Money and Banking: Money is the universally accepted medium of exchange. In a hypothetical economy consisting of only one individual, there is no exchange of goods or services, and thus, money has no role. Similarly, if a group of individuals lives in isolation and does not participate in market transactions, such as a family on a remote island, money holds no function for them.
However, once there are multiple economic agents engaging in market transactions, money becomes an essential tool for facilitating exchanges. Without money, economic exchanges would rely on a barter system, where goods and services are traded directly. Barter systems require the unlikely occurrence of a double coincidence of wants—where each party must have exactly what the other desires and be willing to exchange it.
For instance, consider an individual with a surplus of rice who wishes to trade it for clothing. Unless this person finds someone who has surplus clothing and simultaneously desires rice, the exchange cannot occur. As the number of individuals increases, the difficulty and cost of finding matching needs (search costs) become prohibitive.
To overcome these challenges, an intermediary good acceptable to all parties is required—this good is called money. Using money, individuals can sell their goods for monetary value and then use that money to purchase the commodities they need.
While facilitating exchange is the primary function of money, it serves additional roles in a modern economy. Below are the main functions of money.
Table of Contents
Functions of Money
Money plays a pivotal role in a modern economy, serving multiple essential functions:
1. Medium of Exchange
The primary function of money is to act as a medium of exchange, eliminating the inefficiencies of a barter system. In a large economy, barter becomes impractical due to the significant costs involved in finding suitable exchange partners with matching surpluses and needs. Money facilitates transactions seamlessly by acting as a universally accepted intermediary.
2. Unit of Account
Money provides a standardized unit of account, allowing the value of all goods and services to be expressed in monetary terms. For instance, if a wristwatch is priced at Rs. 500, it signifies that the watch can be exchanged for 500 units of money. Similarly, relative prices between goods can be calculated, such as determining that a pen priced at Rs. 10 is equivalent in value to five pencils priced at Rs. 2 each.
The concept extends to the value of money itself relative to commodities. For example, if the price of all goods rises—indicating inflation—the purchasing power of money decreases since each unit can now buy fewer goods. This decline reflects a deterioration in money’s value.
3. Store of Value
Money also acts as a store of value, enabling individuals to preserve wealth for future use. Unlike perishable goods like rice, money does not deteriorate over time, incurs minimal storage costs, and is widely accepted at any time. These attributes make money a reliable medium for saving wealth.
However, the stability of money’s value is critical for this function. Inflation can erode purchasing power, diminishing money’s effectiveness as a store of value. Alternative assets, such as gold, property, or bonds, also serve as stores of value, but they lack money’s universal acceptability and ease of exchange.
4. Transition to Digital Transactions
Modern economies are increasingly moving toward cashless systems, where financial transactions are conducted digitally rather than through physical cash. In such systems, money exists as electronic representations, facilitating faster and more efficient exchanges.
In India, the government has taken significant steps to promote financial inclusion and digital transactions. Initiatives like Jan Dhan accounts, Aadhaar-enabled payment systems, e-wallets, and the National Financial Switch (NFS) have paved the way for a less-cash society. With the widespread penetration of mobile phones and smartphones, the dream of financial inclusion through digital means is becoming a reality.
Money, in its various forms, continues to evolve, but its core functions as a medium of exchange, unit of account, and store of value remain fundamental to economic activity.
Demand for Money
The demand for money refers to the factors that influence how much money people wish to hold. Since money facilitates transactions, the volume of transactions directly impacts the amount of money individuals require. In essence, as the scale of transactions increases, the demand for money rises proportionally.
1. Income and Transactions
The quantum of transactions depends on the level of income. A higher income typically results in a greater volume of transactions, thereby increasing the demand for money. In this sense, income serves as a primary determinant of how much money people wish to hold.
2. Interest Rates and Opportunity Cost
Another key factor influencing money demand is the interest rate. When people hold money instead of depositing it in interest-earning accounts, they forgo the opportunity to earn interest. As interest rates rise, the opportunity cost of holding money also increases, making individuals less inclined to hold large amounts of cash. Consequently, at higher interest rates, the demand for money decreases.
