Money and Banking Complete Study Guide

Barter System and Its Drawbacks

• Barter Exchange (C-C Economy): Barter exchange refers to the direct exchange of goods for goods without the mediation of money. An economy where commodities are exchanged for commodities is termed a C-C Economy (Commodity-for-Commodity Economy).

• Drawbacks of Barter System:

  • Lack of Double Coincidence of Wants:

  • Definition: Double coincidence of wants refers to the simultaneous fulfillment of the mutual wants of both buyer and seller. Trade can only occur when both parties are willing to exchange their respective goods.

  • Example: If Person A has rice and wants a cycle, while Person B has a cycle but wants clothes (not rice), no trade can take place because their wants do not match.

  • Lack of a Common Unit (Measure) of Value:

  • In a barter system, commodities are not equal in value, and there is no common unit or measure of value in which the exchange ratio of goods and services can be expressed or recorded in accounts (e.g., measuring 1 sheep directly against $50\,\text{kg}$ of rice without a monetary price).

  • Lack of Standard of Deferred Payments (Contractual Payments):

  • Deferred payments refer to payments made in the future. Making credit transactions or future repayments in goods is difficult due to:

    • Inability to arrange goods of the exact same quality at the time of repayment (e.g., borrowing high-quality Basmati rice but repaying with low-quality rice because Basmati could not be arranged).

    • Conflicts regarding which specific commodity should be used for repayment.

    • Risk that the commodity to be repaid may gain or lose market value over time.

  • Lack of Store of Value and Transfer of Value:

  • Storing wealth in the form of goods for future use is problematic because:

    • Most commodities lack durability and are perishable (e.g., wheat, rice, vegetables).

    • Storage requires significant physical space, time, and effort.

    • Transferring wealth or buying property in a different location is difficult because physical/immovable goods (like land or heavy machinery) cannot be easily transported.

Definition and Forms of Money

• Functional Definition of Money: "Money is what money does." Money is defined as anything that is generally accepted as a medium of exchange, a measure of value, a store of value, and a standard of deferred payment.

• Legal Definition of Money: Money is what the law declares as money. Anything declared by the government as legal tender is money.

• Classification / Forms of Money:

  • Fiat Money vs. Fiduciary Money:

  • Fiat Money: Money issued by the order or authority of the government. It includes all paper notes and coins that citizens are legally bound to accept. It does not possess intrinsic value equal to its face value.

  • Fiduciary Money (Non-Legal Tender / Optional Money): Money accepted as a medium of exchange based on mutual trust between the payer and the payee, rather than a legal mandate. Acceptance is optional (e.g., cheques, bank drafts, bills of exchange).

  • Legal Tender Money:

  • Limited Legal Tender: Legal tender that can be legally paid in discharge of debt only up to a maximum statutory limit. Beyond this limit, a person can refuse acceptance without legal penalty. In India, coins are limited legal tender (e.g., coins are legal tender up to $\text{₹}1{,}000$).

  • Unlimited Legal Tender: Legal tender that can be paid in discharge of debt of any amount. In India, paper currency notes are unlimited legal tender.

  • Full-Bodied Money vs. Credit Money:

  • Full-Bodied Money: Money in the form of coins whose commodity value (intrinsic value) equals its money value (face value) at the time of issue (e.g., a silver Rupee coin during the British colonial period; $\text{Money Value} = \text{Commodity Value}$).

  • Credit Money: Money whose face value/money value is strictly greater than its intrinsic commodity value (e.g., modern paper notes and metal coins; $\text{Money Value} > \text{Commodity Value}$).

  • Bank Money: Demand deposits created by commercial banks. They are repayable by banks on demand and serve as non-legal tender money.

Functions of Money

• Primary Functions (Conventional / Static Functions):

  • Medium of Exchange:

  • Facilitates transactions of goods and services due to general acceptability.

  • Separates the acts of sale and purchase, eliminating the need for double coincidence of wants.

  • Grants purchasing power to acquire goods that satisfy human utility.

  • Measure of Value (Unit of Account):

  • Serves as a common denominator in which the value of all goods and services is expressed.

  • Facilitates maintenance of business accounts and determination of relative prices.

