Chapter 3 Money And Banking

Introduction

This chapter explores the fundamental role of money in an economy, explaining how it facilitates transactions and overcomes the limitations of simpler exchange systems like barter. It also introduces the concept of banking and how banks are involved in the creation and management of money supply.

Evolution From Barter To Money

In an economy with only one person or a self-sufficient group (like a family on an isolated island), there is no need for exchange, and thus no role for money. However, as soon as multiple economic agents engage in transactions through a market, the need for a facilitator arises.

Economic exchanges conducted without money are called barter exchanges, where goods are directly traded for other goods (e.g., rice for clothing). A major drawback of barter is the requirement of a double coincidence of wants, meaning both parties must simultaneously possess the good the other wants and desire the good the other has. Finding such a match can be extremely difficult and time-consuming, especially in a large economy, leading to high search costs.

To overcome this inefficiency, an intermediate good emerged that is universally acceptable to all parties involved in transactions. This commonly accepted medium of exchange is known as money. With money, individuals can sell their surplus goods for money and then use that money to buy the goods they need, eliminating the need for a direct match of wants.

Functions Of Money

Beyond simply facilitating exchange, money performs several crucial functions in a modern economy:

Medium Of Exchange

This is the primary function. Money is something that is generally accepted by people in exchange for goods and services. It breaks the direct link required in barter (commodity for commodity) and allows for commodity-money and money-commodity exchanges, significantly reducing transaction costs and making trade more efficient.

Unit Of Account

Money serves as a common measure for expressing the value of all goods and services. Prices of diverse items can be quoted in monetary units (e.g., the price of a car is $\textsf{₹}5,00,000$, the price of a book is $\textsf{₹}500$). This allows for easy comparison of the relative value of different commodities and facilitates economic calculation.

When the prices of commodities rise in terms of money (inflation), the purchasing power of money decreases, meaning a unit of money can buy fewer goods and services than before.

Store Of Value

Money allows individuals to save wealth earned from current production or income for future use. Instead of holding perishable or difficult-to-store goods (like rice in the barter example), wealth can be converted into and held as money. Money is relatively durable and easy to store. For money to function well as a store of value, its purchasing power should be reasonably stable over time (low inflation). While other assets like gold or property also serve as stores of value, money is the most liquid, meaning it can be easily and quickly converted into goods and services without significant loss of value.

Digital Transactions And Cashless Society

Modern economies are increasingly moving towards digital transactions, using electronic transfers of money instead of physical cash. This concept of a cashless society relies on the transfer of digital information to settle transactions. Initiatives like Jan Dhan accounts, Aadhar-enabled payments, e-Wallets, and the National Financial Switch in India are examples of efforts to promote financial inclusion and facilitate digital payments, leveraging technologies like mobile phones.

Demand For Money And Supply Of Money

This section delves into the factors that influence how much money individuals and the economy as a whole desire to hold (demand for money) and how the total amount of money in circulation is determined (supply of money).

Demand For Money

The demand for money represents the amount of money that individuals and firms want to hold at a particular point in time. People demand money for various reasons, primarily motivated by the trade-off between holding liquid cash (which earns no interest but is easy to use for transactions) and holding less liquid assets (like bonds or deposits that earn interest).

The main motives for holding money are:

• Transaction Motive: People need to hold money to carry out everyday transactions (buying goods and services). The amount of money needed for transactions depends on the volume and value of these transactions. Since the value of transactions is closely related to nominal income (or nominal GDP), the transaction demand for money is positively related to nominal GDP.

  $ \text{M}_\text{T}^\text{d} = k \cdot \text{T} $ or $ \text{M}_\text{T}^\text{d} = k \cdot \text{PY} $

  Where $M_T^d$ is transaction demand, T is total value of transactions (or PY, Nominal GDP where P is price level and Y is real GDP), and k is a positive constant representing the proportion of transactions value (or income) held as money. The reciprocal of k, $v = 1/k$, is the velocity of circulation of money, indicating how many times a unit of money changes hands in a given period ($v \cdot M_T^d = T$).

