CHAPTER 5

MONEY AND SUPPLY OF MONEY

TO DO:-
❖ 5.1 Introduction
❖ 5.2 Drawbacks of Barter System
❖ 5.3–Functions of Money
MONEY
❖ 5.4 Forms of Money
❖ 5.5 Evolution
BARTER SYSTEMof OFMoney
EXCHANGE-
❖ 5.6 Supply of Money – Concept of Money Supply and Measurement of Money
Supply
❖ 5.7 Credit Creation by Commercial Banks

5.1 Introduction

Barter system of exchange is a system in which goods are exchanged for goods. It is also called
as the C-C economy (commodity for commodity exchange economy)

5.2 Drawbacks of barter system

1) Lack of common measure of value -

1) The barter system does not provide a common unit in which the value of all goods and
services can be stated.
2) Different goods and services are measured in different physical units
3) It is difficult to determine the proportion in which two goods are to be exchanged.
4) The value of such goods and services has to be exchanged. The value of goods and
services has to be expressed vis-à-vis all other kinds and qualities of goods and
services. For example the value of car can be expressed in terms of horses, cows or
grains.
5) Lack of common unit of value implies lack of an accounting system.Accounting also
becomes a big problem due to the absence of a common unit.

2) Lack of double coincidence of wants –

1) Double coincidence of wants implies that goods in possession of two different

individuals must be useful and needed by each other.
2) It means that a person having a surplus of one commodity should be able to find another
person who not only wants that commodity but has something acceptable to offer in
exchange.
3) Therefore under barter system, exchange remained extremely limited.
4) It became more difficult and time consuming if goods needed by a person were many.

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3) Lack of standard of deferred/future payments –

1) In any exchange economy, contracts requiring future payments such as wages, interest,
salaries etc. are common.
2) In a barter economy such payments have to be made in specific goods.
3) This creates problems related to quality of goods, types of goods and variations in the
value of goods over time.
4) Contractual payments or future payments are very difficult under the barter system of
exchange.

4) Lack of store of value -

1) The barter system did not provide any method for storing generalized purchasing
power.
2) The stocks of commodities held by people were subject to appreciation or depreciation
in value.
3) It also involved storage costs.
4) Besides, quick disposal was also difficult.

5.3 FUNCTIONS OF MONEY –

1) Money is a unit of value -

1) Money works as a measure of value. We can measure and express the value of all
goods and services in terms of money or price.
2) Its use helps in measuring the exchange values of commodities. For example, if a pen
is worth Rs 10 and a notebook is worth Rs 20 then a notebook is worth 2 pens.
3) Accounting is simplified as additions and subtractions are possible.
4) This function of money also enables the trading firms to ascertain their costs,
revenues, profits and losses.
5) Money is a useful measuring rod of value only if the value of money itself remains
constant. The value of money is linked to the purchasing power. Purchasing power is
the inverse of general price level. As general price level increases, a unit of money can
purchase lesser amount of goods and services. So the purchasing power of money
declines. Therefore money is a useful unit of value as long as its own value or purchasing
power remains constant.

2) Money is a medium of exchange

1) People can exchange goods and services through the medium of money. Use of money as
a medium of exchange has removed the major difficulty of double coincidence of
wants in the barter system
2) It represents generalized purchasing power or the bearer of options.
3) Its use reduces the time and energy spent in Barter.
4) It facilitates trade and widens the market.

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 5) It has separated the acts of sale and purchase of goods. In the barter system, a purchase
always implied a simultaneous sale of equal value. Money system of exchange has
removed this hardship.

3) Money as a standard of deferred payments-

1) Money serves as a standard of deferred or future payments

2) All loans and credits are measured and expressed in terms of money.
3) Other payments such as pensions, salaries etc. can be easily paid in money terms.
4) This function of money facilitates borrowing and lending activities and leads to the
creation of financial institutions.
5) Money is accepted as a standard of deferred payments because – (i) its price remains
relatively stable. (ii) It has general acceptability. (iii) It is more durable compared to
other commodities.

