Chapter Notes

Money and Banking

Imagine trying to trade your extra lunch for a pen you need in class. What if the person with the pen doesn't want your lunch? This problem is at the heart of why we need money. Money is simply a commonly accepted medium of exchange. It's an instrument that makes buying and selling things smooth and easy.

Without money, we would have to rely on barter exchanges, which means trading goods directly for other goods. This system has a major drawback: it requires a double coincidence of wants. This means you not only have to find someone who has what you want, but that person must also want what you have.

Money solves this problem by acting as an intermediate good that everyone accepts. You can sell your rice for money and then use that money to buy clothing from anyone who is selling it.

Functions of Money

While its main job is to make exchanges easier, money serves three key functions in a modern economy.

• Medium of Exchange: This is the most important function. Money eliminates the need for a double coincidence of wants, allowing people to buy and sell goods and services freely.
• Unit of Account: Money provides a common measure of value. We can express the price of all goods and services in a single unit (like Rupees, Dollars, etc.). This makes it easy to compare the value of different items. For instance, if a pen costs Rs 10 and a pencil costs Rs 2, we know the pen is worth five pencils. It also allows us to understand the value of money itself; if prices rise, the purchasing power of money falls.
• Store of Value: Money allows you to store your wealth for future use. Unlike perishable goods like rice, money doesn't spoil and is easy to store. You can sell your surplus goods today, hold the money, and spend it later. While other assets like gold or property can also store value, money is the most easily convertible and universally accepted.

Towards a Cashless Society

Many countries, including India, are moving towards using less physical cash and more digital transactions. A cashless society is one where financial transactions happen through the transfer of digital information (like e-Wallets, online banking) rather than physical notes and coins. Initiatives like Jan Dhan accounts and Aadhar-enabled payment systems are helping India move in this direction.

Demand for Money and Supply of Money

Demand for Money

The demand for money refers to why people want to hold a certain amount of money. There are two main reasons:

1. To Conduct Transactions: People need money to buy goods and services. The more transactions they need to make, or the higher their income, the more money they will demand.
2. To Hold Savings: People can save their money either by holding cash or by putting it in a bank to earn interest. The rate of interest is the opportunity cost of holding cash. When interest rates are high, people prefer to put their money in the bank to earn more, so the demand for holding money comes down. When interest rates are low, holding cash is less costly, so the demand for money may rise.

Supply of Money

In a modern economy, the money supply consists of cash (currency) and bank deposits. The supply of money is created and managed by two main types of institutions: the central bank and the commercial banking system.

Central Bank

The central bank is the most important financial institution in a country. In India, the central bank is the Reserve Bank of India (RBI), established in 1935.

The key functions of the RBI include:

• Issuing Currency: The RBI is the sole authority for issuing currency notes in the country.
• Controlling Money Supply: It uses various tools (like bank rates, reserve ratios) to manage the amount of money in the economy.
• Banker to the Government: It manages the government's accounts and financial transactions.
• Custodian of Foreign Exchange Reserves: It manages the country's reserves of foreign currencies.
• Banker to the Banking System: It acts as a bank for all the commercial banks in the country.

The currency issued by the central bank is called high-powered money or reserve money. This is because it forms the base upon which commercial banks create more money (credit).

Commercial Banks

Commercial banks are institutions that accept deposits from the public and provide loans to those who need them. They play a crucial role in the money-creating system.

• How they work: Banks pay a certain interest rate to people who deposit money with them. They then lend out a part of these deposits to borrowers at a higher interest rate. The difference between the lending rate and the deposit rate is called the 'spread', which is the bank's profit.

Money Creation by Banking System

Commercial banks have the ability to create money. This doesn't mean they print new currency notes; instead, they create credit, which functions as money. They can do this because they know that all depositors will not withdraw their funds at the same time.

When a bank gives a loan to someone, it typically opens a new deposit account in that person's name. This new deposit adds to the total money supply in the economy.

Balance Sheet of a Fictional Bank

A balance sheet is a statement of a firm's assets and liabilities.

• Assets: What a firm owns or what others owe to it. For a bank, assets include reserves (cash and deposits with the RBI) and loans given to the public.
• Liabilities: What a firm owes to others. For a bank, the main liability is the deposits that people have kept with it. The fundamental accounting rule is: Assets = Liabilities.

Limits to Credit Creation and Money Multiplier

Banks cannot create an unlimited amount of money. Their ability to create credit is limited by the central bank. The RBI mandates that every bank must keep a certain percentage of its total deposits as reserves. This is called the Required Reserve Ratio or Cash Reserve Ratio (CRR).

• Cash Reserve Ratio (CRR): The fraction of deposits that a bank must legally keep as cash reserves with the RBI.
• Statutory Liquidity Ratio (SLR): Apart from CRR, banks also need to keep a certain proportion of their deposits in the form of liquid assets (like government bonds).

These reserve requirements act as a limit on how much a bank can lend.

