Money and Banking Notes

Module 3: Money and Banking

Definitions of Money

  • According to "Walker", "Money is what money does".
  • Economists define money differently:
    • Descriptive Definitions
    • Legal Definitions
    • General Acceptability Definitions

Descriptive Definitions

  • Crowther: "Anything that is generally acceptable as a means of exchange and that at the same time acts as a measure and store of value."
  • Coulborn: "Money may be defined as a means of valuation and of payment".
  • Cole: "Money is anything that is widely used as a mean of payment and is generally acceptable in settlement of debts."

Legal Definitions

  • Professor Knap: "Anything which is defined by the state as money is money".
  • Professor Hartley: Money should be legal tender.

General Acceptability Definitions

  • Kents: "Money is anything which is commonly used and generally accepted as a medium of exchange or as a standard of value."
  • D.H. Robertson: Money is described as "anything which is widely accepted in payment of goods or in discharge of other kinds of business obligations".
  • E. Mishkin: "Money is anything that is generally accepted in payment of goods and services or in the repayment of debts."
  • General Definition: MONEY IS ANYTHING THAT IS REGULARLY USED IN ECONOMIC TRANSACTIONS AND SERVES AS A MEDIUM OF EXCHANGE, A UNIT OF ACCOUNT AND A STORE OF VALUE.

Functions of Money

  • Mainly classified into:
    • Primary functions
    • Secondary functions

Primary Functions

  • MEDIUM OF EXCHANGE:
    • Money can be used to make payments for all transactions of goods and services.
    • A buyer can buy goods through money and a seller can sell goods for money.
    • It is an essential function of money.
  • MEASURE OF VALUE:
    • Money serves as a measure of value.
    • Value of all goods and services is expressed in terms of money.

Secondary Functions

  • STANDARD OF DEFERRED PAYMENTS:
    • Money acts as a ‘standard’ for making future payments.
    • It has made deferred payments much easier than before.
    • Example: Borrowing money requires returning the principal and interest in the future.
    • Money is a convenient mode of calculation & payment of interest amount to be paid in the future.
    • This function has facilitated borrowing and lending and led to the creation of financial institutions.
  • STORE OF VALUE:
    • Implies a store of wealth.
    • Money can be easily stored for future use.
    • It is the most convenient and economical means of storing earnings and wealth.
  • TRANSFER OF VALUE:
    • Money also serves for transfer of value.
    • It facilitates buying and selling of goods not only in the domestic country but also in other parts of the world.

Demand and Supply of Money

Supply of Money

  • Money Supply refers to the amount of money which is in circulation in an economy at any given time.
  • Includes all the notes, coins and demand deposits held by the public on such a day.
  • Money supply, like money demand, is a stock variable.
  • Money Supply plays a crucial role in the determination of price level and interest rates in an economy.
  • The stock of money kept with the government, central bank, etc. is not taken into account in money supply.
    • This money is not in actual circulation in the economy and hence does not form a part of the monetary supply.
  • Three main sources of money supply:
    • The government who produces all the coins and the one rupee notes
    • The Reserve Bank of India (RBI) which issues all the paper currency
    • Commercial banks as they create the credit as per the demand deposits

Measures of Money Supply

  • RBI publishes figures for four alternative measures of Money Supply:
Money Supply M1 or Narrow Money

  • Narrow Money is that part of money, which is highly liquid and comprises of currency, demand deposits with the banking system and other deposits with RBI.

  • Formula: M1 = C + DD + OD

    • Where:
      • C = Currency with the public
      • DD = Demand deposits with the public in the Commercial and Cooperative Banks.
      • OD = Other deposits held by the public with Reserve Bank of India.

  • The money supply is the most liquid measure of money supply as the money included in it can be easily used as a medium of exchange

  • Currency with the public (C) consists of:

    • Notes in circulation.
    • Circulation of rupee coins as well as small coins
    • Cash reserves on hand with all banks.

  • When measuring demand deposits with the public in the banks (i.e., DD), inter- bank deposits, that is, deposits held by a bank in other banks are excluded from this measure.