In summary, the demand for money is shaped by the level of income, which drives the need for transactions, and the interest rate, which affects the opportunity cost of holding money. These two factors collectively determine the quantity of money that individuals and businesses prefer to hold at any given time.
Supply of Money
In a modern economy, money consists of cash and bank deposits. The specific definition of money supply varies based on the types of bank deposits included. The monetary system is managed by two key institutions: the central bank and the commercial banking system.
Central Bank
The central bank is a pivotal institution in any modern economy, with nearly every country having one. India’s central bank, the Reserve Bank of India (RBI), was established in 1935. The central bank performs several critical functions:
- Issuance of Currency: It is responsible for issuing the country’s currency.
- Control of Money Supply: It regulates the money supply using tools such as the bank rate, open market operations, and changes in reserve ratios.
- Banker to the Government: It manages government accounts and financing.
- Custodian of Foreign Exchange Reserves: It safeguards and manages the nation’s foreign currency reserves.
- Banker to Banks: It provides financial services to commercial banks.
From the perspective of money supply, its role in issuing currency is especially significant. This currency, known as “high-powered money,” “reserve money,” or the “monetary base,” forms the foundation for credit creation. It is held by the public or commercial banks.
Commercial Banks
Commercial banks form the other key component of the money-creation system. Their primary activities include accepting deposits from the public and providing loans to borrowers. The difference between the interest rate charged on loans and the rate paid on deposits—referred to as the “spread”—constitutes the bank’s profit.
The Process of Credit Creation
To understand how banks create credit, consider a historical analogy:
In a village, a goldsmith named Lala safeguarded gold for villagers, issuing paper receipts as proof of deposit. These receipts eventually became accepted as a medium of exchange, effectively functioning as money. One day, Lala realized that not all depositors would claim their gold simultaneously. He decided to lend some of the gold to others, issuing additional receipts. This practice effectively increased the money supply, as the receipts in circulation exceeded the actual gold in his vault.
Modern banks operate on a similar principle. They mediate between depositors with surplus funds and borrowers in need of money. Depositors trust banks because:
- Banks pay interest on deposits.
- Deposits in banks are perceived as safer than keeping cash at home.
- Banks offer convenient services such as checks and debit cards.
Lending Activities
Banks do not lend all deposited funds; they retain a portion to meet withdrawal demands. This portion is held as reserves, ensuring that depositors can retrieve their money when needed. Balancing reserves and lending is essential for a bank’s stability. While lending maximizes profits, sufficient reserves are crucial to maintaining public trust and operational sustainability.
In essence, commercial banks play a critical role in the modern monetary system by facilitating credit creation and managing financial resources efficiently.
Money Creation by the Banking System
Banks create money through a process similar to the one described in Lala’s story. This is possible because banks operate under the assumption that not all depositors will withdraw their funds simultaneously. When a bank lends money to a borrower, it creates a new deposit in the borrower’s name, effectively increasing the money supply. The total money supply becomes the sum of the old deposits, the new deposit, and any currency in circulation.
Example of Money Creation
Assume there is only one bank in the country. To understand its functioning, let’s construct a hypothetical balance sheet, which records the assets and liabilities of the bank.
- Assets: Represent what the bank owns or can claim from others. For a bank, this includes:
- Loans: When a bank lends Rs. 100 to a person, this amount becomes a claim the bank has on the borrower.
- Reserves: These are deposits that commercial banks maintain with the central bank (e.g., the Reserve Bank of India, RBI) and the cash held by the bank. Reserves are further divided into:
- Cash Reserves: Physical currency held by the bank.
- Reserve Instruments: Financial instruments like bonds and treasury bills issued by the RBI.
- Liabilities: Represent the bank’s obligations or what it owes to others. For a bank, the primary liability is deposits, which people have entrusted to the bank.
Formula: Liabilities = Deposits
Balancing the Balance Sheet
According to accounting principles, a bank’s total assets must equal its total liabilities. If the assets exceed liabilities, the difference is recorded as Net Worth, representing the bank’s equity.
