Unit 2

MONEY AND BANKING

Money-Meaning and Functions

Meaning of Money: Anything which is commonly accepted as a medium of exchange is called money.

FUNCTIONS OF MONEY
1. Medium of exchange: Money serves as a medium of exchanging goods and services. People sell goods for
money and use the money for buying goods they want. It has removed the problem of double coincidence of
wants faced in the barter system. Money facilitates the exchange. The buyer can pay money to the seller, and
the seller in turn can buy what he wants to buy.
2. Store of value: Under the barter system, there were difficulties in storing wealth. Money in the form of wealth
can be stored early for future use. Money is the most convenient and economical way to transfer purchasing
power from present to future use. This is because money comes in convenient denominations, easily mobile
and can easily be used for transactions. It is also acceptable to anyone at any point in time. Money is durable
in nature and occupies less space for storage. Money is not perishable and its storage costs are also
considerably lower.
3. Unit of account: Money acts as a unit of account, as the value of all goods and services can be expressed in
terms of money. Unit of account function of money means that money can be used for quoting prices or
recording transactions. This function removes the difficulty of keeping accounts and makes possible the
existence of financial institutions.
4. Standard of deferred payments: Deferred payments are postponed payments contracted to be made at some
future date. Money serves as a standard of such deferred payments. This function of money has facilitated
borrowing and lending. It has also led to the creation of financial institutions.

Money Supply - Meaning and Components

Money supply refers to the total quantity of money in circulation in the economy at a given point in time.
The basic measure of Money Supply (M1) has two components: M1 = CU + DD

1. Currency held by the public (CU): The currency issued by the central bank (Reserve Bank of India) can be
held by the public or by the commercial banks, and is called the high-powered money 'or 'reserve money or
'monetary base' as it acts as a basis for credit creation by commercial banks.
 Currency notes and coins are called legal tenders as they cannot be refused by any citizen of the country for
settlement of any economic transaction.
 Currency notes and coins are also called that money because RBI will be responsible for giving purchasing
power equal to the value printed on the note or coin.
 However, they do not have intrinsic value like a gold or silver coin. Eg. the value of the metal in a ten-rupee
coin is probably not worth ₹10.
2. Net demand deposits held by commercial banks (DD)
Demand deposits are the deposits which can be easily withdrawable on demand, by cheque or otherwise, by
the depositor from his/ her bank account, eg. current account deposits and savings account deposits.
 The word 'net' here implies that money supply includes only deposits of the public held by the banks, not
inter-bank deposits).
 Demand deposits are created by the commercial banks and are called Blank money

Money is created by a system comprising two types of institutions: - central bank and the commercial banking
system.
Central Bank issues the currency of the country. Commercial banks accept deposits from the public and advance loans
to those who want to borrow. In this process, they create credit money.

In a modern economy, money comprises cash and bank deposits.

  In Money consists mainly of currency notes and coins issued by the monetary authority of the country. In
India, all currency notes (except one rupee notes) are issued by the Reserve Bank of India (RBI). However,
one rupee notes and coins are issued by the Ministry of Finance (Government of India),
 Apart from currency notes and coins, the balance in savings, or current account deposits, held by the public in
commercial banks is also considered money since cheques drawn on these accounts are used to settle
transactions. Such deposits are called demand deposits as they are payable by the bank on demand from the
account-holder, Other deposits have a fixed period to maturity and are referred to as time deposits. Time
deposits are deposits which have a fixed period of maturity or which can be withdrawn only after a specified
period of time, e.g. fixed deposits

Money creation (or credit creation or deposit creation) by commercial banks

Commercial banks create credit money through their lending operations. Money creation (or credit creation or deposit
creation) is determined by:
 Primary deposits - The amount of the initial fresh deposits with the commercial banks.
 The Legal Reserve Ratio (LRR)-LRR is the minimum reserve that a commercial bank must maintain as per
the instructions of the central bank. Legal Reserve Ratio is also called Reserve Ratio or Required Reserve
Ratio or Reserve Deposit Ratio.
 Money Multiplier: Money Multiplier (or Deposit Multiplier) is the number by which total deposits can
increase due to a given change in deposits. It is inversely related to legal reserve ratio.
Money multiplier = 1/Legal Reserve Ratio (LRR)
Total Money Creation (or deposit creation) Initial Deposits x 1/Legal Reserve Ratio
Process of credit creation is based on the following assumptions:
 Entire banking system is a single unit.
 All transactions are routed through the bank only.

