Pre Evaluation & Assessment Test ( Flashcard Quiz Game )
- The Flashcard Quiz contains questions that are based on this unit in the following tabs.
- Attempt this quiz and pay sufficient attention to each question and think for the probable answer.
- This exercise will give you a clear insight needed to approach the topics in this unit for a better understanding.
- Re-attempt this test after you finish reading the topics for a deep rooted interpretation of basic concepts.
- Happy Learning !!
In ancient days when there was no money, people used to exchange goods for goods to satisfy their wants without the use of money. Such a system was called barter system.
However with passage of time the barter system had to be abandoned because of its inherent problems. Some of the demerits of barter system are as follows –
- Search Cost
- Lack of double coincidence of wants
- Lack of division of goods
- Lack of common unit of measurement
- Problem of Storage
- Loss of Value
A common problem of barter system was that, one had to spend a lot of time in search for the person who is willing to exchange the good at the given terms and conditions. In the early period of human civilization, this was a very difficult task as there was no proper facility with regard to transport and communication.
Lack of double coincidence of wants
A common problem with the barter system is the lack of double coincidence of wants which means that if one wants to exchange some good with another person then the latter must also be willing to exchange his/her good with the former.
For example, let a person wants cloth and he has stock of wheat with him to exchange for it. In such a case the person can exchange wheat for cloth with another person who has cloth and who also wants wheat.
In practical life, such situation may or may not arise. If the person who has cloth does not want wheat, then exchange of wheat for cloth will never take place and both the individuals cannot satisfy their wants. This is an example of lack of double coincidence of wants. So barter system will work when there is double coincident of wants, otherwise it will not work.
Lack of division of goods
Certain goods are not physically divisible into small pieces. Suppose, a person possesses a buffalo and he wants items, such as food grains. Then how much of buffalo can be traded for food grains? It was very difficult to determine because, a buffalo cannot be divided into several pieces.
Lack of common unit of measurement
Under barter system, it was difficult to equate the values of different goods which were traded because of lack of common unit of measurement.
Taking the buffalo example again, it will be very difficult to determine the amount of buffalo required to trade for some specific amount of food grains. Also it sounds absurd. This happens because a buffalo can never become a common measure of value.
This problem is same for all other goods.
Problem of Storage
Another problem of barter system is that a person must store a large volume of his own good in order to exchange for his/her desired goods with others on day-to-day basis.
Take the example of a farmer who has produced wheat. Obviously, he will use some amount of wheat for his own consumption and keep some amount to get other necessary items by trading with others. If he wants furniture, then he will go to a carpenter who is willing to trade furniture in return of his wheat. Similarly, if he wants cloth, then he has to trade with a weaver who is ready to give cloth by receiving wheat and so on. So the farmer must construct a warehouse first to keep a stock of his wheat in order to carry out the transactions at the time of need for his desired good. But constructing and maintaining a warehouse was itself a very difficult task in early days of civilization.
Loss of Value
Finally, a major problem of barter system is that, a good looses its original quality and value if it is stored for a long period. Many goods, such as salt, vegetables etc., are perishable. Hence, goods were never accepted for trading in future because they could not be used as store of value. This also implies that no good could be used for the purpose of lending and borrowing.
Due to above problems, the barter system could not continue for long. As human civilization progressed, people realized that there has to be some common medium of exchange which can be easily carried, stored, and used to express the value of a good. So money came into being. Hence the need for money arose due to the failure of barter system.
Money is one of the most important discoveries of the human civilization. It is difficult to think about the world without money. Everybody needs money for various purposes; starting from day–to–day transactions to saving for future.
If you go back to history, you will find that before money came into existence there was barter system to facilitate transactions among individuals in the society. With development of civilization over time, barter system lost its ground and was replaced by money.
Meaning of Money
Money has been defined differently by different economists. But the most acceptable definition of money can be stated in terms of all the functions of money. Money is anything which is generally accepted as a means of exchange, a measure and store of value and which also acts as standard of deferred payments.
Functions of Money
The use of money has removed the drawbacks of barter system. Broadly speaking the functions of money may be classified into primary (basic) and secondary functions.
- Primary or Basic Functions
- Medium of Exchange
- Measure of Value
- Secondary Functions
- Store of Value or Wealth
- Standard of Deferred Payments
- Transfer of Value
- Other functions of Money
- Distribution of National Income
- Liquidity and Uniformity of Value
Primary or Basic Functions
Medium of Exchange
Money acts as a medium of exchange of all goods and services. The use of money has greatly facilitated process of exchange by dividing it into two parts i.e. sale and purchase. It has removed the difficulty of double coincidence of wants found under the barter system. Therefore, in modern world we hardly find any evidence of exchange of goods and services without the use of money.
Example: You pay ₹ 10 to buy a pen. The seller receives ₹ 10 from you by selling the pen. So a pen is exchanged for ₹ 10.
Measure of Value
Money helps to measure value of goods and services in terms of price. The use of money has completely removed the confusion regarding value of one good/service vis-a-vis the other. This function has greatly facilitated the process of exchange of different goods and services. The value of a good is determined by multiplying its price with the quantity purchased. Since the price is expressed in monetary units, the value of a good is also expressed in monetary terms.
Example: Let price of rice be ₹ 20 per Kilogram. One bag full of rice weighs 25 Kilograms. Then the value of the bag of rice is ₹ (20 X 25) = ₹ 500
Store of Value or Wealth
Money is the most convenient and economical means to store wealth which does not lose its value so quickly over time. Thus, it is the most accepted means to store wealth or value.