  • Example: If 1 pen costs $\text{₹}10$ and 1 pencil costs $\text{₹}2$, the relative price of a pen is $\frac{10}{2} = 5$ pencils. Conversely, the value of $\text{₹}1$ in terms of pencils is $\frac{1}{2} = 0.5$ pencils, and in terms of pens is $\frac{1}{10} = 0.1$ pens.

  • A general rise in price levels reflects a deterioration in the purchasing power of money.

• Secondary Functions (Subsidiary / Derivative / Static Functions):

  • Standard of Deferred Payments:

  • Acts as a standard benchmark for future/contractual payments, simplifying borrowing and lending operations and enabling the establishment of financial institutions.

  • Store of Value (Asset Function of Money):

  • Allows purchasing power to be transferred from the present to the future.

  • Features fractional denominations, high portability, minimal storage cost, and general acceptability, making monetary savings safer than commodity storage.

  • Transfer of Value:

  • Enables individuals to sell immovable property in one location and purchase assets elsewhere, providing spatial mobility to capital, land, and machinery.

• Static vs. Dynamic Functions (Paul Einzig Classification):

  • Static Functions: Conventional primary and secondary functions that facilitate smooth economic operations without directly altering economic activity levels.

  • Dynamic Functions: Functions that actively influence economic activity, stability, liquidity, and GDP growth (e.g., money acting as the foundation for credit expansion and investment).

Demand for Money

• Concept of Liquidity Preference: Money is the most liquid asset because it is universally acceptable, but holding cash incurs an opportunity cost (the interest foregone by not holding interest-bearing deposits or bonds). The demand for money balance is referred to as liquidity preference.

• The Transaction Motive ($M^d_T$):

  • Money held to conduct day-to-day transactions due to the time gap between receiving income and incurring continuous expenditure.

  • Example: An individual earning $\text{₹}100$ on the first day of the month who spends it evenly until reaching $\text{₹}0$ at month-end holds an average money balance of $\frac{100 + 0}{2} = \text{₹}50$.

  • Two-Person Economy Model: A firm pays a worker $\text{₹}100$ at month start. The worker spends $\text{₹}100$ over the month buying output from the firm. Average holding of the worker = $\text{₹}50$; average holding of the firm = $\text{₹}50$. Total transaction money held = $\text{₹}100$. Total monthly volume of transactions = $\text{₹}200$ ($\text{₹}100$ worker services + $\text{₹}100$ firm goods).

  • Velocity of Circulation ($v$): The number of times a unit of money changes hands during a unit period ($v = \frac{1}{k}$).

  • Equation: $v \cdot M^d_T = T$ or $M^d_T = k \cdot T$, where $T$ is total nominal transactions and $k$ is a positive fraction.

  • Relationship to Nominal GDP: $M^d_T = kPY$, where $Y$ is real GDP, $P$ is the general price level (GDP deflator), and $k$ is a positive fraction. Transaction demand is positively related to real income ($Y$) and general price level ($P$).

• The Speculative Motive ($M^d_S$):

  • Holding wealth in liquid cash versus bonds (representing all financial assets other than money that promise a future stream of monetary returns).

  • Bond Price and Market Interest Rate Relationship: Bond prices are inversely related to the market interest rate ($r$).

  • Derivation / Calculation of Present Value ($PV$):

  • Consider a 2-period bond issued at face value $\text{₹}100$ with a coupon rate of $10\%$, paying $\text{₹}10$ at year 1 end, and $\text{₹}10$ principal + $\text{₹}100$ at year 2 end.

  • At market interest rate $r = 5\%$:

$\text{Present Value of Year 1 return } (X) = \frac{10}{1 + \frac{5}{100}} = \frac{10}{1.05}$

$\text{Present Value of Year 2 return } (Y) = \frac{110}{\left(1 + \frac{5}{100}\right)^2} = \frac{110}{(1.05)^2}$

$PV = X + Y = \frac{10}{1.05} + \frac{110}{1.1025} \approx \text{₹}109.29$

- Since $\text{₹}109.29 > \text{face value } \text{₹}100$, demand for bonds rises, pushing competitive bond prices up until $\text{Bond Price} = PV$.
- If market interest rate increases to $r = 6\%$:

$PV = \frac{10}{1 + \frac{6}{100}} + \frac{110}{\left(1 + \frac{6}{100}\right)^2} = \frac{10}{1.06} + \frac{110}{1.1236} \approx \text{₹}107.33$

- Higher interest rates reduce bond present value ($PV$) and bond market price.

