Money & Banking PDF

# Money & Banking ## Commercial Bank - Financial institutions whose main function is to accept deposits, granting of loans, making investment for the purpose of earning profits. ## Credit creation by commercial banks - A process where commercial banks are able to create much more credit as co...

# Money & Banking ## Commercial Bank - Financial institutions whose main function is to accept deposits, granting of loans, making investment for the purpose of earning profits. ## Credit creation by commercial banks - A process where commercial banks are able to create much more credit as compared to their initial deposits. ## Assumptions: 1. All banking sectors are one unit. 2. All transactions are done through the bank. ## Initial deposit, LRR, & Loan calculation | Initial Deposit |LRR (20%) | Loan| |---|---|---| | 5000 | 1000 | 4000 | | 4000| 800 | 3200 | | 25,000 | 5000 | 20,000 | - K = 1/LRR = 1/20% = 5 times ## Example - If a depositor deposited 5000 Rs in a commercial bank, the bank will deduct LRR 20% i.e 1000 and will be able to generate a loan of 4000. - This 4000 will again come to bank as a derived deposit. Out of which bank will deduct 800, and will be able to generate a loan of 3200. This process will continue till the money is multiplied by 5 times i.e. K = IRR, 20% - Total deposits would be 25000. Total LRR would be 5000 (equal to initial deposit), and total loan would be 20,000. ## Central Bank - An apex institution which controls, operates, regulates and directs the entire banking system of the country. ## Functions of Central Bank 1. **Bank of Note Issue** - In every country, central bank has the sole authority to issue currency, in India this authority has been given to RBI. RBI issues every denomination of rupee except one rupee note and coin which are being issued by Ministry of Finance. **Merits of Monopoly of Note Issue** * It helps to control money supply in the country. * It helps to maintain external value of currency. * It gives a certain prestige to note issuance. * It brings uniformity to note issuance. 2. **Banker, Agent, & Advisor to the government** * As a *banker*, it receives all the money, pays all the payments on behalf of the government. * As an *agent*, it advises the government on making fiscal and other policies. 3. **Custodian of Foreign Exchange Reserve** - Only RBI and its authorized representatives are allowed to hold foreign exchange reserves in the country. ## Banker's Bank - Every commercial bank is required to maintain a Current Account with the central bank, and it performs the following functions: * **Lender of last resort:** If a commercial bank fails to meet their financial obligation, they can always approach the central bank for the same. * **Clearing house:** Every commercial bank has an account with central bank. Therefore, any transaction between two commercial banks can be settled by central bank by passing a single entry. ## Custodian of Cash Reserve Ratio - Every commercial bank is required to maintain a certain percentage of net deposits with central bank. Therefore central bank is the custodian of cash reserve ratio. ## Controller of Money Supply ### Monetary Policy - **Quantitative** - **Qualitative** **1.** **Bank rate:** The rate at which central bank gives loans to commercial banks to meet its long term borrowings. * If RBI wants to reduce the money supply, it will increase the bank rate which in turns increases the lending rates of commercial banks. Thus discourages the borrower to take a loan. * Similarly, if RBI wants to increase the money supply, it will decrease the bank rate which in turn decreases the lending rates of commercial banks. Thus encouraging the borrower to take loans. **2.** **Repo rate:** The rate at which central bank gives loans to commercial banks to meet its short term borrowings. * If RBI wants to reduce the money supply, it will increase the repo rate which in turns increases the lending rates of the commercial banks. Thus discourage the borrower to take loans. * Similarly, if RBI wants to increase the money supply, it will decrease the repo rate which in turn decreases the lending rate of the commercial banks. Thus encouraging the borrower to take loans. **3. Reverse Repo Rate:** The rate at which the central bank of commercial banks gives loans or parks their excess funds with central bank. * If the central bank wants to reduce the money supply, it will increase the reverse repo rate which encourages commercial bank to deposit money with central bank thus reduces overall money supply. * Similarly, if the central bank wants to increase the money supply, it will decrease the reverse repo rate which discourages the commercial bank to deposit money with central bank, thus increases overall money supply. **4.** **Open Market Operation:** Buying and selling of government securities by central bank through commercial bank in the open market is known as open market operations. * If RBI wants to reduce the money supply, it will start selling the securities. Similarly, if RBI wants to increase the money supply, it will start purchasing the securities. **5.** **Legal Reserve Ratio:** It has two components: * **CRR:** This is a certain percentage of net deposits which every commercial bank has to maintain with central bank. * **SLR:** This is a certain percentage of net deposits which every commercial bank has to maintain with themselves. **In case, if central bank wants to reduce the money supply, it will increase the reserve ratio which reduces the credit creating capacity of commercial bank. Similarly, if central bank wants to increase the money supply, it will decrease the reserve ratio which reduces the credit creating capacity of commercial banks.** ## Qualitative Measures **1. Margin Requirement:** This is the difference between the value of securities offered and the amount loan granted. * If central bank wants to reduce the money supply, it will increase the margin. * Similarly, if central bank wants to increase the money supply, it will reduce the margin which encourages the borrower to take loans. **2. Moral suasion:** This is an appeal in the form of an order by the central bank to commercial banks to act as per the policy. **3. Selective credit control:** Commercial bank grants loans for various reasons. * If central bank wants to reduce the money supply, it will do credit rationing. * Similarly, if central bank wants to increase the money supply, it will do credit derationing. ## Money **Barter System:** This is a system where goods are exchanged for goods. The economy in which it takes place is known as C to C economy (commodity to commodity). **Problems of barter system:** 1. **Lack of double coincidence of wants:** In a barter system, if a person needs a certain commodity, it is necessary that, for completing the transaction, the other person should want the same commodity which the first person is offering. This type of coincidence was very rare in a barter system. * The problem is that if a person wants to trade something they have for something they need, they need to find someone who has what they need and wants what they have. 2. **Lack of common measure of value:** In a barter system, different people or commodities possess different values. There was no common measure in which those values can be expressed. * This problem happens because if a person wants to trade a certain amount of one commodity (such as 5 goats) for a certain amount of another commodity (like 10 bushels of wheat), they need to find someone who agrees that the value is equivalent. This means getting a lot of people to agree on a system of equivalence. 3. **Lack of store of value:** In a barter system, wealth was stored in the form of crops or animals. Storing wealth in such form requires effort and time. * You might have a crop of wheat that you need to store and protect, or an animal that needs to be cared for regularly. This is very different from holding money that is secure and easy to store. 4. **Lack of standard for deferred payment:** In a barter system, future payments were not possible. Because over a period of time, the commodity might lose its value. The buyer might not be able to arrange the same quality of goods in the future. * This problem is that if someone agrees to pay for something in the future with something else, there is no way to guarantee that the value will be equivalent. **Money** is anything which is generally acceptable as medium of exchange, has a store of value, is a common measure of value, and can act as a standard of deferred payment. **Fiat Money** - Anything which is under the order of the government is acting as a money. **Money Supply:** The volume of money held by general public at a particular point in time. - money supply = CASA + CR + SA - M1 = CC + DD + OD + other deposits with RBI of foreign institutions - M2 = M1 + saving deposit with post office - M3 = M2 + Net Time Deposit with commercial bank - M4 = M3 + saving deposit with post office (excluding NSC and National Saving Cert).