  • In the other deposits with Reserve Bank of India (i.e., OD) deposits held by the Central and State Governments and a few others such as RBI Employees Pension and Provident Funds are excluded.

  • Other deposits of Reserve Bank of India include:

    • Deposits of Institutions such UTI, IDBI, IFCI, NABARD etc.
    • Demand deposits of foreign Central Banks and Foreign Governments.
    • Demand deposits of IMF and World Bank.

  • Other deposits of Reserve Bank of India constitute a very small proportion (less than one percent).

Money Supply M2
  • M2 is a broader concept of money supply in India than M1.
  • In addition to the three items of M1, the concept of money supply M2 includes savings deposits with the post office savings banks.
  • Formula: M2 = M1 + Savings deposits with the post office savings banks
  • Saving deposits with post office savings banks are not as liquid as demand deposits with Commercial and Co-operative Banks as they are not chequable accounts
  • Saving deposits with post offices are more liquid than time deposits with the banks.
Money Supply M3 or Broad Money
  • Broad money refers to the money supply whose liquidity extends from currency to time deposits with the banking system.
  • Currency with the public, demand deposits with the banking system and other deposits with the RBI (M1), time liabilities portion of saving deposits with the banking system, certificate of deposit issued by banks and term deposits with a maturity up to and one year with the banking system are the components of broad money.
  • M3 is a broad concept of money supply.
  • Formula: M3 = M1 + Time Deposits with the banks
  • Time deposits serve as store of value and represent savings of the people and are not liquid as they cannot be withdrawn through drawing cheque on them.
  • Loans from the banks can be easily obtained against these time deposits, they can be used if found necessary for transaction purposes in this way.
  • They can be withdrawn at any time by foregoing some interest earned on them.
  • M3 has recently become a popular measure of money supply.
  • The working group on monetary reforms under the chairmanship of Late Prof. Sukhamoy Chakravarty recommended its use for monetary planning of the economy and setting target of the growth of money supply in terms of M3.
Money Supply M4
  • The measure M4 of money supply includes not only all the items of M3 described above but also the total deposits with the post office savings organisation.
  • Excludes contributions made by the public to the national saving certificates.
  • Formula: M4 = M3 + Total Deposits with Post Office Savings Organisation

Determinants of Money Supply

  • Two important determinants of Money supply:
    1. High Powered Money – H
    2. Size of Money Multiplier
High-Powered Money (H)
  • Also known as Reserve Money.
  • Reserve Money is currency in circulation plus deposits of commercial banks with RBI.
  • High Powered Money is currency that has been issued by the Govt. and Reserve Bank of India.
  • Some portion of this currency is kept along with public. Rest is kept as fund in Reserve Bank
  • Denotes currency and coins issued by the Government and Reserve bank of India.
  • Formula: H= Cp +R
    • Cp = Currency held by the public
    • R = Cash reserves of currency with the banks RBI and Government are producers of high- powered money and Banks are producers of demand deposits.
  • Cash reserves leads to multiple creation of DD and larger expansion of money supply.
Money Multiplier (m)
  • It is the degree to which money supply is expanded as a result of the increase in high powered money.
  • Formula: m =1/Reserve Ratio
  • Money supply will increase, when the supply of high – powered money H increases, When currency- deposit ratio of public decreases

Velocity of Circulation of Money

  • To find out supply of money over a period of time, we have to consider the velocity of circulation of money.
  • "It is the average number of time money circulates from one hand to another"
  • Formula: Ms = MV
    • Supply of money during a given period is the total amount of money circulation multiplied by the average number of times it has changed hands during that period.

Role and Functions of Commercial Banks and Central Bank

Origin of the word “bank”

  • The term ‘Bank’ is derived from the Italian word ‘banca’, Latin word ‘bancus’ and French word ‘banque’ which means bench.
    • Medieval European bankers transacted banking activities displaying coins on a bench.
  • Another view is that ‘bank’ might be originated from German word ‘banc’ which means joint stock fund.