1. Assume the CRR is 20%. Someone deposits Rs 100 in a bank.
2. The bank must keep 20% of Rs 100 (i.e., Rs 20) as a reserve.
3. It can now lend out the remaining Rs 80.
4. The person who borrows Rs 80 spends it, and this money eventually gets deposited back into the banking system.
5. Now, the bank has a new deposit of Rs 80. It keeps 20% of this (Rs 16) as a reserve and can lend out the remaining Rs 64.
6. This process continues. The initial deposit of Rs 100 leads to the creation of a much larger amount of total deposits in the economy.

This leads to the concept of the money multiplier. It tells us how many times the total money supply will be of the initial reserve amount.

Policy Tools to Control Money Supply

The RBI uses several tools to control the money supply and influence the economy. This is known as monetary policy. The tools can be quantitative (affecting the total volume of money) or qualitative (directing credit for specific purposes).

Quantitative Tools

1. Reserve Ratios (CRR and SLR): By changing the reserve ratios, the RBI can directly affect the amount of money banks can lend.

   • Increasing CRR/SLR: Banks have to keep more money as reserves, so they have less to lend. This reduces the money supply.
   • Decreasing CRR/SLR: Banks have more money available to lend. This increases the money supply.

2. Open Market Operations (OMO): This refers to the buying and selling of government bonds by the RBI in the open market.

   • Buying Bonds: When the RBI buys bonds, it pays for them by giving a cheque, which increases the reserves in the banking system and thus increases the money supply.
   • Selling Bonds: When the RBI sells bonds, it receives payment, which reduces the reserves in the banking system and thus decreases the money supply.

3. Bank Rate: This is the interest rate at which the RBI lends long-term funds to commercial banks.

   • Increasing the Bank Rate: Loans from the RBI become more expensive for commercial banks. They, in turn, increase their lending rates, which discourages borrowing and reduces the money supply.
   • Decreasing the Bank Rate: Loans from the RBI become cheaper, encouraging banks to borrow more and lend more, thus increasing the money supply.

4. Repo Rate and Reverse Repo Rate: These have become the main tools of monetary policy in India.

   • Repo Rate: The interest rate at which the RBI lends money to commercial banks against government securities for a short period. An increase in the repo rate makes borrowing from the RBI more expensive, thus reducing the money supply.
   • Reverse Repo Rate: The interest rate at which the RBI borrows money from commercial banks. An increase in the reverse repo rate encourages banks to park their funds with the RBI, reducing the amount of money available for lending and thus decreasing the money supply.

Demand and Supply for Money: A Detailed Discussion

Motives for Demanding Money

People's desire to hold money is also called liquidity preference. There are two primary motives:

1. The Transaction Motive: This is the demand for money to carry out everyday transactions like buying groceries, paying bills, etc. The amount of money needed for transactions is directly related to a person's income and the general price level. Higher income or higher prices mean a higher transaction demand for money.
2. The Speculative Motive: This relates to holding money as an asset, in anticipation of changes in the interest rate. People can hold their wealth in the form of money or in assets like bonds (which pay interest).
   • There is an inverse relationship between the market rate of interest and the price of bonds. When the interest rate rises, the price of existing bonds falls. When the interest rate falls, the price of existing bonds rises.
   • If people expect the interest rate to rise in the future, they will anticipate a fall in bond prices (a capital loss). To avoid this loss, they will sell their bonds and prefer to hold cash. This increases the speculative demand for money.
   • If people expect the interest rate to fall, they will anticipate a rise in bond prices (a capital gain). They will buy bonds and hold less cash. This decreases the speculative demand for money.

Liquidity Trap

A liquidity trap is a situation where the interest rate is so low that everyone expects it to rise in the future. In this case, nobody wants to hold bonds because they anticipate a capital loss. Everyone prefers to hold cash. Even if the central bank injects more money into the economy, it gets absorbed as cash holdings without lowering the interest rate further.

The Supply of Money: Various Measures

Money in a modern economy is fiat money. This means its value comes from the "fiat" or order of the government, not from its intrinsic value (the paper in a Rs 100 note is worth very little). It is also legal tender, meaning it cannot be refused by any citizen for the settlement of transactions.

The RBI publishes four alternative measures of money supply, categorized by their liquidity (how easily they can be used for transactions).

• M1 = CU (Currency held by public) + DD (Net Demand Deposits with commercial banks)
• M2 = M1 + Savings deposits with Post Office savings banks
• M3 = M1 + Net time deposits of commercial banks
• M4 = M3 + Total deposits with Post Office savings organisations

• M1 and M2 are known as narrow money because they include the most liquid forms of money.
• M3 and M4 are known as broad money.
• M3 is the most commonly used measure of money supply and is also known as aggregate monetary resources.

Demonetisation

In November 2016, the Government of India undertook demonetisation, a major policy initiative.

• What happened? The old Rs 500 and Rs 1000 currency notes were declared no longer legal tender. New Rs 500 and Rs 2000 notes were introduced.
• Why was it done? The stated goals were to tackle corruption, black money, terrorism (which uses fake currency), and tax evasion.
• Impact:
  • Negative: There were long queues at banks and ATMs, and a temporary shortage of cash hurt economic activity.
  • Positive: It led to improved tax compliance, as more people were brought into the tax system. It also channelized savings into the formal financial system, giving banks more resources to lend. The move encouraged a shift from cash to digital payments.