NCERT Textbook: Money & Banking | Indian Economy for UPSC CSE PDF Download

 Page 1


36 36 36 36 36
Introductory Macroeconomics
Money and Banking Money and Banking Money and Banking Money and Banking Money and Banking
Money is the commonly accepted medium of exchange. In an
economy which consists of only one individual there cannot be
any exchange of commodities and hence there is no role for money.
Even if there is more than one individual but these individuals do
not take part in market transactions, example: family living on an
isolated island, money has no function for them. However, as soon
as there is more than one economic agent who engage themselves
in transactions through the market, money becomes an important
instrument for facilitating these exchanges. Economic exchanges
without the mediation of money are referred to as barter
exchanges. However, they presume the rather improbable double
coincidence of wants. Consider, for example, an individual who
has a surplus of rice which she wishes to exchange for clothing. If
she is not lucky enough she may not be able to find another person
who has the diametrically opposite demand for rice with a surplus
of clothing to offer in exchange. The search costs may become
prohibitive as the number of individuals increases. Thus, to
smoothen the transaction, an intermediate good is necessary which
is acceptable to both parties. Such a good is called money. The
individuals can then sell their produces for money and use this
money to purchase the commodities they need. Though facilitation
of exchanges is considered to be the principal role of money, it
serves other purposes as well. Following are the main functions of
money in a modern economy.
3.1 FUNCTIONS OF MONEY
As explained above, the first and foremost role of money is that it
acts as a medium of exchange. Barter exchanges become extremely
difficult in a large economy because of the high costs people would
have to incur looking for suitable persons to exchange their
surpluses.
Money also acts as a convenient unit of account. The value of
all goods and services can be expressed in monetary units. 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. If the price of a pencil
is Rs 2 and that of a pen is Rs 10 we can calculate the relative
price of a pen with respect to a pencil, viz. a pen is worth 10 
÷
 2 =
5 pencils. The same notion can be used to calculate the value of
Reprint 2024-25
Page 2


36 36 36 36 36
Introductory Macroeconomics
Money and Banking Money and Banking Money and Banking Money and Banking Money and Banking
Money is the commonly accepted medium of exchange. In an
economy which consists of only one individual there cannot be
any exchange of commodities and hence there is no role for money.
Even if there is more than one individual but these individuals do
not take part in market transactions, example: family living on an
isolated island, money has no function for them. However, as soon
as there is more than one economic agent who engage themselves
in transactions through the market, money becomes an important
instrument for facilitating these exchanges. Economic exchanges
without the mediation of money are referred to as barter
exchanges. However, they presume the rather improbable double
coincidence of wants. Consider, for example, an individual who
has a surplus of rice which she wishes to exchange for clothing. If
she is not lucky enough she may not be able to find another person
who has the diametrically opposite demand for rice with a surplus
of clothing to offer in exchange. The search costs may become
prohibitive as the number of individuals increases. Thus, to
smoothen the transaction, an intermediate good is necessary which
is acceptable to both parties. Such a good is called money. The
individuals can then sell their produces for money and use this
money to purchase the commodities they need. Though facilitation
of exchanges is considered to be the principal role of money, it
serves other purposes as well. Following are the main functions of
money in a modern economy.
3.1 FUNCTIONS OF MONEY
As explained above, the first and foremost role of money is that it
acts as a medium of exchange. Barter exchanges become extremely
difficult in a large economy because of the high costs people would
have to incur looking for suitable persons to exchange their
surpluses.
Money also acts as a convenient unit of account. The value of
all goods and services can be expressed in monetary units. 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. If the price of a pencil
is Rs 2 and that of a pen is Rs 10 we can calculate the relative
price of a pen with respect to a pencil, viz. a pen is worth 10 
÷
 2 =
5 pencils. The same notion can be used to calculate the value of
Reprint 2024-25
37 37 37 37 37
Money and Banking
money itself with respect to other commodities. In the above example, a rupee is
worth 1 
÷
 2 = 0.5 pencil or 1 
÷
 10 = 0.1 pen. Thus if prices of all commodities
increase in terms of money i.e., there is a general increase in the price level, the
value of money in terms of any commodity must have decreased – in the sense
that a unit of money can now purchase less of any commodity. We call it a
deterioration in the purchasing power of money.
A barter system has other deficiencies. It is difficult to carry forward one’s
wealth under the barter system. Suppose you have an endowment of rice which
you do not wish to consume today entirely. You may regard this stock of surplus
rice as an asset which you may wish to consume, or even sell off, for acquiring
other commodities at some future date. But rice is a perishable item and cannot
be stored beyond a certain period. Also, holding the stock of rice requires a lot of
space. You may have to spend considerable time and resources looking for people
with a demand for rice when you wish to exchange your stock for buying other
commodities. This problem can be solved if you sell your rice for money. Money
is not perishable and its storage costs are also considerably lower. It is also
acceptable to anyone at any point of time. Thus money can act as a store of
value for individuals. Wealth can be stored in the form of money for future use.
