Money and Banking

Unit III

1
What is Money?
• What Can Become a Money?
• Who Needs Money and Why?
• Where Does Money Come From?
• Demand and Supply of Money
• What are the Effects of Money on Individual and
Economy?
 What is Money?
• Barter System
• Problems with Barter System

• Inability to make deferred payments,

• Lack of common measure value,
• Difficulty in the storage of goods,
• Lack of double coincidence of wants
• Monetary System
• Functions of Money

• First: Money is a store of value

Money is a matter of functions four
• Second: Money is a unit of account A medium, a measure, a standard
• Third: Money is a medium of exchange and a store…
• Fourth: Deferred Payment
 What is Money? Definition
• According to Robertson “Anything which is widely
accepted in payment for goods or in discharge of other
kinds of business obligations.”

• According to Pigou, "In order of anything to be classed as

money, it must be accepted fairly widely as an instrument
of exchange, which means that a good number of people
are ready to accept in payment for goods and services
provided by them.”
• According to Crowther, "Money can be defined as
anything that is generally accepted as a means of
exchange (as a means of settling debts) and that at
the same time acts as a measure and as a store of
value.”
• According to Hartley Withers, "Money is what money
does.”
• According to W.A.L.Coulborn, ”Money may be
defined as the means of valuation and of payment.”

• According to Hawrtrey,” Money is used in two main

forms, one is the unit of account and secondly, it is
law acceptable.”
Forms of Money
• Commodity Money
• Fiat Money
• Fiduciary Money
• Commercial Bank Money
 Fiat Money
• The word fiat means “the command of the sovereign”.
• Fiat currency is the kind of money which don’t have any
intrinsic value and it can’t convert into a valuable
resource.

Legal Tender Money

• Legal tender is anything recognized by law as a means to
settle a public or private debt or meet a financial
obligation.
• The National currency is legal tender in practically every
country. A creditor is legally obligated to accept legal
tender toward repayment of a debt.
Fiduciary Money
• Today’s monetary system is highly fiduciary.
• When the customer can sell the promise or transfer
it to somebody else, it is called fiduciary money.
• Fiduciary money is generally paid in cheques and
banknotes, some kind of token which are used as
money and carry the same value.

Commercial Bank Money

• Credit created through commercial banks function
of accepting deposits and giving loans
 Convertible Paper Money
• A convertible currency is any nation's legal tender that
can be easily bought or sold on the foreign exchange
market with little to no restrictions.
• The paper currency issued by the Central Bank – is fully
backed by Gold and Silver reserves

• Also known as Full Reserve System

• Due to the growing deficit of Metals

• Proportional Reserve System – 1927 to 1957 the central

bank keeps 30 to 50 % of total currency issued as
reserve in form of G/S
 Minimum Reserve System
• Due to needs of growing economy – Proportional
Reserve System was becoming inadequate
• It was abandoned in India – 1957
• Now RBI was required to keep minimum amount of gold
and silver also securities and foreign currencies

• Of value equal to Rs 200 crores of which gold should be

of 57.5% (115 crores).
• On basis of MRS – RBI can issue any amount of currency
depending upon economic conditions
How Much Money is their in the
Economy?
• Printed by RBI
• In Circulation
Money Supply
Issued by the Central Bank
Measurement of Money Supply
• A single measure of MS is inadequate
• RBI in 1977 adopted FOUR different concepts of
measuring quantum and variations in MS
• M1
• M2
• M3
• M4
 M1 – Narrow Money
M1 = C + DD + OD
Where
C = Currency with Public (coins & currency)
DD = Demand Deposits with Comm Banks
OD = Other Deposits with Central Banks
(deposits of fin inst, govt with RBI)

M1 is most liquid measure of Money Supply

Used as a medium of exchange
M2
M2 = M1 +
Saving Deposits with Post Office

PO deposits are liquid Ms

Due to lack of banking habits – huge money is
deposited in PO also
M3 – Broad Money
M3 = M1 +
Time Deposits with Commercial Banks

TD – store of value – lacks liquidity

It notifies aggregate monetary resources in the
country
It gives true picture of money supply in the country
M4
M4 = M3 +
Time Deposits in Post Offices
Money Stock Measures Calculate M1 and M3