Definitions of a Bank

  • Definition of bank varies from countries to countries.
  • Under English common law, a banker is defined as a person who carries on the business of banking, which is specified as
    • Conducting current accounts for his customers,
    • Paying cheques drawn on him/her, and
    • Collecting cheques for his/her customers.

Importance of Banks

  • Bankers play very important role in the economic development of the nation.

  • The health of the economy is closely related to the growth and soundness of its banking system.

  • Banks create no new wealth but their fund collection, lending and related activities facilitate the process of production, distribution, exchange and consumption of wealth.

  • They become very effective partners in the process of economic development.

    1. Banks mobilise small, scattered and idle savings of the people, and make them available for productive purposes.
    2. By offering attractive interests, Banks promote the habit of thrift and savings.
    3. By accepting savings, Banks provide safety and security to the surplus money.
    4. Banks provide convenient and economical means of payments.
    5. Banks provide convenient and economical means of transfer of funds.
    6. Banks facilitate the movement of funds from unused regions to useful regions.
    7. Banking help trade, commerce, industry and agriculture by meeting their financial requirements.
    8. Banking connect saving people and investing people.
    9. Through their control over the supply of money, Banks influence the economic activities, employment, income level and price level in the economy.

Types of Banks

1.  Commercial banks/Deposit banks
2.  Industrial banks/Investment banks
3.  Agricultural banks
4.  Exchange banks
5.  Savings bank
6.  Central / National banks
1. Commercial Banks / Deposit Banks

  • Banks accept deposits from public and lend them mainly for commercial purposes for comparatively shorter periods.

  • They provide services to the general public, organisations and to the corporate community.

  • They are oldest banking institution in the organised sector.

  • Commercial banks make their profits by taking small, short-term, relatively liquid deposits and transforming these into larger, longer maturity loans.

  • This process of asset transformation generates net income for the commercial bank.

  • Many commercial banks do investment banking business although the latter is not considered the main business area.

  • The commercial banking system consists of scheduled banks (registered in the second schedule of RBI) and non scheduled banks.

  • Features of Commercial banks are:

    • They accepts deposits on various accounts.
    • Lend funds to organisations, trade, commerce, industry, small business, agriculture etc. by way of loans, overdrafts and cash credits.
    • They are the manufacturers of money.
    • They perform many subsidiary services to the customer.
    • They perform many innovative services to the customers.
2. Industrial Banks / Investment Banks

  • Industrial banks are those banks which provide fixed capital to industries.

  • They are also called investment banks, as they invest their funds in subscribing to the shares and debentures of industrial concerns.

  • They are seen in countries like US, Canada, Japan, Finland, and Germany.

  • In India industrial banks are not found. Instead, special industrial finance corporations like IFC and SFC have been set up to cater to the needs of industries.

  • Features of Industrial Banks are:

    • Participate in management.
    • Advise industries in making right investment
    • Advise govt. on matters relating to industries
3. Agricultural Banks

  • Agricultural banks are banks which provide finance to agriculture and allied sectors.

  • It is found in almost all the countries. They are organised generally on co-operative basis.

  • In India, Co- operative banks are registered under the Co-operative Societies Act, 1912.

  • They generally give credit facilities to small farmers, salaried employees, small-scale industries, etc.

  • Co-operative Banks are available in rural as well as in urban areas.

  • Agricultural banks are of two types:

    • Agricultural co-operative banks: They provide short term finance to farmers for purchasing fertilizers, pesticides and seeds and for the payment of wages.
    • Land Development Banks: They provide long term finance for making permanent improvement on land. They assist to purchase machinery, equipments, installation of pump sets, construction of irrigation works etc.
4. Exchange Banks
  • Exchange banks finances foreign exchange business (export, import business) of a country.
  • Special exchange banks are found only in some countries.
  • The main functions of exchange banks are remitting money from one country to another country, discounting of foreign bills, buying and selling gold and silver, helping import and export trade etc.
5. Savings Bank

  • Savings banks are those banks which specialise in the mobilisation of small savings of the middle and low income group.

  • In India, saving bank activities are done by commercial banks and post offices.