• Capital Gains and Losses:

  • When market interest rate $r$ is very high ($r = r_{\max}$), bond prices are low. Everyone expects interest rates to fall and bond prices to rise, anticipating capital gains. People convert cash into bonds; speculative money demand $M^d_S = 0$.

  • When market interest rate $r$ is very low ($r = r_{\min}$), bond prices are high. Everyone expects interest rates to rise and bond prices to fall, anticipating capital losses. People sell bonds and hold cash; speculative money demand $M^d_S \rightarrow \infty$.

• Speculative Demand Equation:

$M^d_S = \frac{r_{\max} - r}{r - r_{\min}}$

• Liquidity Trap: When market interest rate drops to its floor ($r = r_{\min}$), everyone anticipates a future rise in interest rates and capital losses on bonds. Nobody wants to hold bonds. Any additional money injected into the economy is absorbed into money balances without lowering interest rates or increasing bond demand. In a liquidity trap, speculative money demand is infinitely elastic.

  • Aggregate Money Demand Equation:

$M^d = M^d_T + M^d_S = kPY + \frac{r_{\max} - r}{r - r_{\min}}$

Supply of Money and Its Measures

• Concept: Money supply is a stock concept defined as the total stock of money held by the public at a specific point in time in an economy.

  • Exclusions: Money held by the suppliers/producers of money—the Government and the Banking System (Central Bank + Commercial Banks)—is excluded from money supply.

• Suppliers of Money:

  1. Central Bank (Reserve Bank of India): Issues paper currency notes (except $\text{₹}1$ notes).

  2. Government of India (Ministry of Finance): Issues all coins and $\text{₹}1$ paper notes (bearing the signature of the Finance Secretary).

  3. Commercial Banks: Create bank money via demand deposits.

• Alternative Measures of Money Supply (RBI Definitions):

  • $M_1$ Measure (Narrow Money):

$M_1 = C + DD + OD$

- **$C$ (or $CU$)**: Currency (paper notes and coins) held by the general public.
- **$DD$**: Net demand deposits held by the public with commercial banks (excludes inter-bank deposits).
- **$OD$**: Other deposits with the RBI, including:
  - Demand deposits of public financial institutions (NABARD, IDBI, SIDBI) with RBI.
  - Demand deposits of foreign central banks and foreign governments with RBI.
  - Demand deposits of international financial institutions (IMF, World Bank) with RBI.

• $M_2$ Measure (Narrow Money):

$M_2 = M_1 + \text{Savings deposits with Post Office Savings Bank Accounts}$

• $M_3$ Measure (Broad Money / Aggregate Monetary Resources):

$M_3 = M_1 + \text{Net Time Deposits (Fixed Deposits) with Commercial Banks}$

• $M_4$ Measure (Broad Money):

$M_4 = M_3 + \text{Total Deposits with Post Office Savings Organisations (excluding National Savings Certificates - NSC)}$

• Liquidity Order and Usage:

  • Liquidity decreases from $M_1$ to $M_4$: $M_1 > M_2 > M_3 > M_4$ ($M_1$ is most liquid, $M_4$ is least liquid).

  • $M_3$ is the most commonly used measure of money supply in India.

High-Powered Money (Monetary Base / Reserve Money)

• Definition: High-powered money ($H$) is the total monetary base or liability issued by the Central Bank, consisting of currency held by the public and bank reserves.

• Formula:

$H = C + R$

• $C$: Currency (notes + coins) held by the general public.

• $R$: Cash reserves of commercial banks, comprising vault cash and cash reserves deposited with the RBI.

  • Comparison:

• Money Supply ($M_1$) = Currency with Public ($C$) + Demand Deposits ($DD$).

