Money and banking

Chapter 17: Money: Nature, Functions, and Role

Difficulties of Barter System & Invention of Money

• Barter System: Exchange of goods directly for other goods without the use of money. Early human history relied on this as families were largely self-sufficient.  

• Lack of Medium of Exchange: No single, generally accepted good or asset existed to facilitate transactions directly.  

• Key Difficulties:

  • Double Coincidence of Wants: The primary issue. For an exchange to occur, both parties must want exactly what the other offers. Finding such a match required significant time and effort. Example: Someone wanting wheat must find someone who has wheat and wants what the first person offers (e.g., cloth).  

  • Lack of a Standard Unit of Account: No common measure existed to express the value of different goods. This resulted in a vast number of exchange ratios (prices) between every pair of goods, making comparisons difficult. Example: How many apples equal one shoe? How many shoes equal one cow?.  

  • Impossibility of Subdivision: Many goods cannot be divided into smaller units without losing value, hindering exchanges where values don't match perfectly. Example: If a cow is worth much more than 5 kg of wheat, you cannot easily divide the cow to make the trade fair.  

  • Lack of Information: Traders needed extensive information about the value of various goods being exchanged, adding to the cost and time of transactions.  

  • Production Constraints: Barter made large-scale production, especially of costly goods, difficult. It was hard to find a single buyer willing to exchange the diverse range of goods (food, clothing, etc.) equivalent to the value of something like a car.  

• Invention of Money: Money evolved to overcome these barter difficulties, providing a common unit of account and a generally accepted medium of exchange.  

Evolution of Money

• Commodity Money: Early forms involved using common commodities as a medium of exchange.

  • Examples: Bows, sea shells, beads, arrows, furs (hunting stage); Sheep, cattle (pastoral stage).  

  • Limitations: Lack of uniformity (not all cows are identical), supply fluctuations, difficulty in storing value.  

   

• Metallic Money (Gold & Silver): Precious metals replaced commodities due to advantages like ease of handling/storage, durability, relative scarcity, and stable supply.

  • Initially used as bits, later standardized into coins.  

  • Scarcity was more crucial than intrinsic value for their function as money.  

   

• Paper Money: Evolved as the importance of scarcity over intrinsic value was recognized.

  • Initial Stage: Representative Paper Money - Claims or substitutes for metallic money, fully backed by gold/silver reserves. Not used today.  

  • Convertible Paper Money: Notes convertible into standard gold/silver coins. Required reserves, initially Full Reserve System (100% backing), later Proportional Reserve System (e.g., 30-50% backing), assuming not everyone would convert at once. India used this from 1927-1957.  

  • Inconvertible Paper Money (Fiat Money): Not convertible into precious metals. Accepted because it's declared legal tender by government order (fiat). Its value comes from general acceptability and what it can buy. Modern standard globally.  

  • Reserve System (India): Moved to Minimum Reserve System in 1957, requiring RBI to hold a minimum value (₹200 crores, with at least ₹115 crores in gold). Allows currency issuance based on economic needs.  

  • Advantage: Elasticity - quantity can be adjusted to economic needs. Crucial for growth and managing economic cycles (depression/inflation). Economical to produce.  

  • Disadvantage: Risk of over-issue by governments leading to inflation. Can cause foreign exchange instability. Requires proper government management.  

   

• Bank Deposits (Credit Money): Demand deposits in commercial banks, transferable via cheques, form a major part of money supply today.

  • Cheques are instructions to transfer deposits; the deposit itself is the money.  

  • Credit cards are not money; they facilitate short-term loans which must be repaid using currency or bank deposits.  

   

• General Acceptability: The core requirement for anything to function as money. Confidence in its acceptance by others is key. Loss of confidence (e.g., during hyperinflation) causes it to cease being money.  

Functions of Money

Summarized as: "Money is a matter of functions four, A medium, a measure, a standard, a store".  

1. Medium of Exchange: The primary function. Money overcomes the need for double coincidence of wants by separating buying and selling acts. Example: Person A sells goods to B for money, then uses that money to buy desired goods from C. Facilitates complex division of labour and specialization.  

2. Measure of Value (Unit of Account): Acts as a common denominator or yardstick to measure and compare the value of diverse goods and services. Simplifies economic calculation and comparison. Example: Prices of cars, bread, and haircuts are all expressed in Rupees in India, making relative value clear.  

