Comprehensive Study Notes on Money and Banking: Functions, Supply, and the Credit System

Conceptual Foundation of Money and its Characteristics

Money is defined as any object or entity that is generally accepted as a medium of exchange, a measure of value, a store of value, and a means of standard deferred payment. These four traits constitute the core characteristics of money. It is an instrument capable of facilitating the purchase of products, services, or other entities. When the Government legalizes a specific form of money, it acquires universal acceptance within that jurisdiction. The existence of money fundamentally solves the economic problem of the "double coincidence of wants," which characterizes barter systems. In a monetary economy, a person can use money to purchase any commodity without the seller needing to have a specific reciprocal need that the buyer can fulfill.

Money encompasses various forms including physical coins, paper notes, cheques, digital money, and plastic money. Its utility is grounded in its ability to be used for all transactions involving goods and services, acting as a bridge between the sale and purchase of economic value.

Primary and Secondary Functions of Money

The functions performed by money are categorized into Primary and Secondary functions. The Primary Functions include the role of Money as a Medium of Exchange and as a Measure of Value or Unit of Account. As a medium of exchange, money is used to facilitate payments for all transactions of goods and services. As a measure of value, it provides a standard unit to express the worth of diverse goods and services, a value typically referred to as the price. This standardization into a single unit (price) makes exchanges efficient and easy to calculate.

Secondary Functions involve the role of money as a Standard of Deferred Payment and a Store of Value. Deferred payments are those intended for the near future. Money serves this purpose effectively because its value remains relatively constant compared to other commodities, it possesses general acceptability, and it is more durable than most goods. Similarly, money acts as a store of value because it can be saved without losing its worth. This is possible because money is easy and economical to store, has universal merit of acceptability, and its value remains relatively stable over time.

Classification and Categories of Money

Money is classified into several types based on its legal status and the relationship between its face value and intrinsic value. Legal Tender Money is defined as money that can be legally utilized to settle an obliged debt. This is subdivided into two types: Limited Legal Tender Money, such as coins, which can only be used to settle debts up to a specific amount, and Unlimited Legal Tender Money, such as paper or currency notes, which can be used for payments of any amount without a fixed limit.

Further classifications include Full Bodied Money, where the face value is exactly equal to the intrinsic value (Commodity Value = Money Value), such as historical gold and silver coins. Representative Full Bodied Money describes a form where the intrinsic value is less than the face value (Commodity Value < Money Value), yet it represents a full-bodied asset, for example, paper notes. Credit Money refers to money where the intrinsic value is significantly lower than the face value (Money Value > Commodity Value), examples of which include credit cards and bank deposits.

The Monetary System of India

In India, the Reserve Bank of India (RBI) serves as the central monetary authority. The country operates under a paper currency standard. While the RBI holds it as a sole monopoly to issue currency, the Ministry of Finance is specifically responsible for issuing $1.0$ rupee coins and $1.0$ rupee notes. Coins in India are classified as limited legal tender money.

India utilizes a Minimum Reserve System for the issuance of notes. Under this system, the RBI is required to maintain a minimum of $\text{Rs. } 200 \text{ crores}$ in the form of gold and foreign exchange with the World Bank as a backing for issuing coins and notes.

Understanding Money Supply and its Measures

Money supply is defined as the total quantity of money held by the public at a specific point in time within an economy. This is a "stock" concept and specifically excludes money held by the government or the banking system themselves. There are four measures of money supply ($M1$, $M2$, $M3$, and $M4$), though standard academic curricula often focus on the focus on the $M1$ measure.

$M1$ is the basic and most liquid measure of money supply. The formula is:
$M1 = C + DD + OD$
Where:
$C$ stands for Currency held by the public (Notes and coins).
$DD$ stands for Demand deposits of the people held with commercial banks.
$OD$ refers to Other Deposits with the RBI, which includes demand deposits of public financial institutions like NABARD, demand deposits of foreign central banks or governments, and demand deposits of international financial institutions.

Other measures expand on this:
$M2 = M1 + \text{Savings deposits with Post office saving bank}$
$M3 = M1 + \text{Net time deposits with banks}$
$M4 = M3 + \text{Total deposits with post office saving bank}$

In terms of characteristics, $M1$ represents the most liquid form of money supply, while $M4$ is the least liquid. $M1$ and $M2$ are classified as the narrow concept of money supply, whereas $M3$ and $M4$ represent the broader concept.