  • Features of savings banks are;

    • Mobilise small and scattered savings
    • Promote habit of thrift & savings
    • Keep only small portion in hand and invest major part in govt. securities
    • They do not lend to general public.
6. Central / National Banks

  • It is the highest banking & monetary institution in a country.

  • It is the leader of all other banks.

  • Since it is occupying a central position, it’s known as Central Bank.

  • It is operating under state’s control and is not a profit motive organisation.

  • Reserve Bank of India (India), Bank of Canada (Canada), Federal Reserve System(USA) etc are the examples of Central Banks.

  • The main functions of a Central Bank are;

    • Monopoly of currency issue
    • Acts as banker to the govt.
    • Serves as bankers’ bank
    • Act as controller of credit
    • Custodian of nation’s gold and foreign exchange reserve.

Functions of Commercial Banks

Functions of a Commercial Bank can be classified into two:

1.  Principal/ Primary/ Fundamental functions
2.  Subsidiary/ Secondary/ Supplementary functions
Principal Functions

  • Commercial banks perform many functions.

  • They satisfy the financial needs of the sectors such as agriculture, industry, trade, communication, so they play very significant role in a process of economic social needs.

  • The functions performed by banks are becoming customer-centred and are widening their functions.

  • Generally, the functions of commercial banks are divided into two categories: primary functions and the secondary functions.

  • Two ‘acid test’ functions of commercial banks are Accepting deposits and Lending loans.

  • These functions along with credit creation, promotion of cheque system and investment in Government securities form basic functions of commercial banks.

  • The secondary functions of commercial banks include agency services, general utility services and innovative services.

    1. Receiving deposits
    2. Granting Loans and Advances
    3. Investment of funds in securities
    4. Credit Creation
    5. Promoting cheque system
1. Receiving Deposits
  • Most important function of a commercial bank is to accept deposit from those who can save but cannot profitably utilise this savings themselves.
  • By making deposits in bank, savers can earn something in the form of interest and avoid the danger of theft.
  • To attract savings from all sorts of customers, banks maintain different types of accounts such as current account, Savings bank account, Fixed Deposit account, Recurring deposit account and Derivative Deposit account.
2. Granting Loans and Advances

  • The second important function of commercial banks is to advance loans to its customers.

  • Banks charge interest from the borrowers and this is the main source of their income.

  • Modern banks give mostly secured loans for productive purposes.

    • At the time of advancing loans, they demand proper security or collateral.
    • Generally, the value of security or collateral is equal to the amount of loan.
    • This is done mainly with a view to recover the loan money by selling the security in the event of non-refund of the loan.

  • Loans:

    • A loan is granted for a specific time period.
    • Generally, commercial banks grant short-term loans. But term loans, that is, loan for more than a year, may also be granted.
    • The borrower may withdraw the entire amount in lump sum or in instalments. However, interest is charged on the full amount of loan.
    • Loans are generally granted against the security of certain assets.
    • A loan may be repaid either in lump sum or in instalments.

  • Advances:

    • An advance is a credit facility provided by the bank to its customers.

    • It differs from loan in the sense that loans may be granted for longer period, but advances are normally granted for a short period of time.

    • The purpose of granting advances is to meet the day to day requirements of business.

    • The rate of interest charged on advances varies from bank to bank. Interest is charged only on the amount withdrawn and not on the sanctioned amount.

    • Commercial banks lend money to the needy people in the form of Cash credits, Term loans, Overdrafts (OD), Discounting of bills, Money at call or short notice etc.

      • Cash Credit:

        • In this type of credit scheme, banks advance loans to its customers on the basis of bonds, inventories and other approved securities.
        • Under this scheme, banks enter into an agreement with its customers to which money can be withdrawn many times during a year.
        • Under this set up banks open accounts of their customers and deposit the loan money. With this type of loan, credit is created.

      • Term loans:

        • A term loan is a monetary loan that is repaid in regular payments over a set period of time.
        • A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate is called Term loan.
        • Term loans usually last between one and ten years, but may last as long as 30 years in some cases.
        • It may be classified as short term, medium term and long term loans.