Net Worth Formula: Net Worth=Assets−Liabilities
This balance ensures that the bank operates sustainably while continuing to manage its lending and deposit activities. Through this process, the banking system plays a critical role in money creation and the functioning of the broader economy.
Balance Sheet of a Fictional Bank
Let’s consider a fictional bank that begins with deposits (liabilities) totaling Rs. 100. For instance, this amount could represent Ms. Fernandes depositing Rs. 100 into the bank. The bank then keeps the entire amount as reserves with the Reserve Bank of India (RBI). The corresponding balance sheet is shown below:
Balance Sheet of a Bank
| Assets | Liabilities |
|---|---|
| Reserves: Rs. 100 | Deposits: Rs. 100 |
| Net Worth: Rs. 0 | |
| Total: Rs. 100 | Total: Rs. 100 |
In this scenario, assuming no currency is in circulation, the total money supply in the economy is equal to Rs. 100.
Money Supply Formula:
M1 ​= Currency + Deposits = 0 + 100 = 100
Limits to Credit Creation and the Money Multiplier
Suppose Mr. Mathew approaches the bank for a loan of Rs. 500. If the bank grants this loan and Mr. Mathew deposits the amount back into the bank, the total deposits—and consequently, the total money supply—will increase. At first glance, it might seem that banks can create unlimited amounts of money.
However, there are limits to money or credit creation, which are set by the central bank (RBI). To prevent excessive lending, the RBI mandates that banks maintain a specific percentage of their deposits as reserves. This requirement, legally binding on all banks, is known as the Required Reserve Ratio or Reserve Ratio. A key component of this reserve is the Cash Reserve Ratio (CRR).
Cash Reserve Ratio (CRR): The percentage of total deposits that a bank must hold as cash reserves.
In addition to CRR, banks must also maintain some reserves in liquid assets for short-term needs. This is called the Statutory Liquidity Ratio (SLR).
An Example of Credit Creation
Let’s assume the following scenario for our fictional bank:
- Initial deposit: Rs. 100
- Reserve ratio (CRR): 20%
- Step 1:
- The bank must keep Rs. 20 (20% of Rs. 100) as reserves.
- The remaining Rs. 80 (Rs. 100 – Rs. 20) is available for loans.
- Step 2:
- The bank lends Rs. 80 to Jaspal Kaur.
- Jaspal deposits this Rs. 80 back into the bank, increasing total deposits to Rs. 180.
- The bank must now hold 20% of Rs. 180, which is Rs. 36, as reserves.
- This leaves Rs. 64 (Rs. 100 – Rs. 36) available for lending.
- Step 3:
- The bank lends Rs. 64 to Junaid, who deposits it back into the bank, raising total deposits to Rs. 244.
- The required reserves now become 20% of Rs. 244, or Rs. 48.80, leaving Rs. 51.20 for further lending.
This cycle continues, with the bank lending and deposits increasing incrementally. The process eventually halts when the required reserves equal the original cash reserves of Rs. 100.
Total Money Supply and the Money Multiplier
In this example, the total deposits stabilize at Rs. 500, as this is the point where the reserves required (20% of Rs. 500 = Rs. 100) match the initial reserves of the bank.
The relationship between the reserve ratio and the maximum money supply is governed by the money multiplier:
Money Multiplier=1/CRR
For a CRR of 20%, the money multiplier is:
1/0.20=5
This means that an initial deposit of Rs. 100 can generate up to Rs. 500 in total deposits within the banking system. The reserve requirements act as a regulatory mechanism, ensuring a balance between credit creation and financial stability.
Since the bank is required to maintain only 20% of its deposits as reserves, reserves amounting to Rs. 100 (20% of Rs. 500) can support total deposits of Rs. 500. This implies that the bank can extend loans up to Rs. 400 (Rs. 500 – Rs. 100). The following balance sheet illustrates this scenario:
Money Supply Calculation:
M1 = Currency + Deposits = 0 + 500 = 500
As a result, the money supply increases from Rs. 100 to Rs. 500.