3. Standard of Deferred Payment: Facilitates borrowing and lending by serving as the unit in which future payments (debts) are specified and made. Requires relative stability of value; high inflation or deflation undermines this function, unfairly benefiting either debtors or creditors.  

4. Store of Value (Asset Function): Allows wealth to be stored conveniently for future use. Money is the most liquid asset, meaning it can be readily exchanged for other goods/services without loss of value.

   • Other assets (houses, bonds, etc.) also store value but lack money's perfect liquidity.  

   • Stability of value is crucial; high inflation erodes money's purchasing power, discouraging saving in money form and diverting it to unproductive assets like gold or real estate.  

    

Forms of Money

• Money of Account: The unit (like Rupee, Dollar, Pound) in which prices, debts, and general purchasing power are expressed and accounts are kept. Doesn't necessarily need to be physically circulating (e.g., the paisa in India).  

• Legal Tender: Currency that, by law, must be accepted as payment for debts. Refusal is an offense.

  • Unlimited Legal Tender: Can be used to pay debts of any amount (e.g., Rupee notes/coins in India).  

  • Limited Legal Tender: Accepted only up to a certain limit (e.g., lower denomination coins in India, up to ten rupees). Legal tender status can be removed by the government (e.g., demonetization of high-value notes).  

   

• Standard Money: The basic monetary unit in which the values of all other forms of money and goods are measured (e.g., the Rupee in India). Always unlimited legal tender. Historically was full-bodied (face value = intrinsic metal value), but now typically token money (face value > intrinsic value).  

• Fiat Money: Money (usually paper notes or token coins) that has little to no intrinsic value and is not convertible into precious metals. It circulates as money based on government order (fiat) declaring it legal tender.  

• Bank Money (Demand Deposits): Deposits in banks payable on demand via cheque. Created through deposits by the public and, significantly, through the process of banks advancing loans. A major component of modern money supply.

  • Distinguished from Time Deposits (Fixed Deposits), which have a maturity period and are not directly usable for payment via cheque, though they are part of broader money measures (like M3).  

   

Importance and Role of Money

• Overcoming Barter: Money removes the inefficiencies of barter (double coincidence, lack of common measure, etc.).  

• Facilitating Exchange & Trade: Makes buying and selling vastly easier, promoting trade within and between nations.  

• Promoting Division of Labour & Productivity: By easing exchange, money enables specialization and division of labour, significantly boosting productivity and allowing the use of advanced technology. Modern complex economies wouldn't be possible without it.  

• Encouraging Saving & Investment: Makes saving easier than storing commodities. Facilitates borrowing/lending and the development of financial institutions, channeling savings into investment and capital formation.  

• Maximizing Satisfaction & Profits: Allows consumers to easily compare prices and allocate income to maximize utility (satisfaction). Enables producers to calculate costs/revenues, compare factor productivities with costs, and make decisions to maximize profits. Simplifies paying wages.  

• Economic Stabilization: Changes in money supply can influence aggregate demand, helping to manage economic cycles. Expansionary monetary policy (increasing money supply) can help revive economies from recession/depression by stimulating demand, output, and employment.  

• Role in Economic Development (Developing Countries):

  • Essential for moving beyond subsistence/barter economies (monetisation).  

  • Facilitates trade, specialization, and productivity growth.  

  • Supports increased transactions accompanying economic growth.  

  • Separates saving and investment acts, allowing investment to potentially exceed current savings through money creation.  

  • Created money can finance development projects, potentially utilizing idle resources. Investing in quick-yielding projects (like small irrigation, agriculture) can mitigate inflationary risks.  

  • Can lead to forced savings via inflation, where rising prices compel reduced consumption, freeing resources for investment (though this is controversial).  

  • Monetisation encourages production for the market (breaking subsistence) and promotes integration with financial institutions, boosting savings.  

• Real Money Balances: Emphasizes the purchasing power of money. Calculated as Nominal Money Balances (M) divided by the Price Level (P), i.e., M/P. What truly matters isn't the amount of money, but what it can buy.  

1-Minute Summary: Money

Money evolved out of the inefficiencies of the barter system, primarily the need for a double coincidence of wants. Starting with commodities, it progressed through metals (valued for scarcity and practicality) to paper money (initially backed by metal, now mostly fiat money based on government decree and acceptability) and bank deposits. Its key functions are serving as a medium of exchange, a unit of account (measure of value), a standard for deferred payments, and a store of value. Money's existence facilitates complex division of labour, trade, saving, investment, and efficient economic calculation, making modern economies possible and playing a crucial role in economic development, though its mismanagement (especially over-issue) can lead to inflation.

