Comprehensive Study Notes on Money, Credit Creation, and Central Banking Functions of the Central Bank

The Medium of Exchange Function of Money

Money serves as a medium of exchange, which is considered its most essential function. In any economy, money can be utilized as a universal medium for making payments for all varieties of goods and services. The introduction of money as a medium of exchange effectively removed the major difficulty associated with the barter system: the lack of the double coincidence of wants. For an object to function as money in this capacity, it must possess the quality of general acceptability among the population. One of the primary benefits of this function is that the purchase and sale of goods can be conducted independently of one another, meaning an individual does not need to find someone who specifically wants what they have and possesses what they want simultaneously.

Money as a Measure of Value

Money functions as a common measure of value, or a unit of account, where the prices of all goods and services are expressed in terms of money. This provides a common denomination for the value of disparate items, which significantly simplifies the process of exchange. Money acts as a measuring rod that expresses the value of various goods and services in a standardized format. Furthermore, this function allows for the easy comparison of the relative values of any two commodities, enabling consumers and producers to make informed economic decisions based on relative prices.

Money as a Store of Value

As a store of value, money represents the most convenient way for individuals and entities to store wealth. This function provides essential security to individuals, allowing them to prepare for and meet unforeseen contingencies or emergencies. Unlike many physical goods, money is not perishable and is easy to store over long periods. Most importantly, it facilitates the transfer of purchasing power from the present into the future, ensuring that wealth earned today can be utilized at a later date without the risk of significant physical degradation of the asset.

Money as a Standard of Deferred Payments

Money serves as a standard for debt and deferred payments, which are payments scheduled to be made in the near future rather than at the time of the transaction. The use of money has immensely simplified borrowing and lending operations within the economy. Money is particularly suited to act as a standard of deferred payments for several reasons: its value remains relatively constant over time, it is generally accepted by all parties in a contract, and it is significantly more durable when compared to physical goods that might be used in a barter-style credit arrangement.

The Process of Credit Creation by Commercial Banks

Money creation, also known as deposit creation or credit creation, is a primary function of commercial banks. The total amount of money a bank can create is determined by two main factors: the amount of the initial fresh deposit and the Legal Reserve Ratio ($LRR$). The $LRR$ is the minimum ratio of deposits that banks are legally required to keep as cash. This ratio includes the Cash Reserve Ratio ($CRR$). The process operates on the assumption that money lent out by banks is used for payments, and those who receive these payments will eventually deposit that money back into the banking system.

To illustrate this with a numerical example, consider a scenario where the $LRR$ is set at $20\%$ and there is an initial fresh deposit of $Rs.\,10000$. According to the legal requirement, the bank must keep $20\%$ of this deposit as cash, which amounts to $Rs.\,2000$. The bank then lends the remaining $80\%$, which is $Rs.\,8000$, to borrowers. These borrowers use the funds to make payments, and the recipients of those payments deposit the money back into the bank.

In the second round, the bank receives a fresh deposit of $Rs.\,8000$. It again keeps $20\%$ as reserve ($Rs.\,1600$) and lends out the remaining $80\%$ ($Rs.\,6400$). In the third round, the $Rs.\,6400$ is deposited back, the bank keeps $20\%$ ($Rs.\,1280$) and lends out $Rs.\,5120$. This cycle continues until the initial deposit has been multiplied throughout the system. Ultimately, the total money created from the initial $Rs.\,10000$ deposit reaches $Rs.\,50000$. This indicates that the total deposits become five times the initial deposit, where five is the value of the Money Multiplier.

Mathematical Calculation of Money Expansion

The relationship between the initial deposit, the legal reserve ratio, and the final money creation is captured through the Money Multiplier formula. The Money Multiplier (or Deposit Multiplier) measures the amount of money banks can create in the form of deposits for every unit of money kept as reserves.

The formulas are as follows:

$\text{Money Multiplier} = \frac{1}{LRR}$

$\text{Total Money Creation} = \text{Initial Deposit} \times \text{Money Multiplier}$

Using the previous example values:

$\text{Money Multiplier} = \frac{1}{20/100} = \frac{1}{0.20} = 5$

$\text{Total Money Creation} = 10000 \times 5 = 50000$

The following table summarizes the rounds of credit creation:

• Round 1: Deposit = $Rs.\,10000$, Loans = $Rs.\,8000$, LRR ($20\%$) = $Rs.\,2000$
• Round 2: Deposit = $Rs.\,8000$, Loans = $Rs.\,6400$, LRR ($20\%$) = $Rs.\,1600$
• Round 3: Deposit = $Rs.\,6400$, Loans = $Rs.\,5120$, LRR ($20\%$) = $Rs.\,1280$
• Total: Deposit = $Rs.\,50000$, Loans = $Rs.\,40000$, LRR ($20\%$) = $Rs.\,10000$

Functions of the Central Bank: Currency Authority and Supervision

The Central Bank, such as the Reserve Bank of India ($RBI$), performs several critical functions for the economy. The first is its role as the Currency Authority or Bank of Note Issue. The Central Bank holds the sole authority to issue currency within the country. There are several advantages to having a single authority for note issue: it ensures uniformity in note circulation, allows for better supervision and control of the monetary system, makes it easier to control credit levels, ensures public faith in the currency, and helps stabilize both the internal and external value of the currency.

Additionally, the Central Bank serves as the Banker's Bank and Supervisor. It acts in three capacities in this role. As a supervisor, it serves as the agency required to regulate and supervise the proper functioning of commercial banks. The $RBI$ regulates and controls the commercial banks to ensure they adhere to policy guidelines and maintain financial stability within the banking sector.