Money and Banking
Money is any generally accepted medium of exchange that facilitates transactions in an economy. Without money, trade would require a double coincidence of wants — both parties needing exactly what the other offers. Money eliminates this problem.
Functions of Money
- 1.Medium of Exchange: Money is accepted in payment for goods and services, eliminating barter.
- 2.Unit of Account (Measure of Value): Money provides a common yardstick to compare the value of all goods and services.
- 3.Store of Value: Money can be saved and used in future transactions. (Inflation erodes this function.)
- 4.Standard of Deferred Payment: Contracts for future payment are written in terms of money.
Supply of Money
The money supply (M) is the total amount of money in circulation. In India, the Reserve Bank of India (RBI) tracks several measures:
- M1 (Narrow Money): Currency in circulation + Demand deposits with banks + Other deposits with RBI. M1 is most liquid.
- M2: M1 + Savings deposits with Post Office Savings Banks.
- M3 (Broad Money): M1 + Time deposits with banks. M3 is the most commonly used measure.
- M4: M3 + All deposits with Post Office Savings Banks.
High Powered Money (H) = Currency in Circulation + Reserves of banks with RBI
Also called Reserve Money or Monetary Base.
Money Multiplier: The money multiplier (m) shows how much M1 can be created from a unit of high-powered money.
m = 1 / (currency-deposit ratio + reserve-deposit ratio)
Or simply: m = 1 / CRR (if we assume people hold no currency).
Credit Creation by Commercial Banks
Commercial banks create money through the process of lending. When a bank receives a deposit, it keeps a fraction as reserve (set by the Cash Reserve Ratio — CRR) and lends out the rest. The borrower deposits this in another bank, which again lends most of it, and so on.
If CRR = 10% and initial deposit = Rs. 1,000:
Total deposits created = 1,000 x (1/0.10) = Rs. 10,000
Credit multiplier = 1 / CRR
The Reserve Bank of India (RBI)
- The RBI is India's central bank, established in 1935. Its key functions:
- Monetary Policy: Controls money supply and credit through repo rate, reverse repo rate, CRR, SLR, and open market operations.
- Banker to Banks: RBI holds reserves of commercial banks and acts as lender of last resort.
- Banker to Government: Manages government accounts and debt.
- Currency Issuance: Sole authority to issue currency notes (except Re 1 coin issued by the government).
- Regulator: Supervises and regulates commercial banks.
- Key RBI Instruments:
- Repo Rate: Rate at which RBI lends to commercial banks. Higher repo rate makes borrowing expensive, reducing money supply.
- Reverse Repo Rate: Rate at which banks lend to RBI. Higher reverse repo encourages banks to park money with RBI.
- CRR (Cash Reserve Ratio): Fraction of deposits banks must keep as cash with RBI. Higher CRR reduces credit creation.
- SLR (Statutory Liquidity Ratio): Fraction of deposits banks must maintain in liquid assets (govt. securities, gold, cash). Higher SLR reduces lendable funds.
- Open Market Operations (OMO): RBI buys or sells government securities. Buying injects money; selling absorbs money.
Double coincidence of wants under barter
A farmer has wheat and wants cloth. Under barter, he must find a cloth producer who also wants wheat. If the cloth producer wants rice, no trade occurs. Money solves this: the farmer sells wheat for money and buys cloth from anyone who has it.
Credit creation
Bank A receives a fresh deposit of Rs. 10,000. CRR = 20%. It keeps Rs. 2,000 as reserve and lends Rs. 8,000. The borrower deposits Rs. 8,000 in Bank B. Bank B keeps Rs. 1,600 and lends Rs. 6,400. This continues until total deposits = 10,000 / 0.20 = Rs. 50,000.
Money multiplier
H (High Powered Money) = Rs. 1,00,000. CRR = 10%, and people hold 10% of deposits as cash. Currency-deposit ratio (c) = 0.10, Reserve ratio (r) = 0.10. Money Multiplier = (1 + c) / (c + r) = 1.10 / 0.20 = 5.5. So M1 = 5.5 x 1,00,000 = Rs. 5,50,000.
Effect of raising CRR
RBI raises CRR from 4% to 5%. Banks now must hold more reserves and have less to lend. Credit supply falls. Interest rates rise, businesses borrow less, investment falls, and aggregate demand decreases. This is a contractionary monetary policy to control inflation.
Open Market Operations
RBI sells government securities worth Rs. 5,000 crore to banks. Banks pay Rs. 5,000 crore to RBI, reducing their reserves. With lower reserves, banks can create less credit. The money supply contracts — used to control inflation.
Repo rate impact
If RBI raises the repo rate from 6% to 6.5%, commercial banks must pay more to borrow from RBI. They raise their own lending rates. Home loans and business loans become costlier. People borrow less, spend less, and inflation cools down.
M1 vs M3
Suppose currency in circulation = Rs. 20,000 crore, demand deposits = Rs. 50,000 crore, other deposits with RBI = Rs. 1,000 crore, time deposits = Rs. 1,00,000 crore. M1 = 20,000 + 50,000 + 1,000 = Rs. 71,000 crore. M3 = M1 + Time Deposits = 71,000 + 1,00,000 = Rs. 1,71,000 crore.
Common mistakes
- RBI does NOT create currency for every rupee it lends — the banking system creates credit through the multiplier process.
- CRR and SLR are both reserve requirements but SLR can be held in govt. securities and gold, not only cash.
- Demand deposits (current accounts and savings accounts) are part of money supply — they are as good as cash for transactions.
- The money multiplier is not fixed — it depends on the currency-deposit ratio set by public behaviour.
Summary
Money serves as medium of exchange, unit of account, store of value, and standard of deferred payment. The RBI controls money supply through repo rate, reverse repo, CRR, SLR, and OMOs. Commercial banks create credit through the multiplier process: a Rs. 1,000 deposit with 10% CRR eventually creates Rs. 10,000 in deposits. M1 and M3 are key monetary aggregates in India.