Money and Banking

The One Thing

Money facilitates exchange, valuation, saving and future payments, while commercial banks expand the money supply through deposit-based lending. The central bank regulates this process through monetary policy, banking supervision and currency management in order to support price stability, economic growth, employment and financial stability.

Chronology

Who and What

• Money: Anything generally accepted as payment for goods, services and debts. It functions as a medium of exchange, measure of value, store of value and standard of deferred payments.
• Medium of Exchange: Money permits buying and selling without direct barter.
• Measure of Value: Money provides a common unit for expressing and comparing prices.
• Store of Value: Money can preserve purchasing power for future use.
• Standard of Deferred Payments: Money provides a common measure for future payments such as loans, rent and interest.
• Fiat Money: Money whose value derives from its status as government-declared legal tender and its acceptance by the public.
• Commercial Bank: A financial institution that accepts deposits and provides loans and advances.
• Demand Deposits: Deposits withdrawable at any time, commonly through cheques, cards or electronic transfers. They are treated as money because they can be used directly for payments.
• Time Deposits: Deposits held for a specified period and generally not withdrawable on demand without conditions.
• Money Supply: The total stock of money held by the public at a particular point in time. A common CBSE measure is M1 = Currency held by the public + Net demand deposits with commercial banks. Net demand deposits generally mean public demand deposits with commercial banks minus interbank deposits.
• M3: A broader measure of money supply: M3 = M1 + Net time deposits with commercial banks. M3 is often called broad money.
• Currency Held by the Public: Notes and coins held by households and firms, excluding cash held by banks.
• Reserve Money: The monetary base, consisting mainly of currency issued by the central bank and bankers’ deposits with the central bank.
• High-Powered Money: Reserve money that supports the expansion of deposits and the total money supply through the banking system.
• Cash Reserve Ratio (CRR): The proportion of deposits that commercial banks must keep as cash reserves with the central bank.
• Statutory Liquidity Ratio (SLR): The proportion of deposits banks must maintain in liquid assets such as cash, gold or approved securities.
• Credit Creation: The process by which commercial banks create additional deposits by lending part of their received deposits. Banks do not create physical currency through lending; they create deposit money by recording loans and corresponding deposits.
• Money Multiplier: The ratio showing how much the money supply can expand from a given increase in reserve money. Under simple assumptions, k = 1/r, where r is the required reserve ratio.
• Central Bank: The apex monetary institution responsible for issuing currency, regulating banks, controlling credit and managing the monetary system.
• Banker’s Bank: The central bank keeps commercial banks’ reserves, provides financial assistance and settles their claims.
• Lender of Last Resort: The central bank provides emergency loans to banks facing temporary shortages of funds.
• Open Market Operations: The central bank’s purchase or sale of government securities to influence liquidity and credit.
• Repo Rate: The rate at which commercial banks borrow short-term funds from the central bank against approved securities.
• Reverse Repo Rate: The rate at which the central bank borrows funds from commercial banks, usually by selling securities with an agreement to repurchase them.
• Bank Rate: The rate at which the central bank is traditionally prepared to lend to commercial banks or rediscount eligible bills.
• Moral Suasion: Persuasion used by the central bank to encourage commercial banks to follow desired credit policies.
• Reserve Bank of India (RBI): India’s central bank, established on 1 April 1935 and nationalised on 1 January 1949. It issues most currency notes in India, while the one-rupee note and coins are issued by the Government of India; the RBI distributes and manages currency. It also acts as the government’s banker, manages public debt, maintains government accounts, makes government payments, and serves as custodian of foreign exchange reserves.

Causes and Consequences

• Barter created significant practical difficulties. It required a double coincidence of wants, lacked a common measure of value, made wealth difficult to store and complicated deferred payments. Money overcame these difficulties by providing a generally accepted means of payment and a common unit of account.

• Money must possess suitable practical qualities. It should be generally acceptable, durable, divisible, portable, relatively stable in value and difficult to counterfeit. Fiat money meets these requirements through legal recognition and public acceptance rather than intrinsic value.

• Commercial banks expand the money supply through deposit-based lending. When banks accept deposits, they retain required reserves and lend excess funds. The loan is recorded as a deposit in the banking system when borrowers or subsequent recipients redeposit funds.

• The simple deposit multiplier explains the potential scale of expansion. The basic formula is k = 1/r. Maximum total deposit creation is approximately Initial deposit × 1/r, while maximum credit creation is approximately Initial deposit × (1/r − 1).

• A reserve ratio of 20 per cent produces a multiplier of five. Since 1/0.20 = 5, a new reserve of Rs. 1,000 can support total deposits of up to Rs. 5,000 under ideal assumptions.

• The theoretical expansion depends on strict assumptions. Banks must lend all excess reserves, borrowers must redeposit all borrowed money, and the reserve ratio must remain constant.

• Actual credit creation is smaller than the theoretical maximum. Cash withdrawals, public preference for currency, excess reserves held by banks, weak demand for loans and central bank regulations limit the process.

• Reserve requirements influence credit creation. A higher CRR or SLR reduces the funds available for lending, lowers the deposit multiplier and restricts credit expansion. A lower reserve ratio increases the potential for deposit and credit creation.

• Commercial banks earn income from intermediation. Their main income comes from the difference between interest received on loans and interest paid on deposits, together with other banking charges.

• The central bank has primary authority over currency issue. In India, the RBI issues most currency notes, whereas the Government of India issues the one-rupee note and coins. The RBI distributes and manages the currency system.

• The central bank regulates the quantity and direction of credit. Quantitative tools include the bank rate, repo rate, reverse repo rate, CRR, SLR and open market operations. Qualitative tools include margin requirements, credit rationing, selective credit control and moral suasion.

• Restrictive monetary policy is used to reduce inflationary pressure. The central bank may raise policy interest rates or reserve requirements, sell government securities and make borrowing more expensive. These measures reduce liquidity, credit expansion and excessive demand.

• Expansionary monetary policy is used during economic slowdowns. The central bank may lower policy interest rates or reserve requirements and purchase government securities. These measures encourage borrowing, investment, production and employment.

• The central bank performs several institutional functions. As the government’s banker, it maintains government accounts, manages public debt and makes payments on behalf of the government. As custodian of foreign exchange reserves, it may manage foreign exchange transactions according to national policy.

• The central bank supports financial stability. Through its roles as banker’s bank and lender of last resort, it provides reserves, settles claims and supplies emergency funds to banks facing temporary shortages.

• Money and credit must be balanced. Excessive money and credit creation can cause inflation, whereas insufficient credit can reduce production, investment and employment. Effective regulation and central bank independence help maintain confidence in the monetary and financial system.

What Gets Asked

• Explain how money performs the functions of medium of exchange, measure of value, store of value and standard of deferred payments, and compare these functions with the weaknesses of barter.
• Distinguish between currency held by the public, demand deposits, time deposits, reserve money, high-powered money, M1 and M3.
• Explain commercial bank credit creation, including k = 1/r, the formulas for maximum total deposit creation and maximum credit creation, and the example in which a 20 per cent reserve ratio and a Rs. 1,000 reserve support deposits of up to Rs. 5,000.
• Evaluate why actual credit creation is below the theoretical maximum, considering cash withdrawals, currency preference, excess reserves, weak loan demand and central bank regulation.
• Compare quantitative and qualitative credit controls, including the bank rate, repo rate, reverse repo rate, CRR, SLR, open market operations, margin requirements, credit rationing, selective credit control and moral suasion.
• Assess how the RBI’s functions as currency issuer, government’s banker, banker’s bank, lender of last resort and custodian of foreign exchange reserves contribute to monetary and financial stability.