Money And Banking | Unit 2 Notes

Money And Banking

Money 

Money is a liquid asset used in the settlement of transactions. It is an economic unit that functions as a generally recognized medium of exchange for transactional purposes in an economy.

Function of money is based on the general acceptance of its value within a governmental economy and internationally through foreign exchange. 

Money is commonly referred to as currency. Each government has its own money system. 

It is a normally recognized medium of exchange that people and global economies intend to hold, and are willing to accept as payment for current or future transactions.

Supply of Money

The overall stock of money circulating in an economy or among the public is the money supply. This circulating money involves the currency, printed notes, money in the deposit accounts and in the form of other liquid assets.

Valuation and analysis of the money supply help the policy makers to frame the policy or to change the current policy of increasing or reducing the supply of money. The valuation of money is important as it ultimately affects the business cycle and thereby affects the economy.

The Reserve Bank of India publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4.

  • 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 organisations (excluding National Savings Certificates)  
  • CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks

Money deposits of the public held by the banks are to be included in the money supply.

The interbank deposits, in which a commercial bank holds in other commercial banks, are not to be regarded as part of the money supply.

  • M1 and M2 are known as narrow money. M3 and M4 are known as broad money.
  • These gradations are in decreasing order of liquidity.
  • M1 is most liquid and easiest for transactions whereas M4 is least liquid of all.
  • M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources.

Money Creation By The Commercial Banking System.

Commercial banks create money through credit against deposits through the bank multiplier. Here credit means granting loans and advances made by banks to the public. 

Credit creation by commercial banks refers to the multiplication of original bank deposits, 

As every loan creates a deposit.

Commercial Banks create deposits via lending. Banks don’t give loans in cash, instead they issue cheques against the name of the borrowers. 

Now the borrower is free to draw money by drawing cheques upon the banks. Borrowers deposit the cheque in another bank. However, the bank knows that the amount of money that the depositors withdraw soon returns to the bank.

Banks are not merely providers of money, but also, manufacturers of money Click To Tweet

Banks keep a certain minimum fraction of the deposits made by customers as reserves. Rest of the deposits they lend. This fraction is called the Legal Reserve Ratio (LRR) and is fixed by the central bank. 

Banks keep this fraction of deposits as Cash Reserves because all the depositors do not withdraw the entire amount in one go.

So, to meet the daily demand for withdrawal of cash, it is sufficient for banks to keep only a fraction of deposits as cash reserves. It means, if experience of the banks show that withdrawals are generally around 20% of the deposits, then it needs to keep only 20% of deposits as cash reserves (LRR).

Let’s take an example:

Suppose, initial deposits in banks is Rs 10000, now banks are required to keep only Rs 2000 (20%) as cash reserve and are free to lend Rs 8000.

Banks do not lend this money in cash. Rather, they open the accounts in the names of borrowers, who are free to withdraw the amount whenever they like.

Suppose borrowers withdraw the entire amount of 8000, it will come back into the banks in the form of deposit accounts of those who have received this payment. 

With these new deposits of 8000, banks keep 20% as cash reserves and lend the balance Rs 6400. Borrowers use this amount and deposits back. 

In this manner the deposits keep on increasing in each round by 80% of the last round deposits. Simultaneously, cash reserves also go on increasing, each time by 80% of the last cash reserve. 

This deposit creation comes to end when total cash reserves become equal to the initial deposit.

Central Bank And Its Functions

A central bank of any country ( e.g. Reserve Bank of India) is an independent national authority that conducts monetary policy, regulates banks, and provides financial services including economic research. 

Central bank’s goals are to stabilize the nation’s currency, keep unemployment low, and prevent inflation.

Most central banks are governed by a board consisting of its member banks. The central bank aligned with the nation’s long-term policy goals. At the same time, it is free from political influence in its day-to-day operations.

Functions of Central Bank

MONEY AND BANKING

There are two kinds of functions of the Central bank.

  • Traditional Functions
  • Developmental Functions

Traditional Functions

The traditional functions of the central bank include the following:

  • Bank of issue:

Possesses an exclusive right to issue notes in every country of the world. The issue of notes by one bank has led to uniformity in note circulation and balance in money supply.

  • Government’s banker, agent:

Central bank performs banking functions for the government as commercial banks performs for the public by accepting the government deposits and granting loans to the government. As an agent, the central bank manages the public debt.