• Speculative Motive: Individuals may hold money as an alternative to other assets like bonds, based on their expectations about future changes in interest rates and bond prices. The price of a bond is inversely related to the market rate of interest. If interest rates are expected to rise, bond prices are expected to fall, leading to potential capital losses for bondholders. In this scenario, people prefer to hold money. If interest rates are expected to fall, bond prices are expected to rise (potential capital gains), making bonds more attractive than money.

  The speculative demand for money is inversely related to the market rate of interest (r). When 'r' is high, speculative demand is low (people hold bonds). When 'r' is low, speculative demand is high (people hold money to avoid potential capital losses). There might be a minimum interest rate ($r_{min}$) below which people expect rates to only rise, leading to an infinitely elastic speculative demand for money, a situation called a liquidity trap.

  The total demand for money ($M^d$) is the sum of transaction demand and speculative demand:

  $ \text{M}^\text{d} = \text{M}_\text{T}^\text{d} + \text{M}_\text{S}^\text{d} $

Supply Of Money

The supply of money in a modern economy primarily consists of currency (notes and coins) and various types of bank deposits. It is a stock variable, measured at a particular point in time.

Money supply is determined and controlled by a system involving:

• The Central Bank: This is the monetary authority of a country (e.g., the Reserve Bank of India - RBI). Key functions include issuing the national currency (fiat money - value derived from government decree, not intrinsic worth; often legal tender - must be accepted for settling debts), controlling money supply, acting as a banker to the government, maintaining foreign exchange reserves, and acting as a banker to commercial banks (lender of last resort). Currency issued by the central bank is called high-powered money or reserve money, as it forms the base for credit creation.
• Commercial Banks: These are institutions that accept deposits from the public and provide loans. They mediate between savers and borrowers. They earn profit from the difference between the interest rate charged on loans and the interest rate paid on deposits (the 'spread').

Money supply is measured using different concepts based on liquidity:

• M1 (Narrow Money): Currency held by the public (CU) + Demand Deposits (DD) with commercial banks (deposits withdrawable on demand, like savings and current accounts). $M1 = CU + DD$
• M2: M1 + Savings deposits with Post Office savings banks.
• M3 (Broad Money): M1 + Net Time Deposits of commercial banks (deposits with fixed maturity periods, like fixed deposits). $M3 = M1 + \text{Net Time Deposits}$
• M4: M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates).

These measures are listed in decreasing order of liquidity, with M1 being the most liquid and M4 the least liquid. M3 is the most commonly used measure of money supply.

Fiat money is currency whose value is not based on its intrinsic worth but on government declaration. Legal tender is currency that must be accepted in payment of debts.

Money Creation By Banking System

Commercial banks play a significant role in expanding the money supply through the process of credit creation, also known as deposit creation. This section explains how this happens and the factors that limit this process.

Balance Sheet Of A Fictional Bank

A bank's financial position can be represented by its balance sheet, which lists its assets and liabilities. Assets are what the bank owns or is owed, while liabilities are what the bank owes to others.

• Liabilities: Primarily consist of Deposits made by the public. These are what the bank owes to its depositors.
• Assets: Include things like the bank's buildings and equipment, Loans made to borrowers (these are assets because the bank has a claim on the borrowers), and Reserves (deposits the commercial bank holds with the Central Bank and its own cash holdings).
• Net Worth: The difference between Assets and Liabilities (Assets - Liabilities). For accounting balance, Assets must equal Liabilities plus Net Worth.

Initially, when a deposit is made, say $\textsf{₹}100$, the bank's assets (reserves/cash) and liabilities (deposits) increase by that amount.

In an economy with only this bank and no currency held by the public, the money supply (M1 = CU + DD) would be $\textsf{₹}0 + \textsf{₹}100 = \textsf{₹}100$.