Outline Tree Structure: Money

I. Barter System & Problems
    A. Definition: Direct Goods Exchange [cite: 2]
    B. Difficulties
        1. Double Coincidence of Wants [cite: 7]
        2. Lack of Standard Unit of Account [cite: 13]
        3. Indivisibility of Goods [cite: 17]
        4. Information Costs [cite: 22]
        5. Production Limits [cite: 32]
II. Evolution of Money
    A. Commodity Money [cite: 43]
        - Examples: Shells, Cattle [cite: 44, 45]
        - Limitations [cite: 47, 48, 49]
    B. Metallic Money (Gold, Silver) [cite: 50]
        - Advantages: Durability, Scarcity, etc. [cite: 51]
        - Coins [cite: 52]
    C. Paper Money [cite: 58]
        1. Representative (Fully Backed) [cite: 66]
        2. Convertible (Partially Backed - Proportional Reserve) [cite: 69, 72]
        3. Inconvertible (Fiat Money) [cite: 76]
            - Legal Tender [cite: 79]
            - Minimum Reserve System (India) [cite: 83]
            - Advantages: Elasticity, Economy [cite: 91, 288]
            - Disadvantages: Inflation Risk, Instability [cite: 87, 294]
    D. Bank Deposits (Credit Money) [cite: 100]
        - Demand Deposits & Cheques [cite: 102]
III. Functions of Money [cite: 131]
    A. Medium of Exchange [cite: 133]
    B. Measure of Value (Unit of Account) [cite: 143]
    C. Standard of Deferred Payment [cite: 154]
    D. Store of Value (Asset Function) [cite: 165]
        - Liquidity [cite: 166]
IV. Forms of Money
    A. Money of Account [cite: 189]
    B. Legal Tender (Limited/Unlimited) [cite: 195]
    C. Standard Money [cite: 208]
    D. Fiat Money [cite: 217]
    E. Bank Money (Demand Deposits) [cite: 226]
V. Importance & Role of Money
    A. Overcoming Barter Inefficiencies [cite: 327]
    B. Facilitating Trade & Specialization [cite: 326, 330]
    C. Promoting Saving & Investment [cite: 341]
    D. Maximizing Consumer/Producer Welfare [cite: 347]
    E. Role in Economic Stabilization & Development [cite: 363, 371]
        - Monetisation [cite: 438]
        - Financing Development (incl. Created Money, Forced Savings) [cite: 401, 430]
    F. Real Money Balances (M/P) [cite: 322]

Chapter 18: Credit and Commercial Banking

Credit: Meaning and Functions

• Credit: Finance provided by one party (lender) to another (borrower) at interest, creating a claim for the lender and an obligation (debt) for the borrower. Involves future repayment.  

• Credit Institutions: Entities specializing in borrowing and lending (e.g., moneylenders, banks, finance corporations). They differ by purpose (agriculture, industry, export) and duration (short, medium, long-term). Commercial Banks are a key segment.  

• Function of Credit: To transfer surplus funds from savers to those needing funds for spending (trade, investment), relieving the constraint of balanced budgets. Efficient management promotes savings, investment, resource allocation, and economic growth. Mismanagement can cause instability (inflation/deflation), misallocation, and inequality.  

• Uses of Credit: Primarily for productive purposes like financing working capital or fixed investment in sectors like agriculture, industry, construction, and trade. Allocation between users (e.g., large vs. small farmers/industries) is crucial for growth and social justice. India's policy emphasizes priority sectors.  

Commercial Banking

• Definition: A business dealing in money, primarily borrowing (accepting deposits) and lending, aiming to make profit from the interest rate difference. Unlike moneylenders who lend their own funds, banks lend funds borrowed from depositors.  

• Origin: Traced to goldsmiths in 17th Century England who stored valuables. Deposit receipts became transferable, acting like money. Eventually, letters of instruction (early cheques) were used. Goldsmiths realized deposited gold often lay idle, leading them to issue more receipts (loans) than gold held, charging interest – the beginning of fractional reserve banking and credit creation.  

• Bank Balance Sheet: Shows Liabilities (sources of funds) and Assets (uses of funds).

  • Liabilities: Primarily Deposits (Demand/Current, Time/Fixed, Savings). Also includes Borrowings (e.g., from Central Bank) and Capital/Reserves.  

