MONEY AND BANKING

Contents of the unit

Money - meaning and 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, CRR, SLR, Repo Rate and
Reverse Repo Rate, Open Market Operations, Margin requirement

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Meaning of money
Money may be defined as anything which is generally acceptable as a medium of exchange and
also acts as common measures of value, store of value and standard of deferred payment

Money is what money does. (Walker)

Anything which is generally acceptable by the people in exchange of goods and services or in
repayment of debts is called money.

Barter System: Meaning and its drawbacks

Direct exchange of goods against goods without the use of money is called Barter exchange. An
economy based on barter exchange is called CC economy. Commodity for commodity exchange
economy.

Drawbacks of barter system

• Lack of double coincidence of wants: The simultaneous fulfillment of mutual wants by
buyers and sellers is known as double coincidence of wants.
• Lack of common measure of value
• Lack of standard for deferred payment:
• Lack of divisibility
• Lack of store of value

In order to overcome the disadvantage of barter system money was invented by the
society.

The primary functions of money are medium of exchange and measure of value. Standard of
deferred payment, store of value and transfer of value are secondary functions of money.

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 Forms of Money

1 Fiat money:- Refers to that money which is issued by order or by the authority of
government. It includes all notes and coins. It is Legal Tender money also.

2 Fiduciary money:- is that money which is accepted as a medium of exchange because of

the trust between the payer and payee. For example:- Cheque.

3 Full Bodied money:- It refers to the money in terms of coin whose commodity value is
equal to money value as and when these are issued. For example, a one-rupee silver coin
during the British period in India.

4 Credit money:- it refers to that money of which money value is more than commodity
value.

FUNCTIONS OF MONEY

1. Medium of Exchange: Money acts as a medium for the sale and purchase of goods and
services. In the absence of money, goods were exchanged for goods. This required double
coincidence of wants. Exchange was difficult and limited in barter system. But introduction
of money facilitated exchange, now much simpler and unlimited. Money has separated the
acts of sale and purchase.

2 Measure of value or Unit of value: Money serves as a measure of value. In other

words, it serves as a Unit of Account. Unit of Account means that the value of each good or
service is measured in the monetary unit. Measurement of value was very difficult in
Barter System. There was no common unit of value. Introduction of money has removed
this difficulty.

3 Standard of Deferred Payments: It refers to those payments which are made

sometime in the future. Money has made deferred payments much easier than before.
Money has made borrowing and lending much easier. This function of money has lead to
the emergence of financial markets.

4 Store of value: It implies store of wealth. Storing wealth has become considerably easy
with the introduction of money. Wealth can be stored just in terms of paper titles like FDR
(Fixed Deposit Receipts). Store of wealth is a source of future investment, productions,
growth, and development.

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5 Transfer of Value: Money serves as a convenient mode of transfer of value or wealth. It
is the transfer of value that has lead to the emergence of MNCs. Accordingly, the concept
of global economy has come into existence.

SUPPLY OF MONEY

Meaning of money supply

It refers to the total stock of money held by public at a particular point of time in an economy.
(Public means private individuals and business firms.) It excludes the government, the central
bank and the commercial bank
The money supply of the economy at any point of time is the total amount of money in
circulation.

There are 2 main components of money supply:

• Currency component: It consists of coins and currency (or paper) notes

• Deposit component: It consists of the bank deposits against which cheques are issued

Items Excluded from money supply

It does not include the money creating sector (Government and banking system) as cash
balances held by them do not come into actual circulation in the country.

The government and the banking system of a country are the suppliers or producers of
money. Hence money held by them is not a part of the stock of money held by the people.

Supply of money includes only that stock of money which is held by the people or those who
demand money.

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Components of money supply
• Currency: it consists of coins and paper currency
Coins: Coins are made of metal. The metallic coins are issued by the monetary authority
of the country, the central bank with the central government of the country
Paper currency: These are the most important part of money supply. The central bank in
every country has monopoly right of issuing currency notes.
• Deposit component: Demand deposits are also the most important component of
money supply. These are the money deposits made by the depositor or owner of the
deposit to the bank.

