Money and Banking

Money is any commodity or token that is generally accepted as a medium of exchange for goods and services and for the settlement of debts. Functions of Money: 1. Medium of Exchange (Primary function): • Money eliminates the need for a 'double coincidence of wants' that plagued barter economies. • In a barter system, a farmer who wants cloth must find a weaver who wants grain. Money allows the farmer to sell grain to anyone and buy cloth from anyone. 2. Unit of Account / Measure of Value (Primary function): • Money provides a common unit in which the value of all goods and services is expressed (prices in rupees, dollars, etc.). • Without a common unit, comparing values would require knowing the exchange ratio between every pair of goods. 3. Store of Value: • Money can be held and used in the future. It allows purchasing power to be stored over time. • Limitation: Inflation erodes the store of value function. 4. Standard of Deferred Payment: • Debts and future contracts are specified in terms of money — money is the basis for credit transactions. Historical Evolution of Money: 1. Commodity Money: Earliest form — goods with intrinsic value used as money (grain, cattle, shells, salt). 2. Metallic Money (Coins): Gold, silver, copper coins — value came from the metal content. Durable and portable but limited in supply. 3. Paper Money (Representative/Fiat Money): Governments issued paper currency — initially backed by gold (gold standard); later 'fiat money' — valuable because the government declares it legal tender, not because of intrinsic value. 4. Bank Deposits (Credit Money): Today, most 'money' is in the form of bank deposits — entries in accounts that can be transferred via cheques, debit cards, and electronic payments. 5. Digital/Electronic Money: Cryptocurrencies, mobile payments (UPI, NEFT, RTGS).

Commercial Banks: • Commercial banks are financial institutions that accept deposits from the public and use those funds to make loans, thereby providing credit to the economy. • Examples: State Bank of India, HDFC Bank, ICICI Bank. • Main functions: (i) Accepting deposits (savings, current, fixed); (ii) Granting loans and advances; (iii) Creating credit; (iv) Providing remittance and payment services; (v) Agency services. Process of Credit Creation (Money Multiplier): • Commercial banks operate on a fractional reserve system — they keep only a fraction of deposits as reserves and lend out the rest. • Legal Reserve Ratio (LRR) / Reserve Requirement: The minimum fraction of deposits that banks must hold in cash/reserves (set by the RBI). Example (LRR = 20%): Round 1: Bank A receives a fresh deposit of ₹1,000. • Keeps ₹200 as reserve (20%), lends ₹800. Round 2: The ₹800 lent out is spent and deposited in Bank B. • Bank B keeps ₹160 (20% of ₹800), lends ₹640. Round 3: Bank C receives ₹640, keeps ₹128, lends ₹512. • This process continues... Total deposits created = Initial deposit × (1/LRR) = ₹1,000 × (1/0.20) = ₹1,000 × 5 = ₹5,000 Money Multiplier = 1/LRR = 1/0.20 = 5 Implications: • A small initial deposit can create a much larger amount of money in the banking system. • The higher the LRR, the lower the money multiplier and less credit creation. • The RBI uses the LRR (Cash Reserve Ratio — CRR) as a tool of monetary policy: increasing CRR reduces credit creation and money supply; decreasing CRR increases it.

Central Bank: • The central bank is the apex monetary institution of a country — it is the 'banker's bank' and the government's bank. • In India: Reserve Bank of India (RBI), established 1935; nationalised 1949. Functions of the Central Bank (RBI): 1. Issue of Currency: • The RBI has the sole authority to issue currency notes in India (except ₹1 coins/notes, issued by the Government of India). • Ensures adequate supply of currency in circulation. 2. Banker to the Government: • Manages the government's accounts, accepts deposits, provides short-term loans. • Manages public debt — issues government bonds and Treasury Bills. 3. Banker's Bank / Lender of Last Resort: • All commercial banks maintain accounts with the RBI (Cash Reserve Ratio). • The RBI lends to commercial banks in times of liquidity crises — it is the lender of last resort, ensuring stability of the banking system. 4. Controller of Credit / Monetary Policy: • The RBI regulates the money supply and credit in the economy to achieve macroeconomic goals: price stability (controlling inflation), economic growth, and exchange rate stability. 5. Custodian of Foreign Exchange Reserves: • Manages India's foreign exchange reserves; intervenes in the forex market to manage the rupee's exchange rate. RBI's Instruments of Monetary Policy: Quantitative (General) Instruments: 1. Bank Rate / Repo Rate: The rate at which the RBI lends to commercial banks. Raising repo rate makes borrowing costlier for banks → they raise lending rates → credit and money supply contract (controls inflation). 2. Reverse Repo Rate: The rate at which RBI borrows from commercial banks. Raising it encourages banks to deposit more with RBI → reduces lendable funds → reduces money supply. 3. Cash Reserve Ratio (CRR): The minimum fraction of deposits banks must keep as cash reserves with RBI. Raising CRR reduces funds available for lending → reduces money supply. 4. Statutory Liquidity Ratio (SLR): The minimum fraction of deposits banks must hold in liquid assets (gold, government securities). Raising SLR reduces lendable funds. 5. Open Market Operations (OMO): RBI buys or sells government securities in the open market. Buying securities injects money into the economy (expansionary); selling absorbs money (contractionary).