Unit 7: Money and Banking Notes PDF

# Unit 7: Money and Banking ## Money **Money is generally defined as a thing that is commonly accepted as a medium of exchange.** ### Evolution of Money * Exchange is essential for human survival. * Initially, people traded goods for goods (barter system). * The barter system was inefficient wit...

# Unit 7: Money and Banking ## Money **Money is generally defined as a thing that is commonly accepted as a medium of exchange.** ### Evolution of Money * Exchange is essential for human survival. * Initially, people traded goods for goods (barter system). * The barter system was inefficient with growing needs. * The invention of money solved this problem. * Gold and silver coins were first used as money, followed by alloy metal coins and paper money. * Today, we have plastic money in the form of cash cards. Money was defined as a thing that is commonly accepted as a medium of exchange to facilitate trade. ## Functions of Money ### Primary Functions: * **Medium of exchange:** * Money acts as a medium for buying and selling goods and services. * It eliminates the need for a double coincidence of wants, simplifying transactions. * **Measure of value and unit of account:** * Money serves as a measure of value. * Each good and service is measured in monetary units. * This standardized measure provides a common reference point for comparing the value of things. ### Secondary or Subsidiary Functions: * **Standard or deferred payments:** * Facilitates the payment for borrowing money, allowing for repayment in the future, along with interest. * **Store of value:** * Money acts as a store of wealth, allowing individuals to accumulate wealth over time. * It is easier to save and invest in money than in goods. * **Transfer of value:** * Money can be easily transferred to facilitate purchases and payments across different locations. ## Demand for Money (Liquidity Preference) * **Transactionary motive:** People and businesses need cash for everyday transactions. * Higher income leads to a higher demand for cash. * **Precautionary motive:** Individuals and firms keep money to deal with unexpected expenses like illness or accidents. * **Speculative motive:** People hold cash to speculate on future market changes. * This motive drives people to hold cash to take advantage of potential opportunities. ## Supply of Money * **Supply of money refers to the total stock of money of all types held by the people of a country at a point in time.** * It includes money held by the public, excluding money held by the government and the banking system. * **The government and the banking system are the suppliers of money.** ### Measurement of Money Supply: * **M1 = C + DD + OD** * **C:** Currency in circulation (coins and banknotes). * **DD:** Demand deposits held by people in commercial banks. * **OD:** Other deposits, including: * Demand deposits with the Reserve Bank of India (RBI) from financial institutions. * Demand deposits with RBI from foreign governments and central banks. * Demand deposits with RBI from international financial institutions. * **M2 = M1 + Deposits with post-office saving bank accounts.** * **M3 = M2 + Time deposits (or fixed deposits) held by people in commercial banks.** * **M4 = M3 + Total deposits with post offices (excluding National Savings Certificates).** ## Commercial Banks * **Commercial banks are financial institutions that accept deposits from the public and offer loans for consumption or investment.** ### Primary Functions of Commercial Banks: * **Accepting deposits:** * **Chequeable deposits:** Allow depositors to withdraw money using checks. * **Non-chequeable deposits:** Money cannot be withdrawn immediately, but may be withdrawn after a specific period. * **Advancing loans:** * Loans are typically provided against collateral, and for productive purposes. * Banks generally lend less than the value of collateral. * Loan amounts are added to demand deposits. * Banks maintain a small percentage of their deposits as cash reserves. * They can lend out significant sums to people, creating credit and increasing the money supply in the economy. ### Primary and Secondary Deposits * **Primary deposits:** Cash deposits made by individuals with commercial banks. * **Secondary deposits:** Arise from loans provided by banks, contributing to demand deposits. ## Central Bank (RBI) * **The apex bank of a country's banking system.** * **Sole issuer of currency and controls the money supply.** * **Acts as banker to the government.** ### Functions of the Central Bank: * **Issuing notes:** The central bank has the exclusive right to print banknotes that act as legal tender in the country. * **Banker to the government:** They manage the government's accounts, providing financial advice and acting as an intermediary between the government and the financial market. * **Banker's Bank:** The central bank holds cash reserves of commercial banks, providing a safety net in case of financial crises. * **Supervising commercial banks:** The central bank monitors the operations of commercial banks, ensuring they are licensed, maintain proper reserves, and operate ethically. * **Lender of last resort:** Provides loans to commercial banks experiencing liquidity problems, safeguarding the banking system. * **Custodian of foreign exchange reserves:** Maintains foreign exchange reserves to support the stability of the currency and promote international trade. * **Controlling credit:** The most crucial function of the central bank, controlling the flow of credit in the economy by influencing the money supply. ### Differences between Central and Commercial Banks: * **Central bank:** * Apex bank, overseeing the entire banking system. * Focus on social welfare and overall economic stability. * Controls the flow of credit. * Issues currency. * Custodian of foreign exchange reserves. * **Commercial bank:** * Profit-maximizing individual entity. * Focus on individual and business transactions. * Facilitates credit flow. * Operates within the framework set by the central bank. ## How the Central Bank Controls the Flow of Credit: ### Quantitative instruments of monetary policy: * **Bank rate:** The interest rate at which the central bank lends money to commercial banks: * Increasing the bank rate discourages borrowing and reduces credit flow. * Decreasing the bank rate encourages borrowing and increases credit flow. * **Open market operations:** Purchase and sale of government securities by the central bank: * Selling securities reduces liquidity and decreases credit flow. * Buying securities increases liquidity and increases credit flow. * **Cash Reserve Ratio (CRR):** The percentage of deposits that commercial banks are required to hold in the central bank: * Increasing CRR reduces the amount of money commercial banks can lend. * Decreasing CRR increases the amount of money commercial banks can lend. * **Statutory Liquidity Ratio (SLR):** The proportion of assets that commercial banks are required to hold in the form of liquid assets (cash, gold, government securities): * Increasing SLR reduces the amount of money commercial banks can lend. * Decreasing SLR increases the amount of money commercial banks can lend. ### Qualitative instruments of monetary policy: * **Margin requirement:** Minimum proportion of value of collateral required for a loan. * **Rationing of credit:** Setting quotas for different business activities to regulate lending. * **Direct action:** Taking measures against commercial banks that do not comply with regulations. * **Moral suasion:** Using persuasion and influence to steer commercial banks towards desired lending practices.