Chapter 3 - Money and Banking

FUNCTIONS OF MONEY

• Money is an important medium of exchange that simplifies transactions and overcomes the limitations of barter systems, fostering economic growth and development.
• Money serves as a unit of account, providing a common language for expressing value and facilitating efficient economic decision-making.
• The barter system's limitations include the inability to store value, which hinders wealth preservation and planning for the future. Money addresses this issue by acting as a durable and universally accepted store of value.
• Moreover, a cashless society relies on digital transactions, such as electronic transfers, mobile payments, and online payments, instead of physical cash. India has made significant progress in this direction through various government initiatives.

Example Jan Dhan accounts have expanded access to banking services, particularly for the unbanked population, by providing zero-balance savings accounts with basic financial services. Aadhaar-enabled payment systems have leveraged the unique identity provided by Aadhaar to facilitate secure and efficient digital transactions, particularly for government subsidy and benefit transfers. E-Wallets have promoted digital payments by offering a convenient and secure platform for cashless transactions, integrating with other payment systems and offering additional features like bill payments and online shopping. The National Financial Switch (NFS) has interconnected ATMs and banks, enabling customers to access their accounts and perform transactions across different banks, enhancing the efficiency and accessibility of financial services.

 

• Additionally, inflation refers to the general increase in the price level of goods and services, resulting in a decrease in the purchasing power of money.

DEMAND FOR MONEY AND SUPPLY OF MONEY

Demand for Money

• The demand for money is influenced by income levels and interest rates. Higher income leads to increased demand for money, known as the income effect.
• Additionally, rising interest rates increase the opportunity cost of holding money, as individuals could earn more interest by investing in interest-bearing assets, such as bonds or savings accounts.

Supply of Money

• Money in modern economies includes both cash and bank deposits, and the money supply signifies the total amount of money circulating within an economy. Money supply helps to assess the economy's liquidity and guide monetary policy.

Central Bank

• The central bank is a key institution in modern economies, responsible for maintaining financial stability, fostering economic growth, and overseeing the monetary system. It manages the currency, regulates banks, sets interest rates, and formulates monetary policy.
• High-powered money issued by the central bank forms the foundation of the money supply, crucial for credit creation in the economy.

Commercial Banks

• Commercial banks are crucial for the economy's money creation process, serving as intermediaries between depositors and borrowers and expanding the money supply.
• They accept deposits from individuals and businesses that have surplus funds and lend out a portion of those deposits to borrowers who need funds for various purposes.
• Fractional reserve banking allows banks to create new money by lending out a portion of their deposits, enhancing liquidity and expanding the money supply.

MONEY CREATION BY BANKING SYSTEM

• The process by which banks create money is known as fractional reserve banking. Fractional reserve banking enables banks to create money by lending out a portion of their deposits, assuming not all depositors will withdraw funds simultaneously.
• The fundamental accounting equation (Assets = Liabilities + Equity) shows a bank's balance sheet. Assets including reserves and loans, while liabilities consist mainly of deposits.
• Commercial banks hold reserves, including cash and financial instruments, to meet obligations and maintain stability, often deposited with the central bank.
• The central bank, acts as the lender of last resort for commercial banks.

Limits to Credit Creation and Money Multiplier

Cash Reserve Ratio (CRR)

• The Cash Reserve Ratio (CRR) is a requirement set by the Reserve Bank of India (RBI) mandating commercial banks to maintain a specific percentage of their deposits as reserves. These reserves are in the form of both physical cash and financial instruments like bonds and treasury bills issued by the RBI.
• CRR is implemented to ensure that banks have enough liquidity to meet depositor demands and maintain financial stability.

 

Example Suppose the RBI sets the CRR at 4%. This means ABC Bank must hold 4% of its total deposits as reserves with the RBI. If ABC Bank has total deposits of ?100 crores, it needs to keep ?4 crores (4% of ?100 crores) as reserves with the RBI. The remaining ?96 crores can be used by the bank for lending and investment activities.

Statutory Liquidity Ratio (SLR)

• The Statutory Liquidity Ratio (SLR) is another requirement imposed by the RBI, stating that the proportion of a bank's net demand and time liabilities (NDTL) that must be held in liquid assets.
• Liquid assets include cash, gold, and approved securities such as government bonds and treasury bills.
• SLR serves to ensure banks have enough liquid assets to cover their liabilities and maintain stability.

 

Example Let's assume the RBI sets the SLR at 18%. This means ABC Bank must invest 18% of its Net Demand and Time Liabilities (NDTL) in approved liquid assets. If ABC Bank's NDTL is ?150 crores, it must invest ?27 crores (18% of ?150 crores) in liquid assets like government bonds, treasury bills, cash, or gold. This ensures that ABC Bank maintains liquidity and can meet depositor demands.

Limit on Credit Creation

• The combined effect of CRR and SLR acts as a limit on the amount of credit banks can create. By mandating banks to hold a portion of their deposits as reserves (CRR) and invest in liquid assets (SLR), RBI restricts the amount of money banks can lend out.
• This ensures that banks maintain a balance between lending and liquidity, preventing excessive credit creation that could lead to financial instability.

 

Example Suppose ABC Bank wants to lend Rs 50 crores to borrowers. Considering the regulatory requirements: It needs to keep Rs 4 crores (CRR) and invest Rs 27 crores (SLR) in liquid assets. Thus, only Rs 69 crores (Rs 100 crores - Rs 4 crores - Rs 27 crores) of its deposits are available for lending. ABC Bank can lend only up to Rs 69 crores, ensuring that it maintains sufficient reserves and liquidity as mandated by the central bank.

Demand and Supply for Money: A Detailed Discussion

• Money's liquidity allows easy exchange for goods and services without significant costs or delays, crucial for daily transactions and meeting financial obligations.

