THE NEW INDIAN SCHOOL WLL

KINGDOM OF BAHRAIN
MACRO ECONOMICS
CHAPTER 3: MONEY AND BANKING
NOTES

LEARNING OBJECTIVE:

• To understand the meaning and functions of money

• To understand money creation of the commercial banks
• To understand the functions of central bank

KEY CONCEPTS

• Money - It is anything which is generally accepted as a medium of exchange and at the same
time acts as a measure of value, store of value and means of deferred payments.

• High Powered Money (H): - High powered money or monetary base refers to the total liability
of the monetary authority of the country i.e., Central Bank (RBI). It consists of currency (notes
and coins in circulation with the public and vault cash of commercial banks) and deposits held by
Government of India and commercial banks with RBI.

• Money multiplier or deposit multiplier: Total deposits created due to a new deposit in bank are
many times the initial deposit. The multiple by which deposits can increased due to an initial
deposit is called money multiplier. Money multiplier =1/LRR, where LRR is legal reserve ratio.

BARTER SYSTEM OF EXCHANGE

• Barter system of exchange is a system in which goods are exchanged for goods. Such a
system is also known as commodity for commodity exchange (i.e., C-C exchange).

Drawbacks of the Barter system

(i) Double coincidence of wants-- Double coincidence of wants is the main requirement
of the barter system of exchange. Double coincidence of wants implies that needs of
two individuals should complement each other for the exchange to take place. For
example, if you have surplus production of Rice, you need to look for a person who
need rice, and at the same possesses cloths which you need to have. It means double
coincidence of wants.

1
 (ii) Lack of a Common unit of value: It was the major drawback in barter system of
exchange. In this system if we ask what is the value of your car? Every one reply that
the value in terms of goods like horse, cows, chair etc, so there was no common unit
of value in Barter system of exchange.
(iii) Lack of a system for future payments: - Contractual payment or future payments
would certainly be very difficult under barter system of exchange because goods are
perishable in nature and it may be possible that in future, we do not have same
quantity.
(iv) Lack of system for storage value: - A Storage of value implies store of wealth. Store
of value is very necessary for the secure of future. Every individual tries to save a part
of their income for their future needs. This is called store of value. It was not possible
to store value in barter system of exchange because goods tend to wear out and
perish. In this system we had some difficulty in store of value like cost of storage,
loss of value, difficulty in quick disposition.
(v) Lack of divisibility: - In barter system of exchange we could not divide the value. For
example, if that time I had a cow I could not half it if I need half now due to money as
a medium of exchange, I pay less amount for anything.

FUNCTIONS OF MONEY

Primary functions of money

There are two main primary functions of money.

(i) Medium of exchange: Medium of exchange is an important function of

money. It means money act as an intermediary for goods and services in an
exchange transaction. As a medium of exchange money has removed all the
limitations of exchange related to the barter system of double coincidence of
wants. Exchange has become convenient and simple. It saves a lot of time and
labour. Sale and purchase of goods and services can be easily done with the
help of money as a medium of exchange.
(ii) Measure of Value or Unit of value: Measure of value is the other function of
money. Value of all goods can be expressed in terms of money. Measurement
of value was the main difficulty in the barter system of exchange. Introduction
of money removed this difficulty. In barter system there is no common unit of
value but in monetary system all the goods have common unit of value that is
money. For example, if someone ask what is the value of your car? You can
reply Rs. 5 lakhs but it was not possible to give the same answer in a barter
system of exchange.

Secondary functions of money

These are those functions that money performs along with its primary
functions. The secondary functions of money can be divided into the following three
parts.
(i) Standard or Deferred Payments: Deferred payments refer to those payments
which are made sometimes in future. Payments of loans also refer to deferred

2
 payments. It is difficult to make such transaction in terms of goods and
services. So, money facilitate such type of deferred payments.