M 1 = Currency held by the public + Demand deposits + other deposits with the Reserve Bank
of India.
Currency held by the public has the merit of general acceptability for making transactions. It is
one of the most important constituent of money supply.
❖ Demand Deposits held by public with the commercial banks are considered money
because they are readily accepted as means of payment. Both currency and demand
deposits are the most liquid assets that form money supply defined in the narrow sense.

❖ Other deposits with the Reserve Bank of India: These include demand deposits of
public financial institutions, foreign central banks, foreign governments, international
financial organization like World Bank. However, it does not include deposits of the

Indian Government and commercial bank with RBI

❖ M2 = M1 + saving deposits with the post office savings bank

❖ It is a broader concept of supply of money compared to M1. It also includes savings of
the people with the post offices.
❖ As post office savings deposits are not withdrawals by cheque they could not be placed
in the same category as bank savings deposits.

❖ M 3 Measurement:
It is also a broader concept of money as compared to M1. Besides all the components of
M1 it includes net time deposits (or fixed deposits/term deposits) of the people with the
commercial banks.
M 3 = M1 + Net Time Deposits with the Commercial Banks

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 ❖ M 4 Measurement:
It is a still broader concept of money than M 3. Besides all the components of M 3 it also
includes the total deposits with the post offices (other than in the form of National
Saving Certificate)
M 4 = M 3 + Total Deposits with the Post Offices (other than in the form of National
Saving Certificate
Flow chart summarizing the components of money supply

+ + + M4
M1 M2 M3

M1 Demand
Currency
with Demand deposits with Net time
deposits with Post Office deposits with M3 Total
public M1
Banks Savings Bank Banks deposits
Account with Post
Other deposits
with Reserve Office (other
Banks than NSCs)

BANKING

COMMERCIAL BANKS

Commercial banks are those financial institutions which accepts deposits from the public,
and advances loans to the consumers and producers. Accordingly, the most important
function of commercial banks is money creation.

• “All financial institutions are not banks”. Why?

The two essential features of banks are

• Acceptance of deposits
• Lending of funds
Post offices are financial institutions accepts deposits, but do not perform the function of
lending. So they are not considered as banks.

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 Similarly, financial institutions like UTI, LIC etc performs the function of lending, but do not
accept deposits and so they are not banks.

MONEY CREATION

❖ The basic measure of money supply has two components.

Currency with public and demand deposits in commercial banks. The currency created
by the RBI is called High powered money and demand deposits created by the
commercial bank is called the bank money
Money is anything usable for undertaking transactions i.e. receipts and payments. The
stock of such money in an economy is called money supply

❖ Money creation is also called deposit creation or credit creation.

Commercial banks receive deposits from the public. The depositors are free to
withdraw, in part or in full, their deposit amounts by writing cheques. The banks use the
money in these deposits to give loans. These functions of the commercial banking
system are the basis of deposit creation. How much are the deposits created is
determined by the amount of initial deposits by the public and the Legal Reserve
Ratio. The quantitative outcome is called money multiplier. Let us explain the process
of money creation and the measure of money multiplier. Note that money creation is
also called ‘deposit creation’ or ‘credit creation’.

The Process of Money Creation

Let us assume that the entire commercial banking system is one unit. Let us call this one unit
simply ‘’banks’. Let us also assume that all receipts and payments in the economy are routed
through the banks. One who makes payment does it by writing cheque. The one who receives
payment deposits the same in his deposit account.
Suppose initially people deposit Rs. 100. The banks use this money for giving loans. But the
banks cannot use the whole of deposit for this purpose. It is legally compulsory for the banks to
keep a certain minimum fraction of these deposits as cash. The fraction is called the Legal
Reserve Ratio (LRR). The LRR is fixed by the central bank. It with the central bank, and this part
ratio is called the Cash Reserve Ratio. The other part is kept by the banks themselves and is
called the Statutory Liquidity Ratio.

Why are the banks required to keep only a fraction of deposits as cash reserves? What will
banks do if the demand for cash withdrawn is more than cash reserves at some point of time?
There are two reasons.
• First the banking experience has revealed that not all depositors approach the banks for
withdrawal of money at the same time, and also that normally they withdraw a fraction
of deposits.
• Secondly, there is a constant flow of new deposits for withdrawal of cash, it is sufficient
for banks to keep only a fraction of deposits as cash reserve.

