UNIT-5

Money & Banking

Topics to be Covered

Barter System

Money - meaning

Supply of money - Currency held by the public and net demand

deposits held by commercial banks.

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 How did
people pay for
goods before
we had
“money”
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 Barter system of exchange :-

Barter system of exchange is the system in which

commodities are exchanged for commodities.

This is also called commodity for commodity exchange

economy

x
Barter system can work when there exists ‘Double
Coincidence of wants’.
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 Double coincidence of wants

No common unit of value

Drawbacks of Barter
System Lack of deferred payments

Lack of store of value

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 Lack of double coincidence of wants

Double coincidence of wants refers to the simultaneous

fulfillment of mutual wants of buyers and sellers. And

barter system can only work when both buyers and sellers

are ready to exchange each other’s goods.

For example – A can exchange goods with B only when A

has what B wants and B has what A wants. However , such

double coincidence is very rare.

x
Hence it leads to high TRADING COST

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Lack of common measure of value

In the barter system , all commodities are not of equal value and there
is no common measure (unit) of value of goods and services, in which
exchange ratios can be expressed.

So the rate was randomly fixed according to the intensity of demand

for each other’s good.

For example – if A has wheat and B has rice , then it is difficult to

x
decide. how much wheat is needed to exchange with one kg of rice.

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Lack Of Standard Of Deferred Payment
Under this system, contracts involving future payments or credit
transactions cannot take place with ease because of the following
reasons –

• The borrower may not be able to arrange goods of exactly same

quality at the time of repayment

• There may be conflicts regarding which specific commodity is to be

used for repayment

• The commodity, to be repaid, may lose or gain its value at the time
of repayment

So , it is very difficult to make deferred payments in the form of goods

x
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Lack Of Store Of Value

Under this system, it is difficult for people to store wealth for future use
because –

• Most of the goods (like wheat, rice, vegetables , etc.) do not possess
durability, i.e. their quality deteriorates with passage of time.

• Storage of goods requires time and efforts

x
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 Commodity Metallic
Money money

Meaning
Money – ‘Anything that is generally
Evolution of
accepted as a medium of exchange’ Money
Or
‘Money is what Money Does’ -
E- money
Crowther Paper money /
/plastic
coins / Cheques
money

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 Forms of money

Forms of Money a) Fiat Money

It refers to that money which is issued by the authority of a country.
Eg : Currency and Coins

Fiat money b) Fiduciary Money

Fiduciary money It is that money which is backed by the trust between the payer and the
payee.
Full bodied Money
Eg: Cheques, Demand Drafts etc.
Credit Money
c) Full Bodied Money :
It is that money whose Commodity value = Money value , as and when it is
issued.

Eg. Metallic Money (during British period, one rupee coin was made of
silver and its value as money was same as its value as a commodity)

d) Credit Money
It is that money whose Money value > commodity value
Eg. Coins

1dhs coin > 50 fills

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 Functions of Money
Functions of Money :-
‘Money is matter of functions four, a medium, A measure, A standard and a store

A. Medium of exchange:- It means that money acts as an intermediary

for the goods and services in an exchange transaction.
B. Measure of value or unit of value:- Money serves as a measure of value in terms of unit of account. Unit of
account means that the value of each good or service is measured in the monetary unit.
C. Standard of deferred payments:-Deferred payments refer to those payments which are made sometimes in
the future. Money is functioning as deferred payments because its price remains relatively stable.
D. Store of value:- Storing of value means store of purchasing power. It is convenient to store value in terms of
money because storage of money does not need much space

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Money Supply

It refers to the total stock of money held by the

people in a country at a point of time.

It includes ‘money held by public only’. The Who produces Who supplies Components of
term public signifies the money using sector , Money in India ? Money ? Money Supply are:-
i.e. individuals and business firms.

It does not include money creating sector , i.e. RBI, Government of RBI, Government, 1) Currency / coins

Government and banking system as the India , Ministry of commercial Banks. 2) Demand Deposits
( deposits that are
reserves with them do not come in actual Finance withdrawn on demand ,
circulation in the country. savings and current account.
3) Other deposits
CC + DD + OD
It is a ‘stock concept’ ,i.e. it is concerned with a
particular point of time.

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 Measures of Money Supply

Till 1967-68, Reserve Bank of India used only the narrow measure of money supply. But
1977, four alternative measures of money supply (M 1 , M2 , M3 and M4) have been evolved.
M1


It is the first and basic measure of money supply.

It is also known as ‘transaction money’ as it can be directly used for making transactions.


M1 = Currency and Coins with public + Demand deposits of commercial banks + other
deposits with RBI

M1 is the most liquid measure of money supply as all its components are easily used as a
medium of exchange.

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 Detail components of M1

Currency and coins with public – it consists of paper notes and coins held by the public.

ANY CURRENCY HELD WITH THE GOVERNMENT AND BANKS IS NOT TO BE INCLUDED


Demand deposits of commercial banks – it refers to demand deposits of the public with the commercial banks. Demand
deposits are the deposits, which can be encashed by issuing cheques at any time by the account holders.