(ii) Store of Value: Money act also as a store of value. A Storage of value implies
store of wealth. Store of value is very necessary for the secure of future. Every
individual tries to save a part of their income for their future needs. This is
called store of value. It was not possible to store value in barter system of
exchange because goods tend to wear out and perish. In this system we had
some difficulty in store of value like cost of storage, loss of value, difficulty in
quick disposition.

(iii)Transfer of value - Money can be transferred easily from one place to another
and from one person to another. Therefore, with the help of money,
purchasing power can be transferred. An individual who has money has
purchasing power and he/she can transfer the purchasing power to anyone just
by transferring this money. For example, when a father gives pocket money to
his son, he transfers purchasing power to his son to buy different goods and
services.

FORMS OF MONEY

1.Fiat money – Fiat money refers to that money which is issued by order/ authority of the
government. It includes all notes and coins which the people in the country are legally bound to
accept as a medium of exchange.

2. Fiduciary money – Fiduciary money is that money which is accepted as a medium of

exchange because of the trust between the payer and the payee. Example Cheque is a fiduciary
money

3. Full bodied money – Full bodied money refers to money in terms of coins whose commodity
value is equal to money value as and when these are issued. Money value= commodity value

4. Credit money – Credit money refers to that money of which money value is more than
commodity value. Money value > commodity value

SUPPLY OF MONEY

Meaning:

Money supply is the total stock of money in circulation among the public at a particular point of
time in a particular economy.

3
MEASURES OF MONEY SUPPLY/LEGAL DEFINITIONS OF MONEY SUPPLY
RBI publishes figures for four alternative measures of money supply. i.e., M1, M2, M3, M4.
These four measures are according to decreasing order of liquidity. M1 is most liquid and easiest
for transactions whereas M4 is the least liquid of all.

(i) M1 = CU + DD + OD
• CU stands for currency held by the public. it consists of coins and notes
• DD stands for Net demand deposits held by commercial banks – the word net implies
only deposits of the public held by the banks are to be included in money
supply. The interbank deposits, which a commercial bank holds in other commercial banks are
not to be regarded as part of money supply
• OD stands for other deposits held with RBI (of foreign banks, foreign government)

(ii) M2= M1 + Saving Deposits with Post Office savings banks

(iii)M3 = M1 + Net time deposits of commercial banks

iv) M4= M3 + Total deposits with Post Office savings organizations (excluding National
Savings Certificates

 M1 and M2 are known as narrow money

 M3 and M4 are known as broad money
 M3 is the most commonly used measure of money supply. It is also known as aggregate
monetary resources.

COMMERCIAL BANK

A commercial bank is that financial institution which accepts deposits from the people and offers loans
for the purpose of consumption or investment.

CREDIT CREATION BY THE COMMERCIAL BANKING SYSTEM

Q. What do u mean by credit/ money creation? Explain the process of money creation by the
commercial banks with the help of a numerical example.

Ans: Money creation is a process in which a Commercial Bank creates total deposit many times
the initial deposits.
The capacity of Commercial Bank to create depends on 2 factors.
1) Amount of initial fresh deposit
2) Legal Reserve Ratio (LRR)

Money Multiplier = 1/ LRR

Money creation = Initial deposit x Money multiplier

4
Working: Suppose (i) initial deposit = Rs. 1000
LRR = 20 %
As required the bank keeps 20 % ie. 200 as cash reserves and lend the remaining 800. Those
who borrow use the money for making payments. As assumed, those who receives these
payments put the money back in to their bank accounts. This creates a fresh deposit of 800
The bank again keeps 20 % ie 160 and lend 640. In this way the money goes on multiplying
leading to total money creation of 5000.