As medium of exchange you can pay money to buy goods. This means if you have money, you have the power to purchase a good or a service. So money has purchasing power. The value of the good is contained in that purchasing power. Hence value of good is indirectly stored in money, you hold. Similarly, as a seller of good, you receive the money which means value of good you sold, comes back to you through money.
Example: Harpreet sells furniture to a buyer for ₹ 2500. This means a value of ₹ 2500 was exchanged. The buyer, who purchased the furniture, has the purchasing power to give ₹ 2500 as value. Hence a value of₹ 2500 was stored in the money received by Harpreet as a seller. Harpreet could not have stored furniture but she can definitely store money which in turn has stored the value of ₹ 2500.
Standard of Deferred Payments
Deferred payments are those payments which are promised to be made in future. Money acts as a means of deferred payments mainly because it has general acceptability. Its value remains relatively constant over time and it is more durable as compared to other goods. In case of borrowing and lending activities only money is normally acceptable to be paid at a future date. Goods loose their value over time and due to possibility of lack of double coincident of wants they are not acceptable to settle debts in future.
Transfer of Value
This function of money is derived from the store of value function of money. Money is used to transfer value from one place to another or from one person to another. As a traveller when you move from one place to another, you can easily carry money to make necessary transactions on the way and in your destination place. You can also transfer the money through bank. Now people carry ATM card and withdraw cash wherever the facility is available.
Other functions of Money
Distribution of National Income
Income is generated by the factors of production engaged in the production process. The factors are land, labour, capital and entrepreneurship. For the supply of these factor services to the production units, the supplier of labour gets wage, the supplier of land gets rent, the supplier of capital gets interest and the supplier of entrepreneurship gets profit. It should be noted that wage, rent, interest and profit are paid by the firms in money terms and received by the respective suppliers as factor incomes. Thus national income is measured by using income method.
Liquidity and Uniformity of Value
Money can be easily carried and is easily divisible into smaller units as per convenience. The liquidity feature of money is manifested at the time when it can be withdrawn from the bank account repeatedly in certain amount in each transaction. For example, your father has ₹10,000 deposited in his bank account. You want to purchase a shoe worth ₹600. Your father can withdraw the amount from the bank to give you. The balance of ₹9,400 will remain in your father’s account.
Money brings uniformity in value of different goods and services which are not comparable physically due to their differences in the units of measurement.
For example: A Kg of rice and a litre of cooking oil cannot be added together as these are given in different units. But they can be added together if expressed in monetary units. If a Kg of rice is worth ₹25 and a litre of cooking oil is worth ₹75, the combined value of rice and oil comes out to be ₹100.
What is Money?
Money is the commonly accepted medium of exchange.
In an economy which consists of only one individual there cannot be any exchange of commodities and hence there is no role for money. Even if there are more than one individual but they do not take part in market transactions, such as a family living on an isolated island, money has no function for them. However, as soon as there are more than one economic agent who engage themselves in transactions through the market, money becomes an important instrument for facilitating these exchanges.
Economic exchanges without the mediation of money are referred to as barter exchanges. However, they presume the rather improbable double coincidence of wants. Consider, for example, an individual who has a surplus of rice which she wishes to exchange for clothing. If she is not lucky enough she may not be able to find another person who has the diametrically opposite demand for rice with a surplus of clothing to offer in exchange.
The search costs may become prohibitive as the number of individuals increases. Thus, for smooth transactions, an intermediate good is necessary which is acceptable to both parties. Such a good is called money. The individuals can then sell their produces for money and use this money to purchase the commodities they need. Though facilitation of exchanges is considered to be the principal role of money, it serves other purposes as well. Following are the main functions of money in a modern economy.
What are the functions of Money?
- The first and foremost role of money is that it acts as a medium of exchange. Barter exchanges become extremely difficult in a large economy because of the high costs people would have to incur looking for suitable persons to exchange their surpluses.
- Money also acts as a convenient unit of account. The value of all goods and services can be expressed in monetary units.
- When we say that the value of a certain wristwatch is ₹ 500 we mean that the wristwatch can be exchanged for 500 units of money, where a unit of money is rupee in this case.
- If the price of a pencil is ₹ 2 and that of a pen is ₹ 10 we can calculate the relative price of a pen with respect to a pencil, viz. a pen is worth 10 ÷ 2 = 5 pencils.
- The same notion can be used to calculate the value of money itself with respect to other commodities. In the above example, a rupee is worth 1 ÷ 2 = 0.5 pencil or 1 ÷ 10 = 0.1 pen.
If prices of all commodities increase in terms of money, it is regarded as a general increase in the price level; then the value of money in terms of any commodity must have decreased – in the sense that a unit of money can now purchase less of any commodity; it is then called as deterioration in the purchasing power of money.
- A barter system has other deficiencies. It is difficult to carry forward one’s wealth under the barter system. Suppose you have an endowment of rice which you do not wish to consume today entirely. You may regard this stock of surplus rice as an asset which you may wish to consume, or even sell off, for acquiring other commodities at some future date. But rice is a perishable item and cannot be stored beyond a certain period. Also, holding the stock of rice requires a lot of space. You may have to spend considerable time and resources looking for people with a demand for rice when you wish to exchange your stock for buying other commodities. This problem can be solved if you sell your rice for money.
Money is not perishable and its storage costs are also considerably lower. It is also acceptable to anyone at any point of time. Thus money can act as a store of value for individuals. Wealth can be stored in the form of money for future use.
However, to perform this function well, the value of money must be sufficiently stable. A rising price level may erode the purchasing power of money.
It may be noted here that any asset other than money can also act as a store of value, e.g. gold, landed property, houses or even bonds. However, they may not be easily convertible to other commodities and do not have universal acceptability.
Money is the most liquid of all assets in the sense that it is universally acceptable and hence can be exchanged for other commodities very easily.
