Money and Banking

What is Money?

Money is an officially-issued legal tender generally consisting of notes and coin, and is the circulating medium of exchange as defined by a government. Money is often synonymous with cash and includes various negotiable instruments such as checks. Each country has its own money that is used as a medium of exchange within that country.

Barter System

Money is the commonly accepted medium of exchange. Economic exchanges without the mediation of money are referred to as barter exchanges.

A system of exchange of goods and services without the help of medium of exchange such as money is called Barter System. The barter system works in principle of double coincidence of wants. For example, an individual who has a surplus of rice wishes to exchange it for clothing. For this he has to find a person who wants to exchange his surplus clothes in exchange of rice. If their mutually coincidence. Then the exchange occurs. This system of direct exchange of goods or services is known as barter system of exchange.


  1. Sometimes it is very difficult to find a person who has the diametrically opposite demand.
  2. The search costs may become prohibitive as the number of individual increases
  3. Barter exchange become extremely difficult in a large economy because of the high costs people would have to incure looking for suitable persons to exchange their surpluses
  4. It is very difficult to carry forward one’ under the barter system

Functions of money

The first and foremost role of the money is that it acts as a medium of exchange. But overall, the money has following three functions:

  • Unit of Account: The value of all goods and services can be expressed in monetary units. For example- When we say that the value of a certain wristwatch is Rs 500 we mean that the wristwatch can be exchanged for 500 units of money, where a unit of money is rupee in this case.
  • Medium of Exchange: It facilitates the exchange of goods and services
  • Store of value: wealth can be stored in the form of money for future use

Demand for money

Money is the most liquid of all assets in the sense that it is universally acceptable and hence can be exchanged for other commodities very easily. On the other hand, it has an opportunity cost. If, instead of holding on to a certain cash balance, you put the money in a savings account in some bank you can earn interest on that money. While deciding on how much money to hold at a certain point of time one has to consider the tradeoff between the advantage of liquidity and the disadvantage of the foregone interest. Demand for money balance is thus often referred to as liquidity preference. People desire to hold money balance broadly from two motives such as:

  1. The Transaction Motives
  2. The Speculative Motives

Transaction Demand

The principal motive for holding money is to carry out transactions. This is called transaction motive or transaction demand for money,

Relation between Transaction Demand and Value of Transactions over a specified Period of Time:

Suppose you earn Rs 100 on the first day of every month and run down this balance evenly over the rest of the month. Thus, your cash balance at the beginning and end of the month are Rs 100 and 0, respectively. Your average cash holding can then be calculated as (Rs 100 + Rs 0) ÷ 2 = Rs 50, with which you are making transactions worth Rs 100 per month.

Hence, your average transaction demand for money is equal to half your monthly income, or, in other words, half the value of your monthly transactions.

Consider, next, a two-person economy consisting of two entities – a firm (owned by one person) and a worker. The firm pays the worker a salary of Rs 100 at the beginning of every month. The worker, in turn, spends this income over the month on the output produced by the firm – the only good available in this economy.

Thus, at the beginning of each month the worker has a money balance of Rs 100 and the firm a balance of Rs 0. On the last day of the month the picture is reversed – the firm has gathered a balance of Rs 100 through its sales to the worker. The average money holding of the firm as well as the worker is equal to Rs 50 each.

Thus the total transaction demand for money in this economy is equal to Rs 100. The total volume of monthly transactions in this economy is Rs 200 – the firm has sold its output worth Rs 100 to the worker and the latter has sold her services worth Rs 100 to the firm. The transaction demand for money of the economy is again a fraction of the total volume of transactions in the economy over the unit period of time.

In general, therefore, the transaction demand for money in an economy = k.T where T is the total value of transactions in the economy over a unit period and k is a positive fraction.

Velocity of Circulation of Money: The number of times a unit of money changes hands during the unit period is called, the velocity of circulation of money.

Speculative Demand

Speculations regarding future movements in interest rate and bond prices give rise to the speculative demand for money.

Why speculative demand for money inversely related to the rate of Interest?

When the interest rate is very high everyone expects it to fall in future and hence anticipates capital gains from bond-holding. Hence people convert their money into bonds. Thus, speculative demand for money is low.

When interest rate comes down, more and more people expect it to rise in the future and anticipate capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money.

Hence speculative demand for money is inversely related to the rate of interest. Assuming a simple form, the speculative demand for money can be written as:

Where r is the market rate of interest and rmax and rmin are the upper and lower limits of r, both positive constants. It is evident from the above equation that as r decreases from rmax to r min, the value of speculative demand of money increases from 0 to ∞.

In this Graph the speculative demand for money is plotted on the horizontal axis and the rate of interest on the vertical axis.

When r = rmax, speculative demand for money is zero. The rate of interest is so high that everyone expects it to fall in future and hence is sure about a future capital gain. Thus, everyone has converted the speculative money balance into bonds.