• https://www.rbi.org.in/Scripts/BS_ViewWss.aspx
Factors Determining Money Supply
• Monetization of Deficit (Government Borrowing)
• Replacement
• Bank Credit to Private Sector
• Changes in Net Foreign Assets (X-M)

Changes on BOP
Deficit in BOP = Sell of FX = Fall in Money Supply
Surplus in BOP = Buy FX = Rise in Money Supply

• Governments Currency Liabilities

https://www.rbi.org.in/Scripts/WSSView.aspx?Id=22069
 Cash in Circulation

• https://www.thehindubusinessline.com/opinion/why-currency-is-still-in-demand/article66421105.ece
Demand for Money
• Who is Demanding Money?
• Why?
• How to estimate the demand for Money?

Money Demand is determined by

• Price Level (Inflation)
• Interest
• Income
Theory of Demand for Money
- Fisher’s Approach
- Marshal and Pigou’s Approach
- Baumol, Tobin and Freidman’s new
theories

- Keynes Theory of Liquidity Preference

Keynes Theory of Demand for
Money
• Keynes Liquidity Preference Theory
How much money people demand to hold in cash
determines their liquidity preference.

• Keynes Propounded Three Motives

Transactions motive {Md = f(Y)}

Precautionary motive. {Md = f(Y)}
Speculative motive {Md = f(r)}
• The Transaction Demand for Money
• For Medium of Exchange
• For Business Payments
• Psychological Factors
• Interest Inelastic

• The Precautionary Demand

for Money
• Unforeseen Contingencies
• Savings
• Psychological Factors
• Interest Inelastic
Speculative motive {Md = f(r)}

money demand is negatively related to the interest rate

At lower rate of interest – higher will be the

demand
for ideal cash and otherwise

At higher rate of interest

more Money would have been invested and
thus less money s
is held in cash.

There is an inverse relation

between the rate of interest and
speculative demand for money.
Liquidity Trap • At lower rate of interest –
people wish to hold cash
• Money demand becomes
perfectly elastic

• The portion of money

demand curve which becomes
flat is called as liquidity trap.
• Because expansion in money
supply is trapped
• The rate of interest and
investment too become
ineffective.
• Central banks force interest rates lower in order to encourage
spending and increase economic activity.

A liquidity trap occurs

when interest rates are
very low, yet consumers
prefer to hoard cash
rather than spend or
invest their money in
higher-yielding bonds
or other investments.
Aggregate Demand for Money
Keynes Approach
Md = Mtp + Msp
Mtp = f(y) and is completely interest inelastic –
unless interest rate is very high.
Msp = f(r)
Aggregate demand for Money thus
Md = f(y, r)
 Quantity Theory of Money –
Fisher’s Transactions Approach
• Irving Fisher – Classical Economist – medium of exchange
function of money.
• Value of goods/services = Value of money (Dm).
10 Rupee Pen = 10 Rupees

• Value of money means its purchasing power in terms of goods

and services in general.
• It depends on the prevalent price level.

• The value of money is inversely proportional to the price level

or we can say that the value of money is the reciprocal of the
price level.
• In simple terms, the quantity theory of money says that
the level of prices varies directly with the quantity of
money.
For example –
• If we double the quantity of money, and other things
being equal,
• prices will be twice as high as before and the value of
money will be one half.
• The main factors which influence the general price level
are –
1. The volume of trade or transactions
2. The quantity of money
3. Velocity of circulation of money.
1. The volume of trade or transactions depends on
the supply of goods and services to be exchanged.
The greater the supply of goods and services in the
economy, the larger the number of transactions and
trade and vice versa.

2. The quantity of money in the economy consists of

not only the notes and currency issued by the
government or central bank but also the amount of
credit or deposits created by the banks.