  • Assets: Reflects the balance between Liquidity (ability to meet withdrawal demands) and Profitability (earning returns). Includes:

    • Cash (in hand and with other banks/RBI): Highly liquid, low/no profit.  

    • Money at Call/Short Notice: Liquid, low profit.  

    • Investments (Govt. & other securities): Relatively liquid, moderate profit. Banks often required by law to hold a percentage (Statutory Liquidity Ratio - SLR).  

    • Loans & Advances: Less liquid, primary source of profit.  

    • Fixed Assets (Buildings, etc.).  

     

   

Functions of Commercial Banks

• Primary Functions:

  1. Accepting Deposits: Borrowing funds from the public. Main types:

     • Demand Deposits (Current Accounts): Withdrawable anytime via cheque, usually no interest, favored by businesses. Banks offer services like cheque collection.  

     • Fixed Deposits (Time Deposits): Deposited for a fixed term, higher interest rate, not withdrawable on demand (though loans against them possible). Attracts savings.  

     • Savings Bank Deposits: Aimed at small savers, allow limited withdrawals via cheque, earn interest lower than fixed deposits but higher than current accounts.  

      

  2. Advancing Loans: Lending deposited funds to earn profit. Requires balancing liquidity and profitability. Forms include:

     • Overdraft: Allowing current account holders to withdraw more than their balance, up to an agreed limit, with interest charged on the overdrawn amount. Typically short-term for businesses.  

     • Cash Credit: A pre-sanctioned credit limit against which borrowers can draw funds as needed, based on their withdrawing power (determined by current assets like stock). Interest charged only on the amount drawn.  

     • Demand Loans: Loans recallable by the bank at any time. Often used by stock-brokers. Interest charged on the entire sum granted.  

     • Short-Term Loans: Granted against security for personal needs (car, housing) or business working capital. Interest charged on the full amount.  

      

  3. Discounting Bills of Exchange (Hundies): Purchasing trade bills from businesses at a discount before their maturity date. Provides immediate funds to sellers who granted credit. A safe and liquid short-term investment for banks.  

• Secondary/Miscellaneous Functions:

  • Transfer of Money: Facilitating payments across locations via drafts or cheques.  

  • Agency Functions: Collecting cheques/dividends, paying bills/insurance premiums, buying/selling shares for customers.  

  • General Utility Functions: Providing lockers for valuables, acting as trustees or executors.  

Credit Creation by Banks

• The "manufacturing" of money (deposits) by banks.  

• Based on the Fractional Reserve System: Banks legally required to hold only a fraction (e.g., 20%) of deposits as cash reserves (Cash Reserve Ratio - CRR).  

• Process:

  1. Initial Deposit: Someone deposits currency (e.g., ₹1,000) into Bank A. Bank A's assets (cash) and liabilities (deposits) rise by ₹1,000.  

  2. Reserve Holding: Bank A keeps the required reserve (e.g., 20% of ₹1,000 = ₹200).  

  3. Loan Extension: Bank A lends the excess reserves (₹800). It does this by creating a new deposit of ₹800 in the borrower's name. Total deposits in Bank A temporarily become ₹1,800.  

  4. Funds Transfer: The borrower spends the ₹800, usually via cheque. The recipient deposits the cheque in another bank (Bank B). Bank A transfers ₹800 cash to Bank B. Bank A is left with ₹200 cash and ₹1,000 original deposit.  

  5. Second Round: Bank B receives ₹800 cash (asset) and ₹800 deposit (liability). It keeps 20% reserve (₹160) and lends out the rest (₹640) by creating a new deposit.  

  6. Continuation: This process repeats, with each subsequent bank lending a smaller amount (80% of the deposit it receives).  

• Deposit Multiplier: The total expansion of deposits is a multiple of the initial cash deposit.

  • Formula: Deposit Multiplier (dm​) = 1 / Cash Reserve Ratio (r).  

  • Example: If r = 20% (or 0.20), dm​=1/0.20=5. An initial ₹1,000 deposit leads to total deposits of ₹5,000 (₹1,000 initial + ₹4,000 created).  

  • Higher CRR leads to a smaller multiplier and less credit creation; lower CRR leads to a larger multiplier and more credit creation.  

   

• Credit Multiplier: Measures the amount of new credit created by the banking system relative to the initial increase in reserves.

  • Formula: Credit Multiplier (Cm​) = (1 - r) / r or dm​ - 1.  