High Powered Money and the Banking Structure

High Powered Money, denoted by the symbol $H$, is the total money produced by the RBI and the government. It includes currency held by the public and the cash reserves held by banks. It differs from the general money supply because money includes demand deposits, whereas high powered money includes the cash reserves that serve as the base for generating those demand deposits.

The banking system consists primarily of Commercial Banks and Central Banks. A Commercial Bank is an institution that accepts deposits and provides loans for the primary purpose of earning profits. Notable examples in India include SBI, PNB, Canara Bank, and Kotak Mahindra Bank.

The Credit Creation Process of Commercial Banks

Credit creation is a vital activity where commercial banks generate credit through excess reserves derived from initial deposits. This process relies on two assumptions: that the entire banking system acts as a single unit or "BANK," and that all receipts and payments in the economy are processed through these banks. Banks are legally required to keep a fraction of their deposits as reserves, known as the Legal Reserve Ratio (LRR). This is possible because banks know that not all customers will withdraw their money simultaneously.

The Money Multiplier or deposit multiplier determines the total amount of deposits banks can create. The formula is:
$\text{Money Multiplier} = \frac{1}{LRR}$

If we assume an Initial Deposit of $\text{Rs. } 100$ and an $LRR$ of $10\%$, the multiplier is $\frac{1}{0.10} = 10$. This results in a total deposit creation of $\text{Rs. } 1000$. The process works in rounds:
Round 1: Deposit of $\text{Rs. } 100$, Reserve ($10\%$) of $\text{Rs. } 10$, Loan of $\text{Rs. } 90$.
Round 2: Deposit of $\text{Rs. } 90$, Reserve ($10\%$) of $\text{Rs. } 9$, Loan of $\text{Rs. } 81$.
Round 3: Deposit of $\text{Rs. } 81$, Reserve ($10\%$) of $\text{Rs. } 8.1$, Loan of $\text{Rs. } 72.9$.
This continues until excess reserves are exhausted, leading to total deposits of $\text{Rs. } 1000$, total loans of $\text{Rs. } 900$, and total reserves of $\text{Rs. } 100$.

Role and Functions of the Central Bank

The Central Bank (RBI in India) is the apex body that regulates the entire banking system. Its functions are extensive:

1. Bank of Issue: Sole authority to issue currency (except $1.0$ rupee notes/coins). It must keep gold reserves equal to the currency issued with the World Bank, ensuring uniformity and stability.

2. Banker to Government: Acts as a banker, agent, and financial advisor to state and central governments, managing public debt and advising on monetary matters.

3. Banker’s Bank: Acts as a banker to all other banks, who keep their reserves with the RBI. It enforces the Cash Reserve Ratio (CRR).

4. Custodian of Foreign Exchange: Manages foreign currency reserves to prevent excessive price fluctuations and ensure availability to the public.

5. Lender of Last Resort: Provides emergency loans to commercial banks and the public when they fail to meet financial needs.

6. Clearing House: Settles claims between different commercial banks by editing entries in their respective accounts held at the RBI.

7. Supervisor: Exercises regular inspection and control over commercial bank operations.

Instruments of Credit Control and Money Supply

The RBI utilizes Quantitative and Qualitative measures to control credit and money supply. Quantitative measures include:

• Repo Rate: The rate for short-term lending to banks without collateral. Increasing it reduces money supply; decreasing it increases supply.

• Bank Rate: The rate for long-term lending to banks involving collateral. Increasing it reduces money supply.

• Reverse Repo Rate: The rate paid to commercial banks for keeping their reserves with the RBI. Increasing it induces banks to hold reserves rather than lending, decreasing money supply.

• Legal Reserve Ratio (LRR): Composed of the Cash Reserve Ratio (CRR), held with the RBI, and the Statutory Liquidity Ratio (SLR), held by the banks themselves. Increasing either reduces money supply.

• Open Market Operations: The sale (to reduce supply) or purchase (to increase supply) of securities in the open market.

Qualitative measures include:

• Margin Requirement: The difference between the loan amount and the market value of collateral. Higher margins reduce borrowing capacity and money supply.

• Rationing of Credit: Fixing quotas for specific business activities that banks cannot exceed.

• Moral Suasion: Using a combination of persuasion and pressure to lead commercial banks to follow RBI directions.