On the other hand, it has an opportunity cost. If, instead of holding on to a certain cash balance, you put the money in a savings account in some bank you can earn interest on that money.
While deciding on how much money to hold at a certain point of time one has to consider the trade off between the advantage of liquidity and the disadvantage of the foregone interest.
Demand for money balance is thus often referred to as liquidity preference.
People desire to hold money balance broadly from two motives –
- The Transaction Motive
- The Speculative Motive
The Transaction Motive
The principal motive for holding money is to carry out transactions.
If you receive your income weekly and pay your bills on the first day of every week, you need not hold any cash balance throughout the rest of the week; you may as well ask your employer to deduct your expenses directly from your weekly salary and deposit the balance in your bank account. But our expenditure patterns do not normally match our receipts. People earn incomes at discrete points in time and spend it continuously throughout the interval. Suppose you earn ₹ 100 on the first day of every month and run down this balance evenly over the rest of the month. Thus your cash balance at the beginning and end of the month are ₹ 100 and 0, respectively. Your average cash holding can then be calculated as (₹ 100 + ₹ 0) ÷ 2 = ₹ 50, with which you are making transactions worth ₹ 100 per month. Hence your average transaction demand for money is equal to half your monthly income, or, in other words, half the value of your monthly transactions.
Consider, next, a two-person economy consisting of two entities – a firm (owned by one person) and a worker. The firm pays the worker a salary of ₹ 100 at the beginning of every month. The worker, in turn, spends this income over the month on the output produced by the firm – the only good available in this economy! Thus, at the beginning of each month the worker has a money balance of ₹ 100 and the firm a balance of ₹ 0. On the last day of the month the picture is reversed – the firm has gathered a balance of ₹ 100 through its sales to the worker. The average money holding of the firm as well as the worker is equal to ₹ 50 each. Thus the total transaction demand for money in this economy is equal to ₹ 100. The total volume of monthly transactions in this economy is ₹ 200 – the firm has sold its output worth ₹ 100 to the worker and the latter has sold her services worth ₹ 100 to the firm. The transaction demand for money of the economy is again a fraction of the total volume of transactions in the economy over the unit period of time.
In general, therefore, the transaction demand for money in an economy can be written in the following form
where T is the total value of (nominal) transactions in the economy over unit period and k is a positive fraction.
The two-person economy described above can be looked at from another angle. You may perhaps find it surprising that the economy uses money balance worth only ₹ 100 for making transactions worth ₹ 200 per month. The answer to this riddle is simple – each rupee is changing hands twice a month. On the first day, it is being transferred from the employer’s pocket to that of the worker and sometime during the month, it is passing from the worker’s hand to the employer’s. The number of times a unit of money changes hands during the unit period is called the velocity of circulation of money. In the above example it is 2, inverse of half – the ratio of money balance and the value of transactions.
Thus, in general, we may rewrite the above equation in the following form –
- T is a flow variable;
- is a stock concept; It refers to the stock of money people are willing to hold at a particular point of time.
- v = 1/k is the velocity of circulation; It has a time dimension. It refers to the number of times every unit of stock changes hand during a unit period of time, say, a month or a year.
- Thus, measures the total value of monetary transactions that has been made with this stock in the unit period of time. This is a flow variable and is, therefore, equal to the right hand side (T).
What is the relationship between the aggregate transaction demand for money of an economy and the (nominal) GDP in a given year?
- The total value of annual transactions in an economy includes transactions in all intermediate goods and services and is clearly much greater than the nominal GDP.
- However, normally, there exists a stable, positive relationship between value of transactions and the nominal GDP.
- An increase in nominal GDP implies an increase in the total value of transactions and hence a greater transaction demand for money.
Thus, in general, the equation can be modified in the following way –
- Y is the real GDP and
- P is the general price level or the GDP deflator.
The above equation tells us that transaction demand for money is positively related to the real income of an economy and also to its average price level.
The Speculative Motive
An individual may hold her wealth in the form of landed property, bullion, bonds, money etc. For simplicity, let us club all forms of assets other than money together into a single category called ‘bonds’.
Typically, bonds are papers bearing the promise of a future stream of monetary returns over a certain period of time. These papers are issued by governments or firms for borrowing money from the public and they can be traded in the market.
Consider the following two-period bond. A firm wishes to raise a loan of ₹ 100 from the public. It issues a bond that assures ₹ 10 at the end of the first year and ₹ 10 plus the principal of ₹ 100 at the end of the second year. Such a bond is said to have a face value of ₹ 100, a maturity period of two years and a coupon rate of 10 per cent. Assume that the rate of interest prevailing in your savings bank account is equal to 5 per cent. Naturally you would like to compare the earning from this bond with the interest earning of your savings bank account. The exact question that you would ask is as follows: How much money, if kept in my savings bank account, will generate ₹ 10 at the end of one year? Let this amount be X.
Therefore, X ( 1 + (5 / 100) ) = 10
In other words, X = 10 / ( 1 + (5/100) )
This amount, ₹ X, is called the present value of ₹ 10 discounted at the market rate of interest. Similarly, let Y be the amount of money which if kept in the savings bank account will generate ₹ 110 at the end of two years. Thus, the present value of the stream of returns from the bond should be equal to
PV = X + Y = [ 10 / ( 1 + (5/100) ) ] + [ (10 + 100) / ( ( 1 + (5/100) )2 ) ] = 109.29 (approx.)
It means that if you put ₹ 109.29 in your savings bank account it will fetch the same return as the bond. But the seller of the bond is offering the same at a face value of only ₹ 100. Clearly the bond is more attractive than the savings bank account and people will rush to get hold of the bond.
