Money and Banking — NCERT Solutions

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• Demand/Current Deposits: Can be withdrawn at any time by cheque; no interest paid.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• Fixed/Time Deposits: Deposited for a fixed period; higher interest paid; cannot be withdrawn before maturity.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:

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.