However, to perform this function well, the value of money must be sufficiently
stable. A rising price level may erode the purchasing power of money. It may be
noted that any asset other than money can also act as a store of value, e.g. gold,
landed property, houses or even bonds (to be introduced shortly). However,
they may not be easily convertible to other commodities and do not have universal
acceptability.
Some countries have made an attempt to move towards an economy which
use less of cash and more of digital transactions. A cashless society describes an
economic state whereby financial transactions are not connected with money in
the form of physical bank notes or coins but rather through the transfer of digital
information (usually an electronic representation of money) between the
transacting parties. In India government has been consistently investing in various
reforms for greater financial inclusion. During the last few years’ initiatives such
as Jan Dhan accounts, Aadhar enabled payment systems, e –Wallets, National
financial Switch (NFS) and others have strengthened the government resolve to
go cashless. Today, financial inclusion is seen as a realistic dream because of
mobile and smart phone penetration across the country.
3.2 DEMAND FOR MONEY AND SUPPLY OF MONEY
3.2.1. Demand for Money
The demand for money tells us what makes people desire a certain
amount of money. Since money is required to conduct transactions, the
value of transactions will determine the money people will want to keep:
the larger is the quantum of transactions to be made, the larger is the
quantity of money demanded. Since the quantum of transactions to be made
depends on income, it should be clear that a rise in income will lead to rise in
demand for money. Also, when people keep their savings in the form of money
rather than putting it in a bank which gives them interest, how much money
people keep also depends on rate of interest. Specifically, when interest rates go
up, people become less interested in holding money since holding money amounts
to holding less of interest-earning deposits, and thus less interest received.
Therefore, at higher interest rates, money demanded comes down.
Reprint 2024-25
Page 3


36 36 36 36 36
Introductory Macroeconomics
Money and Banking Money and Banking Money and Banking Money and Banking Money and Banking
Money is the commonly accepted medium of exchange. In an
economy which consists of only one individual there cannot be
any exchange of commodities and hence there is no role for money.
Even if there is more than one individual but these individuals do
not take part in market transactions, example: family living on an
isolated island, money has no function for them. However, as soon
as there is more than one economic agent who engage themselves
in transactions through the market, money becomes an important
instrument for facilitating these exchanges. Economic exchanges
without the mediation of money are referred to as barter
exchanges. However, they presume the rather improbable double
coincidence of wants. Consider, for example, an individual who
has a surplus of rice which she wishes to exchange for clothing. If
she is not lucky enough she may not be able to find another person
who has the diametrically opposite demand for rice with a surplus
of clothing to offer in exchange. The search costs may become
prohibitive as the number of individuals increases. Thus, to
smoothen the transaction, an intermediate good is necessary which
is acceptable to both parties. Such a good is called money. The
individuals can then sell their produces for money and use this
money to purchase the commodities they need. Though facilitation
of exchanges is considered to be the principal role of money, it
serves other purposes as well. Following are the main functions of
money in a modern economy.
3.1 FUNCTIONS OF MONEY
As explained above, the first and foremost role of money is that it
acts as a medium of exchange. Barter exchanges become extremely
difficult in a large economy because of the high costs people would
have to incur looking for suitable persons to exchange their
surpluses.
Money also acts as a convenient unit of account. The value of
all goods and services can be expressed in monetary units. 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. If the price of a pencil
is Rs 2 and that of a pen is Rs 10 we can calculate the relative
price of a pen with respect to a pencil, viz. a pen is worth 10 
÷
 2 =
5 pencils. The same notion can be used to calculate the value of
Reprint 2024-25
37 37 37 37 37
Money and Banking
money itself with respect to other commodities. In the above example, a rupee is
worth 1 
÷
 2 = 0.5 pencil or 1 
÷
 10 = 0.1 pen. Thus if prices of all commodities
increase in terms of money i.e., there is a general increase in the price level, the
value of money in terms of any commodity must have decreased – in the sense
that a unit of money can now purchase less of any commodity. We call it a
deterioration in the purchasing power of money.
A barter system has other deficiencies. It is difficult to carry forward one’s
wealth under the barter system. Suppose you have an endowment of rice which
you do not wish to consume today entirely. You may regard this stock of surplus
rice as an asset which you may wish to consume, or even sell off, for acquiring
other commodities at some future date. But rice is a perishable item and cannot
be stored beyond a certain period. Also, holding the stock of rice requires a lot of
space. You may have to spend considerable time and resources looking for people
with a demand for rice when you wish to exchange your stock for buying other
commodities. This problem can be solved if you sell your rice for money. Money
is not perishable and its storage costs are also considerably lower. It is also
acceptable to anyone at any point of time. Thus money can act as a store of
value for individuals. Wealth can be stored in the form of money for future use.