• High-Powered Money ($H$) = Currency with Public ($C$) + Cash Reserves with Banks ($R$).

Commercial Banks and Credit Creation

• Definition: A commercial bank is a financial institution that accepts deposits from the general public and advances loans for consumption and investment purposes to earn profits.

• Banking vs. Non-Banking Financial Institutions: An institution qualifies as a bank only if it performs both primary functions: (1) accepting chequeable deposits, and (2) advancing loans. (e.g., LIC is a financial institution but not a bank because it does not accept chequeable deposits; Post Offices are not full banks because they do not advance loans).

• Spread (Bank Profit): The difference between the higher interest rate charged from borrowers (lending rate) and the lower interest rate paid to depositors (borrowing/deposit rate).

$\text{Spread} = \text{Lending Rate} - \text{Deposit Rate}$

• Functions of Commercial Banks:

  • Primary Functions:

  1. Accepting Deposits:

     • Current Account Deposits: Maintained primarily by businessmen; highly liquid, chequeable without restriction, no interest paid, banks charge service fees.

     • Fixed Deposits (Time/Term Deposits): Deposited for a fixed tenure; non-chequeable, highest interest rate.

     • Savings Deposits: Maintained by individuals/salaried class; chequeable with restrictions on withdrawal frequency/amount, interest rate is lower than FDs.

     • Recurring Deposits (RD): Regular monthly deposits over a specified tenure.

  2. Advancing Loans:

     • Cash Credit: Sanctioned credit limit against current assets (shares, stocks); interest charged on the amount actually withdrawn.

     • Short-term Loans: Personal loans against collateral security; interest payable on the full sanctioned amount.

     • Demand Loans: Loans recallable by the bank on demand at any time; interest payable on the full sum.

  • Secondary Functions:

  1. Overdraft Facility: Allowing current account holders to overdraw beyond their balance up to a specified limit; interest charged on the overdrawn amount.

  2. Discounting Bills of Exchange: Purchasing a bill of exchange before maturity at a discount.

  3. Agency Functions: Transfer of funds (Demand Drafts), collection and payment of periodic items (rent, bills), buying/selling foreign exchange, trading securities, income tax consultancy, acting as trustee/executor.

  4. General Utility Functions: Locker facilities, issuing traveler's cheques, letters of credit, underwriting securities.

• Process of Credit Creation / Money Creation:

  • Key Assumptions:

  1. The entire commercial banking system is treated as a single unified unit ("Banks").

  2. All transactions are routed through banks via cheques/deposits (all receipts deposited, all payments paid via cheques).

  • Primary vs. Secondary Deposits:

  • Primary Deposits: Initial cash deposits made by the public into banks.

  • Secondary (Derivative) Deposits: Deposits generated when banks grant loans by crediting borrowers' accounts rather than handing over physical cash.

  • $\text{Total Demand Deposits} = \text{Primary Deposits} + \text{Secondary Deposits}$

  • Legal Reserve Ratio (LRR): The mandatory minimum fraction of deposits that banks must legally keep as cash reserves (determined by the RBI). Banks hold only a fraction as reserves because historical experience proves that all depositors do not withdraw cash simultaneously, and new deposits flow in continuously.

  • Step-by-Step Numerical Example:

  • Let Initial Cash Deposit ($ID$) = $\text{₹}1{,}000$ and Legal Reserve Ratio ($LRR$) = $20\%$.

• Formulas for Credit Multiplier / Money Multiplier:

$\text{Credit Multiplier (Money Multiplier)} = \frac{1}{\text{LRR}} = \frac{1}{\text{CRR}}$

$\text{Total Credit Creation (Total Demand Deposits)} = \text{Initial Deposit} \times \frac{1}{\text{LRR}}$

- For $LRR = 20\% = 0.2$, $\text{Money Multiplier} = \frac{1}{0.2} = 5$
- $\text{Total Deposits} = 1000 \times 5 = \text{₹}5{,}000$
- Inverse relationship: Higher LRR reduces the credit creation capacity of banks.

• Mathematical Proof of Geometric Series (Appendix 3.1):

  • Infinite geometric series sum $S = a + ar + ar^2 + \dots = \frac{a}{1 - r}$ where $0 < r < 1$.