Money creation = Initial deposit x 1/ LRR

= 1000 x 1/0.2 = 1000 x 5 = 5000

Thus, the initial deposit gets multiplied 5 times and hence the money multiplier is 5

Deposit Loan Reserves

1000 800 200
800 640 160
640 512 128
-------- --------- ---------
5000 4000 1000

CENTRAL BANK

Meaning:
The apex institution of a country’s monetary system is called the Central Bank of that country

Functions:

(a) Bank of Issue / Currency authority

• It is the sole authority for the issue of currency in the country
• No other individual or institution can legally issue currency
• It issues all currency except Re.1 notes and coins (which are issued by the government of
India
• This function promotes efficiency in the financial system because
• It leads to uniformity in the issue of currency
• It gives central bank direct control over money supply

b) Banker to the Government

RBI acts as a banker, agent and financial advisor to the Centre and state government.
• As a banker it carries out all banking business of the government.
a) Government maintains its cash balances in the current account with the RBI.
b) RBI accepts and make payments on behalf of the government and carries out other
banking operations for the government.

5
 c) The central bank also provides short- term credit to the government so that the
government can meet any shortfalls in receipts over disbursements. The government
carries on short term borrowings by selling ad- hoc treasury bills to the central bank.
• As an agent – The central bank also has the responsibility of managing the public debt.
This means that the central bank has to manage all new issues of government loans.
• As a financial advisor – The central bank advises the government from time to time on
economic, financial and monetary matters.
c) Bankers’ Bank
• The central bank supervises, regulates and controls the commercial banks related to their
licensing, branch expansion, management, amalgamation etc. The control is exercised by
periodic inspection of banks and returns filed by them.
• It acts as a banker’s bank as follows.

i. Custodian of cash Reserves

• It maintains the CRR (a percentage of total deposits which commercial banks are
stipulated to keep with RBI) of the commercial bank
• The purpose of this stipulation is to use these reserves as an instrument of monetary and
credit control

ii. Clearing House

• Central bank settles the interbank claims as it maintains the cash reserves of all banks.

d) Lender of the last Resort

• In case of crisis or emergency central bank stands by the commercial banks as guarantor
and extends loan to ensure the solvency of the commercial banks acting in the capacity of
Lender of the Last Resort against the excess reserves commercial banks hold with the
central bank
• This system of guarantee assures individual account holders that their banks will be able
to pay their money back in case of a crisis and there is no need to panic thus avoiding
bank runs

e) Custodian of Foreign Exchange Reserves

• Central bank acts as the custodian of foreign exchange reserves
• Centralization of foreign exchange transactions with RBI serve two objectives.
i. It helps the bank in stabilizing the external value of currency.
ii. It helps to promote international trade and stabilize exchange rate.

f) Controller of credit
Supply of credit must be controlled so as to ensure the smooth functioning of the economy. For
this purpose, central bank adopts quantitative and qualitative methods of credit control.

6
CREDIT CONTROL BY THE CENTRAL BANK

Though credit is created by the commercial bank but it is controlled by the central bank. This is
done through its following monetary policy instruments:

QUANTITATIVE INSTRUMENTS OF MONETARY POLICY

1. Bank Rate Policy

Bank Rate: The bank rate is the minimum rate at which the central bank of a country (as
lender of a last resort) is prepared to give credit to the commercial bank. The increase in
bank rate increases the rate of interest and credit becomes expensive. Accordingly, the
demand for credit is reduced. On the other hand, decrease in the bank rate lowers the
market rate of interest charged by the commercial banks from their borrowers. Credit
becomes cheap. Accordingly, the demands for credit expands the central banks adopts
dear money policy when the supply of credit needs to be reduced during period of
inflation. It adopts cheap money policy when credit needs to be expended during
deflation.
2.Variable reserve ratio OR Legal Reserve ratio
(a) Cash reserve ratio
(b) Statutory liquidity ratio

