Chapter 3 Money And Banking

Functions Of Money

Money is a crucial instrument in economies with market transactions, facilitating exchanges that would be difficult under a barter system.

In a barter system, goods and services are directly exchanged for other goods and services without the use of money. This requires a double coincidence of wants (each party must have what the other wants and want what the other has), which is inefficient, especially as the number of participants and variety of goods increase.

Money serves as an intermediate good that is universally accepted, enabling individuals to sell their goods for money and then use that money to buy desired commodities.

The main functions of money in a modern economy are:

• Medium of Exchange: The most important function. Money is commonly accepted in exchange for goods and services, avoiding the need for barter and reducing search costs.
• Unit of Account: Money serves as a common measure of value. The value of all goods and services can be expressed in monetary units, allowing for easy comparison of relative prices. Changes in the general price level affect the purchasing power of money.
• Store of Value: Money can be held as a form of wealth for future use. It is not perishable, has lower storage costs, and is universally accepted, making it a convenient way to store value compared to many physical commodities. Other assets (gold, property, bonds) also serve as stores of value but may not be as easily convertible or universally acceptable.

Some economies are moving towards becoming cashless societies, relying more on digital transactions and electronic transfers of money.

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Demand For Money And Supply Of Money

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Demand For Money

The demand for money refers to the amount of money individuals and entities in an economy wish to hold. Demand for money is primarily driven by:

• Transaction Motive: Money is needed to carry out everyday transactions (buying goods and services). The amount of money needed for transactions is related to the level of income and the total value of transactions in the economy. Higher income or transaction volume leads to higher demand for money for transaction purposes.
• Speculative Motive: People may hold money as an alternative to holding other assets like bonds, based on expectations about future asset prices and interest rates. Holding money is liquid but earns no interest; holding bonds earns interest but has a risk of capital loss if bond prices fall (which happens when interest rates rise). Speculative demand for money is inversely related to the rate of interest. At high interest rates, speculative demand for money is low (prefer bonds for high returns); at low interest rates, speculative demand for money is high (expecting interest rates to rise and bond prices to fall, so prefer holding money).

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Supply Of Money

In a modern economy, money supply primarily consists of currency (cash) and bank deposits. The money supply is created and controlled by the country's monetary system, which typically involves a Central Bank and commercial banks.

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Central Bank

The Central Bank (like the Reserve Bank of India - RBI) is the monetary authority. Its key functions include:

• Issuing Currency: Sole authority to issue the country's currency notes.
• Controlling Money Supply: Regulates the amount of money in circulation using various policy tools (like reserve ratios, open market operations, bank rate).
• Banker to the Government: Manages government accounts and debt.
• Custodian of Foreign Exchange Reserves: Holds and manages the country's foreign currency reserves.
• Banker to Banks: Provides banking services to commercial banks, including lending funds. It is the lender of last resort to commercial banks facing liquidity problems.

The currency issued by the central bank, when held by the public or commercial banks, is called high-powered money (or reserve money or monetary base) because it forms the base for credit creation by commercial banks.

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Commercial Banks

Commercial Banks are institutions that accept deposits from the public and provide loans to borrowers. They mediate between savers and investors. Banks earn profit from the difference between the interest rate charged on loans and the interest rate paid on deposits (the 'spread').

Commercial banks play a crucial role in money creation through the process of deposit and loan creation, which is explained in the next section.

People deposit money in banks for interest earnings, safety, and convenience (using cheques, debit cards). Banks lend out a portion of these deposits, retaining reserves to meet depositors' demands.

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Money Creation By Banking System

Commercial banks create money when they lend funds. When a bank provides a loan, it typically credits the borrower's account, creating a new deposit. This new deposit is added to the money supply.

The ability of banks to lend is based on the assumption that not all depositors will withdraw their funds simultaneously.

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Balance Sheet Of A Fictional Bank

A bank's Balance Sheet lists its assets (what it owns or is owed) on the left side and liabilities (what it owes to others) on the right side. Total Assets must equal Total Liabilities plus Net Worth.