When r = rmin, the economy is in the liquidity trap. Everyone is sure of a future rise in interest rate and a fall in bond prices. Everyone puts whatever wealth they acquire in the form of money and the speculative demand for money is infinite.

To conclude, Total demand for money in an economy is, therefore, composed of transaction demand and speculative demand. The former is directly proportional to real GDP and price level, whereas the latter is inversely related to the market rate of interest. The aggregate money demand in an economy can be summarized by the following equation:

Demand for Money = Transaction Demand + Speculative Demand

Liquidity Trap

As we know, interest rate can be thought of as an opportunity cost or ‘price’ of holding money balance.

If supply of money in the economy increases and people purchase bonds with this extra money, demand for bonds will go up, bond prices will rise and rate of interest will decline. In other words, with an increased supply of money in the economy the price you have to pay for holding money balance, viz. the rate of interest, should come down. However, if the market rate of interest is already low enough so that everybody expects it to rise in future, causing capital losses, nobody will wish to hold bonds. Everyone in the economy will hold their wealth in money balance and if additional money is injected within the economy it will be used up to satiate people’s craving for money balances without increasing the demand for bonds and without further lowering the rate of interest below the floor r min. Such a situation is called a liquidity trap.

The 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.

  • Demand Deposits: The Balance in Savings and Current Account Deposits held by the Public in commercial Banks are also considered as money since cheques drawn on these accounts are used to settle transactions. These are called Demand Deposits as they are payable by the bank on demand from the account holder.
  • Time Deposits: Deposits such as Fixed Deposits are called Time Deposit because they have a fixed period to maturity.
  • Fiat Money: The value of currency notes and coins is derived from the guarantee provided by the issuing authority of these items. Every currency note bears on its face a promise from the governor of RBI that if someone produces the note to RBI or any other commercial Bank, RBI will be responsible for giving the person purchasing power equal to the value printed on the note. The same is also true of coins. Currency notes and coins are therefore called Fiat Money. They do not have intrinsic value like a gold or silver coin.
  • Legal Tenders: Notes and coins are also called Legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transactions.
  • Note: Cheques drawn on Savings or current accounts, however can be referred anyone as a mode of payment. Hence, demand deposits are not legal tenders.

Narrow Money & Broad Money

Money supply, like money demand, is a stock variable.

Money Supply: The total stock of money in circulation among the public at a particular point of time is called money supply. RBI published figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows:

  • M1 = CU + DD , where CU is currency (Notes and coins) held by public and DD is net demand deposits held by commercial banks.
  • M2 = M1 + Savings deposits with Post Offices Savings Banks
  • M3 = M1 + Net time deposits of commercial banks ( the word net implies that only deposits of the public held by the banks are to be included in money supply, the interbank deposits are not to be regarded as part of money supply)
  • M4 = M3 + total deposits with Post Office Savings Organization excluding National Savings certificates

M1 and M2: Narrow Money

M3 and M4: Broad Money

These gradations are in decreasing order of liquidity. M1 is the most liquid and easiest for transactions, whereas M4 is least liquid of all.

M1> M2> M3> M4

M3 is most commonly used measure of money supply. It is also known as aggregate Monetary Resources.

Factors Affecting Money Supply

Money supply will change if the value of any of its components such as CU, DD or Time Deposits changes. For simplicity, we use the most liquid definition of money viz. M1= CU + DD, as the measures of money supply in the economy.

Various actions of monetary authority (RBI) and commercial banks are responsible for changes in the value of issue items. The preference of the public for holding cash balance vis-à-vis deposits in banks also affects the money supply. The influences on money supply can be summarized by the key ratios such as: the Currency Deposit Ratio (CDR), the Reserved Deposit Ratio (RDR) and High Powered Money (H).

Let’s discuss them one by one-

Currency Deposit Ratio (CDR):

The currency Deposit ratio (CDR) is the ratio of money supply held by the public in currency to that they hold in Bank deposits.

CDR = CU/DD  where CU is the currency held by public and DD is the Demand Deposit

Example: If a person’s monthly income is Rs 100 and in festive session- he holds cash balance (CU) of Rs 80 and rest Rs 20 deposit in Bank (DD) then the CDR

                                                CU/DD=80/20  = 4

But in lean session- he holds cash balance of Rs 20 and rest Rs 80 deposit in the Bank then,

The CDR = 20/40=1/4

The above example reflects people’s preference for liquidity. It is purely behavioral parameter which depends among other things, on the seasonal pattern of expenditure. E.g. as above example, CDR increases during the festive session as the people convert deposits to cash balance for meeting extra expenditure during such periods.

If a person gets Rs C , he will put Rs C/1+CDR  in his bank account and keeps Rs C x CDR/1+CDR  in cash.

