Chapter 29

The Monetary System

• Money Aggregates: Standard Measures of Money Supply
• In short, there are two types of money.
• Central bank money (M0) – obligations of a central bank,
including currency and central bank depository accounts.
• Commercial bank money (M1 and M3) – obligations of
commercial banks, including current accounts and savings
accounts.
• In the money supply statistics, central bank money is M0 while the
commercial bank money is divided up into the M1 and M3
components. M2 and M4 components also include Post-Office
deposits as well.
• Generally, the types of commercial bank money that tend to be
valued at lower amounts are classified in the narrow category of
M1 while the types of commercial bank money that tend to exist
in larger amounts are categorized in M2 and M3. M3 is the largest
of all money aggregates (M1-M3).
• Note: In this article, we cover the Monetary Aggregates as per the
old convention (M1, M2, M3, and M4). In the new convention,
aggregates are represented as NM1, NM2, and NM3.
• Reserve Money (M0):
• Reserve money is also called central bank money,
monetary base, base money, or high-powered money.
It is the base level for the money supply or the
high-powered component of the money supply.
• In the most simple language, Reserve Money
is Currency in Circulation plus Deposits of Commercial
Banks with RBI.
• Mo
• = Currency in circulation + Bankers’ deposits with the
RBI + ‘Other’ deposits with the RBI
• = Net RBI credit to the Government + RBI credit to the
commercial sector + RBI’s claims on banks + RBI’s net
foreign assets + Government’s currency liabilities to
the public – RBI’s net non-monetary liabilities.
• M1 (Narrow Money)
• =Currency with the public + Deposit money of the public (Demand
deposits with the banking system + ‘Other’ deposits with the RBI).
• M2:
• =M1 + Savings deposits with Post office savings banks.
• M3: (Broad Money)
• = M1+ Time deposits with the banking system
• = Net bank credit to the Government + Bank credit to the
commercial sector + Net foreign exchange assets of the banking
sector + Government’s currency liabilities to the public – Net
non-monetary liabilities of the banking sector (Other than Time
Deposits).
• M4:
• =M3 + All deposits with post office savings banks (excluding
National Savings Certificates).
• What are the main functions of Reserve Bank
of India?
• Reserve Bank of India (RBI) is the Central Bank
of India. RBI was established on 1 April 1935
by the RBI Act 1934. Key functions of RBI are,
banker’s bank, the custodian of foreign
reserve, controller of credit and to manage
printing and supply of currency notes in the
country.
• Reserve Bank of India (RBI) is the central bank of the
country. RBI is a statutory body. It is responsible for
the printing of currency notes and managing the
supply of money in the Indian economy.
• Initially, the ownership of almost all the share capital
was in the hands of non-government shareholders. So
in order to prevent the centralisation of the shares in
few hands, the RBI was nationalised on January 1,
1949.
•
• Functions of Reserve Bank
• 1. Issue of Notes —The Reserve Bank has a monopoly for printing the
currency notes in the country. It has the sole right to issue currency notes
of various denominations except one rupee note (which is issued by the
Ministry of Finance).
• The Reserve Bank has adopted the Minimum Reserve System for
issuing/printing the currency notes. Since 1957, it maintains gold and
foreign exchange reserves of Rs. 200 Cr. of which at least Rs. 115 cr. should
be in gold and remaining in the foreign currencies.
• 2. Banker to the Government–The second important function of the
Reserve Bank is to act as the Banker, Agent and Adviser to the
Government of India and states. It performs all the banking functions of
the State and Central Government and it also tenders useful advice to the
government on matters related to economic and monetary policy. It also
manages the public debt of the government.
• 3. Banker’s Bank:- The Reserve Bank performs the same functions for the
other commercial banks as the other banks ordinarily perform for their
customers. RBI lends money to all the commercial banks of the country.
• 4. Controller of the Credit:- The RBI undertakes the responsibility of controlling
credit created by commercial banks. RBI uses two methods to control the extra flow
of money in the economy. These methods are quantitative and qualitative
techniques to control and regulate the credit flow in the country. When RBI
observes that the economy has sufficient money supply and it may cause an
inflationary situation in the country then it squeezes the money supply through its
tight monetary policy and vice versa.