However, to perform this function well, the value of money must be sufficiently
stable. A rising price level may erode the purchasing power of money. It may be
noted that any asset other than money can also act as a store of value, e.g. gold,
landed property, houses or even bonds (to be introduced shortly). However,
they may not be easily convertible to other commodities and do not have universal
acceptability.
Some countries have made an attempt to move towards an economy which
use less of cash and more of digital transactions. A cashless society describes an
economic state whereby financial transactions are not connected with money in
the form of physical bank notes or coins but rather through the transfer of digital
information (usually an electronic representation of money) between the
transacting parties. In India government has been consistently investing in various
reforms for greater financial inclusion. During the last few years’ initiatives such
as Jan Dhan accounts, Aadhar enabled payment systems, e –Wallets, National
financial Switch (NFS) and others have strengthened the government resolve to
go cashless. Today, financial inclusion is seen as a realistic dream because of
mobile and smart phone penetration across the country.
3.2 DEMAND FOR MONEY AND SUPPLY OF MONEY
3.2.1. Demand for Money
The demand for money tells us what makes people desire a certain
amount of money. Since money is required to conduct transactions, the
value of transactions will determine the money people will want to keep:
the larger is the quantum of transactions to be made, the larger is the
quantity of money demanded. Since the quantum of transactions to be made
depends on income, it should be clear that a rise in income will lead to rise in
demand for money. Also, when people keep their savings in the form of money
rather than putting it in a bank which gives them interest, how much money
people keep also depends on rate of interest. Specifically, when interest rates go
up, people become less interested in holding money since holding money amounts
to holding less of interest-earning deposits, and thus less interest received.
Therefore, at higher interest rates, money demanded comes down.
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38 38 38 38 38
Introductory Macroeconomics
3.2.2. Supply of Money
In a modern economy, money comprises cash and bank deposits.
Depending on what types of bank deposits are being included, there are
many measures of money
1
. These are created by a system comprising two types
of institutions: central bank of the economy and the commercial banking system.
Central bank
Central Bank is a very important institution in a modern economy.
Almost every country has one central bank. India got its central bank in
1935. Its name is the ‘Reserve Bank of India’. Central bank has several
important functions. It issues the currency of the country. It controls
money supply of the country through various methods, like bank rate, open
market operations and variations in reserve ratios. It acts as a banker to the
government. It is the custodian of the foreign exchange reserves of the economy.
It also acts as a bank to the banking system, which is discussed in detail later.
From the point of view of money supply, we need to focus on its function of
issuing currency. This currency issued by the central bank can be held by the
public or by the commercial banks, and is called the ‘high-powered money’ or
‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.
Commercial Banks
Commercial banks are the other type of institutions which are a part of
the money-creating system of the economy. In the following section we look at
the commercial banking system in detail. They accept deposits from the public
and lend out part of these funds to those who want to borrow. The interest rate
paid by the banks to depositors is lower than the rate charged from the borrowers.
This difference between these two types of  interest rates, called the ‘spread’ is the
profit appropriated by the bank.
The process of deposit and loan (credit) creation by banks is explained below.
In order to understand this process, let us discuss a story.
Once there was a goldsmith named Lala in a village. In this village,
people used gold and other precious metals in order to buy goods and
services. In other words, these metals were acting as money. People in
the village started keeping their gold with Lala for safe-keeping. In return
for keeping their gold, Lala issued paper receipts to people of the village
and charged a small fee from them. Slowly, over time, the paper receipts
issued by Lala began to circulate as money. This means that instead of
giving gold for purchasing wheat, someone would pay for wheat or shoes
or any other good by giving the paper receipts issued by Lala. Thus, the
paper receipts started acting as money since everyone in the village
accepted these as a medium of exchange.
Now, let us suppose that Lala had 100 Kgs of gold, deposited by
different people and he had issued receipts corresponding to 100 kgs of
gold. At this time Ramu comes to Lala and asks for a loan of 25 kgs of gold. Can
Lala give the loan? The 100 kgs of gold with him already has claimants. However,
Lala could decide that everyone with gold deposits will not come to withdraw
their deposits at the same time and so he may as well give the loan to Ramu and
charge him for it. If Lala gives the loan of 25 kgs of gold, Ramu could also pay Ali
with these 25 kgs of gold and Ali could keep the 25 kgs of gold with Lala in
return for a paper receipt. In effect, the paper receipts, acting as money, would
1
See the box on the measures of money supply at the end of the chapter.