Reserve Deposit Ratio (RDR):

Banks hold a part of the money people keep in their bank deposits as reserved money and loan out the rest to various investment projects.

Reserve Money consists of two things-

  1. Vault Cash in Banks and
  2. Deposits of commercial Banks with RBI

Banks use these resources to meet the demand for cash by account holder. Hence, Reserves Deposit Ratio (RDR) is the proportion of the total deposits commercial banks keeps as serves.

So, RDR = Reserve Money / Total Deposits

Keeping reserve is costly for banks; as otherwise, they could lend this balance to interest earning investment projects. However, RBI requires commercial Banks to keep reserves in order to ensure that banks have a safe Cashion of assets to draw on when an account holder want to be paid.

RBI Policy Instruments:

RBI uses various policy instruments to bring forth a healthy RDR in commercial banks such as- Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and Bank Rate or Repo Rate.

  • Cash Reserve Ratio (CRR): Fraction of their deposits that banks must keep with RBI
  • Statutory Liquidity Ratio (SLR): Fraction of their total demand and time deposits, the banks must have to maintain in the form of Specified Liquidity Assets.
  • Bank Rate or Repo Rate: The rate at which Commercial Banks can borrow money from RBI when they run short of reserves.  A high Bank Rate makes borrowing from RBI costly and, in effect encourages the commercial banks to maintain a healthy RDR.

Commercial Banks

Commercial banks accept deposits from the public and lend out this money to interest earning projects.

  1. The rate of interest offered by the bank to deposit holder is called the Borrowing Rate.
  2. The rate at which banks lend out their reserves to investors is called the Lending Rate.
  3. The difference between the borrowing rate and the Lending Rate is called Spread, is the profit that is appropriated by the Bank.

Deposits at Commercial Banks

Deposits at commercial banks are broadly of two types-

  1. Demand Deposits: Payable by the banks on demand from the account holder, e.g. current and savings account deposits
  2. Time Deposits: Which have a fixed period of maturity, e.g. fixed deposits

Lending by Commercial Banks: Lending by commercial banks consists mainly of cash credit, demand and short term loans to private investors and banks investments in government securities and other approval bonds.

Note: The credit worthiness of a person is judged by her current assets or the collateral (a security pledged for the repayment of a loan) he can offer.

High Powered Money

The total liability of a monetary authority of a country such as RBI in India is called the monetary base or High-Powered Money.

High Powered Money consists of:

  1. Currency (Notes and Coins in circulation with Public and vault cash of commercial banks); and
  2. Deposits held by the Government of India and Commercial banks with RBI.

If a member of the public produces a currency note to RBI, the RBI must pay him value equal to the figure printed on the note. Similarly, the deposits are also refundable by RBI on demand from deposit-holders. These items are claims which the general public, government or banks have on RBI and hence are considered to be the liability of RBI. RBI acquires assets against these liabilities.

Example: suppose RBI purchases gold or dollars’ worth Rs 5. It pays for the gold or dollar by issuing currency to the seller. Now the currency in circulation in the economy thus goes up by Rs 5- this shows uo on the liability side of the balance sheet. The value of the acquired assets, equal to Rs 5 is also entering under the appropriate head on the assets side. Similarly, RBI acquires debt bonds or securities issued by the Government and pay the Government by Issuing currency in return. It issues loans to commercial banks in a similar fashion. 

Mechanism of Money Creation by RBI

Suppose RBI wishes to increase the money supply, it will then inject additional high-powered money into the economy in the following way-

Let us assume that RBI purchases some asset, say government bonds or gold worth Rs H from the Market. It will issue a cheque of Rs H on itself to the seller of the bond.

Assume also that the values of CDR and RDR of this economy are 1 and 0.2 respectively. The seller encashes the cheque issued by RBI at his account in Bank A, keeping Rs H/2 in his account and taking Rs H/2 away as cash.

Now, the currency held by public thus goes up by Rs H/2 because of this increment in in deposits. But its assets also go up by the same amount through the possession of this cheque, which is nothing but a claim of the same amount on RBI. The liability of RBI goes up by Rs H, which is the sum total of the claims of Bank A (Rs H/2) and its client, the seller (Rs H/2)

Bank Failure

As we know that the amount of money stock in the economy is much greater than the volume of High Powered Money (Refer above Figure). Commercial Banks create this extra amount of money by giving out a part of their deposits as loans or investment credits.

It is also true that the total amount of deposits held by all commercial banks in the country is much larger than the total size of their reserves. If all the account-holder of all commercial banks in the country wants their deposits back at the same time, the banks will not have enough means to satisfy the needs of every account holder and there will be a Bank Failure.

