CHAPTER TWO

MONEY AND BANKING

Definition of Money:

Money is anything, which is widely accepted as the payment for goods or

in discharge of other kinds of business obligation. However, the most
common definition of money is as follow:-

Money is a means of valuation and of payment; as both the unit of

account and the generally acceptable medium of exchange. Money can
also be defined as anything that is generally acceptable as a means of
exchange and at the same time acts as a measure and store of value. It
should be declared as a legal tender by the State.

Functions of Money:

Money is unique in that by itself, it can produce nothing useful, but it has
a very high indirect productivity owing to its ability to facilitate exchange
and specialization. The fundamental purpose of money is, therefore, to
facilitate exchange.

Primary Function:

Money performs its function as the great wheel of circulation, the great
instrument of commerce by performing two primary functions.

a. Money is significant as a medium of exchange:

It generalizes the purchasing power. Money facilitates trade by serving as

a medium of exchange. In a barter economy rates of exchange fixed by
custom and rigid convention, cannot go together with economic progress.
Whereas barter requires coincidence of wants and is tolerable only when
exchange is small. It can be said that, "to be given money in exchange is
to receive the magic thing, which can be turned into any of the manifold
things which money will buy."

b. Money serves as a standard of value and exchange:

Money enables us to measure in quantitative terms the value of economic goods.

We express the value of everything in terms of the monetary units. In a money
economy, it is a simple matter to ascertain the relative exchange values of goods
by comparing their market prices in terms of monetary units.

In addition to the above two functions money performs, two derivative or

subsidiary functions:

1. Money facilitates transactions over time: It serves as a standard for

deferred payments. Lending and borrowing are common in any economy.
These contracts are entered in terms of money. This is because money is a
commodity, which will keep its value stable over a reasonable period.
Money is a standard in which present and future obligation or borrowing
and lending is expressed.

2. Money Acts as a store of Value:

This function of money enables an individual to save a part of his current

income and store it in the form of money. In the absence of 510ney, wealth will
have to be stored in the form of commodities, most of which are perishable and
are liable to lose value in the course of time. Money is expected to maintain its
value stable over a reasonable period of time and therefore, serves as a very
convenient means of storing wealth.This function of money may also be called
as the liquidity function of money.

3. Money Serves as a Unit of Account:

In this form it is not as to display the abstract side of money. The expression
means that we can express the value of every thing in the same terms i.e. the
monetary unit.

Significance of money:

EconomicAdvancement

The economic development of present times is the cause of

money. It serves not only as a medium of exchange and as a
measure of value, but it facilitates maximum production and
consumption. “Money IS the pivot around which economic
science cluster” Money has Influenced production, consumption,
exchange distribution and public finance.

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 1. Production:

The expanding demand of consumers are being easily met by mass

production which is possible with division of labour takes place only
with a medium of exchange. A large number of organizations,
production facilities, labour specialization and determination of prices
all is possible with money.Banking system was evolved only due to
money which attracts savings to a pool from where a large number of
production units ate financially assisted. The depositors get interest for
the deposited money and producers get sufficient capital for production.

2. Consumption

Money ensures each member of the society to get maximum satisfaction from I
ts available resources. The existence of monetary economy helps society to
discover what people want and how much they want It to help decide what
should be produced and in what quantities and to make best of Its limited
productive power. Money serves as a medium of exchange a measure of value, a
store of value and as standard for deferred Wages, salaries and other returns to
several factors are evaluated and paid in money. Workers are free to choose any
occupation based on their reward. The planning authorities also frame their
plans in terms of money.
Savings, investments, loan payment receipts etc. are also made in form of
money.
Type of Money:

The classification of money into it's various forms is an interesting problem

but is complicated due to the fact that many kinds of money which may be
enumerated as below, are not found in practice.

1. Commodity money:
It is that money which is universally acceptable within a given
political area, without special arrangements: In the early stages, it
took the form of commodities like grains, cattle etc. later on
precious metal like gold and silver and then paper came to be used
as money. The commodity money can be either full-bodied money
or token money. A full-bodied money is one whose value (Face
value) is not materially greater than the value of the material of
which it is composed up of (Intrinsic value). Token money, on the
other hand, is one whose face value is materially greater than the
intrinsic value. When full-bodied money circulates, there is a
 necessity for token currencies of lower denomination also to
circulate side by side, to facilitate small transactions. One
characteristic feature of token money is that it is a limited legal
tender. Full-bodied money and the token money can collectively be
known as the money proper because it is the money that is issued by
the State and is the legal tender, the acceptance of which is
enforceable by law.