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Let us now explain the process. Suppose the initial deposits in banks is Rs. 100 and the
LRR is 20 percent. Further suppose that banks keep only the minimum required i.e. Rs.
20 as cash reserve, no more no less – Banks are now free to lend the remainder Rs. 80.
Suppose they lend Rs. 80. What banks do is to open deposit accounts in the names of
the borrowers who are free to withdraw the amount whenever they like. Suppose they
withdraw the whole of amount for making payments.
Now, since all the transactions are routed through the banks, the money spent by the
borrowers comes back into the banks into the deposit accounts of those who have
received this payment. This increase demand deposits in banks by Rs. 80. It is 80 percent
of the initial deposit. These deposits of Rs. 80 have resulted on account of loans given by
the banks. In this sense the banks are responsible for money creation. With this round
increase in total deposits is now Rs. 180 (=100+80).
When banks receive new deposit of Rs. 80, they keep 20 percent of it as cash reserves
and use the remaining Rs. 64 for giving loans. The borrowers use these loans for making
payments. The money comes back into the accounts of those who have received the
payments. Bank deposits again rise, but by a smaller amount of Rs. 64. It is 80 percent of
the last deposit creation. The Total deposits now increase to Rs. 244 (=100+80+64). The
process does not end here.
The deposit creation continues in the above manner. The deposits go on increasing
round after round but each time only 80 percent of the last round deposits. At the same
time cash reserves go on increasing, each time 80 percent of the last cash reserve. The
deposit creation comes to end when total cash reserves become equal to the initial
deposit. The total deposit creation comes to Rs. 500, five times the initial deposit as
shown in the table below
Round Deposits Loans
(Rs) (Rs) LRR =0.2(20%)
Initial 100 80 20
Round 1 80 64 16
Round 2 64 51.2 12.80
- - - -
- - - -
Total 500 400 100

Money Multiplier
How many times the total deposits would be of the initial deposit is determined by the
LRR.
The multiple called the money or deposit multiplier, is:
Money multiplier =
1 /LRR In our above illustration the LRR is 0.2 therefore,
Money multiplier =
1/ 0.2 = 5

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 The total money creation is thus:
Money creation = initial deposit x 1/ LRR = 100 x 1/0.2 = 500
Note that lower the LRR, higher the money multiplier and more the money creation. If
the LRR = 0.1, the money multiplier is 10(=1/0.1). If the LRR is 0.4, the money multiplier
is 2.5(1/0.4)

CENTRAL BANK

The central bank is the apex institution of a country’s monetary

system. It controls the entire banking system of a country. The design
and the control of the country’s monetary policy is its main
responsibility. India’s Central bank is the Reserve Bank of India.

FUNCTIONS OF THE CENTRAL BANK

1. BANKER TO THE GOVERNMENT

The Central Bank acts as a banker to the government - both Central as well as State
governments.
As a banker to the government, it performs the following functions:
a) It receives deposits from the government and collects cheques and drafts
deposited in the government account
b) It provides cash to the government as required for payments of salaries and wages
to their staff and other cash disbursements
c) It makes payment on behalf of the government to meet the budget deficit
d) It advances loans to the government
e) It supplies foreign exchange to the government for repaying external debt or
making other payments.
f) It advises the government on banking and financial matters
As a fiscal agent
a) It manages public debt
b) It collects taxes and other payments on behalf of the government
c) It represents the government in the international financial institutions like
the World Bank international monetary fund etc.
d) The government borrows money by selling treasury bills to the Central
Bank. The government carries on short term borrowings by selling ad-hoc
(meaning necessary/ needed) treasury bills to the Central Bank.
As adviser
a) The central bank also acts as a financial adviser to the government.it gives
advice to the government on all financial and economic matters such as

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 deficit financing, devaluation of currency, trade policy, foreign exchange
policy etc.

