4. BARTER SYSTEM – existed in early times when a commodity was
exchanged for another. It was difficult to carry out transactions under this
system due to many problems that came between the people who
transacted. One of the major problems was ‘double coincidence of
wants’.
Introduction of money has solved all these problems.
5.
6. MONEY is a commonly accepted ‘Medium of Exchange’.
It is also a ‘Measure of Value’, a ‘Store of Value’ and a ‘Standard of
Deferred Payments’.
MONEY SUPPLY – refers to the total quantity of money in circulation in
the economy at a given point of time. It is a stock variable since the
total stock of money in circulation among the public is measured at a
particular point of time.
7. The components of M1 supply of money are:-
M1 = CC + DD + Other deposits with RBI.
1) Currency and coins held by the public.
a) The currency issued by the Central Bank is called ‘High Powered Money’.
b) Currency notes & coins are called ‘Legal Tender.’
c) Currency notes & coins are called ‘Fiat Money’.
2)Net demand deposits held by the commercial banks (only deposits of the
public held by the banks)
a) Demand deposits created by commercial banks are called ’bank money.’
b) Inter bank deposits not included.
3) Other deposits with the RBI (demand deposits of foreign Central banks
and international financial institutions.)
8. [M2 = M1 + Savings deposits with Post office savings bank
M3 = M1 + Net time deposits of commercial banks.
M4 = M1 + Total deposits with post office savings organisations (excluding
NSC)]
M1 is the most liquid form of money supply and is referred to as ‘narrow
money’.
M2 is also narrow money while M3 and M4 are broad money. The level of
liquidity decreases from M1 to M4.
9. Money supply is created by a system comprising of two types of
institutions – Central Bank of the economy (RBI) and Commercial
Banking System.
Central Bank of India or RBI regulates the supply of money in the
economy by issuing currency notes.
It controls money supply in the country through bank rate, open
market operations and variations in reserve ratios.
Commercial Banks are the other type of institutions which are part of
the money creating system in the economy.
13. COMMERCIAL BANKS - are financial institutions which accepts
deposits from the general public and extends loans for investment with
the aim of earning profit.
The interest paid by the commercial banks to depositors is lower than
the rate charged from the borrowers. The difference between these
two interest rates is called the ‘spread’ and is the profit appropriated
by the bank.
Two distinctive functions of commercial banks are borrowing and
lending, or in other words accepting deposits and giving loans.
14. Demand deposits can be withdrawn on demand by depositors by issuing
a cheque. They are also referred to as chequable deposits. Since they are
highly liquid they are treated as part of money supply. Current account
deposits and savings account deposits are demand deposits.
Time deposits also called as fixed or term deposits. They are kept with
the bank for a fixed period and can be withdrawn only after the expiry of
the specified period.
Interest on time deposits are higher than those on savings account
deposits.
15. Credit Creation/ Deposit Creation/ Money Creation by Commercial Banks
Commercial banks receive deposits from the public. It cannot use the total
deposits for giving loans. It is legally compulsory for the banks to keep a certain
minimum fraction of net demand and time deposits as legal reserves. This
fraction is called Legal Reserve Ratio ( LRR).
Credit creation is a process by which a commercial bank creates total deposits
which is number of times the initial deposit.
LRR has two components – 1) Cash Reserve Ratio
2) Statutory Liquidity Ratio
Credit Multiplier = 1/ Legal Reserve ratio
Total credit creation = Initial deposit x 1/ Legal Reserve Ratio
16. Credit creation is based on the following assumptions –
1) There is a single banking system in the economy.
2) All transactions are routed through banks.
3) A depositor does not normally withdraw his entire deposit at one time.
Credit Creation by Commercial Banks ( Initial deposit = Rs.1000 & LRR = 20%)
Rounds Deposits (Rs.) Loans (Rs.) Reserve (Rs.)
I 1,000 800 200
II 800 640 160
III 640 512 128
“ “ “
“ “ “
TOTAL 5,000 4,000 1,000
17. Suppose a customer deposits Rs.1,000 in a bank and the legal reserve
ratio is 20% as proposed by RBI. The bank will retain Rs.200 to meet
customer obligation and remaining Rs. 800 is lent to others. Those who
borrow , will spend and the amount will come back to the bank as
deposits. Now bank retains 20% of Rs. 800,ie, Rs. 160 and the remaining
Rs. 640 is available for lending. This process continues till there is no
further amount available for lending.
