UNIT 6 : MONEY AND

BANKING SYSTEM

PROF. SHIRSENDU ROYCHOWDHURY

ST.XAVIER’S COLLEGE KOLKATA
 UNIT 6 : MONEY AND BANKING SYSTEM

MONEY – DEFINITION, FUNCTIONS, TYPES, CONTROL OF MONEY SUPPLY – OPEN MARKET

OPERATIONS, MEASURES OF MONEY SUPPLY, HIGH – POWERED MONEY, MONEY MULTIPLIER,
CREDIT CREATION BY COMMERCIAL BANKS, SEIGNIORAGE AND INFLATION TAX

WHAT IS MONEY ?

Money is a financial asset that is universally accepted as a means of payment in transactions and
settlement of debt. It does not need to be converted into something else before it can be used for
transactions. So it represents purchasing power in the most liquid form. So, money can be defined as the
stock of assets that can be readily used to make transactions.

WHAT ARE THE FUNCTIONS OF MONEY ?

I ) MEDIUM OF EXCHANGE

The most important function of money is that it acts as a means of payment. We can buy goods and
services using money. Without money, exchanges would have been extremely inconvenient as it used to
be in barter system. But with money, it becomes a lot easier as it is the most liquid form of financial
asset.

II ) UNIT OF ACCOUNT

Money acts as an unit of account as the values of goods and services are expressed in units of money. In
other words, prices are quoted and debts are recorded in terms of money. It is the yardstick for
measuring transactions. So it acts as an unit of account.

III) STORE OF VALUE

Wealth can be held in the form of money for future use. In other words, it can be used to transfer
purchasing power from the present to the future. For example, if a person earns Rs. 100 today, he has
the choice of spending it either today, or tomorrow or next week or next year. Thus, his purchasing
power can be transferred from the present to the future. But money is an imperfect store of value. This
is because, with change in prices over time, the purchasing power of money today might not be same as
it is in some future date, that is, if prices rise in future, then his purchasing power of the money would
fall.

TYPES OF MONEY

i) COMMODITY MONEY

When commodities with some intrinsic value are used as money, then it is known as
commodity money. The most common example of commodity money is gold. The country
which uses gold as money or paper money that is redeemable for gold is said to follow gold
standard. Before the late 19th century, gold standard was very common. But now the
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countries have shifted from commodity money to fiat money.

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PROF.SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST.XAVIER’S COLLEGE (AUTONOMOUS),KOLKATA

 ii) FIAT MONEY

Fiat money is that type of money that does not have any intrinsic value but becomes money
by Government decree or fiat. Currency notes and coins are examples of fiat money.

MEASURES OF MONEY SUPPLY

The amount of money available in an economy is known as money supply. In case of commodity money,
the amount of the commodity available in the economy is a measure of money supply. In case of fiat
money, the supply of money is controlled by the Government. Due to legal restrictions, the Government
has monopoly over printing money. In some countries like India, the Central Bank has been given the
sole authority to control money supply.
In a modern economy, money usually consists of coins, currency notes and current/savings deposits of
commercial banks, time deposits or term deposits in commercial banks, savings and other types of
deposits in post offices.
Note :
i) Current/savings account deposits in commercial banks are also known as demand deposits
as the deposits are payable on demand through cheques or otherwise. These are also
considered as money as cheques drawn on such deposits are readily accepted in the
settlement of transactions or debt.
Other deposits have a fixed term on maturity and cannot be withdrawn on demand. They
are called time deposits or term deposits.
ii) There is a distinction between legal tender and non-legal tender or credit money. Coins and
currency notes are legal tender. They cannot be refused in settlement of payments of any
type. This is not true of non-legal tender money like demand deposits of banks. A payee may
choose not to accept a cheque drawn on demands deposit in a commercial bank.

Supply of money is a stock variable whose value can be measured at particular date. The Reserve
Bank of India publishes figures for four measures of money supply. These are also known as
monetary aggregates :

M1 = CURRENCY + DEMAND DEPOSITS

M2 = M1 + SAVINGS DEPOSITS WITH POST OFFICE SAVINGS BANKS
M3 = M1 + NET TIME DEPOSITS OF BANKS (INTER BANK DEPOSITS ARE NETTED OUT)
M4 = M3 + TOTAL DEPOSITS WITH THE POST OFFICE ( EXCLUDING NATIONAL SAVINGS
CERTIFICATES )

