Money & Banking- 1 | Indian Economy for UPSC CSE PDF Download

Introduction

Money and banking stand as pivotal pillars within a robust and efficient economic and financial framework. However, their journey spans centuries of evolution, tracing back to a time when neither concept existed. Initially, people engaged in direct commodity exchange, known as the barter system, as a means of acquiring goods they lacked. During this era, subsistence sufficed, and there was little impetus for change until production levels surged, revealing the limitations of bartering.
As societies began to produce surpluses, the inherent shortcomings of the barter system prompted a transition toward a more sophisticated arrangement: money. This pivotal shift eventually gave rise to the invention of banking systems to facilitate increasingly complex economic functions. The intertwined history of money and banking underscores their symbiotic development.
Evidence of early financial practices can be found globally. For instance, in India, historical records from the Vedic period document the provision of loans. During the Mauryan period, instruments like "adesha" were utilized—a precursor to modern bill of exchange concepts—wherein a banker was directed to pay a specified amount to a third party.
The trajectory of money and banking illustrates a gradual progression from simple commodity exchange to intricate financial systems. While contemporary monetary and banking systems may appear formidable and intricate, their origins lie in the humble beginnings of ancient exchanges between individuals.
Examining this narrative through the lens of the UPSC underscores the foundational role of the barter system in shaping subsequent economic and financial structures.

The Barter system 

• Exchange of commodities with the mediation of money is called Barter exchange.
• In earlier times, when there was no concept of money and banking, people used the barter system of exchange.
• They exchanged commodities.
  
• Let us illustrate this with a simple example:
  • Suppose I want to buy clothes and I have 1 kg apple with me.
  • Now, all I have to do is to find a person who wants apples and has clothes to sell.
  • I’ll approach the person and we both shall finalize a mutually agreeable deal wherein I get what I want (clothes) and the other person gets what he wants (apples).
  • Both parties return home satisfied. This transaction has been successfully done under a barter system.
• But there are a few obvious problems with this system.

Major problems of the Barter system 

There are many issues with barter exchange, but here are few major ones: 

• Double coincidence of wants: Everyone must find a person who is willing to buy what they are willing to sell and a person who is willing to sell what they want to buy. In the above example, I need to find someone who has surplus clothing to sell and not only this but a person who also wants apples in exchange for clothing. 
• Difficult to carry forward wealth: In the above example, I cannot store apples for an indefinite amount of time. They cannot act as a store of wealth like gold or cash can.  
• Absence of a standard unit of account: How many apples must I give in return for how much clothing would always be an issue in the above example. There is no standard unit of account.  
• As we can see above, to facilitate a transaction, a common medium of exchange acceptable to parties involved was necessary. Hence, the concept of money originated.  

Now, a person was able to sell apples for money & buy clothes from the money earned. Similarly, the other person was able to sell clothing for money and then buy apples from that money.
Note: Barter system has its advantages too, like in cases of a monetary crisis or hyperinflation when the currency has lost its value, barter system works perfectly as an alternative.
Money and banking is an important topic for UPSC preparation but to understand it fully one must be thorough with underlying concepts, like money, money supply, monetary aggregates, etc. 

What is money? 

• Money is the most commonly accepted medium of exchange.
• Any object that is generally accepted as a means of payment.
• Currency, in the form of notes or coins, is one type of money.
• Do remember that money is not a necessity and our society can exist without it.
• It acts as a facilitator only.

 Functions of money  

• It acts as a medium of exchange: Any commodity can be bought through money 
• A common measure of value: All commodities have their value that is expressed in terms of money 
• Store of value 
• Acts as a standard for deferred payments: Future monetary obligations can be settled using money. For example A loan which is taken today is settled in installments. 

Types of money 

• Full-bodied money 
• Token money (paper money/credit money) 
• Paper money 
• Representative full-bodied paper money 
• Inconvertible paper money 
• Fiat money 
• Legal tender 
• Non-legal tender/optional money 
• Fiduciary money 
• Near money 
• Plastic money 
• Deposit money

Full-bodied money 

• Money whose face value is equivalent to its intrinsic value. Full value is embedded in the currency itself 
• Money value = commodity value 
• For example; gold currency

Token Money 

• Its value as money is much more than its value as a commodity 
• Money value > commodity value
  

 As an example, consider the following two coins: 

• One coin is made of gold and its monetary value is 1000 Rs, meaning it can buy goods worth this amount.
• The second coin is made of copper and its monetary value is 10 Rs.
• If you decide to sell the gold coin as a commodity, you'll still get 1000 Rs because its intrinsic value is the same as its assigned monetary value.
• This type of currency is termed Full-bodied money.
• Conversely, if you sell the copper coin in the market as a commodity, you'll receive much less than 10 Rs because its monetary value exceeds its actual worth as copper.
• This type of currency is known as Token money.
• Another example of token money is a paper note. A 500 Rs note holds little value as a commodity in the market, as it's essentially just a piece of paper with 500 Rs printed on it.