2. Money on Account:
Money on account is that in which rates, general purchasing power
and prices are expressed, i.e, a medium through which all
transactions are expressed.

3. Representative Money:
It is that type of money, which possesses no or very low intrinsic
value but are accepted as money because they represent it e.g.
paper currency. Representative money can be of two kinds:
Convertible and inconvertible currency. Convertible currency is
backed by 100% metallic reserve. The State guarantees the
convertibility into equivalent value of gold or silver. Inconvertible
paper currencies cannot be converted into gold or silver but still
circulate and a responsible government regulates command value
since their issue.

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4. Flat Money:

It is representative money in that its intrinsic value is divorced from its monetary face
value. It is created and issued by the State but is not convertible by law into anything
other than itself and has no fixed value in terms of an objective value. It is usually
issued during war. Another form of fiat money is managed money. In this casa the
State undertakes to manage the condition of its issue in such a way that by
convertibility or otherwise it shall have a determinate value in terms of an objective
standard.

Evils of Money

1. Economic Evils:

Economic evils are pertaining to evils of financial and economic activities.

a) Value of Money: The value of money does not remain stable. It

changes from time to time. Sometimes a violent fluctuation
occurs in the value of money, which benefits one section of the
society at the cost of others. Trade and commerce are adversely
affected by such changes. When money in circulation is more
than the value of production, prices increase. This inflationary
trend continues until the production in adequately increased.
Sometimes, inflationary situation becomes intolerable-
Common men and persons of fixed earnings suffer a lot.
Similarly, when prices go down, lower than a standard level,
industry and trade suffers tremendously. Inadequate capital and
losses force the industries to close down.

b) Increase in unmanageable credit: Credit is a source of

advancement but increases in volume of credit above a certain
level is unmanageable. It causes inflation and the society
suffers from it. The excess credit causes displacement of
internal equilibrium so the government may take over the
control.
c) Class conflicts: Money makes a man greedy. If some persons gain,
the others suffer. The class conflict, thus, arises and labour, in most
of the cases, suffers.

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 d) Unequal distribution: Money causes unequal distribution of the
product. It leads to concentration of wealth in few hands. They do not
use it for more production and the money in their hands is wasted.

e) Trade Cycles: Sometimes, production becomes more than required or

production goes down because demand is minimized. Depression
and inflation are the two extreme points of trade cycle where the
society suffers.

f) Dangerous situation: Sometimes the willingness of the people is

adversely affected when there is no progress. Progressive prospective
saving is minimized thus, the investment and capital is reduced,
which causes lesser production in the society.

Thus the economic evils, mostly results due to unplanned supply of money and
creation of credit. It means the government must be careful in issuing currency
notes, credit and money expansion should be controlled and restrained. There
should be a pre-planning to supply the quantity of money.

2. Social Evils:

a. Symbols of Repute: Today the person who has money is well

regarded by the members of society; this is the reason why one person
tries to topple down the other person.

b. Enemity: It is money material, which instigates enemity between real

brothers. Relation and the closest friends become enemy because of
wealth.

c. Exploitation: It has been rightly pointed out that money causes

exploitation because capitalist to gain maximum profit or surplus-
values, pays less to the labour.

d. Social Crime: Greedy person avoid taxation. They try to accumulate

money as much as possible by this or that means.

3. Moral Evils:

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Robbery, murder, thefts etc. are the various moral evils, which occur
due to the illusions of money. An officer becomes corrupt and politics
becomes contemptuous due to money. Moral values are weighed on
money scale. Religion, politics, domestic systems etc. are not credited
on merit and happiness but on basis on money. Money minded people
might not be happier.

Qualities of Good Money:

Good money not only facilitates the working of the economic system,
but also acts as a conducive factor for promoting economic growth. In
order to discharge the essential functions expected of it money should
possess certain qualities, which are given below:

i. Cognisability :- The material with which money is made must

be instantly recognizable and distinguishable from other
materials whether by eye, ear or touch, for eg. the milled edge if
they are coins and the water mark if they are notes. This is
essential if Counterfeiting is to be made difficult. In this respect,
their distinctive features can easily recognize gold and silver.

ii. Utility:- The material of which the money is made up of should

have the capability to satisfy the desire of individuals as
material.

iii. Portability:- The portability of money is an important quality

not merely because it enables the owner to carry small sums in
the pockets without trouble but because large sums can be
transferred from place to place or from continent to continent at
little cost. The material should not be heavy. In order to be
portable a thing must possess more value in small size

iv. Divisibility: All units of the same metal/material which works as money must
be capable of division without difficulty so that all pieces of whatever value
are of uniform quality and value as material in proportion to their weight. It
should maintain the utility even on being divided into fractional portions.