- Competitive bidding will raise the price of the bond above its face value, till price of the bond is equal to its PV.
- If price rises above the PV the bond becomes less attractive compared to the savings bank account and people would like to get rid of it. The bond will be in excess supply and there will be downward pressure on the bond-price which will bring it back to the PV.
- Thus, under competitive assets market condition the price of a bond must always be equal to its present value in equilibrium.
Now consider an increase in the market rate of interest from 5 per cent to 6 per cent. The present value, and hence the price of the same bond, will become
[ 10 / ( 1 + (6/100) ) ] + [ (10 + 100) / ( ( 1 + (6/100) )2 ) ] = 107.33 (approx.)
It follows that the price of a bond is inversely related to the market rate of interest.
Different people have different expectations regarding the future movements in the market rate of interest based on their private information regarding the economy. If you think that the market rate of interest should eventually settle down to 8 per cent per annum, then you may consider the current rate of 5 per cent too low to be sustainable over time. You expect interest rate to rise and consequently bond prices to fall. If you are a bond holder a decrease in bond price means a loss to you – similar to a loss you would suffer if the value of a property held by you suddenly depreciate in the market. Such a loss occurring from a falling bond price is called a capital loss to the bond holder. Under such circumstances, you will try to sell your bond and hold money instead. Thus speculations regarding future movements in interest rate and bond prices give rise to the speculative demand for money.
When the interest rate is very high everyone expects it to fall in future and hence anticipates capital gains from bond-holding. Hence people convert their money into bonds. Thus, speculative demand for money is low. When interest rate comes down, more and more people expect it to rise in the future and anticipate capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money. Hence speculative demand for money is inversely related to the rate of interest. Assuming a simple form, the speculative demand for money can be written as –
As mentioned earlier, interest rate can be thought of as an opportunity cost or ‘price’ of holding money balance.
- If supply of money in the economy increases and people purchase bonds with this extra money, demand for bonds will go up, bond prices will rise and rate of interest will decline.
- In other words, with an increased supply of money in the economy the price you have to pay for holding money balance, viz. the rate of interest, should come down.
- However, if the market rate of interest is already low enough so that everybody expects it to rise in future, causing capital losses, nobody will wish to hold bonds. Everyone in the economy will hold their wealth in money balance and if additional money is injected within the economy it will be used up to satiate people’s craving for money balances without increasing the demand for bonds and without further lowering the rate of interest below the floor rmin. Such a situation is called a liquidity trap. The speculative money demand function is infinitely elastic here.
Total demand for money in an economy is composed of transaction demand and speculative demand. The former is directly proportional to real GDP and price level, whereas the latter is inversely related to the market rate of interest. The aggregate money demand in an economy can be summarised by the following equation –
In a modern economy money consists mainly of currency notes and coins issued by the monetary authority of the country.
- In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India.
- However, coins are issued by the Government of India.
- Apart from currency notes and coins, the balance in savings, or current account deposits, held by the public in commercial banks is also considered money since cheques drawn on these accounts are used to settle transactions.
- Such deposits are called demand-deposits as they are payable by the bank on demand from the account-holder.
- Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time-deposits.
Though a hundred-rupee note can be used to obtain commodities worth Rs 100 from a shop, the value of the paper itself is negligible – certainly less than Rs 100. Similarly, the value of the metal in a five-rupee coin is probably not worth Rs 5.
Why then do people accept such notes and coins in exchange of goods which are apparently more valuable than these? The value of the currency notes and coins is derived from the guarantee provided by the issuing authority of these items. Every currency note bears on its face a promise from the Governor of RBI that if someone produces the note to RBI, or any other commercial bank, RBI will be responsible for giving the person purchasing power equal to the value printed on the note. The same is also true of coins.
- Currency notes and coins are therefore called fiat money.
- They do not have intrinsic value like a gold or silver coin.
- They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction.
- Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of payment. Hence, demand-deposits are not legal tenders.
Money supply refers to the total quantity of money held by public in various forms at any point of time in an economy.
The main components of money supply are currency held by the public and net-demand deposits held by the commercial banks.
The money supply in Indian economy is generally measured in following forms –
- M1 = Currency (notes and coins) with the public + Demand deposits + other deposits held with the Reserve Bank of India.
- M2 = M1 + Post Office saving deposits.
- M3 = M1 + Time deposits of all commercial banks and co-operative banks (excluding interbank time deposits).
- M4 = M3 + Total deposits with the Post Office Saving Organisation (excluding National Saving Certificate).
Of all the concepts of money supply stated above –
- M1 is referred to as narrow measure and M3 the broader measure of money supply.
- M1 is the most important measure of money supply.
- M1 is most liquid whereas M4 is least liquid.
The High-Powered Money refers to the currency held by the public (C), cash reserves of banks (R) and other deposits of the Reserve Bank of India (RBI).
Money supply, like money demand, is a stock variable. The total stock of money in circulation among the public at a particular point of time is called money supply.
RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows –
M1 = CU + DD
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)
- CU is currency (notes plus coins) held by the public and
- DD is net demand deposits held by commercial banks.
- The word ‘Net’ implies that only deposits of the public held by the banks are to be included in money supply. The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of money supply.
M1 and M2 are known as narrow money.
M3 and M4 are known as broad money.
These gradations are in decreasing order of liquidity –
- M1 is most liquid and easiest for transactions whereas
- M4 is least liquid of all.
M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources.