  • Multiplying by $r$ and subtracting: $(1 - r)S = a \Rightarrow S = \frac{a}{1 - r}$.

  • In the credit multiplier process, $a = 1{,}000$ and $r = 1 - \text{LRR} = 1 - 0.2 = 0.8$, yielding $\text{Total Deposits} = \frac{1000}{1 - 0.8} = \frac{1000}{0.2} = \text{₹}5{,}000$.

  • Balance Sheet Representation:

• Initial Balance Sheet:

  • Assets: Reserves = $\text{₹}100$

  • Liabilities: Deposits = $\text{₹}100$, Net Worth = $\text{₹}0$

• Final Balance Sheet (after credit expansion with $CRR = 20\%$):

  • Assets: Reserves = $\text{₹}100$, Loans = $\text{₹}400$ (Total = $\text{₹}500$)

  • Liabilities: Deposits = $\text{₹}500$ ($100 + 400$) (Total = $\text{₹}500$)

The Central Bank (Reserve Bank of India - RBI)

• Establishment: The Reserve Bank of India (RBI) was established on April 1, 1935, under the Reserve Bank of India Act, 1934.

• Definition: The central bank is an apex monetary institution that controls, regulates, and directs the entire banking and monetary structure of a country.

• Functions of Central Bank:

  1. Currency Authority (Bank of Issue):

  • Holds sole monopoly right to issue paper currency notes in the country (except $\text{₹}1$ notes and coins issued by the Ministry of Finance).

  • Issued notes are unlimited legal tender.

  • Deficit Financing (Monetizing Government's Debt): When government expenditure exceeds revenue, the government sells Treasury Bills to the RBI, against which the RBI issues new currency.

  1. Banker, Agent, and Financial Advisor to the Government:

  • Banker: Manages government accounts, accepts receipts, makes payments, and grants short-term advances.

  • Agent: Manages public debt by buying/selling government securities in financial markets.

  • Advisor: Advises the government on financial, economic, and monetary policy matters.

  1. Banker's Bank and Supervisory Role:

  • Banker to Banks: Custodian of cash reserves of commercial banks; grants short-term financial accommodation; provides clearing house facilities to settle inter-bank claims (e.g., clearing cheques between SBI and HDFC).

  • Supervisor: Regulates bank licensing, branch expansion, liquidity of assets, and conducts periodic inspections.

  1. Lender of the Last Resort:

  • When commercial banks face liquidity crises and fail to secure funds from market sources, the central bank provides emergency financial accommodation against approved securities.

  1. Custodian of Foreign Exchange Reserves:

  • Holds and manages the nation's foreign exchange and gold reserves.

  • Conducts managed floating: purchasing/selling foreign currencies in foreign exchange markets to stabilize domestic exchange rate fluctuations.

  1. Controller of Money Supply and Credit:

  • Formulates and executes monetary policy to control inflation and deflation.

Policy Tools to Control Money Supply

• Quantitative Instruments (Control volume/extent of money supply):

  1. Bank Rate (Discount Rate):

  • The rate of interest at which the RBI lends money to commercial banks to meet long-term credit requirements (without collateral).

  • Inflation: RBI increases Bank Rate $\rightarrow$ Commercial bank borrowing costs rise $\rightarrow$ Commercial banks raise lending rates to public $\rightarrow$ Demand for credit falls $\rightarrow$ Money supply decreases.

  • Deflation: RBI decreases Bank Rate $\rightarrow$ Commercial bank lending rates fall $\rightarrow$ Credit demand increases $\rightarrow$ Money supply increases.

  1. Repo Rate (Repurchase Rate):

  • The rate of interest at which the RBI offers short-term loans (2 to 14 days) to commercial banks against government securities with a repurchase agreement.

  • Inflation: Increase Repo Rate $\rightarrow$ Increases short-term borrowing costs for banks $\rightarrow$ Lending rates rise $\rightarrow$ Money supply falls.

  • Deflation: Decrease Repo Rate $\rightarrow$ Money supply rises.

