Money and Banking — Notes

Barter is the direct exchange of goods for goods. Its problems:

1. Lack of double coincidence of wants: each party must want exactly what the other offers.
2. No common measure of value: endless exchange ratios.
3. Indivisibility of goods such as cattle.
4. Difficulty of storing value: goods rot or need upkeep.
5. No standard for deferred payments: disputes over the quality of goods repaid.

Money is anything generally accepted as a medium of exchange and a measure of value. Its form has changed (commodity money, coins, paper notes, bank deposits, digital payments).

Legal tender: money that cannot be refused in payment by law, such as RBI notes and coins. Fiat money: money whose value rests on the government's order, not its material. Demand deposits are money but not legal tender.

Primary functions

1. Medium of exchange: splits barter into sale and purchase.
2. Unit of account (measure of value): prices and accounts in one unit.

Secondary functions 3. Store of value: saving purchasing power for the future. 4. Standard of deferred payment: loans, instalments and salaries stated in money.

Money supply is the stock of money held by the public at a point of time. The "public" means households, firms and local bodies; it excludes the producers of money (the government and the banking system).

Narrow money (M1) = currency held by the public (notes and coins) + net demand deposits of commercial banks (savings and current accounts, leaving out inter-bank deposits) + other deposits with the RBI.

Not counted in M1: cash in bank vaults, government cash, and time (fixed) deposits, which enter broader measures.

Issuers in India: the RBI issues currency notes except one-rupee notes; the Government of India issues one-rupee notes and coins.

A commercial bank accepts deposits and lends. Since depositors do not all withdraw at once, it keeps a fraction as reserves and lends the rest. The legal reserve ratio (LRR) is the minimum fraction fixed by the central bank (CRR with the RBI + SLR with the bank).

Process: deposit → reserve kept → loan → loan spent and redeposited → next round, smaller each time.

Formulae

• Money multiplier = 1 ÷ LRR
• Total deposits = initial deposit × money multiplier
• Credit created = total deposits − initial deposit

Example: ₹10,000 at LRR 20%: multiplier 5, total deposits ₹50,000, credit ₹40,000.

Assumptions: all money stays in the banking system (no cash drain); banks keep only the required reserves; there are enough borrowers. In practice, cash drain, excess reserves and weak loan demand make actual creation smaller.

The central bank is the apex monetary institution; it works in the public interest, not for profit. India's central bank is the Reserve Bank of India (set up in 1935, nationalised in 1949).

1. Bank of issue: sole issuer of currency notes except one-rupee notes.
2. Banker, agent and adviser to the government: accounts, payments, public debt, advice.
3. Bankers' bank and supervisor: holds banks' reserves, clears payments, licenses and regulates banks.
4. Lender of last resort: lends to sound banks facing a sudden shortage, protecting depositors.
5. Controller of credit: regulates the volume and direction of credit.
6. Custodian of foreign exchange reserves.

Quantitative (general) instruments

• Repo rate: rate at which the RBI lends short-term funds to banks against government securities.
• Reverse repo rate: rate the RBI pays on funds banks park with it (the RBI borrows).
• Bank rate: rate at which the RBI lends to banks for longer periods without a repurchase deal.
• Cash reserve ratio (CRR): share of deposits kept as cash with the RBI.
• Statutory liquidity ratio (SLR): share kept by banks in liquid assets (cash, gold, approved securities).
• Open market operations: buying (injects money) or selling (absorbs money) government securities.

Qualitative (selective) instruments

• Margin requirement: the part of a security's value not lent; a higher margin means a smaller loan.
• Moral suasion: persuading banks through advice and meetings.

Excess demand: raise rates and ratios, sell securities, raise margins. Deficient demand: the reverse.