NOTE : i) Demand deposits of the public in banks do not include interbank deposits.
(When one bank holds deposits on behalf of another bank then they are known as
Interbank deposits)
ii) M1 is called Narrow money and M3 is known as broad money or Aggregate Monetary
Resources (AMR)
iii) M2 and M4 have been devised to accommodate post office deposits.
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PROF.SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST.XAVIER’S COLLEGE (AUTONOMOUS),KOLKATA

HIGH POWERED MONEY / MONETARY BASE (M0)

The monetary base of the economy is also known as reserve money or high powered money. It is
generally denoted by M0. It represents all the cash in the economy. It comprises of the following :
i) Currency in the hands of the public
ii) Other deposits with the RBI
iii) Cash reserves of the banks held with themselves
iv) Cash reserves of the banks held with RBI

WHEN WE TALK ABOUT MONEY SUPPLY WE USUALLY REFER TO BROAD MONEY SUPPLY OR M3

THE MODEL OF MONEY MULTIPLIER

The purpose of the model of money multiplier is to show how the Monetary Base, Currency-Deposit
ratio and the Reserve-Deposit ratio together determine the money supply of the economy.

• In this model we consider M1 as the measure of money supply. M1 = Currency in the hands of
the public (C) + Demand Deposits (D).
• The monetary base of the economy is denoted by M0. M0 = Currency (C) + Reserves (R)
• The currency-deposit ratio is denoted by cr ( cr = C/D ). This shows the fraction of deposits that
people hold as currency. It represents the preference of the households regarding the type of
money they wish to hold.
• The reserve-deposit ratio is denoted by rr ( rr = R/D ). This shows the fraction of deposits that is
held as reserves. This depends on the laws regulating banks as well as the business policy of the
banks.

M1 = C + D ……………………(I)
M0 = C + R ……………………(II)

Step I : Dividing (I)/(II) we get : M1/M0 = C + D / C + R

Step II : Dividing the numerator and denominator of R.H.S by D, we get :

M1/M0 = (C/D + 1) / (C/D + R/D) = (cr + 1)/(cr + rr)

Or, M1 = [(cr + 1)/(cr + rr)] x M0

Or, M1 = m x M0 where m = (cr + 1)/(cr + rr)

Here “m” represents MONEY MULTIPLIER and m = (cr + 1)/(cr + rr)

OBSERVATIONS :

• M0 and M1 are directly related, i.e if M0 rises then M1 rises. If M0 rises by 1 unit, then
M1 rises by “m” units. Therefore the monetary base has a multiplied effect on money
supply. Hence the monetary base is also known as High powered money.
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PROF.SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST.XAVIER’S COLLEGE (AUTONOMOUS),KOLKATA

 • If the reserve-deposit ratio or rr rises, then M1 will fall.
[ If rr rises, cr + rr will rise, and hence (cr + 1)/(cr + rr) will fall,i.e m will fall and so M1
will fall.]
• If the currency-deposit ratio or cr rises, then M1 will fall.
[ If cr rises, cr + 1 will rise as well as cr + rr will rise. As rr is a fraction ,i.e rr < 1,
so (cr + 1) > (cr + rr). So, proportional rise in cr + rr will be relatively more than cr + 1
for the same rise in cr. Since proportional rise in numerator is relatively less than
proportional rise in denominator, so the fraction will fall. Hence m will fall and so M1
will also fall with rise in cr.]

CREDIT CREATION BY COMMERCIAL BANKS

The model of credit creation shows how commercial banks can affect money supply.
Let us consider M1 = Currency(C) + Demand Deposits(D) as the measure of money supply.

Assumption 1 : An economy without banks.

In this case the total money supply is equal to the total currency in the hands of the public, because
there are no banks and so demand deposits = 0. If 1000 units of currency is circulated, then volume of
money supply is equal to 1000 units. M1 = C + D = 1000 + 0 = 1000 units.

Assumption 2 : An economy with commercial banks with 100% reserve banking.

Here we assume that people keep money in banks because banks are a safe custody for keeping money
but banks do not advance deposits or loans. The total money deposited is kept as reserve in the banks.
So it is called 100% reserve banking. Here the banks do not earn any profit but they charge nominal fees
for maintaining the accounts. So a person having units of currency keeps it in banks, and the bank keeps
the deposits as reserve until the person draws a cheque to withdraw the deposit.
Suppose there are 1000 units of currency in the economy and people holding the currency keeps it in
banks. Here also the total money supply is 1000 units. Here M1 = C + D = 0 + 1000 = 1000.
The balance sheet of the bank can be represented as follows :

ASSETS LIABILITIES

RESERVES = 1000 DEPOSITS = 1000

In both these cases, the money supply is same as the units of money that was initially available , that is
1000 units. That is, no credit was created.