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36 36 36 36 36
Introductory Macroeconomics
Money and Banking Money and Banking Money and Banking Money and Banking Money and Banking
Money is the commonly accepted medium of exchange. In an
economy which consists of only one individual there cannot be
any exchange of commodities and hence there is no role for money.
Even if there is more than one individual but these individuals do
not take part in market transactions, example: family living on an
isolated island, money has no function for them. However, as soon
as there is more than one economic agent who engage themselves
in transactions through the market, money becomes an important
instrument for facilitating these exchanges. Economic exchanges
without the mediation of money are referred to as barter
exchanges. However, they presume the rather improbable double
coincidence of wants. Consider, for example, an individual who
has a surplus of rice which she wishes to exchange for clothing. If
she is not lucky enough she may not be able to find another person
who has the diametrically opposite demand for rice with a surplus
of clothing to offer in exchange. The search costs may become
prohibitive as the number of individuals increases. Thus, to
smoothen the transaction, an intermediate good is necessary which
is acceptable to both parties. Such a good is called money. The
individuals can then sell their produces for money and use this
money to purchase the commodities they need. Though facilitation
of exchanges is considered to be the principal role of money, it
serves other purposes as well. Following are the main functions of
money in a modern economy.
3.1 FUNCTIONS OF MONEY
As explained above, the first and foremost role of money is that it
acts as a medium of exchange. Barter exchanges become extremely
difficult in a large economy because of the high costs people would
have to incur looking for suitable persons to exchange their
surpluses.
Money also acts as a convenient unit of account. The value of
all goods and services can be expressed in monetary units. 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. If the price of a pencil
is Rs 2 and that of a pen is Rs 10 we can calculate the relative
price of a pen with respect to a pencil, viz. a pen is worth 10 
÷
 2 =
5 pencils. The same notion can be used to calculate the value of
Reprint 2024-25
37 37 37 37 37
Money and Banking
money itself with respect to other commodities. In the above example, a rupee is
worth 1 
÷
 2 = 0.5 pencil or 1 
÷
 10 = 0.1 pen. Thus if prices of all commodities
increase in terms of money i.e., there is a general increase in the price level, the
value of money in terms of any commodity must have decreased – in the sense
that a unit of money can now purchase less of any commodity. We call it a
deterioration in the purchasing power of money.
A barter system has other deficiencies. It is difficult to carry forward one’s
wealth under the barter system. Suppose you have an endowment of rice which
you do not wish to consume today entirely. You may regard this stock of surplus
rice as an asset which you may wish to consume, or even sell off, for acquiring
other commodities at some future date. But rice is a perishable item and cannot
be stored beyond a certain period. Also, holding the stock of rice requires a lot of
space. You may have to spend considerable time and resources looking for people
with a demand for rice when you wish to exchange your stock for buying other
commodities. This problem can be solved if you sell your rice for money. Money
is not perishable and its storage costs are also considerably lower. It is also
acceptable to anyone at any point of time. Thus money can act as a store of
value for individuals. Wealth can be stored in the form of money for future use.
However, to perform this function well, the value of money must be sufficiently
stable. A rising price level may erode the purchasing power of money. It may be
noted that any asset other than money can also act as a store of value, e.g. gold,
landed property, houses or even bonds (to be introduced shortly). However,
they may not be easily convertible to other commodities and do not have universal
acceptability.
Some countries have made an attempt to move towards an economy which
use less of cash and more of digital transactions. A cashless society describes an
economic state whereby financial transactions are not connected with money in
the form of physical bank notes or coins but rather through the transfer of digital
information (usually an electronic representation of money) between the
transacting parties. In India government has been consistently investing in various
reforms for greater financial inclusion. During the last few years’ initiatives such
as Jan Dhan accounts, Aadhar enabled payment systems, e –Wallets, National
financial Switch (NFS) and others have strengthened the government resolve to
go cashless. Today, financial inclusion is seen as a realistic dream because of
mobile and smart phone penetration across the country.
3.2 DEMAND FOR MONEY AND SUPPLY OF MONEY
3.2.1. Demand for Money
The demand for money tells us what makes people desire a certain
amount of money. Since money is required to conduct transactions, the
value of transactions will determine the money people will want to keep:
the larger is the quantum of transactions to be made, the larger is the
quantity of money demanded. Since the quantum of transactions to be made
depends on income, it should be clear that a rise in income will lead to rise in
demand for money. Also, when people keep their savings in the form of money
rather than putting it in a bank which gives them interest, how much money
people keep also depends on rate of interest. Specifically, when interest rates go
up, people become less interested in holding money since holding money amounts
to holding less of interest-earning deposits, and thus less interest received.