Determinants Of Money Supply
Money supply will change if the value of any of its components such as CU, DD or Time Deposits changes. Let us, for simplicity, use the most liquid definition of money, viz. M1 = CU + DD, as the measure of money supply in the economy. Various actions of the monetary authority, RBI, and commercial banks are responsible for changes in the values of these items. The preference of the public for holding cash balances vis-a-vis deposits in banks also affect the money supply. These influences on money supply can be summarised by the following key ratios –
- The Currency Deposit Ratio
- The Reserve Deposit Ratio
- High Powered Money
The Currency Deposit Ratio
The currency deposit ratio (cdr) is the ratio of money held by the public in currency to that they hold in bank deposits.
cdr = CU/DD
If a person gets ₹ 1 she will –
- put ₹ 1 / (1 + cdr) in her bank account and
- keep ₹ cdr / (1 + cdr) in cash.
It reflects people’s preference for liquidity. It is a purely behavioural parameter which depends, among other things, on the seasonal pattern of expenditure.
For example, cdr increases during the festive season as people convert deposits to cash balance for meeting extra expenditure during such periods.
The Reserve Deposit Ratio
- hold a part of the money people keep in their bank deposits as reserve money and
- loan out the rest to various investment projects.
Reserve money consists of two things –
- vault-cash in banks and
- deposits of commercial banks with RBI.
Banks use this reserve to meet the demand for cash by account holders. Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves.
Keeping reserves is costly for banks, as, otherwise, they could lend this balance to interest earning investment projects. However, RBI requires commercial banks to keep reserves in order to ensure that banks have a safe cushion of assets to draw on when account holders want to be paid. RBI uses various policy instruments to bring forth a healthy rdr in commercial banks.
- The first instrument is the Cash Reserve Ratio which specifies the fraction of their deposits that banks must keep with RBI.
- There is another tool called Statutory Liquidity Ratio which requires the banks to maintain a given fraction of their total demand and time deposits in the form of specified liquid assets.
- Apart from these ratios RBI uses a certain interest rate called the Bank Rate to control the value of rdr. Commercial banks can borrow money from RBI at the bank rate when they run short of reserves. A high bank rate makes such borrowing from RBI costly and, in effect, encourages the commercial banks to maintain a healthy rdr.
Commercial Banks accept deposits from the public and lend out this money to interest earning investment projects.
Deposits are broadly of two types –
Lending by commercial banks consists mainly of cash credit, demand and short-term loans to private investors and banks’ investments in government securities and other approved bonds.
The creditworthiness of a person is judged by her current assets or the collateral (a security pledged for the repayment of a loan) she can offer.
The total liability of the monetary authority of the country, RBI, is called the monetary base or high-powered money.
It consists of currency (notes and coins in circulation with the public and vault-cash of commercial banks) and deposits held by the Government of India and commercial banks with RBI.
If a member of the public produces a currency note to RBI the latter must pay her value equal to the figure printed on the note. Similarly, the deposits are also refundable by RBI on demand from deposit-holders. These items are claims which the general public, government or banks have on RBI and hence are considered to be the liability of RBI.
RBI acquires assets against these liabilities. The process can be understood easily if we consider a simple stylised example.
- Suppose RBI purchases gold or dollars worth ₹ 5. It pays for the gold or foreign exchange by issuing currency to the seller. The currency in circulation in the economy thus goes up by ₹ 5, an item that shows up on the liability side of the balance sheet. The value of the acquired assets, also equal to ₹ 5, is entered under the appropriate head on the Assets side.
Similarly, RBI acquires debt bonds or securities issued by the government and pays the government by issuing currency in return. It issues loans to commercial banks in a similar fashion.
We are now ready to explain the mechanism of money creation by the monetary authority, RBI. Suppose RBI wishes to increase the money supply. It will then inject additional high-powered money into the economy in the following way.
Let us assume that RBI purchases some asset, say, government bonds or gold worth ₹ H from the market. It will issue a cheque of ₹ H on itself to the seller of the bond. Assume also that the values of cdr and rdr for this economy are 1 and 0.2, respectively. The seller encashes the cheque at her account in Bank A, keeping ₹ H/2 in her account and taking ₹ H/2 away as cash. Currency held by the public thus goes up by H/2. Bank A’s liability goes up by ₹ H/2 because of this increment in deposits. But its assets also go up by the same amount through the possession of this cheque, which is nothing but a claim of the same amount on RBI. The liability of RBI goes up by ₹ H, which is the sum total of the claims of Bank A and its client, the seller, worth ₹ H/2 and ₹ H/2, respectively. Thus, by definition, high-powered money increases by ₹ H.
The process does not end here. Bank A will keep ₹ 0.2H/2 of the extra deposit as reserve and loan out the rest, i.e. ₹ (1– 0.2)H/2 = ₹ 0.8H/2 to another borrower*. The borrower will presumably use this loan on some investment project and spend the money as factor payment. Suppose a worker of that project gets the payment. The worker will then keep ₹ 0.8H/4 as cash and put ₹0.8H/4 in her account in Bank B. Bank B, in turn, will lend ₹ 0.64H/4. Someone who receives that money will keep 0.64H/8 in cash and put 0.64H/8 in some other Bank C. The process continues ad infinitum.
- The second column shows the increment in the value of currency holding among the public in each round.
- The third column measures the value of the increment in bank deposits in the economy in a similar way.
- The last column is the sum total of these two, which, by definition, is the increase in money supply in the economy in each round (presumably the simplest and the most liquid measure of money, viz. M1).
Note that the amount of increments in money supply in successive rounds are gradually diminishing. After a large number of rounds, therefore, the size of the increments will be virtually indistinguishable from zero and subsequent round effects will not practically contribute anything to the total volume of money supply. We say that the round effects on money supply represent a convergent process. In order to find out the total increase in money supply we must add up the infinite geometric series in the last column, i.e.
