income will lead to rise in demand for money.
• Higher interest rates mean money demand comes down.

Supply of Money
• Money supply refers to total volume of money held by public at a particular point of time in an economy.
• Till

1967 – 68, Reserve Bank of India [RBI] used only narrow measures of money supply. But since 1977, four alternative measures of money supply [M1, M2, M3, & M4] have been evolved.

Central Bank
• Central Bank is an Apex body that controls, operates, regulates & directs entire banking and monetary structure of country.
• Almost every country has one central bank.
• ‘Reserve Bank of India’ is central bank for India which was established in 1935.
• currency issued by central bank can be held by public or by commercial banks, and is known as ‘high-powered money’ or ‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.

Functions of Central Bank
• It gives out country’s money. It controls country’s money supply in a number of ways, such as through bank rates, open market operations, and changes in reserve ratios. It acts as government’s banker. This is in charge of economy’s foreign exchange reserves. This is a way for banks to talk to each other.

Commercial banks
• A Commercial Bank is an institution that performs functions of accepting deposits, granting loans, and making investments with aim of earning a profit. They accept deposits from public and lend out part of these funds to those who want to borrow.
• interest rate paid by banks to depositors is lower than rate charged from borrowers.
• This difference between these two types of interest rates, known as ‘spread’, is profit appropriated by bank.
• Commercial banks mediate between individuals or firms with excess funds and lend to those who need funds.
• People with excess funds can keep their funds in form of deposits in banks and those who need funds, can borrow funds in form of home loans, crop loans.
• People prefer to keep money in banks because banks offer to pay some interest on any deposits made.

Money Creation by Banking System
• Balance sheet is a record of assets and liabilities of any firm. Conventionally, assets of firm are recorded on left hand side and liabilities on right hand side.

• Assets are things a firm owns or can claim from others.
• In case of a bank, apart from buildings, furniture., its assets are loans given to public.
• Another asset that a bank has is reserves.
• Reserves are deposits which commercial banks keep with Central Bank, Reserve Bank of India [RBI] and its cash.
• These reserves are kept partly as cash and partly in form of financial instruments i.e., bonds & treasury bills issued by RBI. Reserves are similar to deposits.
• Commercial banks like SBI keep their deposits with RBI and these are known as Reserves. Assets = Reserves + Loans

• Liabilities for any firm are its debts or what it owes to others. For a bank, main liability is deposits that people keep with it. Liabilities = Deposits

Net Worth
• accounting rule states that both sides of account must balance. Hence if assets are greater than liabilities, they are recorded on right hand side as Net Worth. Net Worth = Assets – Liabilities

Reserve Ratio
• RBI decides a certain percentage of deposits which every bank must keep as reserves. It is done to ensure that no bank is ‘over lending’. It is a legal requirement and is binding on banks. It is known as ‘Required Reserve Ratio’ or ‘Reserve Ratio’ or ‘Cash Reserve Ratio’ [CRR].
• If Central bank changes reserve ratio, this would lead to changes in lending by banks which, in turn, would impact deposits and hence, money supply.

Cash Reserve Ratio [CRR]
• CRR = Percentage of deposits which a bank must keep as cash reserves with bank. Apart from CRR, banks are required to keep some reserves in liquid form in short term. This ratio is known as Statutory Liquidity Ratio or SLR.

Policy Tools to Control Money Supply
• Reserve Bank is only institution which can issue currency.
• When commercial banks need more funds in order to be able to create more credit, they may go to market for such funds, or go to Central Bank.
• This role of RBI, that of being ready to lend to banks at all times, is another important function of central bank, and due to this, central bank is said to be ‘lender of last resort’.
• RBI controls money supply in economy through various tools, which are classified as quantitative or qualitative.
• Quantitative tools: Quantitative tools control extent of money supply by changing CRR, or bank rate, or open market operations.
• Open Market Operations: It refers to buying and selling of bonds issued by government in open market. This purchase and sale is entrusted to central bank on behalf of government.
• When RBI buys a government bond in open market, it pays for it by giving a cheque.
• This cheque increases total amount of reserves in economy and thus increases money supply. Selling of a bond by RBI [to private individuals or institutions] leads to a reduction in quantity of reserves and hence money supply. They are permanent in nature. When central bank buys these securities [thus injecting money into system], it is without any promise to sell them later. Similarly, when central bank sells these securities [thus withdrawing money from system], it is without any promise to buy them later.
• Qualitative tools: Qualitative tools include persuasion by central bank in order to make commercial banks discourage or encourage lending which is done through moral suasion, margin requirement.

