Money and Banking

What is a Barter System?

A barter system is a system of exchange in which goods and services are directly exchanged for other goods and services without the use of money as a medium of exchange. For example, a farmer may exchange wheat for cloth with a weaver.

Drawbacks of the Barter System:

1. Lack of Double Coincidence of Wants: Barter requires that two parties must simultaneously want exactly what the other has to offer. For example, if a farmer wants cloth and has wheat, he must find a weaver who wants wheat and has cloth. This is very difficult in practice.

2. Lack of a Common Measure of Value: In a barter system, there is no common unit in which the value of goods can be measured and compared. For example, how many kilograms of wheat equals one metre of cloth? This makes exchange very complicated.

3. Lack of Store of Value: It is difficult to store wealth for future use in the form of commodities, as most goods are perishable and lose value over time.

4. Lack of Divisibility: Some goods (like a cow) cannot be divided into smaller units for making change, making it difficult to exchange goods of unequal value.

5. Difficulty in Deferred Payments: Barter makes it very difficult to make contracts for future payments, since the value of goods changes over time and there is no standard unit for such agreements.

Conclusion: These drawbacks made barter exchange highly inefficient, leading to the evolution of money as a medium of exchange.

Main Functions of Money:

1. Medium of Exchange: Money acts as an intermediary in the exchange of goods and services. A seller accepts money in exchange for goods, and uses that money to buy other goods.

2. Unit of Account (Measure of Value): Money provides a common unit in which the value of all goods and services can be expressed (e.g., in rupees in India).

3. Store of Value: Money can be stored for future use without losing its value (unlike perishable commodities). It allows people to save purchasing power over time.

4. Standard of Deferred Payment: Money makes it possible to express future obligations (loans, contracts) in a standard unit, facilitating credit transactions.

How Money Overcomes the Shortcomings of Barter:

| Drawback of Barter | How Money Overcomes It |
|---|---|
| Double coincidence of wants | Money separates the act of buying from selling; a person can sell goods for money and use money to buy anything, anywhere, from anyone. |
| No common measure of value | Money serves as a unit of account — all goods are priced in monetary units, making comparison easy. |
| Lack of store of value | Money can be stored easily without deterioration, serving as a store of value. |
| Indivisibility of goods | Money is perfectly divisible into smaller units (e.g., rupees and paise), solving the problem of making change. |
| Difficulty in deferred payments | Contracts for future payments can be made in monetary terms, as money retains its value over time. |

Conclusion: Money, by acting as a medium of exchange, unit of account, store of value, and standard of deferred payment, effectively resolves all the major problems associated with the barter system.

Transaction Demand for Money:

Transaction demand for money refers to the demand for money held by individuals and firms to carry out their day-to-day transactions — such as buying goods, paying wages, meeting household expenses, etc. People need to hold money in liquid form (cash) because income is received at discrete intervals (e.g., monthly salary) but expenditure occurs continuously throughout the period.

Relationship with Value of Transactions:

The transaction demand for money ($L_T$) is directly and positively related to the total value of transactions undertaken in the economy over a specified period of time.

This is expressed as:
$$L_T = k \cdot T$$

where:
- $L_T$ = Transaction demand for money
- $T$ = Total value of transactions during the period
- $k$ = A positive fraction (the proportion of total transactions that people wish to hold as money)

Since the total value of transactions in an economy is closely related to the nominal income (GDP) of the economy, the transaction demand for money can also be written as:
$$L_T = k \cdot Y$$

where $Y$ is the nominal national income.

Key Points:
- If the value of transactions (or income) increases, the transaction demand for money increases proportionally.
- If the value of transactions decreases, the transaction demand for money decreases.
- Thus, transaction demand for money is a positive function of the level of income/value of transactions.

Conclusion: The higher the level of economic activity and the value of transactions, the greater is the need to hold money for transaction purposes.

Alternative Definitions of Money Supply in India:

The Reserve Bank of India (RBI) has defined money supply in four alternative ways, classified from the narrowest to the broadest measure, based on decreasing order of liquidity:

1. $M_1$ (Narrow Money):
$$M_1 = \text{Currency and coins held by the public} + \text{Demand deposits of commercial banks} + \text{Other deposits with RBI}$$
- This is the most liquid measure of money supply.
- Demand deposits are chequeable deposits that can be withdrawn on demand.

2. $M_2$:
$$M_2 = M_1 + \text{Savings deposits with Post Office savings banks}$$
- Slightly broader than $M_1$.