With a CRR of 20%, the bank cannot extend loans beyond Rs. 400. This reserve requirement acts as a constraint on the extent of money creation, ensuring a balance between lending and financial stability.
Policy Tools to Control Money Supply
The Reserve Bank of India (RBI) holds exclusive authority to issue currency in the country. When commercial banks require additional funds to expand credit, they can either turn to the financial markets or seek assistance from the RBI. The RBI, as the lender of last resort, provides funds to commercial banks through various instruments. This role underscores the central bank’s critical function in maintaining liquidity and stability within the banking system.
The RBI employs several tools to regulate the money supply in the economy. These tools are categorized as quantitative or qualitative:
- Quantitative Tools: These tools influence the overall money supply by adjusting parameters such as the Cash Reserve Ratio (CRR), bank rate, or through open market operations (OMO).
- Qualitative Tools: These tools focus on influencing the behavior of commercial banks. Methods include moral suasion, where the RBI persuades banks to adjust lending practices, and margin requirements, which regulate the amount of collateral needed for loans.
Effect of Reserve Ratio Changes
Adjustments to the reserve ratio directly impact lending by banks, deposits, and the money supply. For example, if the RBI increases the reserve ratio from 20% to 25%, the money multiplier decreases, reducing the total money supply. In the previous example:
- At 20% CRR, Rs. 100 in reserves supported Rs. 500 in deposits.
- At 25% CRR, the same Rs. 100 in reserves can support only Rs. 400 in deposits.
Banks would need to recall loans to meet the increased reserve requirements, leading to a contraction in the money supply.
Open Market Operations (OMO)
Open market operations involve the buying and selling of government bonds in the open market by the RBI.
- Purchasing Bonds: When the RBI buys government bonds, it injects money into the economy by issuing payments (usually through cheques). This increases the reserves held by banks and expands the money supply.
- Selling Bonds: When the RBI sells government bonds, it reduces the reserves held by banks, leading to a contraction in the money supply.
Types of Open Market Operations:
- Outright Operations: These are permanent transactions where the central bank either buys or sells securities without any commitment to reverse the transaction later.
- Repo and Reverse Repo Operations:
- Repo (Repurchase Agreement): The RBI lends money by purchasing securities with an agreement to sell them back at a specified date and price. The interest rate for this transaction is called the repo rate.
- Reverse Repo: The RBI withdraws money by selling securities with an agreement to buy them back later. The rate for this transaction is the reverse repo rate.
The RBI conducts repo and reverse repo operations across varying maturities (e.g., overnight, 7-day, 14-day) to manage liquidity effectively. These operations have become a primary monetary policy tool for the RBI.
Bank Rate
The bank rate is the interest rate at which the RBI lends to commercial banks. Adjustments to the bank rate influence money supply:
- Increase in Bank Rate: Loans from the RBI become more expensive, reducing reserves and limiting credit creation, thereby decreasing the money supply.
- Decrease in Bank Rate: Loans become cheaper, encouraging borrowing and increasing the money supply.
Through these tools, the RBI maintains control over the money supply, ensuring economic stability and growth.
The Supply of Money: Various Measures
In a modern economy, money primarily comprises currency notes and coins issued by the country’s monetary authority. In India, the Reserve Bank of India (RBI) issues currency notes, while coins are issued by the Government of India.
Beyond physical currency, money also includes balances held in savings and current account deposits by the public in commercial banks. These deposits are considered money because they can be used to settle transactions through cheques. Such deposits are termed demand deposits, as they are payable by the bank upon demand from the account holder. In contrast, time deposits, like fixed deposits, have a specific maturity period and cannot be withdrawn on demand.
Fiat Money and Legal Tender
Although a hundred-rupee note can be exchanged for goods worth Rs. 100, the intrinsic value of the paper is minimal—far less than Rs. 100. Similarly, the value of the metal in a five-rupee coin is not worth Rs. 5. Why, then, do people accept these notes and coins for goods and services of higher value?