  • Example: If r = 0.20, Cm​=(1−0.20)/0.20=0.8/0.2=4.  

   

• Limitations on Credit Creation:

  • Amount of Cash (Reserves): Total credit depends on the initial amount of cash reserves in the system, influenced by the central bank's control over currency issue.  

  • Public's Desire to Hold Cash: If people prefer holding cash over deposits, withdrawals will deplete bank reserves faster, reducing credit creation potential. Habit of using cheques facilitates more credit creation.  

  • Cash Reserve Ratio (CRR): The minimum ratio set by law or prudential norms limits how much banks can lend out.  

  • Public's Desire to Hold Deposits: Banks can only create credit based on the funds deposited with them. If people prefer other investments (shares, mutual funds, etc.), bank deposits and credit creation potential are lower. Interest rates offered influence this.  

  • Availability of Borrowers/Demand for Loans: Banks need creditworthy borrowers demanding loans. During recessions, even with ample reserves, banks might not find enough borrowers.  

  • Availability of Securities/Assets: Banks generally create credit against some asset or security, essentially converting less liquid wealth into more liquid money (deposits).  

Role of Commercial Banks in Economic Development

• Banks support development via: (a) Promoting savings, (b) Mobilizing savings, (c) Allocating savings.  

• Promotion of Savings: Offer safe, liquid, and interest-earning deposit options, suiting different savers' needs and encouraging thrift. Especially effective in unbanked areas. Requires price stability, as inflation erodes real returns and diverts savings to unproductive assets.  

• Mobilisation of Savings: Collect scattered savings from numerous households/firms and channel them to producers/investors. Act as crucial financial intermediaries, bridging savers and borrowers. Reduce search costs and risks for lenders. Issue secondary securities (deposits) which are safer for risk-averse savers compared to primary securities (shares, bonds).  

• Allocation of Funds: Direct mobilized savings (and created credit) towards various sectors and users. Ideally, allocate based on credit-worthiness and potential returns, maximizing the productivity of scarce resources. However, banks might not always align with social priorities (e.g., neglecting agriculture or small industries before nationalization in India).  

• Credit Creation for Investment: By creating credit beyond initial deposits, banks augment the funds available for production and investment, boosting economic growth.  

1-Minute Summary: Credit & Commercial Banking

Credit involves lending money with the expectation of future repayment plus interest. Commercial banks are key institutions that borrow (accept deposits) and lend, profiting from the interest spread. They evolved from goldsmiths who started lending deposited funds. Banks perform crucial functions: accepting deposits (demand, fixed, savings), advancing loans (overdrafts, cash credit, term loans), discounting bills, and providing other services like fund transfers and safe custody. A vital function is credit creation, where banks, operating under a fractional reserve system, create new deposits (money) by lending out multiples of their cash reserves, determined by the deposit multiplier (1/CRR). This process is vital for mobilizing savings and financing economic development but is limited by factors like reserve levels, public preferences, and loan demand.  

Outline Tree Structure: Credit & Commercial Banking

I. Credit
    A. Meaning: Lending/Borrowing Finance [cite: 466]
    B. Function: Transfer Surplus Funds, Promote Investment [cite: 483, 485]
    C. Uses: Working Capital, Fixed Investment (Various Sectors) [cite: 493, 494]
II. Commercial Banking
    A. Definition & Origin (Goldsmiths) [cite: 499, 507]
    B. Bank Balance Sheet [cite: 519]
        1. Liabilities (Deposits, Borrowings, Capital) [cite: 525]
        2. Assets (Cash, Investments, Loans - Balancing Liquidity & Profitability) [cite: 535]
    C. Functions [cite: 556]
        1. Accepting Deposits (Demand, Fixed, Savings) [cite: 560]
        2. Advancing Loans (Overdraft, Cash Credit, etc.) [cite: 584]
        3. Discounting Bills of Exchange [cite: 612]
        4. Miscellaneous (Fund Transfer, Agency, etc.) [cite: 629]
    D. Credit Creation [cite: 700]
        1. Fractional Reserve System [cite: 720]
        2. Process (Multiple Rounds of Lending) [cite: 736]
        3. Deposit Multiplier (1/r) [cite: 791]
        4. Credit Multiplier ((1-r)/r) [cite: 803]
        5. Limitations (Reserves, Public Habits, CRR, Loan Demand) [cite: 804]
    E. Role in Economic Development [cite: 642]
        1. Promoting Savings [cite: 646]
        2. Mobilizing Savings (Financial Intermediation) [cite: 663]
        3. Allocating Funds [cite: 685]
        4. Enhancing Investment via Credit Creation [cite: 694]

Chapter 19: Central Banking & Chapter 19A: Monetary Policy

Central Banking

• Definition: An apex monetary institution regulating commercial banks and the overall monetary system. India's central bank is the Reserve Bank of India (RBI), established 1935.  