3. $M_3$ (Broad Money):
$$M_3 = M_1 + \text{Net time deposits of commercial banks}$$
- Time deposits (fixed deposits) have a fixed maturity period and are less liquid than demand deposits.
- $M_3$ is the most commonly used measure of money supply and is referred to as broad money.

4. $M_4$:
$$M_4 = M_3 + \text{Total deposits with Post Office savings organisations (excluding National Savings Certificates)}$$
- This is the broadest and least liquid measure of money supply.

Summary Table:

| Measure | Components | Liquidity |
|---|---|---|
| $M_1$ | Currency + Demand Deposits + Other Deposits with RBI | Highest |
| $M_2$ | $M_1$ + Post Office Savings Deposits | High |
| $M_3$ | $M_1$ + Time Deposits of Banks | Moderate |
| $M_4$ | $M_3$ + Post Office Total Deposits | Lowest |

Conclusion: $M_1$ and $M_2$ are called narrow money, while $M_3$ and $M_4$ are called broad money. The RBI primarily uses $M_3$ as the key indicator of money supply for policy purposes.

Legal Tender:

Legal tender refers to money that is legally recognised by the government as an acceptable medium for settling debts and making payments. No person can legally refuse to accept legal tender in settlement of a debt.

- In India, currency notes and coins issued by the RBI and the Government of India are legal tender.
- Legal tender can be of two types:
- Limited legal tender: Money that can be used to pay debts only up to a certain limit (e.g., coins above a certain denomination).
- Unlimited legal tender: Money that can be used to pay debts of any amount (e.g., currency notes in India).

Fiat Money:

Fiat money is money that is declared by the government (by fiat or order) to be legal tender, but it has no intrinsic value of its own — it is not backed by any physical commodity like gold or silver.

- The value of fiat money comes entirely from government decree and public trust/acceptance.
- Modern currency notes (paper money) are the best example of fiat money.
- For example, a ₹500 note has no intrinsic value as a piece of paper, but it is accepted as money because the government has declared it to be legal tender.

Key Difference:

| Aspect | Legal Tender | Fiat Money |
|---|---|---|
| Meaning | Money legally accepted for payments | Money with no intrinsic value, backed by government order |
| Basis of value | Government law | Government decree and public trust |
| Example | Currency notes, coins | Paper currency notes |

Conclusion: All fiat money is legal tender, but the emphasis of fiat money is on the absence of intrinsic value, while legal tender emphasises legal enforceability of acceptance.

High Powered Money (H):

High Powered Money, also called the monetary base or reserve money, refers to the money produced by the RBI and the Government of India. It consists of:

$$H = \text{Currency held by the public} (C) + \text{Cash reserves held by commercial banks with RBI} (R)$$

Or equivalently:
$$H = C + R$$

where $R$ includes both the Cash Reserve Ratio (CRR) deposits with RBI and the vault cash held by banks.

Why is it called 'High Powered'?

It is called high powered money because one rupee of H leads to the creation of more than one rupee of money supply in the economy through the process of credit creation (money multiplier).

The relationship between money supply ($M$) and high powered money ($H$) is given by:
$$M = m \times H$$

where $m$ is the money multiplier, defined as:
$$m = \frac{1 + \text{Currency-Deposit Ratio (cdr)}}{ \text{Currency-Deposit Ratio (cdr)} + \text{Reserve-Deposit Ratio (rdr)}}$$

Since m > 1, a given amount of high powered money supports a much larger amount of total money supply.

Sources of High Powered Money:
- Currency notes and coins issued by RBI
- Government currency (small coins)
- Deposits of commercial banks with RBI

Conclusion: High powered money is the foundation of the money supply in the economy. The RBI controls the money supply by regulating the stock of high powered money.

Functions of a Commercial Bank:

Commercial banks perform a wide range of functions, which can be broadly classified as follows:

A. Primary Functions:

1. Accepting Deposits:
Commercial banks accept deposits from the public in various forms:
- Demand/Current Deposits: Can be withdrawn at any time by cheque; no interest paid.
- Savings Deposits: Meant for small savers; limited withdrawals; low interest paid.
- Fixed/Time Deposits: Deposited for a fixed period; higher interest paid; cannot be withdrawn before maturity.

