MONEY AND BANKING

1. Functions of Money 

1. Medium of exchange
2. Unit of account. The value of all goods and services can be expressed in monetary units.
3. Store of wealth

Standard of deferred payment

Types of Money

• Full Bodied Money: it is the type of money whose value as money is equivalent to its value as a commodity e.g. gold coin
• Token Money/ Credit Money/ Paper Money: value as money is much more than value as a commodity e.g. paper currency
• Representative Full Bodied Money: It is a kind of token money but is issued against the backing of equivalent value of bullion with issuing authority
• Legal Tender Money: money which cannot be denied in settling the monetary obligation
• Non-Legal Tender Money/ Optional Money/Fiduciary Money: money which can be denied
• Fiat Money: serves as money on the order of the government
• Near Money: highly liquid financial assets like shares and bonds. 

Two Motives to Hold Money

1. The Transaction Motive- The principal motive for holding money is to carry out transactions.

The relationship between the aggregate transaction demand for money of an economy and the (nominal) GDP in a given year. The total value of annual transactions in an economy includes transactions in all intermediate goods and services and is much greater than the nominal GDP. However, normally, there exists a stable, positive relationship between the value of transactions and the nominal GDP. An increase in nominal GDP implies an increase in the total value of transactions and hence a greater transaction demand for money from the equation.

2. The Speculative Motive -An individual may hold her wealth in the form of landed property, bullion, bonds, money etc. For simplicity, let us club all forms of assets other than money together into a single category called ‘bonds’. Typically, bonds are papers bearing the promise of a future stream of monetary returns over a certain period. These papers are issued by governments or firms for borrowing money from the public and they are tradable in the market-

2. Supply of Money

In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India. However, coins are issued by the Government of India. Apart from currency notes and coins, the balance in savings, or current account deposits, held by the public in commercial banks is also considered money since cheques drawn on these accounts are used to settle transactions. Such deposits are called demand deposits as they are payable by the bank on demand from the account holder. Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits Currency notes and coins are therefore called fiat money. They do not have intrinsic value like a gold or silver coin. They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction

1. Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of payment. Hence, demand deposits are not legal tenders.

3. Narrow and Broad Money

• Money supply, like money demand, is a stock variable. The total stock of money in circulation among the public at a particular point in time is called the money supply.
• RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4.
• They are defined as follows M1 = CU + DD M2 = M1 + Savings deposits with Post Office savings banks 39Money and Banking M3 = M1 + Net time deposits of commercial banks M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates) where CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks.
• The word ‘net’ implies that only deposits of the public held by the banks are to be included in the money supply.
• The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of the money supply.
• M1 and M2 are known as narrow money. M3 and M4 are known as broad money. These gradations are in decreasing order of liquidity.
• M1 is the most liquid and easiest for transactions whereas M4 is the least liquid of all. M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources. Money Creation by the Banking System.

4. Money Creation by Banking System

For simplicity, use the most liquid definition of money, viz. M1 = CU + DD, as the measure of money supply in the economy.

 The Currency Deposit Ratio: The currency deposit ratio (cdr) is the ratio of money held by the public in currency to that they hold in bank deposits. cdr = CU/DD. If a person gets Re 1 she will put Rs 1/(1 + cdr) in her bank account and keep Rs cdr/(1 + cdr) in cash. It reflects people’s preference for liquidity. It is a purely behavioural parameter which depends, among other things, on the seasonal pattern of expenditure. For example, CDR increases during the festive season as people convert deposits to cash balance to meet extra expenditures during such periods.

 The Reserve Deposit Ratio: Banks hold a part of the money people keep in their bank deposits as reserve money and loan out the rest to various investment projects. Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI. Banks use this reserve to meet the demand for cash by account holders. Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves.

5. Monetary System in India

In India currency is printed as per the provision of the Minimum Reserve System. RBI has to maintain reserves of 200 crores in the form of-

1. Gold has to be at least 115 cr
2. Foreign securities-no minimum requirement
3. RBI can print unlimited currency

Monetary Policy

Instruments of Monetary Policy

• Cash reserve ratio-percentage of bank deposits which the bank has to keep with RBI
• Statutory Liquidity ratio--the percentage of bank deposits which the bank has to keep with itself.

• Bank rate rate of interest at which RBI provides rediscounting facilities to banks against their first-class securities
• Open market operations selling government securities
• Another component of open market operations is the Liquidity Adjustment Facility(LAF)
• LAF is done by
• A)Repo rate-RBI lends money to banks by buying government securities
• B)Reverse repo rate this banks buy government securities from RBI
• Marginal standing facility-banks can borrow loan to 1% on their deposits, this facility is created to facilitate borrowing from RBI by banks who do not have extra government securities and pledging the existing securities will affect their SLR requirements of 23%

It's objective to overcome the liquidity crunch

b) Qualitative or Selective measures-sector specific

• Credit rationing-quota of credit eg priority sector lending
• Margin requirements-difference between the market value of collateral security and the maximum amount of loan sanctioned against that security by a bank in a particular sector
• Differential rate of interest-different rates of interest for different sectors

a)Moral suasion

6. Reserve Bank of India

• Central Bank of country
• Established on 1 Aril 1935 under the RBI ACT 1934
• RBI was nationalized on 1 January 1949
• Financial year of RBI 1 July to 30 June

Functions of RBI

1. Lender of Last Resort
2. Government's Bank all government transactions undertaken through RBI
3. Open Market Operations
4. Bank Rate Policy
5. Sterilisation: RBI will undertake an open market sale of government securities of an amount equal to the amount of foreign exchange inflow in the economy, thereby keeping stock of high-powered money and total money supply unchanged. Thus it sterilises the economy against adverse external shocks. This operation of RBI is known as sterilization.
6. Banker's Bank -commercial banks keep reserves in RBI and RBI lends money to banks

7. Clearing House Facility: it provides a clearing house facility to banks –settlement of claims of one bank on another bank using –National Electronic Fund Transfer and Real Time Gross Settlement System
8. Custodian of Foreign Exchange Reserves

Additional Information

• Foreign securities are any kind of financial assets. In India, we maintain four currencies as Foreign Securities –the US dollar, UK pound, Japanese Yen, Euro
• Lower denomination values of rs 1 and less are printed by the Finance Ministry, Government of India
• Gresham's Law bad money drives out good money