Therefore, at higher interest rates, money demanded comes down.
Reprint 2024-25
38 38 38 38 38
Introductory Macroeconomics
3.2.2. Supply of Money
In a modern economy, money comprises cash and bank deposits.
Depending on what types of bank deposits are being included, there are
many measures of money
1
. These are created by a system comprising two types
of institutions: central bank of the economy and the commercial banking system.
Central bank
Central Bank is a very important institution in a modern economy.
Almost every country has one central bank. India got its central bank in
1935. Its name is the ‘Reserve Bank of India’. Central bank has several
important functions. It issues the currency of the country. It controls
money supply of the country through various methods, like bank rate, open
market operations and variations in reserve ratios. It acts as a banker to the
government. It is the custodian of the foreign exchange reserves of the economy.
It also acts as a bank to the banking system, which is discussed in detail later.
From the point of view of money supply, we need to focus on its function of
issuing currency. This currency issued by the central bank can be held by the
public or by the commercial banks, and is called the ‘high-powered money’ or
‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.
Commercial Banks
Commercial banks are the other type of institutions which are a part of
the money-creating system of the economy. In the following section we look at
the commercial banking system in detail. They accept deposits from the public
and lend out part of these funds to those who want to borrow. The interest rate
paid by the banks to depositors is lower than the rate charged from the borrowers.
This difference between these two types of  interest rates, called the ‘spread’ is the
profit appropriated by the bank.
The process of deposit and loan (credit) creation by banks is explained below.
In order to understand this process, let us discuss a story.
Once there was a goldsmith named Lala in a village. In this village,
people used gold and other precious metals in order to buy goods and
services. In other words, these metals were acting as money. People in
the village started keeping their gold with Lala for safe-keeping. In return
for keeping their gold, Lala issued paper receipts to people of the village
and charged a small fee from them. Slowly, over time, the paper receipts
issued by Lala began to circulate as money. This means that instead of
giving gold for purchasing wheat, someone would pay for wheat or shoes
or any other good by giving the paper receipts issued by Lala. Thus, the
paper receipts started acting as money since everyone in the village
accepted these as a medium of exchange.
Now, let us suppose that Lala had 100 Kgs of gold, deposited by
different people and he had issued receipts corresponding to 100 kgs of
gold. At this time Ramu comes to Lala and asks for a loan of 25 kgs of gold. Can
Lala give the loan? The 100 kgs of gold with him already has claimants. However,
Lala could decide that everyone with gold deposits will not come to withdraw
their deposits at the same time and so he may as well give the loan to Ramu and
charge him for it. If Lala gives the loan of 25 kgs of gold, Ramu could also pay Ali
with these 25 kgs of gold and Ali could keep the 25 kgs of gold with Lala in
return for a paper receipt. In effect, the paper receipts, acting as money, would
1
See the box on the measures of money supply at the end of the chapter.
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Money and Banking
have risen to 125 kgs now. It seems that Lala has created money out of thin air!
The modern banking system works precisely the way Lala behaves in this example.
Commercial banks mediate between individuals or firms with excess funds
and lend to those who need funds. People with excess funds can keep their funds
in the form of deposits in banks and those who need funds, borrow funds in
form of home loans, crop loans, etc.  People prefer to keep money in banks because
banks offer to pay some interest on any deposits made. Also, it may be safer to
keep excess funds in a bank, rather than at home, just as people in the example
above preferred to keep their gold with Lala instead of keeping at home. In the
modern context, given cheques and debit cards, having a demand deposit makes
transactions more convenient and safer, even when they do not earn any interest.
(Imagine having to pay a large amount in cash – for purchasing a house.)
What does the bank do with the funds that have been deposited with it?
Assuming that not everyone who has deposited funds with it will ask for their
funds back at the same time, the bank can loan these funds to someone who
needs the funds at interest (of course, the bank has to be sure it will get the
funds back at the required time). So the bank will typically retain a portion of the
funds to repay depositors whenever they demand their funds back, and loan the
rest. Since banks earn interest from loans they make, any bank would like to
lend the maximum possible. However, being able to repay depositors on demand
is crucial to the bank’s survival. Depositors would keep their funds in a bank
only if they are fully confident of getting them back on demand. A bank must,
therefore, balance its lending activities so as to ensure that sufficient funds are
available to repay any depositor on demand.
3.3 MONEY CREATION BY BANKING SYSTEM
Banks can create money in a manner similar to that as given in Lala’s story.
Banks can lend simply because they do not expect all the depositors to withdraw
what they have deposited at the same time. When the banks lend to any person,
a new deposit is opened in that person’s name. Thus money supply increases to
old deposits plus new deposit (plus currency.)
Let us take an example. Assume that there is only one bank in the country.
