Unit 5: Money and Banking

ECOIDC-151: Foundation of Economics - II | 2nd Semester Notes

1. Money: Definition, types, and functions

Definition

Money is anything that is **generally accepted** as a medium of exchange for goods and services and for the settlement of debts.

Types of Money

  • Commodity Money: An item with intrinsic value (value in itself), like gold, silver, or salt.
  • Fiat Money: An item with no intrinsic value (like a paper note) that is declared by government decree ("fiat") to be legal tender. This is what we use today.
  • Fiduciary Money (or Bank Money): A promise to pay, like a cheque or a bank deposit. It works based on "fiducia" (trust) that the bank will honor it.

Functions of Money

This is a classic exam question. Money has four main functions:

  1. Medium of Exchange: This is its primary function. Money solves the "double coincidence of wants" problem of the barter system. You don't have to find someone who has what you want *and* wants what you have.
  2. Measure of Value (or Unit of Account): Money provides a common yardstick for measuring and comparing the value of different goods and services (e.g., this car is worth 20,000, this apple is1).
  3. Store of Value: Money allows you to save your purchasing power for the future. (Note: Inflation can erode its value).
  4. Standard of Deferred Payment: Money is a standard way to express the value of a debt or a future payment (e.g., "Pay 100 in 30 days").

2. Determination and Measurement of money supply and demand

Determination of Money Demand

As covered in Unit 4, the demand for money (Liquidity Preference) is determined by:

  • Income (Y): Positively related (for Transaction and Precautionary motives).
  • Interest Rate (i): Negatively related (for the Speculative motive).

The **money market** reaches equilibrium at the interest rate where Money Demand (MD) equals Money Supply (MS).

Measurement of Money Supply

The money supply is the total stock of money in circulation in an economy. The central bank (RBI in India) measures this using different "monetary aggregates":

  • M1 (Narrow Money): This is the most liquid form of money.
    M1 = C + DD + OD
    C = Currency (notes and coins) held by the public.
    DD = Demand Deposits (chequing accounts) with banks.
    OD = Other Deposits with the RBI.
  • M2 = M1 + Deposits with Post Office savings banks.
  • M3 (Broad Money): This is the most common measure of money supply.
    M3 = M1 + Time Deposits with banks
    (Time Deposits are fixed deposits, or FDs, which are less liquid).
  • M4 = M3 + Total Post Office deposits.

3. Functions of Commercial bank

A commercial bank (like SBI, HDFC, ICICI) is a financial institution whose main business is to accept deposits and give loans, with the aim of making a profit.

Primary Functions:

  1. Accepting Deposits:
    • Demand Deposits (Current/Chequing Accounts): Payable on demand, no interest.
    • Time Deposits (Fixed Deposits, FDs): Deposited for a fixed term (e.g., 1 year), pay higher interest.
    • Savings Deposits: A hybrid, allowing chequing but also paying a small amount of interest.
  2. Advancing Loans:
    • Cash Credit/Overdraft: Allowing businesses to borrow against their assets.
    • Term Loans: For purchasing machinery, cars, houses (e.g., a home loan).
    • Discounting Bills of Exchange: Providing cash to a business immediately for a bill that is due in the future.

Secondary Functions:

  • Agency Functions: Acting as an *agent* for the customer (e.g., transferring funds, paying bills, collecting cheques).
  • General Utility Functions: (e.g., providing locker facilities, issuing debit/credit cards, foreign exchange).

4. Credit creation

This is the most important *macroeconomic* function of commercial banks. It is the process by which banks "create" new money (deposits) in the economy by making loans.

This process is based on two assumptions:

  1. All transactions are routed through banks.
  2. Banks are required by the central bank to hold a certain fraction of their deposits as reserves (Cash Reserve Ratio, or CRR) and must loan out the rest.

How it Works (The Money Multiplier):

  • Example: Assume CRR = 10%.
  • Step 1: Person A deposits 1000 in Bank 1.
  • Step 2: Bank 1 keeps 10% (100) as reserves and loans out 900 to Person B.
  • Step 3: Person B uses the 900 to buy something, and the seller deposits it in Bank 2.
  • Step 4: Bank 2 keeps 10% (90) as reserves and loans out 810.
  • Step 5: This810 is deposited in Bank 3, which keeps 10% (81) and loans out 729...

Result: The initial 1000 deposit has *created* new loans and deposits of900 + 810 +729...
The total amount of deposits created will be:

Total Deposits = Initial Deposit * (1 / CRR)
Total Deposits = 1000 * (1 / 0.10) =1000 * 10 = $10,000

The Money Multiplier is (1 / CRR). In this case, it is 10.

5. Role of central bank

A central bank (like the Reserve Bank of India, or RBI) is the apex financial institution in a country. It is *not* a for-profit bank; its goal is to manage the country's money supply and banking system to ensure stability and growth.

Key Functions:

  1. Monopoly of Note Issue: It is the *only* authority with the right to issue currency (paper notes).
  2. Banker to the Government: It manages the government's bank accounts, makes payments on its behalf, and issues government bonds (manages public debt).
  3. Bankers' Bank: It acts as a bank for all the commercial banks.
    • All banks must keep deposits with the central bank (CRR).
    • It acts as a "Lender of Last Resort"—if a commercial bank is in trouble, the central bank will lend to it to prevent a collapse.
  4. Custodian of Foreign Exchange: It manages the country's reserves of foreign currency (e.g., US Dollars, Euros) and manages the exchange rate.
  5. Controller of Credit: This is its most important function. It controls the total amount of money and credit in the economy using Monetary Policy.

6. Credit control- tools of monetary policy

Monetary Policy refers to the actions taken by the central bank to control the money supply and interest rates, with the goal of achieving macroeconomic objectives like price stability (controlling inflation) and economic growth.

The tools can be divided into two types:

A. Quantitative Tools (General)

These tools affect the *total volume* of credit in the economy.

  • Bank Rate (or Repo Rate): The interest rate at which the central bank lends money to commercial banks.
    • To fight inflation: *Increase* the bank rate. This makes borrowing expensive, slows down lending, and reduces the money supply.
  • Open Market Operations (OMOs): The buying and selling of government bonds by the central bank.
    • To fight inflation: *Sell* bonds. This sucks money *out* of the economy (as people give their money to the central bank) and reduces the money supply.
  • Cash Reserve Ratio (CRR): The percentage of deposits that banks *must* keep with the central bank.
    • To fight inflation: *Increase* the CRR (e.g., from 10% to 20%). This forces banks to hold more and lend less, shrinking the money multiplier and the money supply.
  • Statutory Liquidity Ratio (SLR): The percentage of deposits that banks must keep with *themselves* in the form of liquid assets (cash, gold, bonds).

B. Qualitative Tools (Selective)

These tools target the *use* or *direction* of credit for specific sectors.

  • Margin Requirements: The percentage of a loan's value that the borrower must pay themselves (e.g., a 20% margin on a car loan means the bank will only lend 80%). Increasing the margin discourages borrowing for that specific item.
  • Moral Suasion: The central bank "persuades" or pressures commercial banks (through letters or meetings) to follow its policy, e.g., "please don't lend so much for speculation."
  • Direct Action: Punishing a bank that does not follow the central bank's directives.