3. Velocity of circulation – the number of times a unit

of money changes hands during exchanges in a year.
 Fisher’s Equation of Exchange –
• PT = MV
• P = MV/T
• P = average price level
• T = total amount of transactions
• M = quantity of money
• V = transactions velocity of circulation of money
• MV represents the money spent on transactions
• PT represents the money received from transactions
• M is given 100,000
In a given year 60 units of Mobile Phones are sold
Price 10000 per unit
• MV = PT
• V = PT/M
•V=
The velocity of money is a measurement of the rate at
which money is exchanged in an economy.
It is the number of times that money moves from one
entity to another.
• Consider an economy consisting of two individuals,
A and B, who have $100 each.
• A buys a car from B for $100.
• Then B purchases a home from A for $100.
• B takes A's help in adding new construction to his
home. For his efforts, B pays A $100.
• A sells a car he owns to B for $100.

• Total Value of Transactions by A and B?

• Velocity of Money ?
• nominal quantity of money supply must be equal to
the nominal quantity of money demand.
• Then, Ms = Md = M
• M is fixed by the central bank of a country.
• So, the Fisher’s equation can be written as
• Md = PT / V
Demand for Money depends upon
P, T, and V
Price Level is most important – changes in P lead to
changes in Md
The Cost of Holding Money
• The money you hold in your wallet does not
earn interest

• The nominal interest rate is the opportunity

cost of holding money

• Interest Rate on Saving/FD

Opportunity Cost of Holding Money
• Higher the Nominal Interest
Rate
• Higher is the Opportunity
Cost of Holding Cash
• As the revenue is forgone
by not depositing money in
bank is high

https://www.paisabazaar.com/fixed-deposit/#psb
Determination of Interest Rate
Functions of Rate of Interest
• Influences Savings
• Determines Investment
• Transforms Saving into Investment
• Availability of Credit to Industry
• Profitability to Banks
Role of Central Bank in
Determination of Interest Rate

• https://www.youtube.com/watch?v=h8gwvEkkif8
Banking in India
 The Term Bank
The word traces its origins back to the
Ancient Roman Empire, Another possible origin
where moneylenders of the word is from the
would set up their stalls Sanskrit words (ब्यय)
on a long bench called Baya (Expense ) and
a bancu, Onka (Calculation) =
BayaOnka
from which
the words banco and
bank are derived.
 A Brief History
• Temple Banking - Rome
• Priests as bankers
• Kings as bankers
• The first state deposit bank, Banco di San Giorgio (Bank of St.
George), was founded in 1407 at Genoa, Italy
Commercial Banks
• As per the commercial bank definition, it is a
financial institution whose purpose is to accept
deposits from people and provide loans and other
facilities.
• Commercial Viability
• Profitability
• Returns to the Investors
• Service to Customers
Changing Form of Banking
• From Physical Banking to Mobile Banking

• https://www.youtube.com/watch?v=fpb-qJv6dBs
• https://www.youtube.com/watch?v=GbECT1J9bXg
Credit Creation
• Commercial Banks – 2nd most important source of money
supply

• Such money is called as Credit Money

• Money created through business transactions of commercial

banks – borrowing (deposits) and lending money

• Money deposited with the bank is called as –

• Primary Deposits
Commercial Banks: Balance Sheet
Liabilities Assets

1. Share capital 1. Cash in hand

2. Reserve Funds Cash with Central Bank
3. Deposits Cash with other banks

i. Time deposits 2. Money at call and short notice

ii. Demand deposits 3. Bills discounted including
iii. Savings deposits treasury bills
4. Investments
4. Borrowings 5. Advances (Loans)
5. Other items 6. Other items
• On basis of Primary Deposits – banks create
Secondary Deposits – also called as
• Derivative Deposits

• The process of deposit creation or credit creation

begins with banks lending money out of its
primary deposits.

• After maintaining cash reserves banks can lend

rest of its excess reserves –
 Reserve Requirement
• Banks cannot loan out its entire PD.
• Cash Reserves have to be maintained.

• Statutory Cash Reserves – CRR and SLR (CR)

• Excess reserves (ER) balance after meeting CR

• https://www.rbi.org.in/
CASH RESERVE RATIO (CRR)
• Cash Reserve Ratio (CRR) is a specified
minimum fraction of the total deposits of customers, which
commercial banks have to hold as reserves either in cash or
as deposits with the central bank. CRR is set according to
the guidelines of RBI.

• Calculated on total of the Net Demand and Time

Liabilities (NDTL), on a fortnightly basis.