For a bank, major assets are loans extended and reserves held. Major liabilities are the deposits held by the public.

Assets	Liabilities
Reserves ₹ 100	Deposits ₹ 100
Net Worth ₹ 0
Total ₹ 100	Total ₹ 100

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Limits To Credit Creation And Money Multiplier

While banks can create money by lending, their ability is limited by requirements set by the Central Bank (RBI).

The Required Reserve Ratio (CRR) is the percentage of deposits that banks must legally hold as cash reserves with the RBI. This is a statutory requirement to ensure banks can meet withdrawal demands and control their lending capacity.

CRR = Percentage of deposits held as cash reserves.

Banks also maintain other reserves for liquidity, like the Statutory Liquidity Ratio (SLR).

The reserve requirement limits the amount of deposits a bank can support with a given amount of cash reserves. If CRR is 20%, reserves of ₹ 100 can support deposits of ₹ 500 (because 20% of ₹ 500 is ₹ 100).

The process of money creation through lending and redepositing continues in rounds. A deposit creates reserves, a portion of which is lent out, creating a new deposit, which again creates reserves and potential for further lending. This process generates an expansion of deposits beyond the initial amount.

Round	Deposit in Bank	Required Reserve (20%)	Loan made by Bank
1	100.00	20.00	80.00
2	180.00	36.00	64.00
...	...	...	...
Last	500.00	100.00	400.00

The total increase in deposits and money supply is a multiple of the initial reserve increase. The Money Multiplier is the ratio of the total money supply (or total deposits) to the initial amount of high-powered money (or reserves). It is determined by the reserve ratio.

Money Multiplier = $\frac{1}{\text{Reserve Ratio}}$.

If CRR = 20% (or 0.2), Money Multiplier = $\frac{1}{0.2} = 5$. This means an initial reserve of ₹ 100 can support a total money supply (or deposits) of ₹ $100 \times 5 = \textsf{₹}500$.

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Policy Tools To Control Money Supply

The RBI uses various tools to control the supply of money and credit in the economy. These tools can be quantitative (affecting the *amount* of money/credit) or qualitative (affecting the *direction* or *purpose* of credit).

Quantitative tools include:

• Cash Reserve Ratio (CRR): By changing the CRR, RBI alters the amount of reserves banks must hold, affecting their lending capacity and thus money supply. Increasing CRR reduces money supply; decreasing CRR increases money supply.
• Statutory Liquidity Ratio (SLR): Requires banks to hold a certain percentage of deposits as liquid assets (cash, gold, approved securities). Affects lending similar to CRR.
• Open Market Operations (OMO): RBI buying and selling government bonds in the open market.
  • RBI buys bonds: Injects money into the system (increases bank reserves), increasing money supply.
  • RBI sells bonds: Withdraws money from the system (reduces bank reserves), decreasing money supply.
  OMO can be outright (permanent) or through repo/reverse repo agreements (temporary lending/borrowing with securities as collateral).
• Bank Rate (or Repo Rate in repo operations): The interest rate at which the RBI lends money to commercial banks. Increasing the bank rate makes borrowing more expensive for banks, reducing their reserves and money supply; decreasing it has the opposite effect.

Qualitative tools are more selective, aiming to encourage or discourage lending for specific purposes (e.g., through moral suasion or setting margin requirements for loans against securities).

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Demand And Supply For Money : A Detailed Discussion

A more detailed look at the demand for money reveals two main motives people have for holding money balances.

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The Transaction Motive

This is the primary reason for holding money: to carry out everyday transactions for buying goods and services. Since income receipts and expenditures don't perfectly align, individuals need to hold cash balances between income payments to make purchases.

The amount of money needed for transactions is related to the total value of transactions in the economy, which in turn is closely related to the nominal GDP (price level multiplied by real GDP). Transaction demand for money is positively related to nominal GDP.