  • Custodian of cash reserves:

Central bank takes care of the cash reserves of commercial banks. 

  • Custodian of international currency:

Central bank maintains a minimum reserve of international currency to meet emergency requirements of foreign exchange and overcome adverse requirements of deficit in balance of payments.

  • Bank of re discount:

Serve the cash requirements of individuals and businesses by Re discounting the bills of exchange through commercial banks. 

  • Lender of last resort:

The central bank provides loans against treasury bills, government securities, and bills of exchange.

  • Bank of settlement and transfer:

The central bank helps in settling mutual indebtedness between commercial banks. 

  • Controller of Credit:

The central bank regulate the credit creation by commercial banks directly or indirectly.

Developmental Functions

Functions that are related to the promotion of banking system and economic development of the country. 

  • Developing specialized financial institutions:

The central bank establishes institutions that serve credit requirements of the agriculture sector and other rural businesses.

  • Influencing money market and capital market:

Central bank deals in short term credit and capital market deals in long term credit. The central bank maintains the country’s economic growth by controlling the activities of these markets.

  • Collecting statistical data:

Gathers and analyzes data related to banking, currency, and foreign exchange position of a country. 

Bank of issue

The central bank is the bank of issue. It issues notes and coins to commercial banks.

In addition to issuing currency to the banks, the central bank also issues currency to the central Government of the country.

Currency which are manufactured by the Government, they are put into circulation through the central bank.

However, the central bank has its monetary liability, it is obliged to back the currency issued by its asset of equal value such as gold and bullions.

Government Bank

Government banks are also called Public Sector Banks (PSBs), where a majority stake  is held by the Ministry of Finance of the Government of India or Ministry of Finance of various State governments of India.

Currently there are 12 Public Sector Banks in India are existing.

  • State Bank of India
  • Punjab National Bank
  • Bank of Baroda
  • Bank of India
  • Central Bank of India
  • Canara Bank
  • Union Bank of India
  • Indian Overseas Bank
  • Punjab and Sind Bank
  • Indian Bank
  • UCO Bank
  • Bank of Maharashtra.

Banker’s Bank

A bankers’ bank is a specific type of bank that exist for the purpose of servicing the charter banks that founded them. 

Their banking services are not open to the public. These institutions are designed to support community banks.

Bankers’ banks can help community banks to effectively compete with larger banking entities.

Control of Credit Through Bank Rate

There are two methods of Credit Control through Bank Rate.

  • Quantitative or general methods, and
  • Qualitative or selective methods.

Quantitative or General Methods

This methods is used by the central bank to influence the total volume of credit in the banking system.

It regulates the lending ability of the financial sector of the whole economy and do not discriminate among the various sectors of the economy. 

The quantitative methods of credit control are- 

  • Bank rate
  • Open market operations
  • Cash-reserve ratio.

Qualitative or Selective Methods

These methods are used by the central bank to regulate the flows of credit into particular directions of the economy. 

The qualitative methods affect the types of credit extended by the commercial banks. They affect the composition rather than the size of credit in the economy.

The qualitative methods of credit control are; 

  • Marginal requirements
  • Regulation of consumer credit
  • Control through directives
  • Credit rationing
  • Moral suasion and publicity
  • Direct action

Bank Rate Policy

The bank rate or the discount rate is the rate at which a central bank is prepared to discount the first class bills of exchange. 

The bank rate is different from the market interest rate. The bank rate is the rate discount of the central bank, while the market interest rate is the lending rate charged in the money market by the ordinary financial institutions.

An increase in the bank rate makes the credit costlier, reduces the volume of credit, discourages economic activity and brings down the price level in the economy.

A declining in the bank rate makes the credit cheaper, increases the volume of credit, encourages the businessmen to borrow and invest, and increases the levels of economic activity.

Bank rate policy aims at influencing:

  • The cost and availability of credit to the commercial banks
  • Interest rates and money supply in the economy
  • The level of economic activity of the economy. 

Cash Reserve Ratio (CRR)

Cash reserve ratio is a certain percentage or share that all banks have to keep with the RBI as a deposit as reserves in the form of liquid cash.

This percentage is fixed by the RBI, which changes from time to time. Currently, the CRR is fixed at 3%. That means for every Rs 100 worth of deposits, the bank has to keep Rs 3 with the RBI.