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 v. Indestructibility: The material which is considered as money does not
deteriorate itself or perish as a result of wear and tear. It should be capable of
retaining its value through time because it represents a store of value.

vi. Stability: The value of money should remain stable. Stability of value means
that there should be relatively less fluctuation in the value of money.
Commodities, which are subject to violent fluctuation, or changes in supply
and demand are useless as money. Moreover, if the value is unstable the
material may not be accepted as money at all.
vii. Homogeneity: All units of the same material, which works as money, must
be as nearly as possible of the same quality throughout. If the material content
of the currency differs, they cease to be generally acceptable and cease to be
money.
viii. Acceptability: The most essential feature of money is that is should be
generally acceptable by all in the country. This the basic and fundamental
quality which money must possess but for which it will lose significance.

ix. Malleability : The material which is to work as money must be capable of

being easily remitted without loss. It must also be such that as can be melted
and molded in an) form.

x. Scarcity:- The material which is considered as money) should be scarce i.e, it

should not be abundantly and freely available. This is so because anything
that is scarce valued when it is in high demand.

xi. Counterfeit: - The unit of money should not be easily

reproduced. T is to ensure that forgeries or counterfeit
currency is minimized.

The Value of Money

The value of money means the number of things, in general that can
be purchased with a given unit of money;- The value of money may
be referred to as its income value, or its transaction value. Income
value refers to the value of money in terms of all the goods and
services which enter into final consumption. Transaction value refers
to the value of money in terms of all the goods and services of

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whatever kind which are exchanged by itself. However, there is
another concept in which value of money may be understood in terms
of the value of labour of a given quality which a unit of money will
command. This is the labour value of money.

Determining the Value Money

The value of money is affected by the following factor:-

1. The total effective demand on all the markets of the economy.

2. The amount of different goods, which can be purchased with a given amount of
money.

3. The flow of money in the market during a given period or the stock of money in
existence at a given point of time.

4. An individual demand for money, which consists of the real aggregate value in
terms of the goods and services in which he is interested as a consumer of his
money income.
5. The communities demand for money, which is the sum of demands of
individuals who compose it.

Quantity Theory of Money

The object of the quantity theory is to explain the causes at

determine the exchange value of money or the general level of
prices according to the standard considered. According to this
theory, it is the quantity of money of all kinds that is primary
importance in determining the value of money. It is often stated that
the general level of price varies directly with the quantity of money
and the velocity of money and inversely with the volume of goods
and services to be purchased with money. Any variation of the price
level may be traceable t changes in any one or more of these factors.
It is maintained that, if one wants to know the price level one has
simply to divide the total supply of money by the total amount of
goods and services, which he calls total transactions. According to
the quantity theory, "If the quantity of money in circulation doubles
then the price level also doubles and the value of money is reduced
to one-half. On the other hand if the quantity of money in circulation

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 is halved, the general price level reduces to one half and the value of
money doubles itself."

In the simplest form, the equation was introduced as:-

Where:- P stands for general price level.

M- Signifies the total quantity of money in circulation.
T -Total transactions
V- Velocity of money

Later on it was observed that the total supply of money di not only consist of total
currency and paper notes but also credit money. The second form of money called
credit money is symbolized as 'Ml.' It was further observed that the actual money in
circulation was not only "M and M " but its velocity circulation as well. On this, the
improved formula is given as-

It must be remembered, however, that though "M" "V" an "T" are generously
granted the status of direct or immediate determinant, they are in no way the
ultimate determinants price level.

Assumptions of the Theory:

In order to explain this theory certain assumptions were made like

Other things being equal. The other assumptions are:-

1. "V" and "T" are independent factors. "V" depends on habits

and customs of people to spend. Since the spending of to
money depends on the standard of living and since the
standard of living cannot change immediately the habit of
the people to spend will also remain the same. 'IT" is an

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 independent factor because whenever the supply of money
increases the total amount of goods and services will not
increase immediately. Moreover, the techniques of
production and other factors, which affect the volume of
trade, are assumed to have no direct bearing on the volume
of trade.
2. P is a passive factor. According to the monetarists, 'P' is a
factor which is determined by other factors and not the one
which in anyway influences them. Accordingly "P" will
change only when "M" changes and in exact portion with
3. "V" and "T" are not variable in the long run. It is pointed
out that although there might be some fluctuations in "V
and T" in the short period, but in the long period such
changes will become normal and can be approximately
taken to be stable.