2. Advancing Loans (Credit Creation):
Banks lend money to individuals and businesses in the form of:
- Cash credit/Overdraft: Borrower can withdraw up to a sanctioned limit.
- Demand loans: Repayable on demand.
- Term loans: For a fixed period (short, medium, or long term).
- Discounting of Bills: Banks purchase bills of exchange before maturity at a discount.

3. Credit Creation:
Banks create credit (money) by advancing loans. When a bank grants a loan, it does not give cash but opens a deposit account in the borrower's name. This new deposit becomes part of the money supply. This process, repeated across the banking system, leads to a multiple expansion of credit.

B. Secondary/Agency Functions:

4. Transfer of Funds: Banks transfer money from one place to another through demand drafts, NEFT, RTGS, etc.

5. Collection and Payment of Cheques: Banks collect cheques and bills on behalf of customers.

6. Payment of Standing Instructions: Banks pay insurance premiums, utility bills, etc., on behalf of customers.

7. Acting as Trustee and Executor: Banks manage estates and trusts on behalf of clients.

8. Safe Custody of Valuables: Banks provide safe deposit lockers for storing jewellery, documents, etc.

C. General Utility Functions:

9. Issuing Letters of Credit and Traveller's Cheques: Facilitating trade and travel.

10. Foreign Exchange Services: Banks deal in foreign exchange to facilitate international trade.

Conclusion: Commercial banks play a crucial role in the economy by mobilising savings, providing credit, and facilitating payments, thereby promoting economic growth.

Money Multiplier:

The money multiplier ($m$) is the ratio of the total money supply ($M$) in the economy to the stock of high powered money ($H$). It measures by how much the money supply increases for every one rupee increase in high powered money.

$$m = \frac{M}{H}$$

Or equivalently:
$$M = m \times H$$

Since m > 1, a given amount of high powered money supports a much larger total money supply.

Formula for Money Multiplier:

Let:
- $cdr$ = Currency-Deposit Ratio $= \dfrac{C}{D}$ (ratio of currency held by public to deposits)
- $rdr$ = Reserve-Deposit Ratio $= \dfrac{R}{D}$ (ratio of reserves held by banks to deposits)

Then:
$$m = \frac{1 + cdr}{cdr + rdr}$$

Determinants of the Money Multiplier:

1. Currency-Deposit Ratio ($cdr$):
- This is determined by the behaviour of the public — how much cash they prefer to hold relative to bank deposits.
- If $cdr$ increases (people hold more cash), the money multiplier decreases, because less money is deposited in banks and less credit can be created.
- If $cdr$ decreases, the multiplier increases.

2. Reserve-Deposit Ratio ($rdr$):
- This is determined by the behaviour of commercial banks and the RBI's policy (through CRR and SLR requirements).
- If $rdr$ increases (banks keep more reserves), the money multiplier decreases, because less money is available for lending.
- If $rdr$ decreases, the multiplier increases.

Numerical Example:
Suppose $cdr = 0.2$ and $rdr = 0.1$:
$$m = \frac{1 + 0.2}{0.2 + 0.1} = \frac{1.2}{0.3} = 4$$
This means every ₹1 of high powered money supports ₹4 of total money supply.

Conclusion: The money multiplier is inversely related to both the currency-deposit ratio and the reserve-deposit ratio. The RBI can influence the multiplier by changing reserve requirements.

Instruments of Monetary Policy of RBI:

The Reserve Bank of India (RBI) uses the following instruments to regulate money supply and credit in the economy:

A. Quantitative (General) Instruments:

1. Bank Rate (Discount Rate):
- The rate at which the RBI lends money to commercial banks for the long term.
- If the bank rate increases, borrowing from RBI becomes costlier → banks raise their lending rates → credit becomes expensive → money supply decreases.
- If the bank rate decreases, the reverse happens → money supply increases.

2. Cash Reserve Ratio (CRR):
- The minimum percentage of a bank's net demand and time liabilities (NDTL) that must be kept as cash reserves with the RBI.
- If CRR increases → banks have less money to lend → money supply decreases.
- If CRR decreases → banks have more money to lend → money supply increases.

3. Statutory Liquidity Ratio (SLR):
- The minimum percentage of NDTL that banks must maintain in the form of liquid assets (gold, government securities, etc.).
- Higher SLR → less funds available for lending → money supply decreases.

4. Repo Rate:
- The rate at which the RBI lends short-term funds to commercial banks against government securities.
- Higher repo rate → borrowing from RBI is costlier → money supply decreases.