CRR keep inflation under control. During high inflation in the economy, RBI raises the CRR to sanction loans. It squeezes the money flow in the economy, reducing investments and bringing down inflation.

Statutory Liquidity Ratio (SLR)

SLR is the minimum percentage of the aggregate deposits that commercial banks has to maintains in the form of liquid cash, gold or other securities. 

Basically it is the reserve requirement that banks are expected to keep before offering credit to customers. 

SLR is not reserved with the Reserve Bank of India (RBI), but with banks themselves. But the ratio is fixed by RBI. The SLR was prescribed by Section 24 (2A) of Banking Regulation Act, 1949.

CRR and SLR are the tools of the central bank’s monetary policy to control credit growth, flow of liquidity and inflation in the economy.

Repo Rate and Reverse

Repo Rate

Repo rate refers to the rate at which commercial banks borrow money from Central bank (Reserve Bank of India) by selling their securities to maintain liquidity, in case of shortage of funds or due to some statutory measures. 

As you borrow money from the bank as a loan on interest, similarly, banks also borrow money from RBI during a cash crunch on which they are required to pay interest to the Central Bank. This interest rate is called the repo rate.

Repo stands for ‘Repurchasing Option’. It is an agreement in which banks provide eligible securities such as Treasury Bills to the RBI while availing overnight loans.

Components of a Repo Transaction

Control inflation – The Central bank increases or decreases the Repo rate depending on the inflation, to control the economy by keeping inflation in the limit.

Hedging & Leveraging – RBI aims to hedge and leverage by buying securities from the banks and provide cash to them 

Short-Term Borrowing – RBI lends money for a short period of time, maximum being an overnight post which the banks buy back their securities deposited at a predetermined price.

Collaterals  – RBI accepts collateral in the form of gold, bonds etc.

Cash Reserve (or) Liquidity – Banks borrow money from RBI to maintain liquidity as a precautionary measure.

Affect Of Repo Rate

Repo rate is a strong system of the Indian monetary policy that can regulate the country’s money supply, inflation levels, and liquidity. 

The levels of repo have a direct impact on the cost of borrowing for banks. If repo rate is  higher then borrowing will be a costly affair for businesses and industries, which in turn slows down investment and money supply in the market.

On the other hand lowers the repo rate, industries find it cheaper to borrow money. It also boost the overall supply of money in the economy.

Reverse Repo Rate 

RBI borrows money from banks when there is excess liquidity in the market is called Reverse Repo Rate. In return the banks benefit out of it by receiving interest for their holdings with the central bank.

When levels of inflation is high in the economy, the RBI increases the reverse repo. It encourages the banks to keep more funds with the RBI to earn higher returns on excess funds. Banks are left with lesser funds to extend loans.

Open Market Operations

Open Market operations are purchases and sales of government securities and sometimes commercial paper by the central bank for the purpose of regulating the money supply and credit conditions on a continuous basis.

Under this system, when the central bank wants to reduce the money supply in the market, it sells securities in the market.

Similarly, when the central bank wants to increase the money supply, it purchase securities from the market. This step is taken to reduce the rate of interest and also to help in the economic growth of the country. 

Margin Requirement

Margin Requirement means the amount of money that you are required to deposit for entering into a Trade and maintaining an Open Position.

It is the amount of equity, that an investor has in their brokerage account. A margin account is a account in which the broker lends the investor money to buy more securities than what they could otherwise buy with the balance in their account.


MCQ & Syllabus Notes

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Frequently Asked Questions

Q1. What is Repo Rate?

Answer: Repo rate refers to the rate at which commercial banks borrow money from Central bank (Reserve Bank of India) by selling their securities to maintain liquidity, in case of shortage of funds or due to some statutory measures. 

Q2. How the Repo Rate affects economy?

Answer: The levels of repo have a direct impact on the cost of borrowing for banks. If repo rate is  higher then borrowing will be a costly affair for businesses and industries, which in turn slows down investment and money supply in the market.

Q3: What is money?

Answer: Money is a liquid asset used in the settlement of transactions. It is an economic unit that functions as a generally recognized medium of exchange for transactional purposes in an economy.

Money and Banking Unit 2 CBSE, class 12 Economics notes. This cbse Economics class 12 notes has a brief explanation of every topic that NCERT  syllabus has. You will also get ncert solutions, cbse class 12 Economics sample paper, cbse Economics class 12 previous year paper.

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