Money multiplier is 5 and when the initial deposit is Rs. 1000, the total
deposits in the banking system will be Rs.5,000.
This is how commercial banks are able to create credit multiple times the
initial deposit.
18.
19. Central Bank of India or The Reserve Bank of India is a very important institution
in modern India. It was instituted on 1st April, 1935.
It is the apex institution of a country’s monetary system. The design and
control of the country’s monetary policy is its main responsibility.
FUNCTIONS OF CENTRAL BANK
1) Authority of Currency Issue / Bank of Issue – The RBI is the sole authority
for the issue of currency in the country. It promotes efficiency in the financial
system, leads to uniformity & monopoly in the issue of currency and has a
direct control over money supply.
The currency issued by the Central Bank can be held by the public or the
commercial banks and is called ‘the high- powered money’ or ‘reserve money’.
20. 2)Banker to the Govt./ Govt’s Bank–Banker to both the Central and State Govts.
Maintains balances, arranges and manages funds of the Govt.
Accepts receipts and makes payments for the Govt.
Manages public debt and is the financial advisor to the Govt. etc.
3) Banker’s Bank – Holds surplus cash of commercial banks.
Gives loans to them when they are in need (Lender of the last resort).
Cheque clearing and remittance facilities. ( Clearing House)
Supervisor and regulator of banking system.
4) Controller of Credit – It is the most crucial function played by the RBI in
modern times. It removes causes for price instability, effectively controls
economic activities and mobilises credit in the desired direction. The RBI
controls the supply of money in the economy through Quantitative and
Qualitative tools.
21. Quantitative Measures – 1) Bank Rate – is the rate of interest at which RBI
lends to commercial banks for long term. During deflation or recession, in
order to increase the supply of money the RBI reduces the bank rate.
Commercial banks in turn will reduce their lending rates which results in mor
investments and money supply.
a) Repo rate – is the rate at which RBI lends to commercial banks for short
term requirements. To increase borrowings by the public and increase money
supply, RBI reduces the repo rate.
b)Reverse Repo Rate – When commercial banks have surplus funds, they can
deposit the same with the RBI and earn interest. This interest is the reverse
repo rate. When this rate is decreased it discourages commercial banks to
park their funds with RBI. It increases the lending capacity of banks.
22. 2) Open Market Operations – refers to buying and selling of Govt. securities
from /to the public by the RBI on behalf of Govt.. During inflation, Govt. securities
are sold to the public and in turn cheques are given to RBI. This reduces the
amount of money in circulation and the capacity of commercial banks to lend.
3)Legal Reserve Ratio – is the minimum reserve that a commercial bank must
maintain as per the instructions of RBI. Its components are cash reserve ratio
and statutory liquidity ratio.
CRR – fraction of net total demand and time deposits that commercial banks
must keep as cash reserves with RBI.
SLR - fraction of net total demand and time deposits that commercial banks
must keep with themselves in the form of liquid assets.
When CRR or SLR or both are increased, commercial banks will have less
money for lending operations. This reduces money supply.
23. Qualitative Measures –
1)Margin Requirement – on loan refers to the difference between current
market value of the security offered and amount of loan granted by the banks.
If margin imposed is 40% then only 60% of the value of the security will be
given as loan. Margin requirements are lowered to allow borrowers to borrow
more and increase supply of money in the economy.
2)Moral Suasion – The RBI cautions the commercial banks to persuade its
customers to either invest more during deflation or invest less during inflation.
3)Selective Credit Control – The commercial banks scrutinise extensively and
sanction loans only for a few projects which are absolutely necessary for the
economy. This happens during times of inflation.
24. Central Bank of India or RBI Commercial Banks
1) It is the apex bank in the money market
of a country.
It is one of the units in the
banking structure.
2) Its primary aim is general public welfare. Its primary aim is profit.
3) It has monopoly right to issue currency. It is denied this function.
4) It cannot deal with the public. It deals with the public
and business firms.
Difference between RBI and
Commercial Banks
Clearing House – Banks receive cheques drawn on the other banks from their
customers which they have to realise from their drawee banks. Similarly, cheques on a
particular bank are drawn and passed into the hands of other banks which have to
realise them from the drawee banks.