Paper money 

• Money made out of paper is termed paper money, further divided into two parts:
  • Representative full-bodied paper money/convertible money: Issued against an equivalent amount of gold/silver by the issuing authority. Holders can convert it to full-bodied money at the central bank.
  • Inconvertible money: Cannot be converted to gold or silver, and there's no obligation on the central bank to do so.
• India currently operates on token money, where the RBI isn't obligated to convert paper money to gold/silver.
• Token money relies solely on trust in the government.
• In medieval India, kingdoms had their own full-bodied coin systems made of gold.
• When a new ruler replaced old coins, similar to sudden demonetization, people's wealth became worthless overnight.
• Without banks, people couldn't exchange their old coins, leading to sudden poverty.
• To safeguard against such situations, people hoarded coins, melted them, and kept gold or silver, which retained value independently of rulers.
• Lack of trust in rulers led to hoarding and a lack of trust in currency.
• With the advent of democracy, trust increased, leading countries to shift to token money systems.

 Fiat system 

• "Fiat" means order and refers to money serving as per the government's decree.
• This type of money is issued without backing from an equivalent amount of gold or silver.
• There's no obligation for anyone to accept this money as a medium of exchange.
• No legal action can be initiated if someone refuses to accept fiat money.

Legal tender 

• It's mandatory to accept this type of money for settling any monetary obligation.
• Legal tender is recognized by the law of the land as valid for debt payment and must be accepted as such.
• The RBI Act of 1934 grants the central bank the exclusive right to issue banknotes, making them legal tender across India.
• The government can issue fiat money and declare it legal tender.
• Coins issued under The Coinage Act, 2011, and One Rupee notes issued by the Ministry of Finance (Government of India) under the Currency Ordinance, 1940 are legal tender.
• Every banknote issued by the Reserve Bank of India under the RBI Act, 1934, unless withdrawn, is legal tender.
• Coins and 1 Rs notes are issued by the Government of India, while banknotes are issued by the RBI.
• Coins are issued under the Coinage Act, while banknotes are issued under the RBI Act, 1934.

Two types of legal tender exist:

• Limited legal tender money: Must be accepted for payment only up to a certain limit.
  For Example: 50 paise coins cannot be used for payments exceeding 10 Rs, and coins worth 1 Rs or more can only be used for payments up to 1000 Rs.
• Unlimited legal tender money: Currency notes are unlimited legal tender and can be used for payments of any size.

Non-legal tender/optional money 

Money which has no legal obligation to being accepted by anyone, like Cheque, Demand Drafts, etc. They are generally used and accepted but no one is legally bound to accept them as a mode of payment. 

 Fiduciary money 

• This form of money relies on the trust between the payer and the payee for acceptance.
• For example, a cheque isn't legally binding to accept, but when there's trust between the parties, the payee readily accepts it as a mode of repayment.

Near money/Quasi money 

• Near money refers to highly liquid assets that can be swiftly converted into cash.
• These assets are typically non-cash and extremely liquid but not directly usable for transactions.
• Near money requires some time to convert into cash.
• For instance, a fixed deposit account in a bank serves as near money. While liquid, it requires a process—such as visiting the bank and completing paperwork—to access the cash before it can be spent, hence termed as near money.

Plastic money 

It is used to refer to credit cards, debit cards, etc that we routinely use instead of actual cash. 

Deposit money 

Money deposited in banks & financial institutions. For example, your saving accounts, fixed deposits, recurring deposits, etc are all different types of deposit money

What is Money Supply? 

• Money supply represents the overall stock of all types of money held by non-governmental and non-banking entities at any given time.
• "Public" in this context refers to all economic entities excluding the government and banking system, as these entities are responsible for creating money.
• Therefore, money supply (MS) signifies the total purchasing power within an economy.
• Various measures are used to quantify money supply, known as Monetary Aggregates.
• Only when the money supply within the entire banking system is understood can the central bank take regulatory actions.
• Understanding banking concepts is essential before delving into monetary aggregates.