Let us construct a fictional balance sheet for this bank. Balance sheet is a record
of assets and liabilities of any firm. Conventionally, the assets of the firm are
recorded on the left hand side and liabilities on the right hand side. Accounting
rules say that both sides of the balance sheet must be equal or total assets must
be equal to the total liabilities.  Assets are things a firm owns or what a firm can
claim from others. In case of a bank, apart from buildings, furniture, etc., its
assets are loans given to public. When the bank gives out loan of Rs 100 to a
person, this is the bank’s claim on that person for Rs 100. Another asset that a
bank has is reserves. Reserves are deposits which commercial banks keep with
the Central bank, Reserve Bank of India (RBI) and its cash. These reserves are
kept partly as cash and partly in the form of financial instruments (bonds and
treasury bills) issued by the RBI. Reserves are similar to deposits we keep with
banks. We keep deposits and these deposits are our assets, they can be withdrawn
by us. Similarly, commercial banks like State Bank of India (SBI) keep their
deposits with RBI and these are called Reserves.
Assets = Reserves + Loans
Liabilities for any firm are its debts or what it owes to others. For a bank, the
main liability is the deposits which people keep with it.
Liabilities = Deposits
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36 36 36 36 36
Introductory Macroeconomics
Money and Banking Money and Banking Money and Banking Money and Banking Money and Banking
Money is the commonly accepted medium of exchange. In an
economy which consists of only one individual there cannot be
any exchange of commodities and hence there is no role for money.
Even if there is more than one individual but these individuals do
not take part in market transactions, example: family living on an
isolated island, money has no function for them. However, as soon
as there is more than one economic agent who engage themselves
in transactions through the market, money becomes an important
instrument for facilitating these exchanges. Economic exchanges
without the mediation of money are referred to as barter
exchanges. However, they presume the rather improbable double
coincidence of wants. Consider, for example, an individual who
has a surplus of rice which she wishes to exchange for clothing. If
she is not lucky enough she may not be able to find another person
who has the diametrically opposite demand for rice with a surplus
of clothing to offer in exchange. The search costs may become
prohibitive as the number of individuals increases. Thus, to
smoothen the transaction, an intermediate good is necessary which
is acceptable to both parties. Such a good is called money. The
individuals can then sell their produces for money and use this
money to purchase the commodities they need. Though facilitation
of exchanges is considered to be the principal role of money, it
serves other purposes as well. Following are the main functions of
money in a modern economy.
3.1 FUNCTIONS OF MONEY
As explained above, the first and foremost role of money is that it
acts as a medium of exchange. Barter exchanges become extremely
difficult in a large economy because of the high costs people would
have to incur looking for suitable persons to exchange their
surpluses.
Money also acts as a convenient unit of account. The value of
all goods and services can be expressed in monetary units. 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. If the price of a pencil
is Rs 2 and that of a pen is Rs 10 we can calculate the relative
price of a pen with respect to a pencil, viz. a pen is worth 10 
÷
 2 =
5 pencils. The same notion can be used to calculate the value of
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Money and Banking
money itself with respect to other commodities. In the above example, a rupee is
worth 1 
÷
 2 = 0.5 pencil or 1 
÷
 10 = 0.1 pen. Thus if prices of all commodities
increase in terms of money i.e., there is a general increase in the price level, the
value of money in terms of any commodity must have decreased – in the sense
that a unit of money can now purchase less of any commodity. We call it a
deterioration in the purchasing power of money.
A barter system has other deficiencies. It is difficult to carry forward one’s
wealth under the barter system. Suppose you have an endowment of rice which
you do not wish to consume today entirely. You may regard this stock of surplus
rice as an asset which you may wish to consume, or even sell off, for acquiring
other commodities at some future date. But rice is a perishable item and cannot
be stored beyond a certain period. Also, holding the stock of rice requires a lot of
space. You may have to spend considerable time and resources looking for people
with a demand for rice when you wish to exchange your stock for buying other
commodities. This problem can be solved if you sell your rice for money. Money
is not perishable and its storage costs are also considerably lower. It is also
acceptable to anyone at any point of time. Thus money can act as a store of
value for individuals. Wealth can be stored in the form of money for future use.
However, to perform this function well, the value of money must be sufficiently
stable. A rising price level may erode the purchasing power of money. It may be
noted that any asset other than money can also act as a store of value, e.g. gold,
landed property, houses or even bonds (to be introduced shortly). However,
they may not be easily convertible to other commodities and do not have universal
acceptability.
