Money and Banking

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 Money and Banking

Anything which is used as a medium of exchange, store of value, measure of value and standard of deferred payments is called money.

Barter System of Exchange – It is a system in which goods are exchanged for goods. Direct exchange of goods against goods without use of money is called barter system. It is also called C – C Economy.

Drawbacks:


(i) It requires double coincidence of wants which is hard to find.

(ii) It lacks a common unit of exchange.

(iii) It lacks the system of future payments or deferred payments.

(iv) It lacks the system of storage and transfer of value.

  Function of Money

 Money as the Medium of Exchange – Money came into use to remove the inconveniences of barter system. Money as medium of exchange has solved this problem as money has separated the act of purchase from sale. A money system is of greater utility of human being. Money is also called generalized purchasing power because it provides freedom of choice to buy things he wants most from those who offer best bargain.

 Money as a Unit of Account – The unit of account function means that money unit is treated as the standard unit for quoting prices and for borrowing and lending activities. Different goods produced in the country are measured in different units, e.g., cloth in metres, milk in litres, rice in kilograms.

 Money as the Standard of Deferred Payments – Deferred payments are payments are payments which are contracted to be made sometime in future. Loans are taken and repaid in terms of money.

 Money as a Store of Value – It means money can be stored for use in future. It serves as a store value of goods in liquid form.

Supply of Money

       Supply of money is a stock concept. It refers to total stock of money held by the people of a country at a point of time.

Measurement of Money Supply

M1=C+DD+OD

Where C = Currency held by public

DD = Net demand deposits of commercial banks

OD = Other deposits with RBI


COMMERCIAL BANK

                         A Commercial bank is a financial institution which performs the functions of accepting deposits from the public and advancing loans. The Bank acts as an intermediary between those who have surplus money and those who are in need of money.

Functions of commercial banks

 Accepting deposits – A commercial bank accepts deposits in the form of current, saving and fixed deposits. It collects the surplus balance of the individuals and firms and finances the temporary needs of commercial transactions. The first task is, therefore, the collecting of the savings of the public. This the bank does by accepting deposits from its customers. Deposits are lifeline of banks.

 Advancing loans – The second major function of a commercial bank is to provide loans and advances particularly to businessmen and entrepreneurs and thereby earn interest. This is, in fact, the main source of income of the bank.

Process of  Credit Creation by Commercial Banks

The Process of Credit Creation is Based on the following Assumptions 

(a) The entire commercial banking system is a single unit i. e., bank

(b) All transactions in the are routed through bank only

Credit Creation is Determined by

(i) Initial Deposit Or Primary Deposits

(ii) Legal Reserve Ratio(LRR) - The RBI decides a certain percentage of net total demand and time deposits which every bank must keep as reserves, called LRR. 

LRR has two components - Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) 

Credit Creation = Initial Deposits x1/ LRR

Numerical Example:

 Let the Legal Reserve Ratio (LRR) be 10% and Primary deposits = ₹1000 crore. The amount required to keep as reserves by the banks = 20% of ₹1000 crore = 100 crore. The banks lend the remaining funds ₹900 crore. People who borrow, use this money for making payments to others. Since all the transactions are routed through the banks, the money spent by the borrowers for making payments comes back into the banks into the deposit accounts of those who have received these payments. This increases deposits in banks by ₹900 crore, which is 80% of the primary deposits. These secondary deposits of 900 crore have resulted on account of loans (credit) given by the banks. In this sense, the banks are responsible for credit creation. With this round, total deposits is now ₹1900 crore (= 1000 crore +900 crore).

When banks receive new deposits of ₹900 crore, they keep 90 crore (i.e. 10% of new deposits) as reserves and use the remaining 810 crore for giving loans. The borrowers use these loans for making payments. The money comes back into the accounts of those who have received the payments. Bank deposits again increase, but by a smaller amount of 2710 crore. It is 80% of the lan deposit creation. The total deposits now increase to ₹2710 crore (=₹1000 crore + ₹900crore +810 crore). The process does not end here. The deposit creation continues in the above manner. The deposits go on increasing round after round but each time only 90% of the last round deposits. At the same time, reserves go on increasing, each time 90% of the reserves. 



CENTRAL BANK

Central Bank is the monetary authority of a country. It controls, regulates and supervises all the monetary institutions. The name of the Central bank in India is Reserve Bank of India (RBI). It was established in 1935.

Functions of Central Bank

 Issue of Currency – The central bank is the sole authority for the issue of currency in the country. Notes issued by it are circulated as legal tender money. It has its issue department which issues notes and coins.

 Banker to the Government – It is a banker, agent and financial advisor to the government. As a banker to the government, it manages accounts of the government banks across all in the country. As an agent to the government, it buys and sells securities, treasury bills on the behalf of the government. As an advisor to the government, it keeps the government in framing policies to regulate the money market.

 Lender of the last resort – It acts as a lender of the last resort for commercial banks. When commercial banks fail to meet obligations of their deposits, the central bank comes to their rescue.

 Bankers’ Bank and supervisor:

All the commercial banks have to keep some percentage of their deposits with the RBI. This is called Cash Reserve Ratio (CRR). The central Bank gives licences to start commercial banks, inspects the work of commercial banks periodically and sometimes asks the banks to wind up. Every commercial bank is required to maintain a fixed percentage of its deposits in the form of cash with itself. This is called Statutory Liquidity Ratio. RBI fixes SLR.

Monetary Policies used to check Credit Creation

  • Quantitative Instruments:
    These affect the overall volume of credit in the economy. 
  • Bank Rate: The interest rate at which commercial banks borrow money from the RBI. 
  • Repo Rate: The rate at which commercial banks can borrow from the RBI against government securities. 
  • Reverse Repo Rate: The rate at which commercial banks can lend to the RBI against government securities. 
  • Open Market Operations: The buying and selling of government securities by the RBI to influence the money supply. 
  • Cash Reserve Ratio (CRR): The percentage of a bank's deposits that it must keep with the RBI. 
  • Statutory Liquidity Ratio (SLR): The percentage of a bank's deposits that it must hold in liquid assets. 
  • Qualitative Instruments:
  • These focus on the direction of credit, influencing where it goes and what it's used for. 
  • Margin Requirements: The percentage of a loan that a borrower must pay upfront. 
  • Credit Rationing: Limiting the amount of credit available for specific sectors. 
  • Moral Suasion: Encouraging banks to follow the RBI's guidelines through persuasion. 

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