Numerical Example: Let the LRR be 20% and Initial deposits ₹10,000. The banks have to keep ₹2,000 as reserves.
The banks lend the remaining amount of ₹8,000. People who borrow use this money for making payments. Since all
the transactions will be carried out through banks, banks receive secondary deposits ₹8,000 The banks again keep
₹1,600 as reserves and lend ₹6,400. The money again comes back to the banks leading to a fresh deposit of ₹6,400. In
this way, the money goes on multiplying. The process of credit creation by commercial banks comes to an end when
the total of required reserves become equal to the initial deposits.
Total deposits creation (or money creation) Initial deposits x 1/LRR = 10,000 x 1/0.2 = 10000×₹50,000
Total credit (loan) creation = Total deposits creation - Initial deposits = ₹50,000-₹10,000 = ₹40,000

HOW DOES LEGAL RESERVE RATIO INFLUENCE THE PROCESS OF MONEY CREATION?
Money creation is inversely related to Legal Reserve Ratio.
For example, suppose LRR is 0.2 and initial deposits are ₹10,000
Total money creation = Initial Deposits x 1/LRR = 10,000 1/0.2 = 10,000 × 5 = ₹50,000
Now suppose, if the LRR is increased by the Central Bank to 0.5 and initial deposits remain the same, i.e. ₹10,000.
Now, total money creation = 10,000 × 1/0.5 = 10,000×2 = ₹20,000.
Any Increase in LRR will decrease the money creation power of the commercial banks (banking system).

WHAT ROLE DOES MONEY MULTIPLIER PLAY IN DETERMINING THE MONEY CREATION
POWER OF THE BANKING SYSTEM?
Money Multiplier is inversely related to legal reserve ratio. Lower the money multiplier, lesser will be the total money
created and vice- versa. Total money creation Initial deposits x Money Multiplier (1/LRR)

For example, suppose the LRR is 0.2 and initial deposit is ₹10,000, Money multiplier 1/LRR = 1/0.2 = 5; and
Total money created = ₹10,000×5 = ₹50,000.

Whereas, suppose LRR is increased by the Central Bank to 0.5 and initial deposits remain the same, le. ₹10,000 Then,
Money multiplier = 1/0.5 = 2, and
Total money created = 10,000 × 2 = 20,000
With the same initial deposit total money creation decreases with a decrease in the value of money multiplier.
Central Bank - Meaning and Functions

The Central Bank is the apex institution of a country's monetary system. It is the apex bank engaged in regulating
commercial banks. India's central bank is the Reserve Bank of India' (RBI)

Four main functions of Central Bank are:

1. Bank of Currency Notes Issue: In most of the economies across the world, there exists a centralised system of
currency issues. The Central Bank of a country has a monopoly over the currency issue. It has the sole responsibility
of printing and putting in circulation all types of currency notes (with a few exceptions)
* This centralised and monopolised system of currency notes issue ensures uniformity of the currency system.
* It also helps in easier control over the monetary system.
* This function of the central bank also builds faith in the currency system of the economy.
2. Government's Bank, Agent and Advisor: Central Bank acts as the Government's banker (both central as well as
state governments). It maintains the banking accounts of the government for the purpose of receiving/making
payments on its behalf. It provides loans to the government, as per its requirements. As Government's agent, the
Central Bank accepts receipts and makes payment on behalf of the government. For instance, Central Bank issues
government securities such as bonds, treasury bills, etc. It manages the national debt on behalf of the government. As
the Government's financial advisor, the Central Bank advises the government on all economic, financial and monetary
matters.
3. Bankers Bank and Supervisor: The Central bank accepts the deposits from commercial banks and also advances
loans to them as and when required. It maintains reserves of all commercial banks and utilises them to settle inter-
bank claims. Being the supreme authority of the banking system, it acts as the lender of the last resort to the
commercial banks.
Central Bank acts as the "Lender of the Last Resort'/ 'financier of the last recourse' : It refers to the role of the Central
Bank (RBI), of being ready to lend to banks, especially when a bank is faced with unanticipated severe financial
crises, and due to this central bank is said to be the lender of last resort If the central bank refuses to extend this help,
there is no option for the bank but to shut down.