Some countries have made an attempt to move towards an economy which
use less of cash and more of digital transactions. A cashless society describes an
economic state whereby financial transactions are not connected with money in
the form of physical bank notes or coins but rather through the transfer of digital
information (usually an electronic representation of money) between the
transacting parties. In India government has been consistently investing in various
reforms for greater financial inclusion. During the last few years’ initiatives such
as Jan Dhan accounts, Aadhar enabled payment systems, e –Wallets, National
financial Switch (NFS) and others have strengthened the government resolve to
go cashless. Today, financial inclusion is seen as a realistic dream because of
mobile and smart phone penetration across the country.
3.2 DEMAND FOR MONEY AND SUPPLY OF MONEY
3.2.1. Demand for Money
The demand for money tells us what makes people desire a certain
amount of money. Since money is required to conduct transactions, the
value of transactions will determine the money people will want to keep:
the larger is the quantum of transactions to be made, the larger is the
quantity of money demanded. Since the quantum of transactions to be made
depends on income, it should be clear that a rise in income will lead to rise in
demand for money. Also, when people keep their savings in the form of money
rather than putting it in a bank which gives them interest, how much money
people keep also depends on rate of interest. Specifically, when interest rates go
up, people become less interested in holding money since holding money amounts
to holding less of interest-earning deposits, and thus less interest received.
Therefore, at higher interest rates, money demanded comes down.
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Introductory Macroeconomics
3.2.2. Supply of Money
In a modern economy, money comprises cash and bank deposits.
Depending on what types of bank deposits are being included, there are
many measures of money
1
. These are created by a system comprising two types
of institutions: central bank of the economy and the commercial banking system.
Central bank
Central Bank is a very important institution in a modern economy.
Almost every country has one central bank. India got its central bank in
1935. Its name is the ‘Reserve Bank of India’. Central bank has several
important functions. It issues the currency of the country. It controls
money supply of the country through various methods, like bank rate, open
market operations and variations in reserve ratios. It acts as a banker to the
government. It is the custodian of the foreign exchange reserves of the economy.
It also acts as a bank to the banking system, which is discussed in detail later.
From the point of view of money supply, we need to focus on its function of
issuing currency. This currency issued by the central bank can be held by the
public or by the commercial banks, and is called the ‘high-powered money’ or
‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.
Commercial Banks
Commercial banks are the other type of institutions which are a part of
the money-creating system of the economy. In the following section we look at
the commercial banking system in detail. They accept deposits from the public
and lend out part of these funds to those who want to borrow. The interest rate
paid by the banks to depositors is lower than the rate charged from the borrowers.
This difference between these two types of  interest rates, called the ‘spread’ is the
profit appropriated by the bank.
The process of deposit and loan (credit) creation by banks is explained below.
In order to understand this process, let us discuss a story.
Once there was a goldsmith named Lala in a village. In this village,
people used gold and other precious metals in order to buy goods and
services. In other words, these metals were acting as money. People in
the village started keeping their gold with Lala for safe-keeping. In return
for keeping their gold, Lala issued paper receipts to people of the village
and charged a small fee from them. Slowly, over time, the paper receipts
issued by Lala began to circulate as money. This means that instead of
giving gold for purchasing wheat, someone would pay for wheat or shoes
or any other good by giving the paper receipts issued by Lala. Thus, the
paper receipts started acting as money since everyone in the village
accepted these as a medium of exchange.
Now, let us suppose that Lala had 100 Kgs of gold, deposited by
different people and he had issued receipts corresponding to 100 kgs of
gold. At this time Ramu comes to Lala and asks for a loan of 25 kgs of gold. Can
Lala give the loan? The 100 kgs of gold with him already has claimants. However,
Lala could decide that everyone with gold deposits will not come to withdraw
their deposits at the same time and so he may as well give the loan to Ramu and
charge him for it. If Lala gives the loan of 25 kgs of gold, Ramu could also pay Ali
with these 25 kgs of gold and Ali could keep the 25 kgs of gold with Lala in
return for a paper receipt. In effect, the paper receipts, acting as money, would
1
See the box on the measures of money supply at the end of the chapter.
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Money and Banking
have risen to 125 kgs now. It seems that Lala has created money out of thin air!
The modern banking system works precisely the way Lala behaves in this example.
Commercial banks mediate between individuals or firms with excess funds
and lend to those who need funds. People with excess funds can keep their funds
in the form of deposits in banks and those who need funds, borrow funds in
form of home loans, crop loans, etc.  People prefer to keep money in banks because
banks offer to pay some interest on any deposits made. Also, it may be safer to
keep excess funds in a bank, rather than at home, just as people in the example
above preferred to keep their gold with Lala instead of keeping at home. In the
modern context, given cheques and debit cards, having a demand deposit makes
transactions more convenient and safer, even when they do not earn any interest.
(Imagine having to pay a large amount in cash – for purchasing a house.)
What does the bank do with the funds that have been deposited with it?