      • Over-Drafts:

        • It is the extension of credit from a bank when the account balance reaches zero level.
        • Banks advance loans to its customer’s up to a certain amount through over-drafts, if there are no deposits in the current account.
        • For this, banks demand a security from the customers and charge very high rate of interest.
        • Overdraft facility will be allowed only for current account holders.

      • Discounting of Bills of Exchange:

        • This is the most prevalent and important method of advancing loans to the traders for short-term purposes.
        • Under this system, banks advance loans to the traders and business firms by discounting their bills.
        • While discounting a bill, the Bank buys the bill (i.e. Bill of Exchange or Promissory Note) before it is due and credits the value of the bill after a discount charge to the customer's account.
        • The transaction is practically an advance against the security of the bill and the discount represents the interest on the advance from the date of purchase of the bill until it is due for payment.
        • Businessmen get loans on the basis of their bills of exchange before the time of their maturity
3. Investment of Funds in Securities
  • Banks invest a considerable amount of their funds in government and industrial securities.
  • Commercial banks are required by statute to invest a good portion of their funds in government and other approved securities.
  • The banks invest their funds in three types of securities—Government securities, other approved securities and other securities.
    • Government securities include both, central and state governments, such as treasury bills, national savings certificate etc.
    • Other securities include securities of state associated bodies like electricity boards, housing boards, debentures of Land Development Banks, units of UTI, shares of Regional Rural banks etc.
4. Credit Creation
  • When a bank advances a loan, it does not lend cash but opens an account in the borrower’s name and credits the amount of loan to this account.
  • Thus a loan creates an equal amount of deposit.
  • Creation of such deposit is called credit creation.
  • Banks have the ability to create credit many times more than their actual deposit.
5. Promoting Cheque System
  • Banks also render a very useful medium of exchange in the form of cheques.
  • Through a cheque, the depositor directs the banker to make payment to the payee.
  • Business transactions by cheques have become much more convenient method of settling debts than the use of cash.
  • Through promoting cheque system, the banks ensure the exchange of accounted cash.
  • At present, CTS (Cheque Truncation System) cheques are used by Indian Banks to ensure speedy settlement of transactions in between banks.
  • In contrast to the declining importance of cheques, the use of electronic payment instruments at the retail level has been growing rapidly.
Secondary Functions
1.  Agency services
2.  General Utility Services
1. Agency Services

  • Banks act as an agent on behalf of the individual or organisations.

  • Banks, as an agent can work for people, businesses, and other banks, providing a variety of services depending on the nature of the agreement they make with their clients.

  • Following are the important agency services provided by commercial banks in India.

    • Commercial Banks collect cheques, drafts, Bill of Exchange, interest and dividend on securities, rents etc. on behalf of customers and credit the proceeds to the customer’s account.
    • Pay LIC premium, rent, newspaper bills, telephone bills etc
    • Buying and selling of securities
    • Advise on right type of investment
    • Act as trustees (undertake management of money and property), executors (carry out the wishes of deceased customers according to will) & attorneys (collect interest & dividend and issue valid receipt) of their customers.
    • Serve as correspondents and representatives of their customers. In this capacity, banks prepare I-Tax returns of their customers, correspond with IT authorities and pay IT of their customers.
2. General Utility Services

  • In addition to agency services, modern banks performs many general utility services for the community.

  • Following are the important general utility services offered by Commercial Banks

    • Locker facility: Bank provide locker facility to their customers. The customers can keep their valuables such as gold, silver, important documents, securities etc. in these lockers for safe custody.
    • Issue travellers’ cheques: Banks issue traveller’s cheques to help their customers to travel without the fear of theft or loss of money. It enable tourists to get fund in all places they visit without carrying actual cash with them.
    • Issue Letter of Credits: Banks issue letter of credit for importers certifying their credit worthiness. It is a letter issued by importer’s banker in favour of exporter informing him that issuing banker undertakes to accept the bills drawn in respect of exports made to the importer specified therein.

CENTRAL BANK / RESERVE BANK OF INDIA / MONETARY AUTHORITY

  • Central Bank may be defined as an institution which is charged with the responsibility of managing the expansion and contraction of the volume of money in the interest of general public welfare.” - ‘Kent’.
  • A national bank that provides financial and banking services for its country's government and commercial banking system, as well as implementing the government's monetary policy and issuing currency.