Assumption 3 : Economy with commercial banks under fractional reserve banking

Here, under fractional reserve banking, the banks accept the deposits from the public and keeps a
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fraction of it as reserves and advances the rest of the money as loans. In this case, the commercial banks
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will be able to affect money supply.

PROF.SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST.XAVIER’S COLLEGE (AUTONOMOUS),KOLKATA

Let us take one example. Suppose the total currency in the hands of the public be 1000 units. Let us
assume that the banks keep 20% as reserve and advances the rest 80% as loans. Suppose person A
deposits 1000 units of currency in bank 1. The bank keeps 20% i.e 200 units as reserve and advances the
rest 80% i.e 800 units as loans to person B. Person B deposits 800 units in bank 2. Bank 2 keeps 20% , i.e
160 units as reserve and advances 80% i.e 640 units as loans to person C. Person C deposits 640 units in
bank 3 which keeps 20% i.e 128 units as reserve and advances 80% i.e 512 units as loans.This process
will continue. The balance sheet of the three banks can be shown as follows :

Bank 1 Bank 2 Bank 3

Assets Liabilities Assets Liabilities Assets Liabilities

Reserves 200 Deposit 1000 Reserves 160 Deposit 800 Reserves 128 Deposit 640

Loan 800 Loan 640 Loan 512

Let us try to understand how banks manage to create credit.

Initial money supply = 1000 units
In the next step money supply = 1000 units + 800 units = 1000 + ( 1 – 20/100 ) x 1000 = 1000 + (1 – rr) x
1000.
[ rr = reserve ratio which denotes the fraction of deposits that bank hold as reserves ]

In the next step money supply = 1000 units + 800 units + 640 units = 1000 + ( 1 – 20/100 ) x 1000 +
(1 – 20/100) x (1 – 20/100) x 1000 = 1000 + (1 – rr) x 1000 + (1 – rr)2 x 1000.

In the next step money supply = 1000 units + 800 units + 640 units + 512 units = 1000 + ( 1 – 20/100 ) x
1000 +(1 – 20/100) x (1 – 20/100) x 1000 +(1 – 20/100) x (1 – 20/100) x ( 1 – 20/100 ) x 1000 = 1000 +
(1 – rr) x 1000 + (1 – rr)2 x 1000 + (1 – rr)3 x 1000 .

This process will continue.

Therefore total money supply = M1 + (1 – rr) x M1 + (1 – rr)2 x M1 + (1 – rr)3 x M1 + …….

= M1 [ 1 + (1 – rr ) +(1 – rr )2 + (1 – rr)3 + …… ]
= M1 x ( 1 / rr )
where [1 + (1 – rr ) +(1 – rr ) + (1 – rr)3 + ……] = 1 / rr which is the sum of the infinite G.P series.
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Thus commercial banks can affect the money supply of the economy. Of all financial institutions only
banks have the legal authority to create assets that are part of money supply. Again it is to be noted that
banks create money and not wealth. In other words, the creation of money by the banking system
increases the economy’s liquidity and not its wealth.
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PROF.SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST.XAVIER’S COLLEGE (AUTONOMOUS),KOLKATA

HOW CENTRAL BANK CONTROLS THE MONEY SUPPLY ?

The control over the supply of money by the central bank or the government is known as monetary
policy.

The central bank controls the money supply to attain the following goals :
i) High and stable employment
ii) Economic growth
iii) Price stability
iv) Financial stability
v) Stability in the foreign exchange market
Some of the goals are consistent with one another whereas others might be conflicting. For example
high economic growth might lead to high employment but again low inflation might lead to rise in
unemployment. So central bank has to face various trade-offs in order to make the right choice of the
policies.
The monetary policy targets are generally classified as
i) Ultimate targets
ii) Intermediate targets
The ultimate targets that the monetary authority attempts to control are major macroeconomic
variables such as unemployment, inflation and growth of real GDP. But it is not possible for the RBI to
act on the ultimate targets directly. Therefore it often chooses to control intermediate targets which
are not important in their own right, but help in influencing the ultimate goals in a predictable way.
Important intermediate targets are the monetary aggregates (M0,M1,M2,M3 and M4) or the interest
rates.
Generally, at the beginning of each quarter, the RBI determines the Money Growth Rate that seems
consistent with achieving the ultimate targets. This money growth rates and ultimate targets are
determined on the basis of data on past performance and forecasts about the next quarter or year made
by a team of analysts. Accordingly, the RBI decides on using the various monetary policy instruments.
Again in the beginning of the next quarter, the money supply target is reviewed and adjusted on the
basis of the experience within the quarter.