Assuming that not everyone who has deposited funds with it will ask for their
funds back at the same time, the bank can loan these funds to someone who
needs the funds at interest (of course, the bank has to be sure it will get the
funds back at the required time). So the bank will typically retain a portion of the
funds to repay depositors whenever they demand their funds back, and loan the
rest. Since banks earn interest from loans they make, any bank would like to
lend the maximum possible. However, being able to repay depositors on demand
is crucial to the bank’s survival. Depositors would keep their funds in a bank
only if they are fully confident of getting them back on demand. A bank must,
therefore, balance its lending activities so as to ensure that sufficient funds are
available to repay any depositor on demand.
3.3 MONEY CREATION BY BANKING SYSTEM
Banks can create money in a manner similar to that as given in Lala’s story.
Banks can lend simply because they do not expect all the depositors to withdraw
what they have deposited at the same time. When the banks lend to any person,
a new deposit is opened in that person’s name. Thus money supply increases to
old deposits plus new deposit (plus currency.)
Let us take an example. Assume that there is only one bank in the country.
Let us construct a fictional balance sheet for this bank. Balance sheet is a record
of assets and liabilities of any firm. Conventionally, the assets of the firm are
recorded on the left hand side and liabilities on the right hand side. Accounting
rules say that both sides of the balance sheet must be equal or total assets must
be equal to the total liabilities.  Assets are things a firm owns or what a firm can
claim from others. In case of a bank, apart from buildings, furniture, etc., its
assets are loans given to public. When the bank gives out loan of Rs 100 to a
person, this is the bank’s claim on that person for Rs 100. Another asset that a
bank has is reserves. Reserves are deposits which commercial banks keep with
the Central bank, Reserve Bank of India (RBI) and its cash. These reserves are
kept partly as cash and partly in the form of financial instruments (bonds and
treasury bills) issued by the RBI. Reserves are similar to deposits we keep with
banks. We keep deposits and these deposits are our assets, they can be withdrawn
by us. Similarly, commercial banks like State Bank of India (SBI) keep their
deposits with RBI and these are called Reserves.
Assets = Reserves + Loans
Liabilities for any firm are its debts or what it owes to others. For a bank, the
main liability is the deposits which people keep with it.
Liabilities = Deposits
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Introductory Macroeconomics
The accounting rule states that both sides of the account must balance. Hence
if assets are greater than liabilities, they are recorded on the right hand side as
Net Worth.
Net Worth = Assets – Liabilities
3.3.1 Balance Sheet of a Fictional Bank
Let our fictional bank start with deposits (liabilities) equal to Rs 100. This could
be because Ms Fernandes has deposited Rs 100 in the bank.  Let this bank
deposit the same amount with RBI as reserves. Table 3.1 represents its balance
sheet.
3.1 Balance Sheet of a Bank
If we assume that there is no currency in circulation, then the total
money supply in the economy will be equal to Rs 100.
M
1
= Currency + Deposits = 0 +100 =100
3.3.2 Limits to Credit Creation and Money Multiplier
Suppose Mr. Mathew comes to this bank for a loan of Rs 500. Can our bank
give this loan? If it gives the loan and Mr Mathew deposits the loan amount
in the bank itself, the total bank deposits and therefore, the total money
supply will rise. It seems as though the banks can go on creating as much
money as they want.
But is there a limit to money or credit creation by banks? Yes, and this is
determined by the Central bank (RBI). The RBI decides a certain percentage of
deposits which every bank must keep as reserves. This is done to ensure that no
bank is ‘over lending’. This is a legal requirement and is binding on the banks.
This is called the ‘Required Reserve Ratio’ or the ‘Reserve Ratio’ or ‘Cash Reserve
Ratio’ (CRR).
Cash Reserve Ratio (CRR) = Percentage of deposits which a bank must
keep as cash reserves with the bank.
Apart from the CRR, banks are also required to keep some reserves
in liquid form in the short term. This ratio is called Statutory Liquidity
Ratio or SLR.
In our fictional example, suppose CRR = 20 per cent, then with deposits of Rs
100, our bank will need to keep Rs 20 (20 per cent of 100) as cash reserves. Only
the remaining amount of deposits, i.e., Rs 80 (100 – 20 = 80) can be used to give
loans. The statutory requirement of the reserve ratio acts as a limit to the amount
of credit that banks can create.
We can understand this by going back to our fictional example of an economy
with one bank. Let us assume that our bank starts with a deposit of Rs 100
made by Leela. The reserve ratio is 20 per cent. Thus our bank has Rs 80 (100 – 20)
Assets Liabilities
Reserves Rs 100 Deposits Rs 100
Net Worth Rs    0
Total Rs 100 Total Rs 100
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