The Reserve Bank of India (RBI)

  • The Reserve Bank of India (RBI) is now the apex financial institution of the country which is entrusted with the task of controlling, supervising, promoting, developing and planning the financial system.
  • RBI is the queen bee of the Indian financial system which influences the commercial banks’ management in more than one way.
  • The RBI influences the management of commercial banks through its various policies, directions and regulations.
  • Its role in banking is quite unique.
  • The RBI performs the four basic functions of management, viz., planning, organizing, directing and controlling in laying a strong foundation for the functioning of commercial banks.
  • RBI possesses special status in our country. It is the authority to regulate and control monetary system of our country.
  • It controls money market and the entire banking system of our country.
  • Prior to the establishment of the Reserve Bank, the Indian financial system was totally inadequate on account of the inherent weakness of the dual control of currency by the Central Government and of credit by the Imperial Bank of India.
  • The Preamble to the Reserve Bank of India Act, 1934 spells out the objectives of the Reserve Bank as: “to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.”

Objectives of RBI

1.  To act as Monetary Authority: Formulates implements and monitors the monetary policy to maintain price stability and ensuring adequate flow of credit to productive sectors.
2.  To Regulate and supervise the financial system of the country: It prescribes broad parameters of banking operations within which the country's banking and financial system functions. It helps to maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public.
3.  To Manage the Exchange Control: Manages the Foreign Exchange Management Act, 1999 to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.
4.  To issue currency: Issues and exchanges or destroys currency and coins not fit for circulation to give the public adequate quantity of supplies of currency notes and coins and in good quality.
5.  To undertake developmental role: RBI performs a wide range of promotional functions to support national objectives.
6.  To undertake related Functions by acting as:
    *   Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker.
    *   Banker to banks: maintains banking accounts of all scheduled banks.

Functions of RBI

  • RBI performs various traditional banking function as well as promotional and developmental measures to meet the dynamic requirements of the country.

  • Traditional Functions: Which are generally performed by central banks all over the world, are classified into two groups;

    • Primary Functions: including issue of notes, regulation of financial system, and conduct of monetary policy
    • Secondary Functions: including management of public debt, management of foreign exchange, advising the government on policy matters, and maintaining close relationships with the international financial institutions

  • Non-Traditional Functions: these functions are performed by the Central Bank include development of financial frame work, provision of training facilities to bankers, and provision of credit to priority sectors.

  • Main functions of RBI can be broadly classified into three. These are primary function include

    • Issue of currency notes
    • Acting as banker to the Government
    • Serving as banker of other banks
    • Controlling credit
    • Controlling foreign exchange operations
A. Issue of Currency Notes
  • Under Section22 of the Reserve Bank of India Act of 1934, the Reserve Bank of India is given the monopoly of note issue.
  • Now RBI is the sole authority for the issue of currency notes of all denominations except one rupee notes and coins in the country.
  • One rupee notes and coins are issued by Ministry of Finance of GOI.
  • The RBI has a separate department called the Issue Department for the issue of currency notes
B. Acting as Banker to Government

  • The Reserve bank act as a banker to the Central and State Governments.

  • As a banker to the Government RBI acts in three capacities:

    • as a banker,
    • as a financial agent, and
    • as a financial advisor.
C. Banker’s Bank
  • RBI acts as banker to Scheduled banks.
  • Scheduled Banks include commercial banks, foreign exchange banks, public sector banks, state co -operative banks and the regional rural banks.
  • As a bankers’ bank it renders the following services:
D. Control of Credit
  • RBI undertakes the responsibility of controlling credit in order to ensure internal price stability and promote sufficient credit for the economic growth of the country.
  • Price stability is essential for economic development.
  • To control credit, RBI makes use of both quantitative and qualitative weapons by virtue of the powers given to it by Reserve Bank of India Act of 1934 and the Indian Banking Regulation Act of 1949.
  • These weapons are listed below.