• Guiding Principle: Acts in the public interest for national economic/financial stability, not primarily for profit. Monetary authority of the country.  

Functions of a Central Bank

1. Note Issuing Agency: Holds the monopoly on issuing currency notes (except specific small denominations sometimes issued by government). Controls currency supply. Operates under reserve systems (historically proportional, now often minimum reserve like India since 1956). Currency value depends on stability and purchasing power, not just gold backing.  

2. Banker to the Government: Manages government accounts (holds balances, makes/receives payments). Manages public debt and issues new loans. Provides short-term loans (often via discounting treasury bills). Acts as fiscal agent and advisor.  

3. Bankers' Bank:

   • Custodian of Cash Reserves: Commercial banks are legally required to keep a portion of their deposits as reserves with the central bank. This aids credit control.  

   • Lender of Last Resort: Provides liquidity support (loans against securities, rediscounting bills) to commercial banks facing emergencies or crises when other sources fail. Essential for stability in a fractional reserve system.  

   • Central Clearance & Settlement: Facilitates settlement of inter-bank claims efficiently through debits/credits in their reserve accounts held at the central bank.  

4. Control of Credit: A primary function aimed at achieving price stability and overall economic stability (managing business cycles). Done by influencing the supply and cost of credit. Uses various methods (explained under Monetary Policy Instruments). Contracts credit during inflation, expands it during recession/deflation.  

5. Managing Exchange Rate: Maintains the stability of the national currency's external value. Under flexible exchange rates, intervenes to prevent excessive volatility.

   • Methods: Can sell foreign currency reserves (e.g., dollars) to curb depreciation or buy foreign currency to curb appreciation. Can also use monetary policy tools (like changing interest rates or reserve ratios) to influence capital flows and demand for foreign currency.  

    

6. Promoting Economic Growth: Especially important in developing countries. Ensures adequate credit availability at reasonable rates for agriculture, industry, and other priority sectors. Helps build financial institutions.  

Monetary Policy

• Definition: Measures concerning the supply of money, cost/availability of credit, distribution of credit, and interest rates.  

• Goals/Objectives: Aligned with overall economic policy. Key objectives include:

  1. Price Stability (Controlling Inflation): Often considered the primary goal best suited for monetary policy. High inflation harms the poor, hurts exports, discourages saving, and promotes unproductive investment. Aim is usually for a reasonable low rate of inflation (e.g., Chakravarty Committee suggested 4% for India).  

  2. Economic Growth: Encouraging growth by ensuring adequate, low-cost credit for working capital and investment. Potential trade-off with price stability in the short run; expansionary policy for growth might fuel inflation. Requires balancing acts (e.g., setting acceptable inflation targets alongside growth goals).  

  3. Exchange Rate Stability: Increasingly important with floating rates and globalization. Volatility (excessive depreciation/appreciation) is harmful. Depreciation can worsen inflation by raising import costs. Requires managing capital flows and foreign exchange market interventions. Conflicts can arise (e.g., tightening policy for exchange rate stability might hinder growth).  

   

• Targets vs. Instruments:

  • Targets: Intermediate variables like money supply, bank credit, or interest rates that policy aims to influence.  

  • Instruments (Tools): The actual measures used to achieve targets and ultimately goals.  

Instruments of Monetary Policy (Credit Control Methods)

• Quantitative (General) Instruments: Affect the overall quantity and cost of credit.

  1. Bank Rate Policy: The minimum rate at which the central bank lends to commercial banks (often via rediscounting).

     • Mechanism: ↑ Bank Rate → ↑ Cost of borrowing for banks → ↑ Banks' lending rates → ↓ Borrowing by public/businesses → ↓ Credit/Money Supply → ↓ Aggregate Demand → Controls Inflation. Opposite for ↓ Bank Rate during recession. Can also affect international capital flows.  