  1. Reverse Repo Rate (Reverse Repurchase Rate):

  • The rate of interest at which commercial banks can deposit surplus funds with the RBI for short periods.

  • Inflation: Increase Reverse Repo Rate $\rightarrow$ Commercial banks prefer parking surplus funds with RBI instead of lending to the public $\rightarrow$ Lending capacity falls $\rightarrow$ Money supply falls.

  • Deflation: Decrease Reverse Repo Rate $\rightarrow$ Banks withdraw funds from RBI to lend to public $\rightarrow$ Money supply rises.

  1. Open Market Operations (OMO):

  • Sale and purchase of government securities in the open market by the RBI to/from the public and commercial banks.

  • Outright OMO: Permanent purchase/sale of securities without commitment for future resale/repurchase.

  • Repo / Reverse Repo OMO: Temporary purchase/sale specifying resale/repurchase date and price.

  • Inflation: RBI sells government securities $\rightarrow$ Absorbs liquidity/reserves from banks/public $\rightarrow$ Credit creation capacity falls $\rightarrow$ Money supply falls.

  • Deflation: RBI purchases government securities $\rightarrow$ Injects liquidity/reserves into the system $\rightarrow$ Money supply rises.

  1. Legal Reserve Requirements (Variable Reserve Ratio Method):

  • Cash Reserve Ratio (CRR): The minimum percentage of Net Demand and Time Liabilities (NDTL) that commercial banks must keep as cash reserves with the RBI.

    • Inflation: Increase CRR $\rightarrow$ Reduces loanable funds available with banks $\rightarrow$ Money multiplier decreases $\rightarrow$ Money supply falls.

    • Deflation: Decrease CRR $\rightarrow$ Money supply rises.

  • Statutory Liquidity Ratio (SLR): The minimum percentage of NDTL that commercial banks must maintain with themselves in liquid assets (cash, gold, unencumbered government securities).

    • Inflation: Increase SLR $\rightarrow$ Reduces lending capacity $\rightarrow$ Money supply falls.

    • Deflation: Decrease SLR $\rightarrow$ Money supply rises.

• Qualitative Instruments (Control direction/allocation of credit):

  1. Margin Requirement:

  • The difference between the market value of the security offered for a loan and the amount of loan granted by the bank.

$\text{Margin Requirement} = \text{Market Value of Security} - \text{Loan Amount Granted}$

 - *Inflation*: RBI increases Margin Requirement $\rightarrow$ Borrowing capacity per unit of security falls $\rightarrow$ Credit creation falls $\rightarrow$ Money supply decreases.
 - *Deflation*: RBI decreases Margin Requirement $\rightarrow$ Money supply increases.

2. Moral Suasion:

   • Persuasion and informal pressure exercised by the RBI on commercial banks through speeches, meetings, discussions, and guidelines to follow central bank policy.

   • Inflation: RBI advises banks to restrict lending.

   • Deflation: RBI advises banks to be liberal in lending.

3. Selective Credit Control:

   • Discriminatory credit policy where RBI instructs commercial banks to extend credit to priority sectors (agriculture, Small Scale Industries [SSI], exports) while restricting credit to non-priority or speculative sectors (e.g., real estate).

Comparison: Central Bank vs. Commercial Banks

Demonetisation (November 2016)

• Context and Purpose: In November 2016, the Government of India invalidated old $\text{₹}500$ and $\text{₹}1{,}000$ currency notes as legal tender to tackle corruption, black money, terrorism, and counterfeit currency.

• New Currency: Introduced new currency notes in denominations of $\text{₹}500$ and $\text{₹}2{,}000$.

• Implementation Timelines:

  • Deposit of old notes in bank accounts allowed till December 31, 2016 (without declaration), and up to March 31, 2017 at RBI offices (with declaration).

  • Daily cash exchange limit set at $\text{₹}4{,}000$ per person per day initially.

  • Old notes accepted for essential dues (petrol pumps, government hospitals, utility bills, taxes) till December 12, 2016.

• Economic Impact:

  • Short-Term: Caused temporary cash crunch, queueing, and adverse effects on cash-dependent economic activities.

  • Long-Term Benefits: Improved tax compliance (brought more people into