The relationship can be expressed as $M_d^T = k \cdot T$, where $M_d^T$ is transaction demand, $T$ is total transaction value, and $k$ is a fraction. Or $v \cdot M_d^T = T$, where $v = 1/k$ is the velocity of circulation (number of times a unit of money changes hands in a period).

Approximating total transactions with nominal GDP, $M_d^T = k \cdot P \cdot Y$, where P is the price level and Y is real GDP. Transaction demand is positively related to real income and the price level.

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The Speculative Motive

This refers to holding money as an asset, as an alternative to holding bonds, based on expectations about future interest rates and bond prices. Bond prices and interest rates are inversely related.

If an individual expects interest rates to rise in the future (and thus bond prices to fall, leading to a capital loss), they might prefer to hold wealth in the form of money (which has no capital loss risk) rather than bonds. This increases speculative demand for money.

Conversely, if they expect interest rates to fall (bond prices to rise, leading to a capital gain), they prefer holding bonds, and speculative demand for money is low.

Speculative demand for money is inversely related to the market rate of interest (r).

At very high interest rates, speculative demand for money is low (everyone expects rates to fall). At very low interest rates ($r_{min}$), everyone expects rates to rise, preferring money over bonds. This creates a liquidity trap, where speculative demand for money is infinitely elastic at $r_{min}$ because any additional money is held as cash, not used to buy bonds, and cannot lower the interest rate further.

Total money demand is the sum of transaction demand and speculative demand: $M_d = M_d^T + M_d^S$.

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The Supply Of Money : Various Measures

Money supply is the total stock of money in circulation in an economy at a point in time (a stock variable).

In India, currency (notes and coins) is issued by the RBI (notes) and the Government of India (coins). Currency notes and coins are called fiat money (their value is by government decree, not intrinsic worth) and legal tender (must be accepted for payment).

Deposits in commercial banks are also part of money supply.

• Demand Deposits: Balances in savings and current accounts, payable on demand. Cheques drawn on these are used for transactions, but are not legal tender (can be refused).
• Time Deposits: Fixed deposits with a fixed maturity period. Less liquid than demand deposits.

RBI publishes four alternative measures of money supply:

• M1 (Narrow Money): CU + DD (Currency held by the public + Net Demand Deposits with commercial banks). Highly liquid.
• M2 (Narrow Money): M1 + Savings deposits with Post Office savings banks.
• M3 (Broad Money): M1 + Net time deposits of commercial banks. Most commonly used measure.
• M4 (Broad Money): M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates). Least liquid.

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Demonetisation

Demonetisation in India (November 2016) involved withdrawing specified high-denomination currency notes (₹ 500, ₹ 1000) from circulation. This aimed to address black money, corruption, terrorism financing, and counterfeit currency.

Citizens were required to deposit old notes in banks or exchange them for new notes (₹ 500, ₹ 2000). This led to temporary cash shortages and disruptions but also increased tax compliance, shifted savings into the formal financial system, and promoted digital transactions. It signaled the government's stance against tax evasion and black money.

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Summary

• Money facilitates exchanges, overcoming barter system limitations (double coincidence of wants, storage/transfer issues).

• Functions of money: medium of exchange, unit of account, store of value.

• Demand for money is for transactions (positively related to nominal GDP) and speculation (inversely related to interest rate, potential for liquidity trap). Total demand is sum of transaction and speculative demand.

• Supply of money consists of currency and bank deposits. Regulated by Central Bank (RBI) and commercial banks.

• Central Bank functions: currency issue, money supply control, banker to government/banks, foreign exchange custodian, lender of last resort.

• Commercial banks accept deposits and lend, creating money.

• Money creation is limited by Reserve Ratio (CRR) set by RBI. Money multiplier = 1/Reserve Ratio (in a simplified model).

• RBI controls money supply via quantitative tools (CRR, SLR, Open Market Operations like outright OMO, repo/reverse repo, Bank Rate) and qualitative tools (moral suasion, margin requirement).