The increment in total money supply exceeds the amount of high-powered money initially injected by RBI into the economy. We define money multiplier as the ratio of the stock of money to the stock of high-powered money in an economy, viz. M/H. Clearly, its value is greater than 1.
We need not always go through the round effects in order to compute the value of the money multiplier. We did it here just to demonstrate the process of money creation in which the commercial banks have an important role to play. However, there exists a simpler way of deriving the multiplier. By definition, money supply is equal to currency plus deposits
M = CU + DD = (1 + cdr )DD
where, cdr = CU/DD.
Assume, for simplicity, that treasury deposit of the Government with RBI is zero. High powered money then consists of currency held by the public and reserves of the commercial banks, which include vault cash and banks’ deposits with RBI. Thus,
H = CU + R = cdr.DD + rdr.DD = (cdr + rdr)DD
Thus the ratio of money supply to high-powered money
This is precisely the measure of the money multiplier.
* We are implicitly assuming that the demand for bank loans at the existing lending rate is infinite, i.e. banks can loan out any amount they wish.
The commercial bank is a financial institution which is primarily concerned with accepting deposits from public and lending to the public besides others. These banks operate both under the public as well private sectors. Some public sector banks include the State Bank of India, Punjab National Bank and Bank of India among others. The private sector commercial banks may include the banks namely HDFC bank, ICICI bank and HSBC bank among others.
Functions of Commercial Banks : The commercial banks normally perform the following functions in an economy –
- Acceptance of deposits
- Extending Loans and Advances
- Creation of Credit
- Transfer of Funds
- Agency Functions
- Sale and Purchase of Foreign Exchange
- General Utility Services
Acceptance of deposits
Every commercial bank accepts deposits from different sections of society including the general public, business entities and other institutions. Commercial banks accept following types of deposit –
- Current Account Deposits or Demand Deposits : This type of account is generally maintained by the business entities and money under these deposits are payable on demand of the depositor. The depositors are free to deposit or withdraw money from their account any number of times without any restrictions.
- Savings Account Deposits : This type of account is generally maintained by the households or individuals. The depositor can deposit or withdraw money deposited under this account only for a limited number of times. This account also attracts a nominal rate of interest payable to the account holder.
- Fixed Deposit or Time Deposit or Term Deposit : Under this account money is deposited for a fixed period and the rate of interest is relatively higher than other accounts depending on the tenure of the fixed deposit.
Extending Loans and Advances
This is another important function of a commercial bank. This is also the main source of income of any commercial bank. Banks grant loans and advances out of the surplus money after keeping certain percentage of their total deposit called as reserves. Some important forms of loans and advances are ordinary loans, overdraft facility and discounting of bills of exchange.
Creation of Credit
This function is derived from the earlier two functions of the commercial banks. This unique function has direct impact on the supply of money in an economy.
Transfer of Funds
The banks provide the facility of fund transfer to its customers through the instruments of cheque, demand draft or electronic transfer from one place to another or one person to another.
Banks receive and collect different types of payments on behalf of their clients through the instruments of cheques, drafts, bills and promissory notes etc. Banks also buy and sell gold, silver and other securities on behalf of their customers.
Sale and Purchase of Foreign Exchange
This is another important function of a commercial bank which has increased tremendously with increasing volume of international trade particularly in the era of globalization.
General Utility Services
In modern days the banks also perform some very useful functions for the benefit of its customers and the economy like collection and publication of data, advisory functions, issue of lockers and underwriting of loans, shares and debentures issued by the government.
Credit creation is one of the most important functions of a commercial bank. Banks create credit out of the deposits that is mobilized by them. Credit creation is also called money creation or deposit creation. Therefore, commercial banks are also known as creator of money or credit.
The process of credit/money creation : Money is not created by commercial banks by actually printing of notes or minting of coins. The money is created by granting loans and advances to public and making relevant entries into the books of accounts of the lending banks.
Loans are granted out of the deposits received by the banks. Normally, the amount of loan granted by a bank is greater than the amount of deposits received by it. This is mainly because of the fact that when money is deposited by the depositors in a bank, the bank by its experience knows that not all the money would be withdrawn by the depositors at once at any point of time. This peculiar habit of the depositors leaves the bank with huge amount of surplus fund which in turn is used to create loans by the banks.
The banks keep certain proportion of its total deposits in form of cash to honour the demand of its customers. Further, every commercial bank is required to keep certain proportion of its total deposits with the R.B.I. which is known as Cash Reserve Ratio (CRR). Besides CRR, the bank is also required statutory to maintain certain proportion of its total deposits as liquid assets in form of cash, gold, and certain government approved securities. This is known as Statutory Liquidity Ratio (SLR).
The CRR and SLR together form the Legal Reserve Ratio (LRR) which is determined by the central bank of a country (RBI in case of India). When LRR is increased by the central bank the capacity of the commercial banks to create deposit or credit decreases and when LRR is decreased the capacity to create more credit increases. Thus, there exists an inverse relationship between LRR and the quantity of money created in an economy.
Given the quantity of deposits and LRR at any point of time, the total quantity of money created in an economy during a given period of time would be as follows –
Total quantity of money created : Quantity of deposits × 1/LRR.
