NIOS Economics • Module 11

Lesson 28: Money and Banking

Lesson 28 Summary

Money and Banking

Explore the evolution from the Barter System to modern money. Master the functions of money, understand the components of Money Supply (\(M_1\) to \(M_4\)), and discover how Commercial Banks create credit. Finally, analyze the role of the Central Bank (RBI) in controlling money supply through quantitative and qualitative policy instruments.

Section 1

1. Failure of Barter System

Historical Context

Before money came into existence, people exchanged goods for goods. This was known as the Barter System. It was abandoned due to several inherent problems:

1. Lack of Double Coincidence of Wants: Both parties must want what the other has. If one wants cloth in exchange for wheat, the other must want wheat in exchange for cloth.
2. Lack of Common Unit of Measurement: Without a standard unit, it was difficult to equate the values of different goods (e.g., how much wheat equals one buffalo?).
3. Lack of Division of Goods: Certain goods (like live animals) are not physically divisible into smaller pieces for trade.
4. Problem of Storage & Loss of Value: Storing large volumes of goods was difficult, and perishable goods lost their value quickly, making them poor stores of wealth.
Section 2

2. Meaning and Functions of Money

"Money is anything which is generally accepted as a means of exchange, a measure and store of value and which also acts as standard of deferred payments."

Primary (Basic) Functions

  • 1
    Medium of Exchange: Facilitates exchange by dividing it into sale and purchase, removing the need for double coincidence of wants.
  • 2
    Measure of Value: Helps measure the value of goods and services in terms of price, providing a common unit.

Secondary Functions

  • 1
    Store of Value (Wealth): Convenient and economical means to store purchasing power for future use without quick loss of value.
  • 2
    Standard of Deferred Payments: Essential for borrowing and lending activities. Money is acceptable for settling debts in the future.
  • 3
    Transfer of Value: Money allows value to be easily transferred from one place or person to another.
Section 3

3. Measures of Money Supply in India

Money Supply refers to the total quantity of money held by the public in various forms at a specific point of time.

\(M_1\) = Currency (notes/coins) with public + Demand deposits + Other deposits with RBI. (Most Liquid, Narrow Measure)
\(M_2\) = \(M_1\) + Post Office saving deposits.
\(M_3\) = \(M_1\) + Time deposits of all commercial & co-operative banks. (Broader Measure)
\(M_4\) = \(M_3\) + Total deposits with Post Office Saving Organisation. (Least Liquid)

High Powered Money (H)

Produced by the RBI and Government. It consists of:
H = Currency held by public (C) + Cash reserves of banks (R) + Other deposits of the RBI.

Section 4

4. Commercial Banks & Credit Creation

Commercial Banks are financial institutions that primarily accept deposits from the public and lend to the public. They operate in both public and private sectors.

Functions:

  • Acceptance of Deposits: Current Account (Demand), Savings Account, Fixed/Term Deposit.
  • Extending Loans and Advances: The main source of bank income.
  • Transfer of Funds & Agency Functions: Cheques, drafts, buying/selling securities.

The Process of Credit Creation

Commercial banks are known as creators of money. They do not print notes, but create credit by granting loans out of deposits.

  • Banks know from experience that all depositors won't withdraw cash simultaneously.
  • Banks keep a certain proportion of total deposits as reserves, known as the Legal Reserve Ratio (LRR), which includes CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio).
  • The surplus funds are used to grant loans, creating new deposits in borrowers' accounts.
Total Quantity of Money Created Formula: Total Money = Initial Deposits \(\times \frac{1}{LRR}\)

Inverse relationship: Higher LRR \(\rightarrow\) Less Credit Created.

Section 5

5. Central Bank & Monetary Policy

The Central Bank (Reserve Bank of India - RBI) is the apex institution that controls, regulates, and supervises all commercial banking operations and implements monetary policy.

Functions of the Central Bank:

  • Bank of Issue: Sole authority to issue currency (backed by Minimum Reserve System).
  • Banker to the Banks: Custodian of cash reserves (CRR) and Lender of the Last Resort.
  • Banker to the Government: Manages government accounts, grants loans, acts as financial advisor.
  • Custodian of Forex: Maintains stability in exchange rates.

Controller of Credit and Money Supply (Monetary Policy)

A. Quantitative Methods

Affects total volume of credit in the whole economy.

  • Bank Rate Policy: Rate at which RBI lends to commercial banks. (Increased during inflation).
  • Open Market Operations (OMO): Sale/purchase of govt. securities. (Sells during inflation to absorb liquidity).
  • Variable LRR (CRR/SLR): Altering reserve requirements. (Increased during inflation).
B. Qualitative (Selective) Methods

Directs credit flow to specific sectors.

  • Margin Requirements: Difference between collateral value and loan amount. (Increased during inflation).
  • Moral Suasion: Persuading banks to follow RBI policy.
  • Credit Rationing: Fixing maximum loan ceilings for specific uses.