Types of deposits held by a bank 

Demand Deposits (DD)

• Money that can be withdrawn at any time (on demand) from the bank.
• Includes:
  • Current account
  • The demand liability portion of a savings account
• These deposits are 100% liquid.

Time Deposits (TD)

• Money that can be withdrawn only after maturity or with a penalty before maturity.
• Includes:
  • Fixed Deposits
  • Recurring Deposits
  • Time liability of a savings account

Other Deposits (OD)

• Demand deposits with RBI, including demand deposits of public financial institutions, demand deposits of foreign central banks, and international financial institutions like IMF, World Bank, etc.

Net Bank Deposits

• Net Bank Deposits = DD + TD

Note:

• Total bank deposits are different from net bank deposits because banks have other deposits like borrowings from the RBI.

Monetary Aggregates:

M1 (Narrow Money)

• M1 = C + DD + OD

  • C – Currency held by the public
  • DD – Net Demand Deposits with banks (excludes interbank deposits)
  • OD – Deposits with RBI held by certain individuals (e.g., former RBI governors) & institutions (e.g., IMF)

• Note:

  • OD is near negligible for practical purposes.
  • M1 is the most liquid form of money, hence termed narrow money.

M2 (Narrow Money)

• M2 = M1 + Savings account deposits with Post office banks
  • M2 is almost equal to M1 since deposits with Post office banks are minimal.

M3 (Broad Money)

• M3 = M1 + TD (time deposits with commercial banks like Fixed deposits, Recurring deposits)
  • M3 represents currency and total bank deposits, indicating the purchasing power of an economy.
  • M3 is the most commonly used measure of the money supply, also known as aggregate monetary resources.

M4 (Broad Money)

• M4 = M3 + Total Deposits with Post Office banks (excludes deposits under National Savings Certificate, Kisan Vikas Patra)
  • For practical purposes, total deposits with Post office banks are minimal, so M4 is nearly equal to M3.

Rank of Monetary Aggregates by Increasing Liquidity

• M1
• M2
• M3
• M4
• M0 (High-powered money/Primary money)

M0 (High-powered money/Primary money)

• Total stock of all types of currency (notes, coins) held by all types of economic entities (public & banks) at any point in time, excluding the government.
• M0 = C + R + OD
  • C – Currency in circulation: Total value of currency issued by the Reserve Bank of India minus the amount withdrawn by it.
  • R – Cash Reserves of banks
  • OD – Other Deposits

Note:

• Vault cash is not a part of the money supply.
• M3 > M0 because M3 includes deposits held by banks, while M0 includes cash reserves of the banks, and deposits held by a bank are always greater than its cash reserve.

Money Multiplier (m) 

• It is the ratio of money supply (MS) to the reserve money (M0) 
• m = MS/M0 

Monetary system in India 

• India follows the ‘Minimum Reserve System (MRS), adopted in place of the Proportional Reserve System.
• Under MRS, the RBI must maintain reserves of at least 200 Crore in the form of gold and foreign securities.
• Of this, at least 115 Crore must be maintained in gold.
• Upon maintaining these reserves, the RBI can print unlimited currency backed by gold, foreign securities, and Government of India (GOI) securities.

Things Against Which RBI Can Print Money:

• Gold
• Foreign securities
• Securities of GOI (G-sec)

Credit Creation by a commercial bank 

Assets and Liabilities for a Bank

• Assets: Loans and advances given to anyone are assets for a bank because they generate interest. An asset is something that generates a cash flow in the future.
• Liabilities: Deposits made in the bank are liabilities for the bank because they have to be paid back to the customer.

Note: Banks are allowed to engage in fractional reserve banking, meaning a fraction of the deposits made in the bank must be kept as a reserve, and the rest can be given out as a loan. This is done to prevent problems for the general public.

This reserve requirement is managed under the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). Together, SRR and CRR are known as the Legal Reserve Ratio (LRR).

Process of Credit Creation

With your money and banking fundamentals clear, let's see how credit creation is actually done by commercial banks.

Assumption: The LRR requirement is 10%.
Consider a person A who has 100 Rs with him. He has not deposited it in the bank yet. Thinking that he is not going to spend that money and that his neighbor might try to steal it from him, he decides to deposit that money in a bank. He goes to an SBI branch and deposits Rs 100 in a savings account. Satisfied that his money is safe, he comes back home happily.

