MONEY AND BANKING

Chapter 3
money & banking

Barter system

•Exchange of goods for goods & Services for services.

Defects of Barter system

1.Double coincidence of wants –need to have mutually exchangeable goods.

2.Indivisibility of commodities

3.Lack of common measure of value

4.Lack of proper store of value.

Money:  definition

Money is the stock  of assets that can be readily used to make transactions.

                        Primary functions

•1.Medium of exchange -we use it to buy stuff

•2.Measure of value – goods & services

                        Secondary functions

•1.Standard of deferred payment – future payment

•2.Store of value 

•3.Transfer of value- transfers purchasing power from the present to the future

CONTINGENT FUNCTION

•1.Basis of credit

•2.Distribution of National Income

•3.Medium of compensation

•4.Liquidity– money is the most liquid of all assets

Classification of money
1.Legal tender money – money which has legal sanction

•2.Full bodied money (standard money) – face value is equal to its intrinsic value (value of metal)

•3.Fiat money – legal tender money having no intrinsic value. e.g.,currency notes and coins

Indian Monetary System

•Meaning – the monetary standard and monetary set up of a country.

•The type of standard money used in the country is its monetary standard .

•The apex monetary authority in our country is RBI.

The system of currency issue

•The Minimum Reserve System

•The system of note issue in India is MRS

•Under this system, a reserve worth Rs.200 crores to be held by the RBI.

•Of this, gold reserves of Rs.115 crores and the rest in the form of foreign exchange securities

•RBI issues currency notes above Rupee 1.

RESERVE BANK OF INDIA ( RBI )

       RBI is the Central Bank of our country

FUNCTIONS OF RBI

1. Note issue – RBI issues currency notes & coins

2. Banker, Agent & Adviser to the Govt.

3. Custodian of foreign exchange reserves

4. Bankers’ Bank – RBI controls & regulates the commercial banks through its Monetary Policy

5.Lender of the last resort – RBI helps the commercial banks in times of crisis.

6. Controller of credit & money supply – through its Monetary Policy RBI controls the volume of credit.

7. Publisher of reports – periodical reports on banking & other monetary matters.

Commercial Banks

•Accept deposits from the public

•Lending money

•Borrowing rate – the rate of interest     offered by the bank to deposit holders

•Lending rate – the rate of interest levied           for lending money

•The difference between lending & borrowing rate is called “spread”,  and is the profit appropriated by the banks.

Deposits

•1. savings deposits / demand deposits— chequeable deposits having low         interest rate.

•2. Time deposits / fixed deposits / term deposits—

Have a fixed period to maturity

Having high interest rate

Money Supply
 Legal definitions of Money

                        Money Supply is a stock variable.

•Money Supply is the total stock of money in circulation at a particular point of time.

•Measures of Money Supply by RBI

•1.  M1= CU + DD

            CU is currency held by the public.

            DD is demand deposits held by the commercial banks.       

•2.  M2= M1 + Savings deposits with Post Office savings         bank

•3.  M3= M1 + Net time deposits of Commercial Banks

•4.  M4= M3 + Total deposits with Post Office             savings organizations

Narrow & Broad Money

•M1 and M2 are known as Narrow Money

•M3 and M4 are known as Broad Money

•M1 is the most liquid asset

•M4 is the least liquid asset

AGGREGATE MONETARY RESOURCE

            M3 is the most commonly used measure of money supply and it is the AMR.

MONEY CREATION BY THE BANKING SYSTEM

•1. The Currency Deposit Ratio (cdr)

                          cdr =CU/DD

                         it reflects people’s preference for liquidity.

2. The Reserve Deposit Ratio (rdr)

                          rdr = R/DD

It is the proportion of the total deposits commercial banks keep as reserves.

Rdr has two instruments

•1. Cash Reserve Ratio (CRR) –

•The fraction of commercial banks deposits kept in RBI is CRR.

•2. Statutory Liquidity Ratio (SLR) –

•Commercial banks have to keep a given fraction of their total deposits n the form of specified liquid assets.

BANK RATE

•To control the value of rdr RBI uses another instrument called Bank Rate,

•It is the rate at which RBI lend money to the commercial banks.

•A high BR makes borrowing costly for commercial banks.

HIGH POWERED MONEY (H)

•The total liability of the Monetary authority of the country,RBI, is called the H or Monetary Base.

•H = CU + R                    R is the reserves

Demand for money

•Demand for money balance is liquidity preference.

•Whether to hold cash or put it in savings bank so as to earn interest.

•People desire to hold money balance from       two motives —

•1. The Transaction Motive

•2. The Speculative Motive

Transaction motive

•Holding money for transactions

•Transaction demand for money in an economy,

MT  can be written as

v.M  = T 

Where,  v is velocity of circulation of money

•                                   T is the total value of transaction in the economy.

Velocity

•basic concept:  the rate at which money circulates

•definition:  the number of times the average rupee changes hands in a given time period

•example:  In 2010,

•Rs.500 crores in transactions

•money supply = Rs.100 crores

•The average Rupee is used in five transactions in 2010

•So, velocity = 5.