• Money supply measures: M1, M2 (narrow), M3, M4 (broad), differing by liquidity.

• Demonetisation aimed to curb black money/corruption, led to shift towards digital transactions.

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Key Concepts

Barter exchange

Double coincidence of wants

Money

Medium of exchange

Unit of account

Store of value

Bonds

Rate of interest

Liquidity trap

Fiat money

Legal tender

Narrow money

Broad money

Currency deposit ratio

Reserve deposit ratio

High powered money

Money multiplier

Lender of last resort

Open market operation

Bank Rate

Cash Reserve Ratio (CRR)

Repo Rate

Reverse Repo Rate

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Exercises

Exercises are excluded as per user instructions.

Suggested Readings

Suggested readings are excluded as per user instructions.

Appendix 3.1 The Sum Of An Infinite Geometric Series

The sum of an infinite geometric series S = $a + ar + ar^2 + ar^3 + \dots$ where $0 < r < 1$ is given by the formula $S = \frac{a}{1-r}$. This formula is relevant to understanding the money multiplier process where initial deposits/reserves ($a$) lead to subsequent rounds of lending and redepositing ($ar, ar^2, \dots$).

Appendix 3.2 Money Supply In India

This section typically provides historical data on M1 (narrow money) and M3 (broad money) in India. M3 > M1 because M3 includes net time deposits of commercial banks, which are less liquid than the components of M1 (currency and demand deposits).

Year	M1 (Narrow Money) (Billion)	M3 (Broad Money) (Billion)
1999-00	3417.96	11241.74
2000-01	3794.33	13132.04
2001-02	4228.24	14983.36
2002-03	4735.58	17179.36
2003-04	5786.94	20056.54
2004-05	6497.66	22456.53
2005-06	8263.89	27194.93
2006-07	9679.25	33100.38
2007-08	11558.10	40178.55
2008-09	12596.71	47947.75
2009-10	14892.68	56026.98
2010-11	16383.45	65041.16
2011-12	17373.94	73848.31
2012-13	18975.26	83898.19
2013-14	20597.62	95173.86
2014-15	22924.04	105501.68
2015-16	26025.38	116176.15
2016-17	26819.57	127919.40
2017-18	32673.31	139625.87

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Appendix 3.3 Changes In The Composition Of The Sources Of Monetary Base Over Time

This appendix provides data on the components contributing to the Monetary Base (High-Powered Money) in India over time. These components typically include Currency in Circulation, Cash with Banks, and Banker's Deposits with the RBI. This data helps analyse the sources of changes in the money supply base.

Year	Currency in Circulation (Billion)	Cash with Banks (Billion)	Currency with the Public (Billion)	Other Deposit with the RBI (Billion)	Banker’s Deposit with the RBI (Billion)
1981-82	154.11	9.37	144.74	1.68	54.19
1991-92	637.38	26.40	610.98	8.85	348.82
2001-02	2509.74	101.79	2407.94	28.31	841.47
2004-05	3686.61	123.47	3563.14	64.54	1139.96
2005-06	4295.78	174.54	4121.24	68.43	1355.11
2006-07	5040.99	212.44	4828.54	74.67	1972.95
2007-08	5908.01	223.90	5684.10	90.27	3284.47
2008-09	6911.53	257.03	6654.50	55.33	2912.75
2009-10	7995.49	320.56	7674.92	38.06	3522.99
2010-11	9496.59	378.23	9118.36	36.53	4235.09
2011-12	10672.30	435.60	10236.70	28.22	3562.91
2012-13	11909.75	499.14	11410.61	32.40	3206.71
2013-14	13010.75	552.55	12458.19	19.65	4297.03
2014-15	14483.12	621.31	13861.82	145.90	4655.61
2015-16	16634.63	662.09	15972.54	154.51	5018.26
2016-17	13352.66	711.42	1241.24	210.91	5441.27
2017-18	18293.48	696.35	17597.12	239.07	5655.25