Role of Reserve Bank of India

Followings are important roles played by the Reserve Bank of India-

  1. Lender of Last Resort
  2. Banker’s to the Bank
  3. Banker’s to the Government (Both Union and States)
  4. Deficit financing and controller of the money supply and credit creation (Most Important)

Let’s discuss few of them in details-

  • Lender of Last Resort: In case of Bank failure RBI stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the commercial banks. The system of guarantee assures individual account holders that their banks will be able to pay their money back in case of a crisis and there is no need to panic, thus avoiding bank runs. This role of the monetary authority is known as the lender of the Last resort.
  • Deficit Financing through Central Bank Borrowing: It is commonly held that the government sometimes prints money in case of a budget deficit. The government however, has no legal authority to issue currency in this fashion. So, it borrows money by selling treasury bills or government securities to RBI, which issues currency to the government in return. The government then pays for its expenses with this money. The money thus ultimately comes into the hands of the general public and becomes a part of the money supply. Financing of budget deficits in this fashion is called Deficit Financing through Central Bank Borrowings.
  • Controller of Money Supply and Credit Creation: The most important role of RBI is – as the controller of money supply and credit creation in the economy. RBI is the independent authority for conducting monetary policy in the best interests of the economy. It increases or decreases the supply of High-Powered money in the economy and creates incentives or disincentives for the commercial banks to give loans or credits to investors.

Instruments of Monetary Policy

The instruments which RBI uses for conducting monetary policy are as follows:

  1. Open Market Operations
  2. Bank Rate Policy
  3. Varying Reserve Requirements and
  4. Sterilization by RBI

Let’s discuss them in details-

Open Market Operations

RBI purchases (or sells) government securities to the general public in a bid to increase (or decrease) the stock of High-Powered Money in the economy

Example: Suppose RBI purchase Rs 100 worth government securities from the bond market, it will issue a cheque of Rs 100 on itself to the seller of the bond i.e. if a person or institution possessing the cheque produces it to RBI. RBI must pay equivalent amount of money to the person or the institution. The seller will deposit the cheque in his bank, which in turn will credit the seller’s account with a balance of Rs 100. The bank’s deposits go up by Rs 100 which is a liability to the bank. However, its assets also go up by Rs 100 by the possession of this cheque, which is a claim on RBI. The bank will deposit this cheque to RBI which, in turn, will credit the banks account with RBI Rs 100. The changes in RBI’s balance sheet will be as follow:

Total liability of RBI, or by definition, the supply of High-Powered Money in the economy has gone up by Rs 100. If RBI wishes to reduce the supply of High-Powered Money it undertakes an open market sale of government securities of its own holding in just the reverse fashion, thereby reducing the monetary base.

Bank Rate Policy

RBI can affect the Reserve Deposit Ratio (RDR) of commercial banks by adjusting the value of the Bank Rate- the rate of interest commercial banks has to pay RBI, if they borrow money from it in case of shortage of reserves.

A low bank rate encourages banks to keep smaller proportion of their deposits as reserves, since borrowing from RBI is now less costly than before. As a result, banks use a greater proportion of their resources for giving out loans to borrowers or investors, thereby enhancing the multiplier process via assisting secondary money creation and vice-versa.

In short- A low Bank Rate reduces RDR and hence increases the value of money multiplier thus, for any given amount of High-Powered Money (H) goes up.

Varying Reserve Requirements

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) also work through the RDR-route.

A high value of CRR or SLR helps increase the value of reserve deposit ratio thus diminishing the value of the money multiplier and money supply in the economy in a similar fashion.

Sterilization by RBI

Suppose due to future growth prospects in India, investors from across the world increase their investments in Indian bonds. They will buy these bonds with foreign currency. A person or a financial institution who sells these bonds to foreign investors will exchange its foreign currency holding into rupees in commercial banks. The bank, in turn, will submit this foreign currency to RBI and its deposits with RBI will be credited with equivalent sum of money.

Here the commercial banks total reserves and deposits remain unchanged- (it has purchased the foreign currency from the seller using its vault cash, which therefore goes down; but the Banks deposit with RBI goes up by an equivalent amount, leaving its total reserves unchanged.)

There will, however, be increments in the assets and liabilities on the RBI balance sheet. RBI’s foreign exchange holding goes up. On the other hand, the deposits of commercial banks with RBI also increase by an equal amount. But that means an increase in the stock of High-Powered Money- which by definition is equal to the total liability of RBI. With money multiplier in operation, this in turn will result in increased money supply in the economy. This increased money supply may not altogether be good for the economy’s health. If the volume of goods and services produced in the economy remains unchanged, the extra money will lead to increase in prices of all commodities- means an increase in the general price level, which is also known as Inflation. RBI often intervenes with its instruments to prevent such an outcome.

In the above case 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 the stock of high-powered money and total money supply unchanged.

Thus, it sterilizes the economy against adverse external shocks. This operation of RBI is known as Sterilization.


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