4. Full employment of all the resources. It is also assumed that

all the factors are fully employed in the sense that all the
units of money and the unit of goods and services are
brought to the market for exchange. This means that people
do not hold money or keep away some stock of goods and
services.

Apart from the above assumptions, two additional hypotheses were

introduced. First, that there exists a very stable relationship between
the primary money people carry in their pockets the amount of liquid
means they keep on checking accounts. Second, that in equilibrium
and for periods that are not too long, there exists a very stable
relation between the reserves of banking system and sum total of
checking deposit

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Criticism of the equation:

The monetary equation has been criticized on various grounds:

1. It is argued that all the assumptions of the equation of exchange are

unrealistic.

2. The relationship between price and other factors are not clear enough to
substantiate the conclusion.

3. In the equation 'P' and 'T' lack significance.

4. There is no consistency in the use of M and V.

5. The theory is nothing but an identity as it has been a said that, the
quantity equations themselves are nothing, more or less than shorthand
expression designed to indicate the nature of variables whose operation
can be shown to influence prices.

6. The equation of exchange ignores all factors except money

7. No distinction is made between consumer and capital goods.

8. The distinction between wholesale and retail price is vague

9. The theory may not work in practice.

The Economic Effects of a Prolonged Fall in the Value of Money:

the value of money varies inversely with the level of prices Therefore, the
rate of change in the value of money may measure by changes in the general
level of prices as indicated by the General Index of the Retail Prices.

A. Firstly Inflation May be the Result of a Situation of Excess Aggregate

Demand Leading to a rise in prices

Domestic Effects:
1. Profits will improve since the cost of raw materials will be relatively
fixed for at least a time.
2. Production will be stimulated. Businessmen will be encouraged to
increase production further.
3. There will be a tendency for prices to rise faster than output.
Therefore, stocks will tend to run down and bottlenecks
appear.
4. There will be a considerable and growing demand for labor.
Employment will be at a high level and unemployment low.
The number of unfilled vacancies will tend to be
particularly high in the skilled trades necessary to support
higher output.
5. There will be pressure for increased wages, together with
evidence of 'wage drift' i.e. narrower differentials for extra
responsibility.
6. The high level of production and employment will
influence an arbitrary redistribution of the National Income.

a. People with fixed income will be worse off.

b. Other individuals and groups, with strong bargaining

power, some wage earners and business owners, may be
able to secure temporary or permanent increase in real
income by keeping their earnings rising at a faster rate than
prices.

7. The redistribution of income will influence people's attitude

to borrowing, lending, saving and investment.
a. All borrowers with debts fixed in money terms i.e.
house mortgages; tend to gain in real terms
compared with lenders.

b. The real value of fixed money contracts declines.

c. The real value of saving declines.

d. Fixed-interest securities appear relatively less

attractive than equities.

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 e. There is some reduction of the burden of the National
Debt- a smaller proportion of real resources is needed to
pay the interest on this debt.

The external effects of inflation upon a country will partly depend

on conditions in other countries. If other countries have less
inflation or if they control it better, then

1. Exports will tend to fall.

2. Imports will tend to rise - both to meet domestic consumption

needs and to meet the demand for raw materials.

3. The balance of payment will become unfavorable.

Effects through action taken by the Government action will have to be

taken by government to check inflation by:

1. Direct controls over prices and incomes

OR
2. Checking demand by restricting the money supply

AND/OR

3. Increased taxation

B. SECONDLY, INFLATION MAY BE THE RESULT OF RISING

COSTS IN RAW MATERIALS OR OTHER FACTORS OF
PRODUCTION WHICH LEAD TO HIGHER PRICES

1.
Domestic Effects:

2. There will be higher wage claims by workers seeking to maintain living

standards. This leads to a cycle of cost-push inflation.
3. uncertainty will be created and Confidence reduced

4. Profits will be squeezed.

 5. Firms will experience cash shortage until higher costs can be passed on in
the form of higher prices.
6. Inflation and unemployment may rise together.

The effects on the distribution of income and the external effects are similar to the
effects of demand-pull inflation.

In both types, inflation at a rapid rate will eventually threaten the stability of the
currency and the economy as a whole.

BANKING:
Central Bank:

A central bank is so called because it occupies a central pivotal position in the

monetary and banking system in the country in which it operates. A Central
bank is known by the functions it performs. It is vested with the authority to
exercise special powers which other baking institutions do not possess or
possess to a limited extent.. The Central Bank is empowered to influence
monetary and credit conditions and development.

