Money and Banking — Study Notes

1. Introduction

Money is anything that is generally accepted as a medium of exchange and can be used to settle debts, measure value, and store purchasing power. In a barter economy, the exchange of goods against goods suffered from several difficulties such as the double coincidence of wants, the absence of a common measure of value, the problem of storing wealth, and the difficulty of making deferred payments. Money evolved to overcome these problems and is one of the most important inventions of economic life.

The functions of money can be classified into primary and secondary functions. The primary functions are acting as a medium of exchange and as a measure of value. The secondary functions include acting as a store of value, a standard of deferred payments, and a means of transferring value across space and time. Money also helps in the distribution of national income and in the development of credit and financial markets.

In modern economies, money takes several forms: commodity money, metallic money, paper money, and bank money (cheques and demand deposits). The supply of money in India is measured in narrow and broad aggregates such as M1 and M3. The banking system, with the central bank at its apex, creates money through the process of credit creation, and the central bank regulates the money supply through its monetary policy instruments.

2. Evolution and Types of Money

2.1 Difficulties of Barter Exchange

The barter system suffers from the double coincidence of wants, whereby each party must have what the other wants and wants what the other has. There is no common unit to measure value, no easy way to store wealth, and difficulty in making deferred payments and divisible goods. These problems made the development of money necessary.

2.2 Forms of Money

Money has evolved from commodity money (cattle, salt, shells) to metallic money (coins) to paper money (currency notes and coins issued by the government and the central bank) and finally to bank money (cheques, demand deposits, and digital money). Fiat money is money that has no intrinsic value but is accepted because the government declares it as legal tender.

3. Functions of Money

3.1 Primary Functions

Money acts as a medium of exchange, removing the double coincidence of wants. It also serves as a measure of value, expressing the value of all goods and services in a common monetary unit, which makes comparisons easy.

3.2 Secondary Functions

Money is a store of value because it can be saved and used for future purchases. It is a standard of deferred payments for credit transactions, a unit of account for accounting purposes, and a means of transferring value from one place to another.

4. Supply of Money

The supply of money is the total stock of money held by the public in an economy at a point of time. It consists of currency held with the public (coins and notes) and demand deposits with banks. The important measures of money supply in India are:

$$\text{M1} = \text{Currency with Public} + \text{Demand Deposits with Banks} + \text{Other Deposits with RBI}$$

$$\text{M3} = \text{M1} + \text{Time Deposits with Banks}$$

The money supply is a stock concept, and it is held by the public, excluding the money held by the government and the banking system itself.

5. Banks and the Process of Money Creation

5.1 Functions of Commercial Banks

Commercial banks accept deposits (demand deposits and time deposits), advance loans (cash credit, overdraft, and term loans), and provide agency and general utility services such as remittance of funds, safe deposit lockers, and clearing of cheques. Banks earn income primarily from the difference between the interest charged on loans and the interest paid on deposits.

5.2 Credit Creation

Commercial banks create credit because deposits are not fully backed by cash reserves. Banks keep a fraction of deposits as cash reserves (required reserves) and lend the rest. When a bank grants a loan, the amount is credited to the borrower's deposit account, creating new deposits. This process is called credit creation.

$$\text{Total Credit Creation} = \text{Initial Deposit} \times \frac{1}{\text{Legal Reserve Ratio (LRR)}}$$

$$\text{Money Multiplier} = \frac{1}{\text{LRR}}$$

For example, if the legal reserve ratio is 20% and the initial deposit is Rs 1,000, the total money created will be $1000 \times \frac{100}{20} = \text{Rs 5,000}$.

6. The Central Bank and its Functions

The Reserve Bank of India (RBI) is the central bank of India. The central bank is the apex institution that supervises and regulates the banking system and controls the supply of money in the economy. Its functions are:

• Issuer of currency: The central bank has the monopoly of issuing currency notes, which helps in maintaining uniformity and public confidence in the currency.
• Banker to the government: It acts as a banker, agent, and adviser to the government, managing its accounts and public debt.
• Banker's bank and lender of last resort: It provides funds to commercial banks in times of liquidity shortage, supervises them, and acts as the custodian of their cash reserves.
• Controller of credit: It regulates the money supply and credit in the economy through quantitative and qualitative instruments of monetary policy.

7. Instruments of Monetary Policy

Quantitative instruments affect the total quantity of credit and include the bank rate, open market operations, and the cash reserve ratio (CRR) and statutory liquidity ratio (SLR). Qualitative instruments affect the direction and composition of credit and include margin requirements, moral suasion, selective credit controls, and credit rationing.

The bank rate is the rate at which the central bank lends to commercial banks, the CRR is the percentage of deposits that banks must keep with the central bank in cash, and open market operations refer to the sale and purchase of government securities by the central bank to expand or contract the money supply.

Quick Revision Tables

Table 1: Functions of Money

Table 2: Quantitative vs Qualitative Instruments

Table 3: Central Bank vs Commercial Bank

Mind Map

Important Diagrams (SVG)

Diagram 1: Credit Creation Process of a Commercial Bank

Diagram 2: Central Bank - Functions and Instruments

Common Mistakes

1. Believing that commercial banks can create credit without any limit; credit creation is limited by the cash reserves available and the reserve ratio.
2. Confusing M1 with M3; M3 includes time deposits with banks, while M1 includes only demand deposits.
3. Forgetting that the double coincidence of wants is the central problem that money solves by acting as a medium of exchange.
4. Writing that the central bank lends at the market rate; the bank rate is the central bank's own lending rate to commercial banks.
5. Confusing the functions of the central bank with those of commercial banks, e.g. saying that commercial banks issue currency.
6. Mixing up quantitative and qualitative instruments, for example listing margin requirements as a quantitative instrument.
7. Computing credit creation without using the money multiplier formula, leading to wrong numerical answers.

Exam Tips

1. Write the money multiplier formula as Total Credit = Initial Deposit x (1/LRR) and show a worked example in credit creation questions.
2. Differentiate between M1 and M3 by defining currency with public, demand deposits, and time deposits.
3. List the primary and secondary functions of money separately with examples for each function.
4. Mention that money supply is a stock concept measured at a point of time.
5. Classify the instruments of monetary policy into quantitative and qualitative and give at least two examples of each.
6. Explain the concept of the lender of last resort with reference to the liquidity crisis of commercial banks.
7. In functions-of-central-bank questions, link each function to a practical duty such as note issue or bank supervision.

Conclusion

Money and banking form the circulatory system of the modern economy. Money overcomes the inefficiencies of barter by serving as a medium of exchange, measure of value, store of value, and standard of deferred payments, while the supply of money is carefully measured through aggregates like M1 and M3. Commercial banks, by keeping only a fraction of deposits as reserves, create credit and thereby expand the money supply, while the central bank stands at the apex to regulate credit through quantitative and qualitative instruments. Understanding the mechanism of credit creation, the functions of the central bank, and the tools of monetary policy is essential before one can analyse the determination of income and employment, the working of the government budget, and the functioning of the open economy.