2. CURRENCY AUTHORITY /BANK OF ISSUE

The Central Bank is the sole authority for the issue of currency in the country. It promotes
efficiency in the financial system.
• Firstly, because this leads to uniformity in the issue of currency.
• Secondly, because it gives Central Bank direct control over money supply
• The central bank is the sole authority for the issue of currency in the country. All
currency issued by central bank is its monetary liability. This means that the central
bank is obliged to back the currency with assets of equal value. These assets usually
consist of gold coins, foreign securities and domestic governments local currency
securities.
• The country’s central government is usually authorized to borrow money from the
central bank. The government does this by selling local currency securities to the
central bank. When the central bank acquires these securities, it issues currency.
This authority of the government gives it flexibility to monetize its debt. Monetizing
the government debt (public debt) is the process of converting its debt (whether
existing or new) which is a non- monetary liability, into Central bank currency which
is monetary liability

3. BANKERS BANK AND SUPERVISOR

As the banker to banks, the Central Bank holds a part of the cash reserves of banks, lends them
short-term funds and provides them with centralized clearing and remittance facilities
❖ The banks are required to deposit a stipulated ratio of their net total liabilities (the CRR) with
the Central Bank.
❖ The purpose of this stipulation is to use these reserves as an instrument of monetary and
credit control.
❖ In addition to this the bank holds excess reserves with the Central Bank to meet any
unexpected crisis arising in the commercial banks. The pool of funds with the Central Bank
serves as a source from which it can make advances to banks temporarily in need of funds,
acting in its capacity as lender of last resort.
❖ The Central Bank supervises, regulates and controls the commercial banks. The Central Bank
supervises, regulates and controls the commercial banks.
❖ The regulation of banks may be related to their licensing, branch expansion, liquidity of
assets, management, amalgamation (merging of banks) and liquidation (the winding up of
banks). The control is exercised by periodic inspection of banks and the returns filed by them

4. LENDER OF THE LAST RESORT

• It means that if a commercial bank fails to get financial accommodation from
anywhere, it approaches the central bank as a resort.

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 • Central bank helps these banks through discounting of approved securities and bills
of exchange.
• The central bank ensures. 1) that banking system of the country does not suffer any
set back and 2) that money market remains stable,

5. CUSTODIAN OF FOREIGN EXCHANGE:

It is the custodian of nation foreign exchange reserve.
a) The central bank maintains foreign exchange reserve in order to promote
international trade and stabilize exchange rate.
b) It is a source of great strength to the banking system of the country.
c) The centralized cash reserves can be used most effectively during periods of
seasonal strains and in financial crisis or emergencies.
d) The central bank provides funds to the commercial banks to overcome the financial
difficulties.

6. CLEARING HOUSE FUNCTION;

• As a custodian of the cash reserves of the commercial banks, the central bank acts as
the clearing house for these banks.
• For example, Bank A receives a cheque of Rs 10000 drawn on Bank B. Bank B receives
a cheque drawn on Bank A both banks A and B have their accounts with the central
bank. The cheques of both the banks are cleared through their accounts with the
central bank. This is how the central bank acts as a clearing house.
• Since all banks have their accounts with the central bank, the central bank can easily
settle the claims of various banks against each other simply by book entries or
transfers from and to their accounts. This method of settling accounts is called
clearing house function of the central bank
• The significance of this function is that it economizes the use of money in the banking
operations.

QUANTITATIVE MEASURES OF CREDIT CONTROL

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4. Statutory liquidity ratio:
Banks are also required to maintain a specified percentage of their net total demand and time
deposits in the form of designated liquid assets with themselves.
This specific percentage is called Statutory Liquidity Ratio (SLR). Increasing the SLR reduces the
ability of banks to give credit and vice versa.

5. Repo Rate: When the commercial banks are in need of funds for a short period, they can
borrow from the Central Bank. The rate of interest charged by the Central Bank on such
lending’s is called Repo Rate. Raising Repo Rate makes such borrowings by the commercial
banks costly. As such when Repo Rate is raised, banks are also forced to raise their lending
rates. This has a negative effect on demand for borrowings from the commercial banks.
Lowering Repo Rate has the opposite effect.

6. Reverse Repo Rate: When the commercial banks have surplus funds they can deposit the
same with the central bank and earn interest. The rate of interest paid by the Central Bank on
such deposits is called Reverse Repo Rate. When this rate is raised, it encourages the 11
commercial banks to park their funds with the central bank. This has the negative effect on the
lending capability of the commercial banks. Lowering Reverse Repo Rate has the opposite
effect which raises demand for borrowings from the commercial banks.
QUALITATIVE METHODS OF CREDIT CONTROL
Qualitative methods or selective methods are those methods which are used by the Central
bank to regulate the flow of credit into particular directions of the economy.
Unlike Quantitative methods, these methods affect the type of credit given by the commercial
banks. It is because of this specific use of credit that they are called ‘selective controls’
The important qualitative methods of credit control are: 1) Imposing Margin Requirements on
secured loans 2) Moral Suasion 3) Selective Credit Controls

1 Margin requirement
• A margin is the difference between the amount of the loan and market value of the
security offered by the borrower against the loan.
• 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.

