Money and Banking Overview

Money and Banking

• Commercial banks are financial institutions that accept deposits, grant loans, and make investments to earn profits.
• Credit creation is a process where commercial banks generate more deposits than their initial deposits.
• Assumptions include considering all banking as a single unit and all transactions processed through banks.

Initial Deposit and LRR Calculation

• An example scenario: A depositor initially deposits ₹5000.
• The bank deducts 20%, i.e., ₹1000 (LRR).
• This leaves ₹4000 for loans.
• This loan amount can be further lent, creating additional deposits

Central Bank Functions

• The central bank controls, operates, and regulates the entire banking system of a country.
• It issues currency (except one rupee notes and coins, which are issued by the Ministry of Finance).
• It manages and controls the money supply in the country.
• It maintains the external value of currency.
• It ensures uniformity in note issuance.
• It acts as a banker and advisor to the government, receiving and managing government funds.
• It acts as a custodian of foreign exchange reserves.

Banking Functions for Commercial Banks

• Lender of last resort: Banks can approach the central bank to meet financial obligations when needed
• Clearing house: facilitates transactions between banks.

Cash Reserve Ratio

• Every commercial bank is required to maintain a certain percentage of its net deposits with the central bank (RBI).
• The central bank acts as the custodian of this cash reserve ratio.

Monetary Policy

• Bank Rate:
  • The rate at which a central bank lends to commercial banks for long-term borrowing.
  • Increasing the bank rate decreases money supply, discourages borrowers.
  • Decreasing the bank rate increases money supply, encourages borrowers.
• Repo Rate:
  • The rate at which central banks lend money to commercial banks for short-term borrowings.
  • Increasing the repo rate decreases money supply, discourages borrowers.
  • Decreasing the repo rate increases money supply, encourages borrowers.
• Reverse Repo Rate:
  • The rate at which central banks borrow money from commercial banks.
  • Raising this rate reduces the money supply.
  • Lowering this rate increases the money supply.
• Open Market Operations (OMO):
  • Buying and selling government securities.
  • Buying securities increases the money supply.
  • Selling securities decreases the money supply.

Legal Reserve Ratio (LRR/CRR)

• A component of LRR is the Cash Reserve Ratio (CRR)
• A percentage of deposits that commercial banks must maintain with the central bank.
• The central bank uses CRR to control the money supply.
• The other component is the Statutory Liquidity Ratio (SLR)

Qualitative Measures

• Marginal Requirements: The difference between the amount of loan granted by a bank to the value of securities offered. A higher margin decreases loan availability and reduces money supply. Lowering the margin stimulates lending and increases money supply
• Moral Suasion: The central bank persuades commercial banks to follow a specific policy through orders and suggestions
• Selective Credit Control: Manipulating the types of loans banks can give to manage the money supply. Credit rationing regulates loan availability either to boost or to reduce the economy.

Barter System Notes

• A system of exchanging goods for goods.
• Issues of the barter system include a lack of a universal measure of value and the need for a "double coincidence of wants," where both parties have what the other wants for an exchange.

Money Definitions

• Money is anything acceptable as exchange medium, with a store of value, measure of value and a standard for deferred payments.
• Money Supply is the overall volume of money in an economy at a specific point.
• Different measures of money supply exist accounting for different types of deposits (M1, M2, M3).