Let us understand the process of money or credit creation in an economy with the help of an example. Let us assume that the bank receives an initial deposit of ₹ 1000 and the LRR is 10%. It means the bank has an excess reserve of ₹ [1000 – (1000 x 10%)] = ₹ 900 to lend to the borrowers. It must be noted that the borrowers are not paid the amount of loan as cash but the same is credited in their account. Thus in the first round an extra deposit of ₹ 900 is created out of which the bank is free to advance loan worth ₹ 900 – (900 × 10%) = ₹ 810. In the second round an extra deposit of ₹ 810 is created and the total amount of money in the economy becomes ₹ 1000 + 900 + 810 = ₹ 2710. If the process continues the total amount of money created in the economy with ₹ 1000 would be ₹1000 × 1/10% = 1000 × 1/0.1 = ₹ 1000 × 10 = 10,000 (Ten Thousand). If the amount of LRR is 20% then the initial deposit of ₹ 1000 would create the total amount of money in the economy worth ₹ 1000 × 1/0.2 = ₹ 5000 (Five Thousand). Thus, a higher LRR would create less amount of money and a lower LRR would create a higher amount of money in the economy.
It should further be noted that only a fraction of total deposits is kept as cash reserves by banks because of two reasons –
- First, Banks by their experiences know that all depositors are not going to withdraw their money at the same time so the surplus money could be used to create loans and extra deposits.
- Second, there is a continuous flow of deposits in the banks, so banks are comfortable with their cash reserves.
Central Bank is an apex bank in an economy which is entrusted with the task to control, regulate and supervise the entire banking operations of all the commercial banks including formulation and implementation of monetary policy in the economy. The central bank of India is Reserve Bank of India (RBI).
Functions of Central Bank –
- Bank of issuing or currency
- Banker to the banks
- Banker to the government
- Custodian of the stock of gold and foreign exchange reserves of the nation
- Controller of credit and money supply
Bank of issuing or currency
Every central bank of an economy is the sole authority to issue currency. The currency issued by the central bank is backed by minimum receive of assets like gold coins, gold bullions and foreign exchange etc. kept with the central bank.
The Minimum Reserve System in India represent the minimum backing of Rs 200 crores by RBI out of which Rs 115 crores worth of gold and Rs 85 crores worth of foreign exchange securities are kept under RBI, the Monetary Authority of India.
The RBI is the sole authority to issue of currency has certain benefits like –
- uniformity in currency,
- better monitoring and control over money supply and
- public trust and confidence in the currency issued and circulated.
Banker to the banks
The central bank acts as a banker to the commercial banks in the following manner –
- Custodian of the cash reserves of the commercial banks (CRR).
- Lender of the last resort in the sense that if commercial banks fail to generate enough cash from its own sources it approaches the central bank as a last resort. The central bank in turn may grant loans and advances to the needy banks.
- The central bank also acts as central clearing house for the commercial banks.
Banker to the government
As a banker to the government the central bank carries out all banking businesses on behalf of both the central government and the state governments.
- It maintains current account of the government for keeping cash balances and also making and receiving payments on behalf of the government.
- It provides loans and advances to the government.
- It also acts as financial advisor to the government.
Custodian of the stock of gold and foreign exchange reserves of the nation
This function helps in maintaining stability in exchange rate as fixed by the government and also enforcing exchange control and other regulations for a favourable balance of payments for the economy.
Controller of credit and money supply
Credit control and control of money supply is probably the most important function of a central bank.
Through various methods/instruments of credit control the central bank aims to achieve growth with stability in an economy. All the instruments of credit control may broadly be divided into following two categories. These are called instruments of monetary policy.
Monetary policy is the policy of the central bank to control and regulate money supply and credit in the economy.
- (A) Quantitative methods of credit control and
- (B) Qualitative or selective methods of credit control.
The Quantitative methods include those instruments which affect the total volume of credit and affect all sections of the economy. It includes the following instruments –
- Bank Rate Policy
- Open Market Operations
- Variable Legal Reserve Ratio
Bank Rate Policy
Bank rate is the rate at which central bank provides loan to the commercial banks.
The increase in bank rate by the central bank increases the cost of funds to the commercial banks which in turn is passed on to their customers. High rate of interest reduces demand for loan and thus the quantity of credit/money in the economy which squeezes aggregate demand in the economy.
Bank rate is increased to control inflation in an economy and it is reduced to fight deflationary situation in the economy.
Open Market Operations
Open market operations refer to the policy of sale and purchase of government securities in the open market by the central bank.
The central bank sells and purchases these securities mainly to and from the public and commercial banks. If the central bank wants to control inflation it sells securities in the market so that the excess liquidity may be transferred from public to the central bank. This measure controls the aggregate demand and inflation in the economy.
The central bank starts purchasing securities in the market to boost aggregate demand and fight deflation in the economy.
Variable Legal Reserve Ratio
The central bank can influence the credit creating power of commercial banks by varying CRR and SLR. Increase in LRR reduces credit creation capacity of commercial banks and decrease in LRR increases this power of the banks. LRR is increased during inflation and decreased during deflation.
The qualitative or selective credit control does not influence the quantity of credit/money in totality but it is directed towards controlling credit in a particular use of credit. The qualitative methods of credit control are as follows –
- Margin Requirements
- Moral Suasion
- Credit Rationing
The commercial banks grant loan to borrowers against some collateral securities whose value is more than the value of loans granted. The difference between the value of collateral securities and the amount of loan is called margin.
Increase in margin requirement reduces loan eligibility of the borrower which central uses at the time of inflation. During deflationary situation margin requirement is reduced to promote the growth of volume of credit/money in the economy.
Under this method central bank persuades and pressurises the commercial banks to adopt a credit policy which is in line with the overall objectives of the economy.
Under this method central bank fixes maximum ceiling of loans to be granted by the commercial banks either on aggregate basis or for a particular use. The rate of interest may vary across sectors or uses.
The total amount of money stock in the economy is much greater than the volume of high-powered money.
Commercial banks create this extra amount of money by giving out a part of their deposits as loans or investment credits. The total amount of deposits held by all commercial banks in the country is much larger than the total size of their reserves. If all the account-holders of all commercial banks in the country want their deposits back at the same time, the banks will not have enough means to satisfy the need of every account-holder and there will be bank failures.