In its supervisory/regulatory role, RBI ensures that the commercial banks follow all the rules regarding their licensing,
brand expansion, liquidity of assets, management, amalgamation and liquidation. The RBI may exercise periodic
inspections/audits of commercial banks, filing of reports by commercial banks and other statutory compliances.
4. Controller of Credit: Central Bank regulates the volume and use of credit by using quantitative and qualitative
tools. Quantitative tools control the extent of money supply by changing the Cash Reserve Ratio (CRR) or Statutory
Liquidity Ratio (SUR) or Bank Rate or Repo Rate or Reverse Repo Rate, or through Open market operations (OMO).
Qualitative tools, include persuasion by the Central Bank in order to make banks discourage or encourage lending
which is done through margin requirement, moral suasion, etc.

Monetary Policy Instruments

Policy adopted by the Central Bank of a country in the direction of credit control and money supply in the economy is
known as Monetary Policy.
1. Bank Rate Policy: Bank Rate is the rate of interest at which Central Bank lends to the commercial banks for
long-term.
* When Central Bank lowers bank rate, commercial banks also lower their lending rates. Since borrowing
becomes cheaper, people may borrow more. This leads to increase in credit creation by banks and thus, rise in
money supply in the hands of general public.

 When Central Bank raises bank rate, commercial banks also raise their lending rates. Since borrowing
becomes costly, people may borrow less. This leads to decrease in credit creation by banks and thus, reduces
the money supply in the hands of general public
2. Open Market Operations (OMO): Open Market Operations refers to buying and selling of government
securities (bonds) by the Central Bank from/to the general public.
 By selling such securities the Central Bank scales liquidity from the economy because those who buy make
payments by cheques to the Central Bank. This reduces the reserves of commercial banks and adversely
affects bank's ability to create credit and thus, reduces the money supply in the hands of general public.
 By purchasing government securities, Central Bank releases liquidity in the economy since it pays for it by
giving a cheque. This cheque increases cash reserves with banks and thus increases bank's ability to create
credit.
3. Legal Reserve Requirements: There are two components of Legal Reserve Ratio (LRR):
(1) Cash Reserve Ratio (CRR) is the fraction of net total demand and time deposits that commercial banks must
keep as cash reserves with the Central Bank
(2) Statutory Liquidity Ratio (SLR) is the fraction of net total demand and time deposits that commercial banks
must keep with themselves in the form of liquid assets.
* When the Central Bank raises Reserve Ratio(s), less money is left with commercial banks for lending. As
lending decreases, the money creation decreases and money supply in the economy decreases.
* When the Central Bank reduces Reserve Ratio(s), more money is left with commercial banks for lending. As
lending increases, the money creation increases and money supply in the economy increases.
4. Repo Rate: Repo rate refers to the rate at which the Central Bank lends to the commercial banks for their short-
term requirements. An increase in repo rate will force the commercial banks to increase their lending rates
making the credit costlier for the general public. Thereby, discouraging the borrowings. Consequently,
aggregate demand will fall and thereby correcting the problem of inflation in the economy.
5. Reverse Repo Rate: Reverse Repo Rate is the rate of interest at which commercial banks can park their surplus
funds with the Central Bank. In order to control the credit creation capacity of the commercial banks, the
Central Bank may increase/decrease Reverse Repo Rate. This induces commercial banks to transfer more/less
funds to the Central Bank which in turn reduces/ increases the lending capacity of the commercial banks. As a
result, credit creation by commercial banks may be reduced/ increased.
6. Margin Requirement on Loan: Margin requirement refers to the difference between the amount of the loan
and value of the security offered by the borrower against the loan. E.g. if the margin imposed by the Central
Bank is 40%, then the bank is allowed to give a loan only up to 60% of the value of the security. By altering the
margin requirements, the Central Bank can alter the amount of loans made against securities by the banks. For
example, an increase in margin requirement implies a decrease in the amount of loan available on the security
offered. Thus, it will lead to a decrease in the availability of credit to control excess money supply in the
economy.