MONEY & BANKING

BY
ASHA M K

P G T ECONOMICS
I E S PUBLIC SCHOOL
MONEY
 Money is what money does.

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 is a system in which goods
and services are exchanged for other goods
and services.

COMMODITY – COMMODITY ECONOMY

NON MONETARY SYSTEM OF EXCHANGE

 MONEY SUPPLY

Money supply refers to the total amount of

money which is in circulation in an economy at a given

point of time.
 Components of Money Supply
M1 = Currency + Net Demand Deposits with
Banks + Other Deposits with RBI.

M2 = M1 + Post Office Savings Deposits

M3 = M1 + Time Deposits with Commercial Banks

M4 = M3 + Post Office Savings Deposits

 Factors that determine the Money Supply

(i) Monetary Policy: It is one of the most

important determinants of money supply. The dear
money policy leads to the decline in the money supply
and cheap money policy leads to increase in money
supply
 (ii) Policy of commercial Banks
If commercial Banks lend more, it will
lead to increase in money supply. Lending activity of
the Commercial Banks is determined by the cash
reserve ratio.
 (iii) Fiscal Policy of the Government
If the Government spends more, money supply will
increase and vice versa. Deficit financing leads to
increase in money supply.
 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.
 Types of deposits held by the Commercial Banks
a) Current account deposits: The depositor can
withdraw his money at any time. Cheque facility
is provided to the depositor. The Bank does not
pay any interest.

b) Saving Account deposits: The depositor can

withdraw his money at any time. However, the bank
may impose some restrictions on withdrawal. Interest
rate is low when compared to time deposits. The
purpose of this deposit is to encourage small savings.
c) Fixed or Time Deposits: Money is deposited for a
fixed period of time. The depositor can withdraw
money only after completing that term. Interest rate
is high.
d) Recurring Deposit: It aims at encouraging regular
savings by the people. The depositor can deposit
money in installments for a given period of time.
Withdrawal can be done only after completing the
term.
 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 the Central Bank (RBI)
Issue of currency
The Central Bank alone can issue
currency notes in India.
Coins and one rupee notes are printed by the
Government. The RBI will put them into circulation.
All other currency notes are printed and issued by RBI.
India follows minimum reserve system. RBI has to
maintain gold and foreign exchange reserves of `200
crores out of which ` 115 crores should be gold.
(ii) Banker to the government
The Central Bank receives and makes all the payments
on behalf of the government. It is called “the ways
and means loans”.
The Central Bank manages public debt. The Central
bank has to manage all issues connected with public
debt.
The Central Bank advises the government on banking
and financial matters.
The government keeps its balances in the current
account of the RBI.
(iii) 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.
Lender of the Last Resort:-
When the Commercial Banks are in financial

difficulties, they can get loans from the RBI. They can

approach the RBI with discounted bills. RBI will

rediscount them and advance loans.

(v) Clearing house function

Representatives from different banks in a city

meet at the clearing house office of the central bank.

Wherever RBI is not there SBI office will have the

clearing facility. Payments from one bank to another

are adjusted in the accounts maintained by the

commercial banks with the RBI or SBI.

(vi)Custodian of foreign exchange reserves

The Central Bank buys and sells foreign

currencies in the market. So, we say central bank is

the custodian of foreign exchange reserves.

(vii)Control of credit
Commercial banks create credit where as
central bank controls credit. The central bank has two
weapons to control credit in the country. They are:
(A) Quantitative credit control measures.
(B) Qualitative credit control measures.
a. Quantitative measures :-
Bank Rate
Repo Rate
Reverse Repo Rate
Open Market operations
Cash Reserve Ratio (CRR)
Statutory Liquidity Ratio (SLR)
1. Bank Rate: Commercial Banks may take loans to meet
their long term credit needs from the Central Bank. The
interest charged on these loans is called Bank Rate.
During Inflation Bank Rate will be increased. The lending
capacity of commercial banks will fall. They will advance
less loans with high interest rate . Money supply will fall.
Aggregate Demand will fall. Inflation will be reduced
During deflation, bank rate will be decreased. Lending
power of banks will increase. They will advance more
loans. Demand will increase . Deflation will be reduced.
2. Repo Rate: Commercial Banks may take loans to
meet their short term credit needs from the Central
Bank. The interest charged on these loans is called
Repo Rate.
During Inflation Repo Rate will be increased. The
lending capacity of commercial banks will fall. They
will advance less loans with high interest rate . Money
supply will fall. Aggregate Demand will fall. Inflation
will be reduced
During deflation, Repo Rate will be decreased.
Lending power of banks will increase. They will
advance more loans. Demand will increase . Deflation
will be reduced
3. Reverse Repo Rate
Reverse Repo Rate: Sometimes, the Central Bank may
borrow money from Commercial Banks. This interest
paid for these loans is called Reverse Repo Rate.
During Inflation, the Reverse Repo rate will be
increased. The Commercial Banks will lend more
money to Central bank. They will lend less to public.
Money supply and Aggregate Demand will fall.
During deflation reverse repo rate will be reduced.
Banks will lend less to RBI and more to public. Money
supply will increase. Deflation will be controlled
4. Open Market Operations:
During Inflation, the Central Bank will sell securities to
the public and get money. Money supply will decrease
and inflation will be controlled.
During deflation, the Central Bank will buy back
securities and give money to public. Money supply
will increase. Deflation will be controlled.
 5. Legal Reserve Ratio

Cash Reserve Ratio Statutory Liquidity Ratio

LRR will be increased during inflation and reduced during

deflation
 Qualitative credit control measures
(or)
Selective credit control measures:-
Margin Requirement: This can be explained with an
example. A person gives a collateral security worth Rs
100 to a commercial bank and the bank may give him
loan of Rs 80. This means the margin is 20%. During
Inflation bank will increase margin requirement.
During deflation margin requirement will be reduced.
 CREDIT CREATION BY COMMERCIAL BANKS
• Assumptions:
• Banking system is considered as one unit, namely
Banks..
• All receipts and payments in the economy are
through the banks.
• All payments are through cheques.
• The one who receives payment deposits the same in
his account.
• Suppose, Bank receives a deposit of Rs 1000. A part
of this deposit Bank keeps as Statutory Liquidity
Ratio (CRR and SLR). Suppose LRR is 20%. The Bank
keeps Rs.200 as reserve and gives Rs. 800 as loans.
The borrower is asked to open an account with the
Bank and the loan amount is credited in his account.
So, Bank receives a deposit of Rs. 800. Suppose, the
man who takes loan withdraws the money, he pays
it to another man and the other person will deposit
that amount in the Bank. Every loan creates a
deposit.
• Now the Bank has Rs. 800 as deposit, it can keep
20% of the amount as reserve and lend the
remaining Rs. 640. The deposit creation continues in
the above manner. So, Bank can lend several times
more than the amount that it receives as deposit.
How many times more than the initial deposit can the
Bank lend? It depends on the LRR.
Money Multiplier =
Money Created = Initial deposit x Multiplier
= 1000 x
= 1000 x = 5000