• Step 1: At this point, SBI has a Demand Deposit of 100 Rs. It is a liability at this moment. It also keeps a reserve of 10 Rs as per the LRR requirement. So, the loanable amount at this point is 90 Rs, not 100 Rs.
  One day, Mr. B enters the bank and asks for a loan. SBI is more than happy to lend money to him. It gives him a loan of 90 Rs, but this loan is not given in cash, for obvious reasons. Mr. B has an account in ICICI, and SBI transfers this amount to his ICICI account.
• Step 2: Now, ICICI receives 90 Rs as a deposit. It keeps 10%, i.e., 9 Rs, as a reserve, and it can now loan 81 Rs to another customer.
• Step 3: Similarly, ICICI loans this amount to Mr. C. He deposits 81 Rs in Axis Bank. Axis Bank keeps 10% (8.1 Rs) and can now loan 72.9 Rs.

Did you notice how an initial deposit with SBI went on to create credit in the economy? That’s how credit is created, and money gets multiplied in the process. This process of credit creation will go on until the initial deposit of 100 Rs is exhausted.

Formula for Credit Creation

• Money Multiplier: 1 / LRR (For this example: Money Multiplier = 1 / 0.1 = 10).
• Credit Creation: Initial deposit * money multiplier = 100 * 10 = Rs 1000.
  So, in the above example, the initial deposit was 100 Rs, which means credit creation will be equal to 100 * 1 / 10% = Rs 1000. Hence, in this case, 100 Rs will generate a credit flow of 1000 Rs in the economy.
• PS: No need to remember the formula for credit creation. It is given just for your better understanding.

Note: Please remember that here we have assumed that all people will not turn up on the same day to ask for their deposit money. This is termed a bank run, and it happens rarely, but if it happens, then obviously a bank will not be able to extend loans to anyone.

We hope you are now clear with the basics of money and banking and have a better idea of how the entire system works to benefit society by encouraging transactions and increased credit flow in an economy.

This is an age of rapid technological innovation and adaptation. As a result, the world economic and financial system has grown tremendously, and so has the concept of money along with it. Everything is being digitized, leading us to a point where we now have a digital form of money, i.e., digital currency.

What is a Digital Currency? 

Digital Currency Overview

Digital currency refers to any currency that exists exclusively in electronic form.

Cryptocurrency as a Subset of Digital Currency

Cryptocurrency is a specific type of digital currency. The majority of the world's currencies are already digital, with an estimated 92% in digital form and only 8% in cash.

Central Bank Digital Currency (CBDC)

• In light of the success of decentralized digital currencies like Bitcoin and Ethereum, many countries are considering introducing their own digital currencies, known as Central Bank Digital Currency (CBDC) or national digital currency.
• A CBDC is the digital form of a country’s fiat currency. Instead of printing paper currency or minting coins, the central bank issues electronic tokens, which are backed by the full faith and credit of the government.

Note: It's important to differentiate between cryptocurrency (like Bitcoin, Dogecoin) and digital currency. They are not the same and have significant differences.

Cryptocurrency vs. Digital Currency

• Decentralization: Digital currencies are centralized, meaning they are regulated and issued by a single entity like a central bank.
• Openness: Cryptocurrencies allow for transparency, as all transactions can be seen in an open ledger (blockchain). In contrast, digital currencies do not offer this visibility.
• Legal Framework: Most cryptocurrencies lack a legal framework, whereas digital currencies are backed by legal regulations.

National Digital Currencies Worldwide

According to the Bank for International Settlements, over 60 countries are experimenting with CBDCs. A few countries have already rolled out their national digital currencies:

• Sweden: Conducting real-world trials of its digital currency, the krona.
• The Bahamas: Issued their digital currency, the "Sand Dollar," to all citizens.
• China: Initiated a trial run of their digital currency, e-RMB, during the pandemic, with plans for nationwide implementation by 2022. This digital currency is highly centralized, with the government able to shut down and seize accounts, unlike more democratic cryptocurrencies.

National Digital Currency in India

• With the global growth of digital currencies, various cryptocurrency start-ups have emerged in India, such as Unocoin in 2013 and Zebpay in 2014. However, their volatility is a concern for India.
• The government-appointed SC Garg Committee recommended banning cryptocurrencies while allowing an official digital currency. The committee also drafted the "Banning of Cryptocurrency & Regulation of Official Digital Currency Bill."