2. Moral Suasion
• This is a combination of persuasion and pressure that the Central bank applies on the
other banks in order to get them fall in line with its policy.
• This is exercised through discussions, letters, speeches and hints to the banks
• The Central bank frequently announces its policy position and urges the banks to fall in
line.
• Moral Suasion can be used both for quantitative as well as qualitative credit control
3. Selective Credit Control –
• This can be applied both in positive as well as negative manner
• Application in a positive manner would mean using measures to channel credit to
particular sectors, usually the priority sectors.
• Application in a negative manner would mean using measures to restrict the flow of
credit to particular sectors.

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Differentiate between Demand Deposits and Fixed Deposits –

Demand Deposits Fixed Deposits

Demand Deposits can be withdrawn by These deposits can be withdrawn only

their depositors at any time without notice after the expiry of a certain fixed period
They are chequable i.e. they can be They are not chequable
withdrawn through cheques
No interest is paid on these deposits. These deposits carry high rates of interest
Rather depositors have to pay something
to the bank for its services
These deposits constitute a part of money They fall under the category of near
supply money

i eren ate et een entral an o ercial an s

entral an o ercial an s

BOARD QUESTIONS
1) Give the meaning of money supply and state its components
2) What is commercial bank?
3) What is meant by cash reserve ratio?
4) What is a central bank?
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5) Define bank rate
6) What are time deposits in banks?
7) Explain currency authority function of the central bank?
8) Explain banker to the government function of the central bank?
9) Explain the lender of last resort function of the central bank?
10) Explain clearing house function of central bank
11) Explain the process of credit creation by commercial banks
12) What is legal reserve ratio? State its components
13) Differentiate between cash reserve ratio and statutory liquidity ratio
14) What is bank rate? How does it work as method of credit control?
15) Explain the open market operation method of credit control used by the central
bank?
16) Explain the role of cash reserve ratio in controlling credit creation.

HOTS
Currency is issued by the central bank yet we say that the commercial banks
create money. Explain. How is this money creation by commercial banks likely to
affect the national income?
Ans. Money supply has two components currency and demand deposits with
commercial banks. Currency is issued by the central bank while demand deposits
are created by the commercial banks by lending money to the people. In this
way commercial banks create money.
Commercial banks lend money mainly to investors. The rise in investment in the
economy leads to rise in national income through the multiplier effect.

MCQ
1. Reverse repo rate is the rate at which Central bank
a) Gives loans to commercial banks for long term
b) Gives loans to commercial banks for short term
c) Borrows money from commercial banks
d) None of these

2. With an increase in margin requirement the availability of credit in the

economy will
a) increase b) decrease c) unchanged d) none of these.

3. Higher the legal reserve ratio ----- will be the credit creation.
a) Higher b) lower c) constant d) none of these

4. Quantitative instrument of RBI can be

a) bank rate policy b) cash reserve ratio c) statutory liquidity ratio d) all of the
above

5. Demand deposits include

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 a) Saving account deposits and fixed deposits b) saving account deposits and
current account deposits c) current account deposits and fixed deposits d) all
types of deposits

6. Which of the following interest rate is applicable to short period lending?

A) Repo rate b) Bank rate c) reverse repo rate d) both a and c
7. Lowering of CRR by the central bank has the following impact on the credit
creation capacity of the commercial banks
a) fall b) increase c) can be fall or can be increased d) no effect.

8. Raising reverse repo rate by the central bank is likely to have the following
impact on the money supply in the economy
a) Money supply will increase b) money supply will decrease c) may rise or fall
d) no effect

9. Which of the following will increase the money supply?

a) Fall in repo rate b) purchase of securities in open market c) decrease in CRR
d) all of these.

10. The rate at which the central bank lends money to commercial banks as a
lender of the last resort is known as
a) Repo rate b) Reverse repo rate c) bank rate d) lending rate

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