The value of currency notes and coins comes from the guarantee provided by the issuing authority. Every currency note bears a promise from the Governor of the RBI that, upon presentation of the note, the RBI or any commercial bank will provide purchasing power equivalent to the value printed on the note. The same applies to coins.
These currency notes and coins are termed fiat money, as their value is derived from the trust and guarantee of the issuing authority, not from any intrinsic value (as with gold or silver coins). They are also referred to as legal tenders, meaning they cannot be refused by anyone for the settlement of any type of transaction.
In contrast, cheques drawn on savings or current accounts, while widely accepted, are not legal tenders. They can be refused as a mode of payment, distinguishing them from currency notes and coins.
Legal Definitions: Narrow and Broad Money
Money supply, like money demand, is a stock variable, representing the total amount of money in circulation among the public at a specific point in time. The Reserve Bank of India (RBI) publishes data on four distinct measures of money supply: M1, M2, M3, and M4. These measures are defined as follows:
- M1 = CU + DD
- M2 = M1 + Savings deposits with Post Office savings banks
- M3 = M1 + Net time deposits of commercial banks
- M4 = M3 + Total deposits with Post Office savings organizations (excluding National Savings Certificates)
Here:
- CU represents currency (notes and coins) held by the public.
- DD refers to net demand deposits held by commercial banks.
The term ‘net’ means only deposits held by the public in banks are included in the money supply. Deposits held by one commercial bank in another are excluded from these calculations.
Narrow Money vs. Broad Money
- M1 and M2 are referred to as narrow money, as they are the most liquid forms of money, easily available for transactions.
- M3 and M4 are referred to as broad money, as they include less liquid components.
These measures are ranked in decreasing order of liquidity:
- M1 is the most liquid and easiest to use for transactions.
- M4 is the least liquid of all.
Among these, M3 is the most commonly used measure of money supply and is often referred to as aggregate monetary resources.
Demonetisation
Demonetisation was an unprecedented initiative undertaken by the Government of India in November 2016, aimed at addressing issues such as corruption, black money, terrorism financing, and the circulation of counterfeit currency. As part of this measure, old currency notes of ₹500 and ₹1,000 were declared invalid as legal tender. In their place, new currency notes of ₹500 and ₹2,000 denominations were introduced.
The public was instructed to deposit their old currency notes into bank accounts without any declaration until 31 December 2016, and up to 31 March 2017 with the Reserve Bank of India (RBI) by making a formal declaration. To mitigate potential cash shortages and ensure smooth transactions, the government allowed individuals to exchange up to ₹4,000 of old notes per day for new ones. Additionally, until 12 December 2016, old notes were still accepted at specific places, including petrol pumps, government hospitals, and for payments of government dues such as taxes and utility bills.
This move was met with mixed reactions. On one hand, it was lauded as a decisive step against black money and corruption. On the other hand, it faced criticism for causing significant inconvenience, including long queues outside banks and ATMs. The sudden shortage of currency in circulation disrupted economic activities, but the situation gradually normalized over time.
Positive Impacts of Demonetisation
- Increased Tax Compliance: A large number of individuals were brought into the tax system, leading to improved compliance.
- Formal Financial Integration: Individuals’ savings were directed into formal financial channels, increasing resources available to banks.
- Lower Interest Rates: With greater liquidity in the banking system, more loans could be extended at reduced interest rates.
- Curb on Black Money: The move demonstrated the government’s commitment to tackling black money and conveyed that tax evasion would attract penalties and societal disapproval.
- Shift to Digital Transactions: Demonetisation encouraged households and businesses to adopt electronic payment methods, moving away from cash-based transactions.
Demonetisation showcased the government’s determination to combat corruption and enhance financial transparency, promoting a shift toward a more formal and accountable economic system.
Suggested Readings
- Dornbusch, R. and S. Fischer (1990). Macroeconomics (5th Edition), pp. 345–427, McGraw-Hill, Paris.
- Sikdar, S. (2006). Principles of Macroeconomics, pp. 77–89, Oxford University Press, New Delhi.