NCERT Gist: Money and Banking | Additional Study Material for UPSC PDF Download

Introduction

Money is the commonly accepted medium of exchange. To smoothen the transaction, an intermediate good is necessary which is acceptable to both parties. Such a good is called money.

Functions of Money

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 fixed deposits in some bank you can earn interest on that money.

Motives for Holding Money

There are two motives for holding the money :
1. The Transaction Motive: The principal motive for holding money is to carry out transactions. The number of times a unit of money changes hands during the unit period is called the velocity of circulation of money. We are ultimately interested in learning 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 clearly much greater than the nominal GDP.
However, normally, there exists a stable, positive relationship between 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 equation.
Transaction demand for money is positively related to the real income of an economy and also to its average price level.

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 of time.These papers are issued by governments or firms for borrowing money from the public and they are tradable in the market.
→ Different people have different expectations regarding the future movements in the market rate of interest based on their private information regarding the economy. If you think that the market rate of interest should eventually settle down to 8 per cent per annum, then you may consider the current rate of 5 per cent too low to be sustainable over time. You expect interest rate to rise and consequently bond prices to fall. If you are a bond holder a decrease in bond price means a loss to you - similar to a loss you would suffer if the value of a property held by you suddenly depreciates in the market. Such a loss occurring from a falling bond price is called a capital loss to the bond holder. Under such circumstances, you will try to sell your bond and hold money instead. Thus speculations regarding future movements in interest rate and bond prices give rise to the speculative demand for money.
→ 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.
→ Speculative demand for money is inversely related to the rate of interest.
→ 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.

Money Creation by the Banking System

→ Money supply will change if the value of any of its components such as currency-notes plus coins (CU), demand deposits (DD) or Time Deposits change.
→ The most liquid definition of money, viz. Ml = CU + DD, as the measure of money supply in the economy. These influences on money supply can be summarised by the following key ratios:
- Currency Deposit Ratio (CDR): It is the ratio of money held by the public in currency to that they hold in bank deposits-^ CDR = CU/DD
- 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 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 . Keeping reserves 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 cushion of assets to draw on when account holders want to be paid.RBI uses various policy instruments to bring forth a healthy RDR in commercial banks.
The first instrument is the Cash Reserve Ratio which specifies the fraction of their deposits that banks must keep with RBI. There is another tool called Statutory Liquidity Ratio which is required to be maintained by the banks with itself.

High Powered Money

The total liability of the monetary authority of the country, RBI, is called the
monetary base or high powered money.
→ It consists of currency (notes and coins in circulation with the public and vault cash of commercial banks) and deposits held by the Government of India and commercial banks with RBI
→ In case of a crisis like the above, RBI stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter.
→ This 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 last resort.
→ Apart from acting as a banker to the commercial banks, RBI also acts as a banker to the Government of India, and also, to the state governments.
It is commonly held that the government, sometimes, prints money in case of a budget deficit, i.e., when it cannot meet its expenses (e.g. salaries to the government employees, purchase of defence equipment from a manufacturer of such goods etc.) from the tax revenue it has earned.
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.
Financing of budget deficits by the governments in this fashion is called Deficit Financing through Central Bank Borrowing.

Role of RBI

However, the most important role of RBI is as the controller of money supply and credit creation in the economy through various instruments:
1. 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.
2. RBI can affect the reserve deposit ratio of commercial banks by adjusting the value of the bank rate - which is the rate of interest commercial banks have to pay RBI - if they borrow money from it in case of shortage of reserves.
A low (or high) bank rate encourages banks to keep smaller (or greater) proportion of their deposits as reserves, since borrowing from RBI is now less (or more) costly than before.
As a result banks use a greater (or smaller) proportion of their resources for giving out loans to borrowers or investors, thereby enhancing (or depressing) the multiplier process via assisting.
3. Varying Reserve Requirements:
a. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) also work through the rdr-route.
b. A high (or low) value of CRR or SLR helps increase (or decrease) the value of reserve deposit ratio, thus diminishing (or increasing) the value of the money multiplier and money supply in the economy in a similar fashion.
4. Sterilization by RBI:
RBI often uses its instruments of money creation for stabilising the stock of money in the economy from external shocks.