Money and BankingClass 12 Introductory Macroeconomics Case Study Questions

Money is the commonly accepted medium of exchange. Economic exchanges without the mediation of money are referred to as barter exchanges. However, they presume the rather improbable double coincidence of wants. For example, an individual with a surplus of rice wishing to exchange it for clothing must find someone with a surplus of clothing who wants rice. To smoothen the transaction, an intermediate good, money, is necessary. The first and foremost role of money is that it acts as a medium of exchange.

Money also acts as a convenient unit of account. The value of all goods and services can be expressed in monetary units. For instance, if a pencil is Rs 2 and a pen is Rs 10, we can say a pen is worth 5 pencils. This allows for a common measure of value.

Finally, money can act as a store of value. Wealth can be stored in the form of money for future use. Unlike perishable goods like rice, money is not perishable and its storage costs are low. However, to perform this function well, the value of money must be sufficiently stable. A rising price level may erode the purchasing power of money.

Commercial banks are a part of the money-creating system. They accept deposits from the public and lend out part of these funds. The process is explained through the story of a goldsmith named Lala. People started keeping their gold with Lala for safe-keeping, and in return, he issued paper receipts. Over time, these paper receipts began to circulate as money, as everyone accepted them as a medium of exchange.

Now, suppose Lala had 100 kgs of gold deposited and had issued corresponding receipts. When Ramu asks for a loan of 25 kgs of gold, Lala could decide that everyone with deposits will not withdraw them at the same time. If Lala gives the loan, and the borrower (Ramu) pays someone else (Ali) who then deposits the gold back with Lala for another receipt, the total paper receipts acting as money would rise to 125 kgs. The modern banking system works precisely this way. Banks lend simply because they do not expect all depositors to withdraw their funds simultaneously. When a bank lends to any person, a new deposit is opened in that person's name, thus increasing the money supply.

Is there a limit to money or credit creation by banks? Yes, and this is determined by the Central bank (RBI). The RBI decides a certain percentage of deposits which every bank must keep as reserves. This is a legal requirement called the 'Required Reserve Ratio' or 'Cash Reserve Ratio' (CRR). Apart from CRR, banks also need to keep some reserves in liquid form, known as the Statutory Liquidity Ratio (SLR).

Let's take an example where CRR = 20 per cent. If a bank has deposits of Rs 100, it must keep Rs 20 as reserves and can lend the remaining Rs 80. This Rs 80 lent out shows up as a deposit in the next round. The bank must now keep 20 per cent of the new total deposits as reserves, and can lend the rest. This process repeats. For an initial reserve of Rs 100, the total deposits can become Rs 500, because 20 per cent of 500 is 100. The amount of deposits that can be created depends on the money multiplier, which is calculated as: Money Multiplier = 1 / Cash Reserve Ratio. In our example, the multiplier is 1 / 0.20 = 5. Thus, initial reserves of Rs 100 create total deposits of Rs 500 (5 x 100).