     • Limitations: Requires responsive market rates and borrowers; banks might have excess reserves; borrowers' decisions influenced more by economic outlook than interest rates alone, especially in deep recession ("can't push on a string"); less effective in poorly organized money markets. More effective at curbing booms than ending recessions. Acts as a signal.  

      

  2. Repo Rate & Reverse Repo Rate (India): Key tools under Liquidity Adjustment Facility (LAF) for managing short-term liquidity.

     • Repo Rate: Rate at which RBI lends overnight funds to banks against securities. ↑ Repo Rate → ↑ Cost of short-term funds for banks → Curbs credit (anti-inflation). ↓ Repo Rate → Encourages credit (anti-recession).  

     • Reverse Repo Rate: Rate at which RBI borrows from banks (absorbs liquidity).  

     • Difference from Bank Rate: Repo is short-term/overnight; Bank Rate is longer-term. Repo used more actively in India for signaling and liquidity management. Limitations similar to Bank Rate.  

      

  3. Open Market Operations (OMO): Central bank buying/selling government securities in the open market.

     • Mechanism: Central bank sells securities → Buyers pay, reducing commercial banks' cash reserves → ↓ Banks' lending capacity → Credit contracts. Central bank buys securities → Pays banks, increasing their cash reserves → ↑ Banks' lending capacity → Credit expands. Considered direct and effective, especially in developed markets.  

     • Limitations: Effect on reserves might be offset by currency movements; banks may not adjust lending based solely on reserves; loan demand might not change; velocity of circulation might change; requires a broad, active securities market. Increasingly used in India.  

      

  4. Changing Cash Reserve Ratio (CRR): Altering the legally required percentage of deposits banks must hold as reserves with the central bank.

     • Mechanism: ↑ CRR → Banks must hold more reserves → Less funds available for lending → Credit contracts. ↓ CRR → Frees up reserves → More funds available for lending → Credit expands. Powerful tool affecting lending capacity directly.  

     • Limitations: ↑ CRR ineffective if banks hold large excess reserves; ↓ CRR ineffective if borrowers lack confidence or demand for loans is low. Used frequently by RBI.  

      

   

• Qualitative (Selective) Instruments: Target the direction or specific uses of credit, rather than the total volume.

  • Purpose: Can be positive (encouraging credit flow to priority sectors like agriculture, small industries) or negative (restricting credit for undesirable/speculative purposes). Often used in India to control hoarding of essential commodities (foodgrains, oilseeds etc.).  

  • Methods:

    1. Changing Margin Requirements: Adjusting the minimum down payment (margin) borrowers must provide when taking loans against specific securities (like stocks or commodity inventories). ↑ Margin → Borrower needs more own funds → Reduces borrowing/speculative holding. ↓ Margin encourages borrowing.  

    2. Ceilings on Credit: Setting maximum limits on loans banks can grant for specific purposes or against specific commodities.  

    3. Discriminatory Interest Rates: Charging different interest rates for credit used for different purposes.  

    4. Prohibition: Banning certain types of financing (e.g., discounting bills for sensitive commodities).  

  • Limitations/Conditions for Success: Can be circumvented if borrowers get general loans and divert funds; effectiveness enhanced when combined with quantitative controls; availability of non-bank finance (including black money) can undermine controls. Requires monitoring end-use of funds.  

   

• Moral Suasion: Central bank using persuasion, advice, or public appeals to influence commercial banks' lending policies. Relies on banks respecting the central bank's guidance.  

1-Minute Summary: Central Banking & Monetary Policy

A Central Bank (like India's RBI) is the apex monetary authority, acting as banker to the government and other banks, issuing currency, managing exchange rates, and crucially, controlling credit to ensure economic and price stability. It operates not for profit but public interest. Monetary Policy refers to the actions taken by the central bank to manage money supply and credit. Its main objectives are usually price stability (controlling inflation), promoting economic growth, and maintaining exchange rate stability. Key instruments include Quantitative controls (affecting overall credit) like adjusting the Bank Rate/Repo Rate (cost of funds for banks), Open Market Operations (buying/selling securities to alter bank reserves), and changing the Cash Reserve Ratio (CRR). Qualitative controls target specific credit uses, like setting margin requirements to curb speculation. The central bank chooses and combines these tools based on prevailing economic conditions and policy goals.  