(a)Cash Reserve Ratio: It refers to the minimum percentage of a bank’s total deposits
required to be kept with the central bank. Commercial banks have to keep with the central bank a
certain percentage of their deposits in the form of cash reserves as a matter of law for example if
the minimum ratio is Rs 10 % and total deposit of certain bank is 100 crores, it will have to keep
Rs10 crore with the central bank. When the cash flow or credit is to be increased, minimum
reserve ratio is reduced When the cash flow or credit is to be reduced, minimum reserve ratio is
increased.
(b)Statutory Liquidity Ratio (SLR): Every bank is required to maintain a fixed percentage of
its assets, called SLR. With a view to reducing the flow of credit in the market, the central bank
increases this liquidity ratio. However, in case of expansion of credit, the liquidity ratio is
reduced.
3. Open market operations - It refers to sale and purchase of government securities by the
central bank in the open market.
• Sale of securities by the central bank will reduce the reserves with commercial banks
when the bank gives the central bank a cheque for the securities which will reduce the
banks’ ability to create credit and reduce lending in the economy and therefore decrease
the money supply in the economy and therefore decrease the money supply in the
economy.
• In order to expand the flow of credit in the economy central bank purchases securities
from the commercial banks and in return gives the banks the cheque drawn on itself in
payment for the securities. When the cheque clears, the central bank increases the
reserves of the bank by the amount thereby increasing their ability to create credit and
lend more and therefore money supply increases in the economy.

7
4. Repo Rate
Repo rate is the rate at which central banks lends short term money to commercial banks
at the time of financial needs. This loan is given by keeping some securities, bonds as
collateral. Repo rate is always lower than the bank rate.

• At the time of excess demand central bank increases the repo rate.
• This leads to increase the cost of borrowing from the central bank.
• So, the credit creation capacity by the commercial banks reduced.

• At the time of deficient demand central bank lowers the repo rate.
• This leads to decrease the cost of borrowing from the central bank.
• So, the credit creation capacity by the commercial banks increased.

5. Reverse Repo Rate

• Reverse Repo rate is the rate at which commercial banks park their excess reserves with
the central bank.

• At the time of excess demand central bank increases the reverse repo rate.
This encourages the commercial bank to park their excess reserves with the central bank.
• So, the credit creation capacity by the commercial banks reduced.

• At the time of deficient demand central bank lowers the reverse repo rate.
• This discourages the commercial bank to park their excess reserves with the central
bank.
• So, the credit creation capacity by the commercial banks increased.

QUALITATIVE INSTRUMENTES OF MONETARY POLICY

These are those instruments of monetary policy which focus on alternative uses of credit in the
economy. These instruments direct or restrict flow of credit to specified area of economic
activity.

(1) Margin Requirement: The margin requirement of loan refers to the difference between the
current value of the security offered for loan and the value of loan granted. Suppose a person

8
mortgages an article worth RS. 100 with bank and the bank gives him loan of Rs. 80.The margin
requirement in this case would be 20%. In case the flow of credit is to be restricted for certain
specific business activities in the economy, the margin requirement of loan is raised for those
very activities. The margin requirement is lowered in case the expansion of credit is desired.

(2) Rationing of credit: Rationing of credit refers to the fixation of credit quotes for different
business activities. Rationing of credit is introduced when the flow of credit is to be checked
particularly for speculative activities in the economy. the central bank fixes credit quota for
different activities commercial banks cannot exceed the quota limits while granting loans.

(3) Moral Suasion: -Sometimes the central bank makes the member banks agree through
persuasion or pressure to follow its directives with a view to controlling the flow of credit. The
central bank has its control overall commercial banks. Therefore, these banks generally care for
the advice of the central bank for expanding or contracting the flow of credit.

Difference between central bank and commercial bank

Central Bank Commercial bank

It is an apex body that controls, operates, Commercial bank is an institution which
regulates, and directs the entire banking and performs the functions of accepting deposits
monetary structure of the country. and providing loans and making investments,
with the aim of earning profits.
It is owned and governed by the government. It can be owned and governed by the
government or the private sector.
It operates for the public welfare without profit It aims to maximize profits.
motive.
It does not do ordinary banking business with It does ordinary banking business with general
general public but only with the government. public.
It has the sole authority of printing new It has the role of credit creation.
currency.
It acts as a banker to the government. It has no such powers.