Other deposits with RBI – It includes deposits held by the RBI on behalf of foreign banks and governments, public financial
institutions (like NABARD), World Bank, IMF, etc. However, it does not include deposits of the Indian Government and
commercial banks with RBI

IT MUST BE NOTED THAT ‘OTHER DEPOSITS WITH RBI’ CONSTITUTE A VERY SMALL PROPORTION OF M1.
THEREFORE, THEY DO NOT HAVE ANY SIGNIFICANT ROLE TO PLAY IN THE MONETARY POLICY
FORMULATION.
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 Measures of Money Supply
M1 = Currency/Coins + Demand Deposits + other deposits (deposits
with RBI ( PFI eg; NABARD) Deposits of foreign currency)
M2 = M1 + Saving Deposits with Post Office (‘Saving deposits with post office
savings bank’ is not withdrawable by cheque. So, they could not be placed under
demand deposits with bank. As a result. The concept of m2 was evolved.)
M3 = M1 + Time deposits ( Fixed deposits ) of commercial banks
M4 = M3 + Total deposits of post office (ex. National Saving
Certificate)
M1 – M2 Narrow Measure of Money Supply
M3 – M4 Broader Measure of Money Supply
M1 is more liquid and M4 is the least liquid measure of money supply.
HIGH POWERED MONEY (H)

 High powered money is money produced by the RBI and the government.
 It consists of two things : (i) Currency held by the public; and (ii) Cash reserves with the banks.

Money (M) vs High powered money (H)

 Money consists of currency and demand deposits, while ‘high powered money’ consists of currency and
cash reserves with banks. It means , ‘Currency held by the public’ is common in both of them. The only
difference is that money includes demand deposits of bank, while ‘high powered money’ includes cash
reserve with the banks.

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RBI has the sole authority to issue currency (other than ₹1 note)

RBI issues currency on the basis of MINIMUM RESERVE SYSTEM

Commercial banks do not issue currency yet they are suppliers of money as they
create money by way of demand deposits.

Money created by the commercial banks by way of demand deposits is called

BANK MONEY

In India, the Ministry of Finance issues one rupee notes and coins of all
denomination

Coins are minted at the Mumbai, Alipore(Kolkata), Saifabad(Hyderabad),

Cherlapally (Hyderabad) and NOIDA (UP). The coins are issued for circulation
only through the Reserve Bank in terms of the RBI Act.
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Board Questions

a) State the components of Money supply

b) State the measure of money supply
c) Money has separated the acts of ‘sales’ and purchases’. Explain.

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RECALL
What is a COMMERCIAL BANK?
• A CB provides specialty services to their business clients

• It accepts deposits and advances loans

• Commercial banks creates credits through Demand deposits

What is a CENTRAL BANK?
• It is the Apex Monetary Institution of a country.
• For India: Reserve Bank of India
• For USA: Federal Reserve
• For England: Bank of England
Functions of Central Bank
• Issue of Currency
• Banker to the Government
• Banker’s bank and Supervisory Role
• Lender of last resort
• Controller of Money Supply and Credit
• Custodian of Foreign Exchange
Issue of Currency
Sole authority for the issue of currency in the
country.

The issuing department is responsible for issuing of

notes.

All the currency issued by the bank is its monetary

liability

It is mandatory that RBI backs all the issue of

currency with equivalent assets such as gold, foreign
securities etc.
Banker to the Government
Acts as a banker, agent and advisor to the central and state govt.

As a banker, it accepts receipts and makes payment for the governments.

As an agent, it sells and purchases securities on behalf of the govt.

Advises the govt. on all Banking and financial matters.

Provides foreign exchange resources to repay external debts

Manages public debt

Banker’s Bank and Supervisory role
• Supervises, controls & regulates other banks

• Provides financial assistance to banks. Accepts deposits and

advances loans to other commercial banks

• Provides centralized clearing and remittance Facilities to

commercial banks

• Supervisory role- ensures that banks maintain CRR & SLR rates
Lender of the last resort
When commercial banks fail to meet
the obligations of their deposits, RBI
comes to their rescue by advancing
necessary credit against eligible
securities subject to terms and
conditions thereby saving them from
break down.
Controller of Money Supply & Credit
RBI is an independent authority for conducting monetary policies in the best interest of the economy.
It controls the money supply and credit through:

Quantitative Measures Qualitative Measures

1. Bank Rate policy 1. Marginal requirement
2. Open Market Operations 2. Moral suasion
3. Varying reserve ratios (SLR & CRR) 3. Direct actions
4. Repo rate & Reverse repo rate 4. Credit rationing
 1. A custodian of nation’s
Custodian foreign exchange reserves

of Foreign 2. Exercise managed floating

systems to ensure stability

Exchange
in foreign exchange rates
Quantitative measures to control the money supply
It is the rate of interest at which the central bank
Bank Rate of the country gives loans to commercial banks
without any collateral.

