Money and Banking
Introductory Macroeconomics • Chapter 3
Barter System is a system of exchange where goods are directly exchanged for other goods without the use of money.
Drawbacks:
- Lack of Double Coincidence of Wants: Exchange is possible only if both parties desire each other’s goods simultaneously.
- Lack of Common Measure of Value: Difficult to determine the exchange rate (e.g., how many shoes = 1 cow?).
- Difficulty in Store of Value: Goods (especially perishables) deteriorate over time, making wealth storage hard.
- Lack of Standard for Deferred Payments: Future payments (loans/wages) are difficult to settle in goods due to quality fluctuations.
Money acts as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment.
| Barter Shortcoming | Money’s Solution (Function) |
|---|---|
| Lack of Double Coincidence of Wants | Medium of Exchange: Money separates the act of sale and purchase. You sell goods for money and use money to buy what you need. |
| Lack of Common Measure | Unit of Account: Money provides a common denominator (price) to value all goods and services. |
| Difficulty in Store of Value | Store of Value: Money is durable and liquid, allowing wealth to be stored easily. |
| Lack of Standard for Future Payments | Standard of Deferred Payment: Contracts can be written in monetary terms for future settlement. |
Transaction Demand for Money ($M_T^d$) is the amount of money people hold to carry out day-to-day transactions (buying goods/services) because income receipts and expenditure are not perfectly synchronized.
Relationship: It is positively related to the total value of transactions ($T$) or nominal GDP ($PY$). As the value of transactions increases, the demand for money increases.
Where $k$ is a positive fraction.
The RBI publishes four alternative measures of money supply ($M1$, $M2$, $M3$, $M4$):
- M1 (Narrow Money): Currency ($CU$) + Demand Deposits ($DD$)
- M2: $M1$ + Savings deposits with Post Office savings banks
- M3 (Broad Money): $M1$ + Net Time Deposits of commercial banks
- M4: $M3$ + Total deposits with Post Office savings organisations (excluding NSC)
| Concept | Definition |
|---|---|
| Legal Tender | Money that cannot be refused by any citizen for the settlement of any transaction or debt by law. (e.g., Currency notes and coins). |
| Fiat Money | Money which has no intrinsic value (like gold/silver) but serves as money on the order/fiat of the government. Its value is derived from government regulation. |
High Powered Money ($H$), also known as the Monetary Base or Reserve Money, is the total liability of the monetary authority (RBI) of the country. It consists of:
- Currency held by the Public ($CU$)
- Cash Reserves held by Commercial Banks ($R$)
It is called “high powered” because it serves as the base for the creation of a much larger supply of money ($M3$) through the money multiplier process.
The primary functions of commercial banks include:
- Accepting Deposits: They accept deposits from the public in various forms like Savings Accounts, Current Accounts, and Fixed Deposits.
- Advancing Loans: They lend the collected deposits to borrowers for investment and consumption purposes, earning interest.
- Credit Creation: Banks create money by lending out a portion of deposits while keeping a fraction as reserves.
- Agency Functions: Collecting cheques, transferring funds, buying/selling securities on behalf of customers.
Money Multiplier is the ratio of the stock of money supply to the stock of high powered money. It shows how much money supply creates from a unit of high powered money.
Determinants:
- Currency Deposit Ratio ($cdr$): The ratio of money held by public in currency to that held in bank deposits.
- Reserve Deposit Ratio ($rdr$): The proportion of total deposits commercial banks keep as reserves (CRR + SLR).
The RBI uses Quantitative and Qualitative instruments:
- Open Market Operations (OMO): Buying and selling of government securities in the open market to inject or absorb liquidity.
- Bank Rate Policy: The rate at which RBI lends long-term funds to commercial banks.
- Repo Rate & Reverse Repo Rate (LAF): Rates for short-term lending and borrowing between RBI and banks.
- Cash Reserve Ratio (CRR): The fraction of deposits banks must keep with RBI.
- Statutory Liquidity Ratio (SLR): The fraction of deposits banks must maintain in liquid assets (gold, cash, approved securities).
Yes, commercial banks are creators of money. While they cannot print currency (which is the RBI’s job), they create Credit Money (Demand Deposits) through the lending process.
When a bank lends money, it does not give cash but credits the borrower’s account. This deposit acts as money. Since banks keep only a fraction of deposits as reserves and lend the rest, the initial deposit gets multiplied, leading to a total money supply that is a multiple of the initial base money.
The Lender of Last Resort function means that if a commercial bank faces a financial crisis and fails to obtain funds from any other source, it can approach the Central Bank (RBI) as a last resort.
The RBI provides financial assistance (loans) against approved securities to ensure the bank remains solvent and to prevent a panic in the banking system, thereby maintaining stability.