Outline Tree Structure: Central Banking & Monetary Policy

I. Central Banking
    A. Definition & Principle (Apex Bank, Public Interest) [cite: 856, 866]
    B. Functions [cite: 873]
        1. Note Issue Monopoly [cite: 876]
        2. Banker to Government [cite: 890]
        3. Bankers' Bank (Reserves Custodian, Lender of Last Resort, Clearing) [cite: 898]
        4. Credit Control [cite: 910]
        5. Exchange Rate Management [cite: 944]
        6. Promoting Economic Growth [cite: 935]
II. Monetary Policy
    A. Definition (Managing Money & Credit) [cite: 1126]
    B. Objectives/Goals [cite: 1132]
        1. Price Stability (Inflation Control) [cite: 1139]
        2. Economic Growth [cite: 1151]
        3. Exchange Rate Stability [cite: 1172]
        - Potential Conflicts/Trade-offs [cite: 1161, 1170]
    C. Instruments/Tools [cite: 1198]
        1. Quantitative/General Methods [cite: 1206]
            a. Bank Rate / Repo Rate Policy [cite: 1212, 1242]
                - Mechanism & Effects [cite: 989, 997]
                - Limitations [cite: 1009, 1278]
            b. Open Market Operations (OMO) [cite: 1300]
                - Mechanism (Buying/Selling Securities) [cite: 1030]
                - Limitations [cite: 1316]
            c. Changing Cash Reserve Ratio (CRR) [cite: 1341]
                - Mechanism & Effects [cite: 1064, 1067]
                - Limitations [cite: 1069, 1071]
        2. Qualitative/Selective Methods [cite: 1363]
            a. Purpose (Targeting Specific Credit Uses) [cite: 1078]
            b. Techniques (Margins, Ceilings, etc.) [cite: 1082, 1083, 1084, 1085]
            c. Limitations [cite: 1103]
        3. Moral Suasion [cite: 1114]

Conceptual & Application Questions

Conceptual Questions

1. Why is the 'double coincidence of wants' considered the main difficulty of a barter system?  

2. Explain the difference between 'representative paper money' and 'fiat money'. Which type do we use today and why?  

3. How does money perform its function as a 'standard of deferred payment', and why is price stability important for this function?  

4. What is 'liquidity'? Why must commercial banks balance liquidity and profitability in managing their assets?  

5. Explain the concept of the 'deposit multiplier' and how it relates to the Cash Reserve Ratio (CRR).  

6. What does it mean for the central bank to be the 'lender of last resort'? Why is this function crucial?  

7. Distinguish between the objectives, targets, and instruments of monetary policy. Give an example of each.  

8. Why might there be a short-run trade-off between the monetary policy objectives of controlling inflation and promoting economic growth?  

9. How do Open Market Operations (OMO) affect the cash reserves and lending capacity of commercial banks?  

10. What is the purpose of 'selective credit controls', and how do they differ from 'quantitative' controls?  

Application Questions

1. If the initial cash deposit in the banking system is ₹50,000 and the CRR is 10%, what is the maximum amount of total deposits the banking system can create? How much new credit is created? (Calculation based on formulas)  

2. Imagine an economy experiencing high inflation (prices rising rapidly). What actions would you expect the central bank to take using (a) Repo Rate, (b) CRR, and (c) OMO? Explain the reasoning for each.  

3. Suppose a country's currency is rapidly appreciating against the US dollar, hurting its export competitiveness. What steps could its central bank take to manage the exchange rate?  

4. A farmer wants a loan to buy seeds and fertilizer (working capital), while a large company wants a loan to build a new factory (fixed investment). How might a commercial bank assess these different loan requests? (Application of banking principles)  

5. During a severe recession, the central bank lowers the bank rate significantly, but businesses are still unwilling to borrow and invest. Explain why this might happen, referencing a limitation of interest rate policy.  

6. The RBI notices excessive speculation and price rises in the sugar market, suspecting hoarding financed by bank loans. What specific selective credit control measure could it implement, and how would it work?  

7. Why might a developing country's central bank prioritize using monetary policy to promote economic growth, even if it risks slightly higher inflation, compared to a developed country focused solely on price stability? (Applying concepts to different contexts)  

8. If people in an economy suddenly decide to hold significantly more currency (cash) instead of depositing it in banks, what effect would this have on the banks' ability to create credit?  

9. Bank X has mostly demand deposits, while Bank Y has mostly long-term fixed deposits. Which bank would likely need to hold a higher proportion of its assets in liquid form, and why?  

10. Explain how the invention of money facilitated the growth of specialization and division of labour compared to a barter system. Provide a real-world example. (Linking concepts with real-world application)