Repo Rate & Reverse Repo Rate
• When central bank buys security, this agreement of purchase has specifications about date and price of resale of this security. This type of agreement is known as a repurchase agreement or repo.
• central bank may sell securities through an agreement that has a specification about date and price at which it will be repurchased. This type of agreement is known as a reverse repurchase agreement or reverse repo. rate at which money is withdrawn in this manner is known as reverse repo rate.
• Reserve Bank of India conducts repo and reverse repo operations at various maturities: overnight, 7-day, 14- day.
• This type of operations have now become main tool of monetary policy of Reserve Bank of India.

Bank Rate
• RBI can influence money supply by changing rate at which it gives loans to commercial banks. This rate is known as Bank Rate in India.
• By increasing bank rate, loans taken by commercial banks become more expensive; this reduces reserves held by commercial bank and hence decreases money supply. A fall in bank rate can increase money supply.

Demand and Supply for Money
• Money is most liquid of all assets in sense that it is universally acceptable and hence can be exchanged for other commodities very easily. On other hand, it has an opportunity cost.
• number of times a unit of money changes hands during a unit period is known as velocity of circulation of money.
• total value of annual transactions in an economy includes transactions in all intermediate goods and services, and is clearly much greater than nominal GDP.

Speculative Motive
Bonds They are papers bearing promise of a future stream of monetary returns over a certain period of time.
• These papers are issued by governments or firms for borrowing money from public, and they are tradable in market.
• If supply of money in economy increases and people purchase bonds with this extra money, demand for bonds will go up, bond prices will rise and rate of interest will decline.

Supply of Money: Various Measures
• Coins are issued by Government of India.
• Apart from currency notes and coins, balance in savings, or current account deposits, held by public in commercial banks is considered money since cheques drawn on these accounts are used to settle transactions. Such deposits are known as demand deposits, as they are payable by bank on demand from account-holder.
• Other deposits, for example, fixed deposits, have a fixed period to maturity and are referred to as time deposits.

Fiat Money
• Currency notes and coins are therefore known as fiat money. They do not have intrinsic value like a gold or silver coin. They are known as legal tenders as they cannot be refused by any citizen of country for settlement of any kind of transaction.
• Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of payment. Hence, demand deposits are not legal tenders.

Aggregate Monetary Resources
• M1 = Currency + Demand Deposits
• M1 = CU + DD
• M2 = M1 + Savings deposits with Post Office savings banks
• M3 = M1 + Net time deposits of commercial banks
• M4 = M3 + Total deposits with Post Office savings organisations [excluding National Savings Certificates]
Where, CU is currency [notes plus coins] held by public and DD is net demand deposits held by commercial banks
• M1 and M2 are called narrow money.
• M3 and M4 are called broad money.
• These measures are in decreasing order of liquidity.
• M1 is most liquid and easiest for transactions, whereas M4 is least liquid of all.
• M3 is most commonly used measure of money supply. This is called aggregate monetary resources. Money Multiplier = 1/Cash Reserve ratio

• Demonetisation was a new initiative taken by Government of India in November 2016, to tackle problem of corruption, black money, terrorism, and circulation of fake currency in economy.
• old currency notes of Rs 500 and Rs 1000 were no longer legal tender. New currency notes in denominations of Rs 500 and Rs 2000 were launched.

Impact of Demonetisation
• It has improved tax compliance as a large number of people were brought in tax ambit.
• savings of an individual were channelised into formal financial system. As a result, banks have more resources at their disposal which can be used to provide more loans at lower interest rates.
• Tax evasion will result in a financial penalty and social condemnation. Tax compliance will improve and corruption will decrease.
• Demonetisation could help tax administration in another way by shifting transactions out of cash economy into formal payment system.
• Households and firms have begun to shift from cash to electronic payment technologies.

Leave a Reply

Your email address will not be published. Required fields are marked *