Monetary Policy and Its Instruments

Monetary policy is the process by which monetary authority of a country, generally a central bank controls the supply of money in the economy by exercising its control over interest rates in order to maintain price stability and achieve high economic growth. In India, the central monetary authority is the Reserve Bank of India (RBI). It is so designed as to maintain the price stability in the economy. Monetary policy can be either expansionary or contractionary. Under an expansionary policy the total supply of money are increased in the economy more rapidly than usual, and under contractionary policy the money supply expands more slowly than usual or even shrinks. Expansionary policy is traditionally used to reduce unemployment in a recession by lowering interest rates in the hope that easy credit will encourage the entrepreneurs to begin new enterprise or expand their existing businesses. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values.

Definition

  • According to Prof. Harry Johnson, "A policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy is a monetary policy."
  • According to A.G. Hart, "A policy which influences the public stock of money substitute of public demand for such assets of both that is policy which influences public liquidity position is known as a monetary policy."
  • From both these definitions, it is clear that a monetary policy is related to the availability and cost of money supply in the economy in order to attain certain broad objectives.
  • The Central Bank of a nation keeps control on the supply of money to attain the objectives of its monetary policy.

Objectives of the Monetary Policy

  • The objectives of a monetary policy in India are similar to the objectives of its five year plans.

  • In a nutshell planning in India aims at growth, stability and social justice.

  • The objectives of the monetary policy of India, as stated by RBI, is:

    1. Price Stability: It implies promoting economic development with considerable emphasis on price stability. The centre of focus is to facilitate the environment which is favourable to the architecture that enables the developmental projects to run swiftly while also maintaining reasonable price stability. All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. When the economy suffers from recession the monetary policy should be an 'easy money policy' but when there is inflationary situation there should be a 'dear money policy'.
    2. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth. Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability.
    3. Controlled Expansion of Bank Credit: One of the important functions of RBI is the controlled expansion of bank credit and money supply with special attention to seasonal requirement for credit without affecting the output.
    4. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability
    5. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved.
    6. Equal Income Distribution: Many economists used to justify the role of the fiscal policy in maintaining economic equality. However in recent years economists have given the opinion that the monetary policy can help and play a supplementary role in attaining an economic equality. Monetary policy can make special provisions for the neglect supply such as agriculture, small-scale industries, village industries, etc. and provide them with cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in reducing economic inequalities among different sections of society.
    7. Full Employment: The concept of full employment was much discussed after Keynes's publication of the "General Theory" in 1936. It refers to absence of involuntary unemployment. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. However it does not mean that there is Zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment. If the monetary policy is expansionary then credit supply can be encouraged. It could help in creating more

  1. Definitions of Money:

    • Money is what money does, with various definitions from economists highlighting its roles as a means of exchange, a measure and store of value, and the state-defined legal tender.

  2. Functions of Money:

    • Primary Functions:

      • Medium of Exchange: Facilitates transactions for goods and services.
      • Measure of Value: Provides a standard value for goods and services.

    • Secondary Functions:

      • Standard of Deferred Payments: Acts as a benchmark for future payments.
      • Store of Value: Stores wealth for future use.
      • Transfer of Value: Enables transactions in both domestic and international markets.

  3. Demand and Supply of Money:

    • Money Supply: Refers to the total amount of money in circulation; crucial for determining price levels and interest rates.
    • Measures of Money Supply: M1 (Narrow Money), M2, M3, and M4 with respective formulas specifying their components.

  4. Determinants of Money Supply:

    • High Powered Money (H) and the Money Multiplier effect explain the capacity of banks to expand money supply through lending.

  5. Role of Commercial Banks:

    • Vital for economic development, these banks accept deposits and grant loans, supporting business and consumer finance.
    • Types include Commercial, Industrial, Agricultural, and Central banks, each serving distinct functions.

  6. Reserve Bank of India (RBI):

    • The apex financial institution responsible for regulating monetary policy, issuing currency, and supervising the financial system in India.
    • It undertakes primary (currency issue, banking to government) and secondary (public debt management, foreign exchange management) functions to