All this is common knowledge to every informed individual in the economy. Why do they still keep their money in bank deposits when they are aware of the possibility of default by their banks in case of a bank run (a situation where everybody wants to take money out of one’s bank account before the bank runs out of reserves)?
The Reserve Bank of India plays a crucial role here. In case of a crisis like the above it stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter. This system of guarantee assures individual account-holders that their banks will be able to pay their money back in case of a crisis and there is no need to panic thus avoiding bank runs. This role of the monetary authority is known as the lender of last resort.
Apart from acting as a banker to the commercial banks, RBI also acts as a banker to the Government of India, and also, to the state governments.
It is commonly held that the government, sometimes, ‘prints money’ in case of a budget deficit, i.e., when it cannot meet its expenses (e.g. salaries to the government employees, purchase of defense equipment from a manufacturer of such goods etc.) from the tax revenue it has earned. The government, however, has no legal authority to issue currency in this fashion. So it borrows money by selling treasury bills or government securities to RBI, which issues currency to the government in return. The government then pays for its expenses with this money. The money thus ultimately comes into the hands of the general public (in the form of salary or sales proceeds of defense items etc.) and becomes a part of the money supply. Financing of budget deficits by the governments in this fashion is called Deficit Financing through Central Bank Borrowing.
However, the most important role of RBI is as the controller of money supply and credit creation in the economy. RBI is the independent authority for conducting monetary policy in the best interests of the economy – it increases or decreases the supply of high-powered money in the economy and creates incentives or disincentives for the commercial banks to give loans or credits to investors. The instruments which RBI uses for conducting monetary policy are as follows –
- Open Market Operations
- Bank Rate Policy
- Varying Reserve Requirements
- Sterilisation by RBI
Open Market Operations
RBI purchases (or sells) government securities to the general public in a bid to increase (or decrease) the stock of high-powered money in the economy.
Suppose RBI purchases ₹ 100 worth government securities from the bond market. It will issue a cheque of ₹ 100 on itself to the seller of the bond. The seller will deposit the cheque in her bank, which, in turn, will credit the seller’s account with a balance of ₹ 100. The bank’s deposits go up by ₹ 100 which is a liability to the bank. However, its assets also go up by ₹ 100 by the possession of this cheque, which is a claim on RBI. The bank will deposit this cheque to RBI which, in turn, will credit the bank’s account with RBI with ₹ 100. The changes in RBI’s balance sheet are shown in table below. Total liability of RBI, or, by definition, the supply of high-powered money in the economy has gone up by ₹ 100. If RBI wishes to reduce the supply of high-powered money it undertakes an open market sale of government securities of its own holding in just the reverse fashion, thereby reducing the monetary base.
Bank Rate Policy
RBI can affect the reserve deposit ratio of commercial banks by adjusting the value of the bank rate – which is the rate of interest commercial banks have to pay RBI – if they borrow money from it in case of shortage of reserves. A low (or high) bank rate encourages banks to keep smaller (or greater) proportion of their deposits as reserves, since borrowing from RBI is now less (or more) costly than before. As a result banks use a greater (or smaller) proportion of their resources for giving out loans to borrowers or investors, thereby enhancing (or depressing) the multiplier process via assisting (or resisting) secondary money creation. In short, a low (or high) bank rate reduces (or increases) rdr and hence increases (or decreases) the value of the money multiplier, which is (1 + cdr)/(cdr + rdr). Thus, for any given amount of high-powered money, H, total money supply goes up.
Varying Reserve Requirements
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) also work through the rdr route. A high (or low) value of CRR or SLR helps increase (or decrease) the value of reserve deposit ratio, thus diminishing (or increasing) the value of the money multiplier and money supply in the economy in a similar fashion.
Sterilisation by RBI
RBI often uses its instruments of money creation for stabilising the stock of money in the economy from external shocks.
Suppose due to future growth prospects in India investors from across the world increase their investments in Indian bonds which under such circumstances, are likely to yield a high rate of return. They will buy these bonds with foreign currency. Since one cannot purchase goods in the domestic market with foreign currency, a person who sells these bonds to foreign investors will exchange her foreign currency holding into rupee at a commercial bank. The bank, in turn, will submit this foreign currency to RBI and its deposits with RBI will be credited with equivalent sum of money.
What kind of adjustments take place from this entire transaction? The commercial bank’s total reserves and deposits remain unchanged (it has purchased the foreign currency from the seller using its vault cash, which, therefore, goes down; but the bank’s deposit with RBI goes up by an equivalent amount – leaving its total reserves unchanged). There will, however, be increments in the assets and liabilities on the RBI balance sheet. RBI’s foreign exchange holding goes up. On the other hand, the deposits of commercial banks with RBI also increase by an equal amount. But that means an increase in the stock of high-powered money – which, by definition, is equal to the total liability of RBI. With money multiplier in operation, this, in turn, will result in increased money supply in the economy.
This increased money supply may not altogether be good for the economy’s health. If the volume of goods and services produced in the economy remains unchanged, the extra money will lead to increase in prices of all commodities. People have more money in their hands with which they compete each other in the commodities market for buying the same old stock of goods. As too much money is now chasing the same old quantities of output, the process ends up in bidding up prices of every commodity – an increase in the general price level, which is also known as inflation.
RBI often intervenes with its instruments to prevent such an outcome. In the above example, RBI will undertake an open market sale of government securities of an amount equal to the amount of foreign exchange inflow in the economy, thereby keeping the stock of high-powered money and total money supply unchanged. Thus it sterilise the economy against adverse external shocks. This operation of RBI is known as sterilisation.