4) Money as a store of value

1) Money as a store of value means that money is an asset and can be stored for future
usein the form of savings without loss of value.
2) It enjoys the advantages in the form of – i) convenient denominations ii) easy portability
iii) general acceptance at all times iv) relative stability of value as compared to other
commodities v) does not need much space in storing.
3) Savings in terms of money are much more secured than those in terms of goods
4) The holders of money are holders of generalized purchasing power that can be spent
through time. It will be accepted at any time for any good or service
5) Any asset other than money may also perform the function of store of value. But there
are some problems like-
i) They involve storage costs
ii) They may note quickly be converted into money without loss of value
iii) They may depreciate in value

5.5FORMS OF MONEY

Legal definition of money Functional definition of money

1) Legally money is anything proclaimed by 1) Functional definition of money will
law as a medium of exchange
2) Paper notes and coins is money as a
matter of law. Nobody can refuse its
acceptance as medium of exchange. In
include all things that perform the 4
functions of money i.e.
a) a unit of value
b) a medium of exchange
c) a standard of deferred payments
d) a store of value
2) According to the definition money
includes both notes and coins
(currency)and chequable deposits

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 other words it is legal tender. It means
people have to accept it legally for
different payments currency being legal
tender is also called flat money
Fiat money
1) It refers to money by order/ authority
of the government
2) It includes notes and coins
(currency)currency being legal tender is
called flat money because it serves as
money on the fiat (order) of the
government
Narrow definition of money
1) It is based upon its medium payments
function
2) It includes only currency (notes and
coins) and demand deposits. Functional
definition of money is narrow definition. In
other words, in its narrow definition,
money includes only those things which
function as money in terms of-
a) Medium of exchange
b) Unit of value
c) Standard of deferred payments
d) Store of value
Money value of money
1) It refers to what is inscribed on the coin
or written on a paper note
2) Thus money value of paper note is what
is written on it- 100 Rs, 500 Rs etc. Thus
with 500 Rs note we can buy goods and
services worth 500 Rs in the market
5.6 EVOLUTION OF MONEY
Money is anything that can serve as a medium of exchange.
Fiduciary money
1) It refers to money backed up by trust
between the payer and the payee
2) For example cheques are fiduciary
money as these are accepted as means of
payment on the basis of trust NOT on the
basis of any order by the government
Broad definition of money
1) Besides the money category it also
includes some other things that have a
high degree of ‘moneyness’ and are widely
used as a store of value
2) Besides currency and demand deposits
it also includes- time deposits, savings
deposits at banks and post offices. These
financial assets have high degree of
‘moneyness’ or ‘liquidity’ but are not
generally acceptable in payment. These
deposits can be converted into demand
deposits or chequable deposits on a short
notice and are ‘near money’ assets. Thus
‘money assets’ and ‘near money assets’
make up the broad definition of money.
Commodity value of money
1) It refers to the value of the thing money
is made of
2) Thus if coins are made of gold and silver
commodity value of money refers to the
market value of gold and silver contained
in the coin
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It is the most important invention of modern times. Evolution of money can be discussed under
the following headings –

1) Use of commodity as money – In ancient times commodities such as pearls, precious

stones, cloth etc. were used as money i.e. as a medium of exchange. Even cattle was used
as a medium of exchange

2) Metallic Coins – Up to the first half of the 18th Century, the medium of exchange were
goods. Afterwards, most of the countries found that metallic coins such as iron, copper,
silver, gold etc. were more suited to serve as money.

3) Paper Money – It was introduced in an organized manner for the first time around 1750s.
From around 1750s till 1930s gold and silver were prominently used but at the same time
there was an increasing use of paper money. From 1930s onwards most countries are now
using paper currency as a medium of exchange.

It is mainly because of the phenomenal rise in the volume of transactions which requires
more and more money. Gold and silver had limited supply. Theworld’s production of gold and
silver were not enough to match the requirements of the increasing volume of internal and
external trade. There was also inconvenience in handling large transactions. There was also
lack of safety during transportation of metals

4) Credit Money – Nowadays, credit money/bank money is used in the form of cheques,
drafts, bills of exchange etc.

5) Plastic Money – Plastic money in the form of debit cards is also becoming popular
nowadays.
High powered money
High powered money (also called monetary base) is money produced by the RBI and the
government. It shows the total liability of the monetary authority of country.
• It consists of : currency held by public and cash reserves with banks
• H=C+R

5.7 CONCEPT OF SUPPLY OF MONEY

Supply of money refers to the total stock of money (of all types) held by the people of the
country at a point of time.

It does NOT include

(i) Stock of money held by the government
(ii) Stock of money held by the banking system of the country
The government and the banking system of a country are the suppliers or
producers of money. Hence money held by them is not a part of the stock of money
held by the people.