• Current rate of CRR is 4.5%

 STATUTORY LIQUIDITY RATIO (SLR)
• Statutory liquidity ratio is the amount of liquid assets such as
precious metals (gold) or other approved securities, that a
financial institution must maintain as reserves other than the
cash

• Used to manage banks liquidity position

• Current rate is 18.25%

Credit creation into a Single Bank Model

• There is a single bank - SBI

• Only DD are accepted by the banks
• Cash reserves are 20% of the total deposits
• CRR – is 8% and SLR is 12%
• Assets and Liabilities
SBI – Balance sheet as on
31st March 2022

Liabilities Amt Assets Amt (Rs)

(Rs)

Customer 100,000 Cash reserves 20,000

A’s deposit Excess Reserves 80,000

Total 100,000 Total 100,000

• PD = 100,000
• Reserves = 20,000
• Excess Reserves = 80,000 – used for giving loans
• Customer B = borrows loan of 80,000
• Opens a bank a/c with SBI – deposits the same amount
for issuing cheques.
• Bank Transfers the Loan amount to B’s Account
• In both the cases 80,000 will remain in the banking
system
 SBI – Balance sheet after 1st round of CC
Amount Assets Amount
Liabilities (Rs) (Rs)

Customer A’s 100,000 Cash reserves 36,000

deposit (20+16)

Customer B’s Loan to B

deposit 80,000 80,000

Excess Reserves 64,000

Total 180,000 Total 180,000

• Suppose B’s Withdraws Money in cash –
• Borrower used money to make payments to his
creditors

• Creditors will again deposit that money in there bank

a/c

• The same position will be reflected

 SBI – Balance sheet after 2nd round of CC
Amount Assets Amount
Liabilities (Rs) (Rs)
A’s deposit 100,000 Cash reserves 48,800

Loan to B
B’s deposit 80,000 80,000
C’s deposit 64,000 Loan to C 64,000
Excess Reserves
51200

Total 2,44,000 Total 2,44000

 SBI – Balance sheet after last round of CC
Amount Assets Amount
Liabilities (Rs) (Rs)
A’s deposit 100,000 Cash reserves 100,000
B’s deposit 80,000 Loan to B 80,000
C’s deposit 64,000 Loan to C 64,000
“ “ “ “
“ “ “ “
“ “ “ “
Nth deposit 000000 Excess Reserves 000000

Total 5,00,000 Total 5,00,000

• The process of credit creation goes on till SBI does not have
any Excess reserves left.

• A PD of 100,000 leads to creation of total 5,00,000 in the

system
• multiplied PD by 5 times
• Deposit Multiplier = 5
• Derivative deposits or Credit creation is
• TD(1) - PD(5) = 4,00,000

• This is a simple model of CC based on the assumption that

no other DD are made during the entire process of CC.
Credit Creation in Multiple Bank Model

• More then one bank – SBI, BOB, ICICI, CITIbank etc

• The rest assumption remain same
• PD – CR – CRR –SLR – ER – etc
• The money now borrowed will be deposited in
another BANK
Bank Liabilities Assets Total Assets
in System
Deposits Reserves Credits

SBI 100,000 20,000 80,000 100,000

BOB 80,000 16,000 64,000 1,80,000
ICICI 64,000 12,800 51,200 2,44,000
” ” ” ” ”
” ” ” ” ”
Nth 00000 00000 00000 00000
Bank
Total 500,000 100,000 400,000 500,000
Deposit Multiplier
• PD leads to creation of Secondary Deposits, which is
a multiple of PD – such a process is called as Deposit
Multiplier.
Dm = ∆D / ∆R
Dm = 500,000 / 100,000
=5
• ∆D = 100,000 + 80,000 + 64,000 + 51,800 + ………+ 00
= 500,000
M1 or M3
• Total Deposit Creation = Rs 10,00,000/-
• Reserve Requirement = 20%

Calculate
• Deposit Multiplier
• What would have been the Primary Deposit?
• If RBI reduces the reserve requirement by 10% - what will be
the impact on total deposit creation?
• If Primary deposit is Rs 50,000/- and deposit multiplier is 10
what will be the total deposit creation?