• 5. Custodian of Foreign Reserves:-For the purpose of keeping the foreign exchange

rates stable, the Reserve Bank buys and sells foreign currencies and also protects the
country's foreign exchange funds. RBI sells the foreign currency in the foreign
exchange market when its supply decreases in the economy and
vice-versa. Currently, India has a Foreign Exchange Reserve of around US$ 487 bn.
• 6. Other Functions:-The Reserve Bank performs a number of other developmental
works. These works include the function of clearinghouse arranging credit for
agriculture (which has been transferred to NABARD) collecting and publishing the
economic data, buying and selling of Government securities (gilt edge, treasury bills
etc)and trade bills, giving loans to the Government buying and selling of valuable
commodities etc. It also acts as the representative of the Government in
the International Monetary Fund (I.M.F.) and represents the membership of India.
•
• Different types of Bank rates
•
• The supply of money in the economic system of any country is determined by the Monetary Policy
formulated by the central bank of the country. The monetary policies control the interest rates in
order to maintain price stability in the economy.
• In India, Reserve Bank of India (RBI) holds the right to control the price stability. Furthermore,
there are many other goals of the monetary policy of India which are directed and driven by the
RBI. Also, the monetary policy governs the various types of rates existing in the banking sector
which are flexible as per the economic scenario of the country and are decided by the RBI from
time to time.
• Some important rates in the Indian banking system are:-
•
• Repo Rate– Repo rate is the rate at which banks borrow money from the RBI to meet their
deficiencies. When the banks fall short of funds, the RBI lends money to the commercial banks at
a certain interest rate which is called as repo rate. The banks mortgage their government bonds as
collateral security to borrow from Reserve Bank of India. Repo rate is used as a tool by monetary
authorities to control inflation. When inflation strikes, RBI increases repo rate as this acts as a
hindrance for banks to borrow. This ultimately reduces the money supply in the economy and
thus helps in controlling inflation. If the Reserve Bank wants to make it more expensive for the
banks to borrow money, it increases the repo rate. Likewise, if it wants banks to borrow more
money, it reduces the repo rate.
• Current Repo Rate-6.25%
• Reverse Repo Rate– On the contrary, reverse repo rate is the
interest rate at which the RBI borrows money from the
commercial banks. The RBI uses this tool when there are more
than enough money floating in the banking system.
• For example, an increase in the reverse repo rate will decrease the
money supply in the banks. An increase in reverse repo rate
means that commercial banks will get more returns on their idle
funds by borrowing it to the RBI, thus decreasing the supply of
money in the market.
• High reverse repo rate encourages the banks to give the money
back to RBI and gross interest on it. This happens when banks
don’t have enough lenders to lend the money to and money is
lying dead with the banks. When the reverse repo rate is
increased, the banks prefer to lend their money to RBI which in
return pays them a substantial rate of interest. Hence, banks
prefer to keep their money with the RBI instead of keeping it at
stake anywhere else.
Current Reverse Repo Rate-6%
• Bank Rate-The rate of interest charged by the central bank on the loans
they have extended to commercial banks and other financial institutions is
called “Bank Rate”. In this case, there is no repurchasing agreement
signed, no securities sold or collateral involved. Banks borrow funds from
the central bank and lend the money to their customers at a higher
interest rate, thus, making profits. Bank Rate is usually higher than Repo
Rate as it is an important tool to control liquidity. Lower bank rates can
help to expand the economy by lowering the cost of funds for borrowers.
When Bank Rate is increased by RBI, the borrowing costs of the banks’
increase which, in return, reduce the supply of money in the market.
• Current Bank Rate-8.65%-9.45%
• Call Rate– Call rate is also known as the interest rate which is paid by the
banks for lending and borrowing for daily fund requirement. The call rate
is the interest rate on a type of short-term loan that banks give to brokers
who in turn lend the money to investors to fund margin accounts. For
both brokers and investors, this type of loan does not have a
set repayment schedule and must be repaid on demand.
• Current Call Rate-4%
•
• Cash Reserve Ratio– Cash reserve ratio (CRR) is generally defined as a particular
minimum amount of deposits that needs to be maintained as a reserve by every
commercial bank in India according to the requirement of the RBI. The CRR will be
fixed as per the rules and regulations of the RBI. It is usually considered that such a
part of bank deposits is totally risk-free. It is actually a certain percentage of bank
deposits which banks are bound to keep with RBI in the form of reserves. It supports
the RBI in controlling the liquidity in the banking system. Besides, it helps to curb the
inflation as well.
• Current Cash Reserve Ratio-4%
• Statutory Liquidity Ratio (SLR)- Statutory Liquidity Ratio refers to the proportion of
deposits the commercial bank is required to maintain with them in the form of liquid
assets in addition to the cash reserve ratio. As per the RBI, the Banks have to
maintain the ratio of the liquid assets to time and demand liabilities in the form of
liquid assets like cash, precious metals, government bonds or government approved
securities.
• The statutory liquidity ratio is determined by the central bank as the percentage
of total demand and time liabilities
• The objective of statutory liquidity ratio is to prevent the commercial banks from
liquidating their liquid assets during the time when CRR is raised.
• A penalty at a rate of 3% per annum above the bank rate is imposed if any
commercial bank fails to maintain the statutory liquidity ratio.