5. Reverse Repo Rate:
- The rate at which the RBI borrows money from commercial banks (i.e., banks park excess funds with RBI).
- Higher reverse repo rate → banks prefer to park funds with RBI → less money available for lending → money supply decreases.

6. Open Market Operations (OMO):
- The RBI buys or sells government securities in the open market.
- RBI sells securities → money flows from banks to RBI → money supply decreases (contractionary).
- RBI buys securities → money flows from RBI to banks → money supply increases (expansionary).
- OMO is also used for sterilisation — to neutralise the effect of foreign exchange inflows/outflows on domestic money supply.

B. Qualitative (Selective) Instruments:

7. Margin Requirements: RBI can change the margin (difference between loan amount and collateral value) to control credit for specific purposes.

8. Moral Suasion: RBI persuades banks to follow certain lending policies through advice and guidelines.

9. Selective Credit Controls: RBI can direct banks to restrict or expand credit to specific sectors.

Conclusion: Through these instruments, the RBI regulates the money supply, controls inflation, and maintains financial stability in the economy.

Yes, a commercial bank is indeed a 'creator of money' in the economy.

Explanation — The Process of Credit Creation:

Commercial banks create money through the process of credit creation (also called deposit multiplication). This works as follows:

Assumptions:
- All banks maintain a fixed Reserve-Deposit Ratio (rdr) — say 20% (i.e., they keep 20% of deposits as reserves and lend out 80%).
- All loan amounts are re-deposited back into the banking system.

Step-by-Step Process:

Suppose the RBI injects ₹1,000 of high powered money into the banking system:

| Round | Deposits (₹) | Reserves kept (20%) (₹) | Loans given (₹) |
|---|---|---|---|
| 1 | 1,000 | 200 | 800 |
| 2 | 800 | 160 | 640 |
| 3 | 640 | 128 | 512 |
| ... | ... | ... | ... |
| Total | 5,000 | 1,000 | 4,000 |

The total deposits created $= \dfrac{1}{rdr} \times \text{Initial Deposit} = \dfrac{1}{0.2} \times 1000 = ₹5,000$

How is Money Created?
- When a bank grants a loan, it does not give physical cash. Instead, it opens a deposit account in the borrower's name and credits the loan amount.
- This new deposit is new money created by the bank — it did not exist before.
- The borrower spends this money; the recipient deposits it in another bank, which again lends a fraction, and so on.
- This process leads to a multiple expansion of deposits and money supply.

Formula:
$$\text{Total Money Created} = \frac{1}{rdr} \times \text{Initial Deposit}$$

Conclusion:
Yes, commercial banks are creators of money. By accepting deposits and making loans (while keeping only a fraction as reserves), they create credit money that is several times larger than the initial deposit. This is why commercial banks are called 'creators of money' in the economy. However, this power is regulated by the RBI through instruments like CRR, SLR, and the bank rate.

Lender of Last Resort — Role of RBI:

Meaning:
The RBI acts as the 'lender of last resort' for commercial banks. This means that when a commercial bank faces a financial crisis or a liquidity shortage and is unable to obtain funds from any other source (other banks, financial markets, etc.), it can approach the RBI as the last resort for financial assistance.

How it Works:
- Commercial banks sometimes face sudden and unexpected demands for cash withdrawals from depositors (a bank run).
- In such situations, the bank may not have sufficient liquid funds to meet these demands.
- Since no other institution is willing to lend to a bank in crisis, the bank approaches the RBI, which provides the necessary funds — usually by discounting bills of exchange or by providing short-term loans against approved securities.
- The RBI charges the bank rate (or repo rate) for such lending.

Significance of this Role:

1. Prevents Bank Failures: By providing emergency funds, the RBI prevents solvent but temporarily illiquid banks from collapsing.

2. Maintains Public Confidence: Knowing that the RBI stands behind them, depositors remain confident in the banking system, preventing panic withdrawals.

3. Ensures Financial Stability: It prevents a crisis in one bank from spreading to the entire banking system (systemic risk).

4. Protects Depositors: It safeguards the savings of ordinary depositors.

Example: During a financial panic, if depositors rush to withdraw money from a bank simultaneously, the bank may run short of cash. The RBI, as lender of last resort, provides emergency liquidity to the bank so it can meet all withdrawal demands.

Conclusion: The 'lender of last resort' function is one of the most important roles of the RBI. It acts as a safety net for the banking system, ensuring financial stability and maintaining public trust in the banking sector.