Functions of Central Banks:

A clearly defined concept has been evolved. A central bank being generally
recognized as a bank which constitutes the apex of the monetary and banking
structure of its country and which performs, as best it can in the national
interest, the following functions:

1. The regulation of currency in accordance with the require

ment of the business and the public for which purpose it is
granted the sole right of currency issue.
2. Banker, advisor and agent to the government,
3. Bankers bank-as custodian to their cash reserves.

4. Custodian of the national reserves of International Currency.

5. As the bank of re-discounting and the Lender of the last resort.

6. International clearing house facility.

 7. Controller of Credit.

8. Regulator of balance of payment situation.

Credit Control by Central Bank:

The Central Bank generally operates the currency and credit system of a country to
its advantage. The methods that may be adopted by a Central Bank to control credit
in an economy is as follows:

1. Quantitative or Traditional Control Method:

(a) Altering the Statutory reserve ratio. The lowering or raising of

the minimum cash reserve to be maintained by the commercial
bank is a means of enabling a Central Bank to expand or contract
their capacity to create credit.

(b) Bank Rate or discount rate policy. The lowering or raising of the
discount and interest rate with a view to lowering or raising rates
and encouraging the expansion or contraction of credit.

(c) Open market operation. The buying or selling of security in the

open market with a view of putting additional funds into the
market or withdrawing fund therefrom and thus expanding or
contracting credit.

2. Qualitative or Selective Controls:

(a) Regulation of margin requirements:- The imposition of minimum reserve

requirements to be maintained by the Commercial Bank in the
form of government security and other specified assets, in order
to restrict their capacity to expand credit for general business
purposes.

(b) Regulation of consumer credit:- The regulation of terms and condition

under which credit repayable in instalments may be granted
on purchasing or carrying consumers durable goods as a
means of exercising some direct control over the volume of
outstanding consumer credit.
 (c) Control through directives:- The regulation of margin
requirements in connection with purchases of stock exchange
security, as an instrument for exercising some direct control
over the volume of credit used in the security market.

(d) Moralsuation:- The use of moralsuation to achieve the desired

objectives.

(e) Rationing of credit:- It is an alternative or an additional

method of raising discount and receipts.

(f) Direct action:- It is either in the form of coercive measures

against any offending bank or financial institutions or in the
form of directives to banks generally concerning their lending
and investment operations in order to assist the Central Bank
in controlling the quantity of credit as well as securing a better
qualitative distribution of credit.

(g) Publicity:- The publication of a definite monetary program to

enable the general public to anticipate future developments
and to enter into future commitments with more confidence.

DIFFICULTIES IN THE WAY OF A CENTRAL BANK CON.

TROLLING CREDIT

The Control of Credit is widely recognized as the main function of a central

Bank. However, there are serious difficulties in the way of achieving
control over credit. In the first place there are difficulties in the way of
controlling credit itself. Secondly, even if the bank is able to control the
volume of credit, the objectives concerned may not be necessarily
achieved.

Several difficulties in the way controlling credit are-

Firstly, bank credit is not the only form of credit. There is commercial credit like
book credit, bills of exchange and promissory notes; over this, the Central Bank
has little control. They have as much purchasing power as any other form of
credit.
Secondly, even as regards bank credit, in the U.S.A. for instance, one-half of the
Commercial banks are outside the Federal Reserve System.

Thirdly, even if all banks are member banks may not always cooperate with the
Central Bank and may not follow its lead.

Fourthly, the Central Bank cannot control the ultimate use to which credit may be
put.

This however, does not mean that any attempt to control credit on the part of the
central bank is bound to fail. The actions of the central bank is subjected to these
limitations.

Even if the Central Bank can control credit, it does not necessarily follow that the
objectives of the bank like price stability, exchange stability etc., will
automatically follow.

Functions of a Commercial Bank

Modern Commercial banks perform a number of functions and render a number

of services to the industrialist, the businessman, a trader and even a common
man. These functions and services rendered by banks can be broadly classified
under two heads

a. Banking function

b. Subsidiary or agency function.

FUNCTIONS OF A COMMERCIAL BANK

Banking functions, Subsidiary functions

1. Attraction of deposits
2. Advancing loan. Agency function General
utility services
3. Creation of money 1. Safe deposits
4. Clearing cheques Collection of 2. Issuing letter
of Credit.
5. Financing foreign cheques, Bills, 3. Underwriting
loans
Currency. promissory notes, raised by Government.
Dividends, interest 4. Collection and distribution