Economics Chapter 1.3 – Money and Banking

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Chapter 1.3 – Money and Banking

Economics Chapter 1.3 – Money and Banking

1. Introduction to Money

  • Role of Money:
    • Money serves as a medium of exchange that facilitates transactions in an economy. It eliminates the need for the barter system, which relies on the improbable coincidence of wants. For instance, someone with excess rice wanting clothes would struggle to find someone with clothes needing rice. Money, as a universal medium of exchange, resolves this.
    • Money also plays multiple roles beyond facilitating transactions:
      • Unit of Account: It allows for the standard measurement of value for goods and services. For example, expressing the value of a wristwatch as Rs 500 simplifies comparison with other goods, like a pencil costing Rs 2.
      • Store of Value: Money allows individuals to store wealth conveniently, unlike perishable goods like rice. Money does not deteriorate and is more efficient for long-term storage of value.
      • Standard of Deferred Payment: It enables future settlements, like loans and credits, ensuring stable transactions over time.

2. Functions of Money

  • Medium of Exchange:
    • The principal function of money is to facilitate exchange, preventing the inefficiencies of the barter system.
  • Unit of Account:
    • Money acts as a common measure to value goods and services. For instance, pricing goods in terms of rupees standardizes their worth and helps in economic planning and budgeting.
  • Store of Value:
    • Money retains its value over time, making it a useful tool for storing wealth. However, this function is most effective when the value of money is stable, as inflation can erode purchasing power.

3. Demand for Money

  • Transaction Motive:
    • The demand for money is largely driven by its necessity for day-to-day transactions. The higher the income and transactions in an economy, the greater the demand for money.
    • For instance, an individual earning Rs 100 may require a cash balance of Rs 50 for their monthly transactions, assuming they evenly spend their earnings.
  • Speculative Motive:
    • Money is also demanded for speculative purposes. People might hold money instead of other assets (like bonds) if they anticipate future changes in interest rates or bond prices. If bond prices are expected to fall (causing capital losses), individuals prefer to hold money.

4. Supply of Money

  • Components of Money Supply:
    • Money supply includes currency (notes and coins) issued by the central bank and demand deposits held in banks.
    • Narrow Money (M1): Currency plus demand deposits.
    • Broad Money (M3): Includes M1 plus time deposits of commercial banks, which are less liquid.
  • Central Bank’s Role:
    • The central bank controls the supply of money through monetary policies such as setting the Cash Reserve Ratio (CRR), conducting open market operations, and adjusting the bank rate.

5. Commercial Banking and Money Creation

  • Role of Commercial Banks:
    • Commercial banks accept deposits from the public and lend these funds, creating money in the process. For example, when a bank receives a deposit of Rs 100 and lends out Rs 80, it effectively increases the total money supply.
  • Money Multiplier:
    • The money multiplier describes how banks can expand the money supply. If the reserve ratio is 20%, a deposit of Rs 100 can lead to a total of Rs 500 in money supply through successive rounds of lending.

6. Money Creation Process

  • Example of Money Creation:
    • When a bank lends money to a borrower, it creates a new deposit account for the borrower. This increases the overall money supply, as both the original deposit and the loaned amount are available for transactions.
    • The process continues as loans are redeposited, further increasing the money supply.
  • Limits to Credit Creation:
    • The central bank controls the money creation process by setting reserve requirements (CRR) and using other monetary tools to regulate the amount of credit banks can create.

7. Monetary Policy and Tools

  • Quantitative Tools:
    • The central bank uses quantitative tools like CRR, Statutory Liquidity Ratio (SLR), and the bank rate to control the money supply. For instance, increasing the CRR forces banks to hold more reserves, limiting their ability to lend.
    • Open Market Operations: The central bank buys and sells government securities in the open market to influence the money supply. When it buys securities, money enters the economy, and when it sells, money is withdrawn.
  • Qualitative Tools:
    • The central bank also uses qualitative tools, like moral suasion (persuading banks to limit or expand lending) and setting margin requirements on loans to control specific sectors of the economy.

8. Role of Interest Rates in Money Supply

  • Repo and Reverse Repo:
    • The repo rate is the interest rate at which the central bank lends money to commercial banks, while the reverse repo rate is the rate at which it borrows from them. These rates influence the money supply by making it easier or harder for banks to access funds.
  • Liquidity Trap:
    • In extreme situations, when interest rates are very low, additional increases in the money supply may not lower rates further. People hold onto cash instead of investing in bonds, which leads to a situation known as a liquidity trap.

9. Measures of Money Supply

  • M1, M2, M3, and M4:
    • Money supply is measured using different aggregates:
      • M1: Narrow money, including currency and demand deposits.
      • M2: M1 plus savings deposits with post offices.
      • M3: M1 plus time deposits (broad money).
      • M4: M3 plus total deposits with post office savings (excluding National Savings Certificates).
  • Money Multiplier:
    • The ratio of the total money supply to high-powered money (reserves plus currency). A larger money multiplier indicates that a given amount of reserves supports a larger money supply.

10. Government Policies on Currency

  • Demonetisation:

In 2016, the Indian government demonetized Rs 500 and Rs 1000 notes to tackle corruption and black money. This policy aimed to bring more people into the formal economy and increase tax compliance, though it initially led to cash shortages.

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