The RBI can affect the money supply by changing the Monetary base or the value of the money
multiplier. This can be done through various monetary policy instruments.
Three major instruments are :
i) Variation in CRR
ii) Variation in Bank Rate
iii) Open market operations

i) Variation in CRR
If the bank raises the CRR ( the reserves of commercial banks held at RBI ), the loanable funds at the
disposal of commercial banks gets reduces at one stroke and the money supply contracts. The opposite
effect happens when CRR is reduced. Changing the CRR is a drastic way of changing the money
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multiplier and it is not used very frequently as frequent changing of CRR might lead to destabilizing of
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the system.

PROF.SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST.XAVIER’S COLLEGE (AUTONOMOUS),KOLKATA

 ii) Variation in the Bank Rate
Commercial banks may approach the RBI for loans to add to their reserves. The bank rate is the interest
rate charged by the Central Bank (RBI) for such loans. If the bank rate is low, the banks are encouraged
to borrow reserves against which they can advance loans. This facilitates credit creation. If the bank rate
is high, banks are discouraged to borrow from RBI. Moreover, with rise in bank rate, the banks also raise
the rates of interest they charge on their loans. This diminishes the demand for credit by firms or
households.
iii) Open Market Operations
Open market operations refer to the sale and purchase of Government Bonds. When Central Bank wants
to increase money supply, it purchases Government bonds from the public and then the currency
available in the hand of the public increases. When it wants to decrease money supply, its sells
Government bonds from its own portfolio, and thus the currency in circulation decreases.

SEIGNIORAGE AND INFLATION TAX

The Government can finance its expenditure in three possible ways :

• Raising tax revenue
• Borrowing from the public by selling Government bonds
• Printing new money
The revenue from printing new money is known as seigniorage. When new money is printed and
circulated in the economy, the money supply of the economy rises. With the rise in money supply, the
general price level of the economy rises (inflation). With rise in general price level, the purchasing power
of money held by public falls. This fall in the purchasing power of money held by the public can be
viewed as a tax that the holders of currency are paying due to inflation caused by printing new money.
This is not tax paid in the real sense but it is implicit tax, as the purchasing power of the money held is
falling. So seigniorage is also known as inflation tax.

Let ∆M be the volume of new money that is printed and circulated in the economy. So the nominal
seigniorage revenue is ∆M. But the real seigniorage revenue ( R ) = ∆M/P. Let M0 be the initial stock of
money in the economy.
R = ∆M/P = ∆M/P x M0/M0 [ since M0/M0 = 1]
= ∆M/M0 x M0/P

So real seigniorage revenue depends on ∆M/M0 and M0/P.

∆M/M0 represents growth of money stock of the economy.

M0/P represents the purchasing power of old money stock.

As money supply rises , ∆M > 0. So ∆M/M0 is positive. With rise in money supply, P will rise and hence
M0/P will fall. So the purchasing power of old money stock will fall. This is why seigniorage is known as
Inflation tax.
Note : If ∆M/M0 > M0/P then R will rise.
If ∆M/M0 = M0/P then R will remain same
If ∆M/M0 < M0/P then R will fall.
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PROF.SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST.XAVIER’S COLLEGE (AUTONOMOUS),KOLKATA

QUESTIONS :
1) What is money ? (3)
2) Is money same as income ? (3)
3) What are the functions of money ? (6)
4) What are the types of money ? (5)
5) What is reserve money or high powered money ? (3)
6) Explain the model of money multiplier. (5)
7) Explain the process of credit creation by commercial banks ? (10)
8) What is seigniorage ? Why is it known as inflation tax ? ( 2 + 3 )
9) Explain the various ways by which the government can control the money supply of the
economy. ( 6 )
10) Briefly describe the measures of money supply used in India. In this context identify the
narrow measure and the broad measure of money supply. ( 5 )

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PROF.SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST.XAVIER’S COLLEGE (AUTONOMOUS),KOLKATA

REFERENCES / SUGGESTED READS :

1) MACROECONOMICS by N.GREGORY MANKIW ; 6TH EDITION , WORTH PUBLISHERS

2) PRINCIPLES OF MACROECONOMICS by SOUMYEN SIKDAR ; 2ND EDITION, OUP
3) MACROECONOMIC POLICY ENVIRONMENT-AN ANALYTICAL GUIDE FOR MANAGERS by
SHYAMAL ROY ; 2ND EDITION, TMH

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PROF.SHIRSENDU ROYCHOWDHURY_B.COM (M)_ST.XAVIER’S COLLEGE (AUTONOMOUS),KOLKATA