The Transaction Motive

Example In Econoville, a hypothetical economy with a nominal GDP of $10 million, residents engage in transactions totaling $10 million annually. This transaction demand for money is directly related to nominal GDP, as money is essential for facilitating these exchanges. Now, suppose Econoville experiences economic growth, leading to a rise in nominal GDP to $12 million the following year. This increase signals a higher volume of goods and services exchanged in the economy. As nominal GDP expands, so does the transaction demand for money. With increased economic activity, individuals and businesses require more money to conduct transactions, such as purchasing goods, paying for services, and engaging in business deals. Thus, while transaction demand for money is related to nominal GDP, it is not necessarily equal to it but tends to increase alongside economic growth.

• Transaction demand for money refers to the need for money to facilitate day-to-day transactions, such as buying goods and services. It represents the portion of money held by individuals and businesses for conducting regular transactions.
• Transaction demand for money arises from facilitating exchanges. Transaction demand for money is related to nominal GDP but not directly equal to it. Increase in nominal GDP leads to higher transaction demand as more money is needed for increased transactions.

The Speculative Motive

• Money, as a highly liquid asset, enables direct purchases of goods and services, unlike bonds which necessitate conversion into cash prior to transactions. 
  • For example, when interest rates rise, bond prices fall, impacting investment decisions and speculative demand for money. This is driven by investors' anticipation of future interest rate movements.
• Speculative demand for money has an inverse relationship with interest rates, influencing market behavior. As rates rise, speculative demand falls, and vice versa, influencing the overall demand for money in an economy.
• An increase in money supply usually results in lower interest rates and higher bond prices, influenced by supply and demand dynamics in the bond market.
• In situations of extremely low interest rates, known as a liquidity trap, people may prefer holding cash instead of investing in bonds due to fears of potential losses. This preference for cash creates an infinitely elastic demand for money, where even small decreases in interest rates lead to significant increases in money demand.

THE SUPPLY OF MONEY: VARIOUS MEASURES

• In modern economies, money goes beyond physical cash to include various bank deposits like savings and current accounts, which can be easily used for transactions through withdrawals or electronic transfers.
• The value of currency notes and coins, also known as known as fiat money, isn't based on their materials but on their role as mediums of exchange and trust in the monetary system. Fiat money's value is guaranteed by the Reserve Bank of India (RBI), as stated on each note, unlike gold or silver coins, which have intrinsic value.

 

Legal Definitions: Narrow and Broad Money The Reserve Bank of India (RBI) publishes data for four primary monetary aggregates: M1, M2, M3, and M4. These aggregates represent different levels of liquidity and breadth of money in circulation. M1 = currency in circulation (CU) + demand deposits (DD), excluding interbank deposits. 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 (excluding National Savings Certificates) The net demand deposits (DD) component of M1 refers to the total demand deposits held by commercial banks for the public minus the interbank deposits held by commercial banks. This exclusion of interbank deposits is crucial for accurately representing the money supply available to the public for transactions. M1 and M2 are categorized as narrow money, while M3 and M4 are considered broad money. This categorization reflects the decreasing liquidity of these monetary aggregates, with M1 being the most liquid and readily available for transactions, and M4 being the least liquid and least accessible form of money.

Demonetization

• Demonetization, a major economic policy move initiated by the Indian government on November 8, 2016, involved the withdrawal of Rs 500 and Rs 1,000 currency notes to address issues like black money, counterfeit currency, and terrorism financing.
• Despite causing disruptions such as long bank queues and cash shortages, demonetization aimed to enhance tax compliance and reduce corruption by promoting formal payment systems and decreasing reliance on cash transactions.

IMPORTANT TERMS

Term	Definition
Stock concept	Refers to the total amount of money available for use in an economy at a particular point in time. It affects economic activity and inflation.
Barter exchange	A system where goods or services are directly exchanged without money.
Double coincidence of wants	A situation where two parties have what the other wants, essential for barter exchange.
Money	Widely accepted medium of exchange, unit of account, store of value, and means of deferred payment.
Medium of exchange	Something used to facilitate transactions, with money being the most common.
Unit of account	A common measure for the value of goods and services, often represented by money.
Store of value	Something that can be stored and used for future purchases, such as money.
Bonds	Debt securities representing loans to companies or governments, usually paying fixed interest rates.
Rate of interest	The cost of borrowing money, expressed as a percentage of the amount borrowed.
Liquidity trap	A situation where monetary policy is ineffective due to near-zero interest rates, hindering economic stimulation.
Fiat money	Currency not backed by a physical commodity, deriving value from trust in the issuing authority.
Legal tender	Recognized currency that must be accepted for payment of debts.
Narrow money	Money supply measure including currency in circulation and demand deposits.
Broad money	Money supply measure including narrow money and other liquid assets like savings and time deposits.
Currency deposit ratio	Proportion of commercial bank deposits held as currency.
Reserve deposit ratio	Proportion of commercial bank deposits held as reserves with the central bank.
High-powered money	Currency held by the public and reserves held by commercial banks.
Money multiplier	Number of times a deposit can be lent out by banks.
Lender of last resort	Central bank providing loans to banks facing liquidity problems.
Open market operation	Central bank buying or selling government bonds to influence money supply and interest rates.
Bank Rate	Interest rate at which the central bank lends long-term funds to commercial banks.
Cash Reserve Ratio (CRR)	Proportion of commercial bank deposits required as reserves with the central bank.
Repo Rate	Interest rate at which the central bank lends short-term funds to commercial banks.
Repurchase rate (repo)	Rate at which the central bank lends short-term funds to banks against securities.
Reverse Repo Rate	Interest rate at which the central bank borrows short-term funds from commercial banks.