Limits To Credit Creation And Money Multiplier

Commercial banks can create money because they operate on the principle that not all depositors will withdraw their money simultaneously. When a bank makes a loan, the borrower often receives the funds as a new deposit in their account, increasing the total volume of deposits and thus the money supply (M1). This process can repeat as portions of new deposits are lent out again.

However, the ability of banks to create credit is limited by regulations set by the Central Bank, primarily through reserve requirements:

• Cash Reserve Ratio (CRR): A percentage of their total deposits that commercial banks are legally required to keep as cash reserves with the Central Bank.
• Statutory Liquidity Ratio (SLR): A percentage of deposits that commercial banks must maintain in liquid assets like cash, gold, or approved securities.

These reserve requirements ensure banks have sufficient liquidity to meet depositor demands and prevent excessive lending. They act as a ceiling on the amount of credit a bank can create.

The process of money creation through the banking system is captured by the money multiplier. This indicates how much the total money supply can change for a given change in high-powered money (reserves held by banks + currency held by the public). The simplified money multiplier is related to the reserve ratio (let's consider only CRR for simplicity here, ignoring currency held by the public and SLR for illustrating the core concept):

If the reserve ratio (CRR) is $r$, then for every $\textsf{₹}1$ of reserves, the banking system can support deposits of $\textsf{₹}1/r$. The money multiplier (in this simplified case) is $1/r$.

Answer:

Policy Tools To Control Money Supply

The Central Bank (RBI in India) is responsible for controlling the money supply in the economy to achieve macroeconomic objectives like price stability and economic growth. It uses various tools to influence the ability of commercial banks to create credit.

These tools are generally categorized as quantitative (affecting the overall quantity of money/credit) and qualitative (targeting specific sectors or types of credit).

Quantitative Tools:

• Reserve Requirements (CRR & SLR): By changing the percentage of deposits banks must hold as reserves, the RBI directly affects the amount of funds available for lending. An increase in CRR or SLR reduces the money multiplier and the capacity of banks to create credit, thus decreasing money supply. A decrease has the opposite effect.
• Open Market Operations (OMOs): The RBI buys or sells government securities (bonds) in the open market.
  • When RBI buys securities, it pays banks or the public, injecting money into the banking system. This increases bank reserves, allowing for more lending and increasing money supply.
  • When RBI sells securities, banks or the public pay the RBI, withdrawing money from the banking system. This reduces bank reserves, decreases lending, and reduces money supply.

  OMOs can be outright (permanent injection/absorption of money) or repo/reverse repo (temporary, with an agreement to reverse the transaction later). Repo rates (interest rate for borrowing from RBI against securities) and Reverse Repo rates (interest rate for parking funds with RBI) are now primary tools for managing liquidity.

• Bank Rate: This is the interest rate at which the Central Bank provides long-term loans to commercial banks without collateral. An increase in the bank rate makes borrowing from the RBI more expensive for commercial banks, discouraging them from taking loans and reducing their ability to lend, thus decreasing money supply. A decrease has the opposite effect. (Note: In recent times, the repo rate has largely replaced the bank rate as the key policy rate for shorter-term lending).

Qualitative Tools: These include measures like moral suasion (persuading banks to follow RBI's advice), margin requirements (setting the loan-to-value ratio for certain types of loans), etc., which are more selective in their impact.

Demonetisation (Box 3.2)

Demonetisation, like the one in India in November 2016 (withdrawal of $\textsf{₹}500$ and $\textsf{₹}1000$ notes as legal tender), is a specific measure taken by the government, sometimes in coordination with the central bank, to address issues like black money, corruption, and fake currency. It forces holders of old currency to deposit it in banks, bringing previously unaccounted funds into the formal financial system. While disruptive in the short term (cash shortages, impact on economic activity), it can improve tax compliance, formalize savings, increase bank liquidity, and signal the state's stance against tax evasion.

Measures Of Money Supply and Monetary Base (Appendices)

The appendices provide statistical data related to money supply components and the monetary base in India over various years, illustrating the concepts discussed in the chapter.