Deflation ( Continuous fall in the price

During Inflation (continuous rise of price
of commodity)
of the commodity)

Bank Rate ↓Bank rate

cost of borrowing ↓ Cost of borrowing

↓ Less demand for loans More demand for loans

↓ Less investment More investment

↓ Money supply Money supply

Hence, inflation is controlled
Hence. Deflation is controlled.
Bank Rate- the rate of interest that the commercial bank
pays to the RBI

Inflation- continues rise in the price of a commodity Deflation- continuous fall in the price of a
commodity
^ Bank Rate (rate of interest)

= ^ cost of borrowing ↓ Bank Rate (Rate of interest)

= ↓ in demand for loans
= ↓ Cost of borrowing
= ↓ in investment
= ^ In demand for loans
= ↓ in Money supply

Hence, Inflation controlled = ^ in investment

= ^ in Money supply

Hence, Deflation controlled

 Rate at which the RBI gives short period
Repo Rate loan to commercial banks with collateral

During Deflation
During Inflation

Repo Rate ↓Repo rate

cost of borrowing ↓ Cost of borrowing

↓ Less demand for loans In demand for loans

↓ Less investment More investment

↓ Money supply Money supply

 Rate at which the banks parks the
Reverse Repo Rate
surplus fund with the RBI

During Inflation During Deflation

^ Reverse Repo Rate ↓Reverse Repo rate

= ^ in storing the surplus funds with RBI = Bank gives surplus funds to the
investors

= ↓ in Money supply = More Money supply in the narket

 Cash reserve ratio- Ratio of money which the
CRR commercial banks keep with the RBI.

SLR Statutory liquidity ratio- Ratio of money which the

commercial banks keep with itself.

During Inflation During Deflation

^ CRR & SLR by the RBI ↓ CRR & SLR by the RBI

= more reserve funds will be kept by the = less reserve funds will be kept by the
bank bank

= ↓ less loans to the people = ^ more loans to the people

= ↓ in Money supply = ^ in Money supply

 Refers to buying and selling of
Open Market Operations
securities in the market

Inflation Deflation
RBI sells its securities (bonds etc.) RBI buys securities

↓ ↓

Money will flow from people to RBI Money will be pumped into the economy
Moral Suasion
Combination of persuasion and pressure that the central bank
applies on other banks to follow the policies. It means advising,
requesting, and persuading the commercial banks to co-operate
with the RBI in implementing it’s monetary policies.

Refers to directions used by the RBI to commercial

Direct Actionbanks regarding their investment policies.
INDICATOR CURRENT RATE

Bank Rate 6.75%

Repo Rate 6.25%
Reverse Repo Rate 6%
CRR 4%
SLR 19.50%
Margi Difference between the actual value and the offered value.
ns
High are set at time of inflation when money supply is to be reduced
Margins
Low
Are set by the RBI at times of deflation so as to increase
Margins the money supply
 Credit
rationing
Refers to fixation of credit quotas for different business activities

This ensures that the commercial banks do not exceed the limit while granting loans

Credit rationing is withdrawn to increase the supply of credit and thereby deflation
is curbed
 Difference between
CENTRAL BANK COMMERCIAL BANK

• Ultimate source of money supply • Not the Ultimate source of

in the economy money supply in the economy
• Has the right to print and issue • Does not have the right to print
currency notes and issue currency notes
• Deals with Banks and • Deals with General public
Government • Many in presence
• Only one presence
Functions of Commercial Bank
It is a financial institution that accepts deposits and advances loans

Two major functions:

• Accepting deposits
• Advancing Loans
 Credit Creation
One of the important functions of a commercial bank is to create credit.

Credit creation is the multiple expansion of demand deposits

Commercial Banks advance a major portion of their deposits to the borrower and keep smaller
parts of deposits to the customers on demand (for them to withdraw)

The customers of the bank are confident that the deposits in the bank are safe and can be
withdrawn on demand. The banks exploit this trust of their clients and expand loans by much
more than the amount of demand deposits possessed by them.

The tendency on the part of commercial bank to expand their deposits as a multiple of their
excess cash reserve is called Creation of Credit
Assumptions:
• Not a single bank, but the banking system as a whole creates credit in
an economy.
• The advanced loans are not given in cash rather a deposit account is
opened in the name of the borrower which allows them to draw from
the bank as and when required.
• The loan advanced becomes the gain of deposits by some other bank.
loans thus makes deposits and deposits makes loans.
• MONEY MULTIPLIER: most common mechanism used to measure
the increase in the money supply. It is the inverse of the reserve
requirement (CRR).
• It calculates the maximum amount of money that an initial deposit can
Example:-
• A person deposits ₹ 1000 in bank. Suppose the Reserve Ratio fixed by the RBI is 20%.
• Money multiplier = 1/CRR
• Then the money multiplier , m, will be calculated as:
• m = 1/20% = 5

• This number is multiplied by the initial deposit to show maximum amount of money it can be expanded to
• i.e Amount of Money Created= Initial deposits * Money Multiplier
• = 1000 * 5
• = 5000