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Supply of money includes only that stock of money which is held by the people or those who
demand money.

Measurement of Money Supply:

There are four alternative measures of money supply. They are known as M1, M2, M 3 and M 4
1) M1 Measurement :

M1 = C + DD + OD

C: refers to the currency and includes coins and paper notes held by the public

DD: refers to the Demand deposits of the people with the commercial banks. These are
chequeable deposits which can be withdrawn or transferred on demand

OD: refers to the other deposits which include-

(i) Demand deposits with RBI of public financial institutions like IDBI
(ii) Demand deposits with RBI of foreign central banks and foreign governments
(iii) Demand deposits of international financial institutions like IMF and World Bank.

2) M2 Measurement:
It is a broader concept of supply of money compared to M1. It also includes savings of the
people with the post offices.
M2 = M1 + Deposits with Post Office Savings Bank Account

3) M 3 Measurement:
It is also a broader concept of money as compared to M1. Besides all the components of M1
it includes net time deposits (or fixed deposits/term deposits) of the people with the
commercial banks.
M 3 = M1 + Net Time Deposits with the Commercial Banks

4) M 4 Measurement:
It is a still broader concept of money than M 3. Besides all the components of M 3 it also
includes the total deposits with the post offices (other than in the form of National Saving
Certificate)
M 4 =M 3 + Total Deposits with the Post Offices (other than in the form of National
Saving Certificate

6
 Chart Showing Different Measures of Money Supply

SUPPLY OF MONEY

M1 M2 M3 M4

Other M1 Deposits M1 Net Time M3 Total

Curren
Deman Deposits with Deposits Deposit
cy with
d with RBI Post /Fixed s with
the
Deposit i) DD of Office Deposits the Post
Public
s with public Savings with the Office
(Coins
the financial Bank Banks (Other
and
Banks institutes Accoun than
paper
(Cheque ii) DD of t NSCs)
notes
able foreign
held by
deposits central
the
which banks
public)
can be and
drawn foreign
or govt.
transferr iii)DD of
ed on internatio
demand nal
) financial
institutes

7
5. 7CREDIT CREATION BY COMMERCIAL BANKS
1) Commercial banks are an important source of money supply in the economy. They
contribute to money supply by creating credit. They create credit in the form of Demand
Deposits.
2) Demand deposits of the commercial banks are many times more than their cash reserves.
3) If cash reserves are Rs 1000 and if demand deposits are Rs 10,000, then the commercial
banks are creating credit ten times of their cash reserves.
4) On the basis of the cash reserves of Rs 1000, the commercial banks are contributing Rs
10,000 to the money supply.
5) Cash reserves with the banking system are not a part of money supply (because banking
system is a supplier of money)
6) Demand deposits or chequeable deposits are a part of the money supply because people
can use demand deposits as a medium of exchange through cheques.

7) The cash reserves are converted into demand deposits in the following way:
1) Legal Reserve Ratio/Liquidity Reserve Ratio is the amount that the commercial banks are
obliged to keep in the form of cash. It has 2 components –
a) Cash Reserve Ratio – Commercial banks are required under law to keep with Central
Bank a minimum percentage of their deposits as cash reserves. This is called as CRR
b) Statutory Liquidity Ratio – SLR require the commercial banks to maintain a specified
percentage of their net total demand and time liabilities in the form of designated
liquid assets with themselves
2) If there are deposits of Rs 1000 with a bank, it knows through its historical experience that,
at a time, all the depositors would not show up in the bank for all the withdrawal.
3) If experience shows that withdrawals are generally around 10% of the deposits then the
banks need to keep only 10% of deposits as cash reserves. This is known as Liquidity
Reserve Ratio (LRR)
4) If LRR = 10% then total cash deposits of Rs 1000 allows the bank to offer loans up to Rs
10,000 in accordance with the following formula –
Demand Deposits = 1 / LRR x Cash Reserves
= 1 / 10% x Rs 1000 = 10 x Rs 1000 = Rs 10,000
It is important to know that loans are never offered in cash. These are always reflected as
demand deposits in favour of the borrowers (also known as secondary deposits which
arise on account of loans by the banks to the people. They are reflected as a part of
demand deposits of the banks).
Therefore when loans are offered worth Rs 10,000, demand deposits of the banks are
raised by Rs 10,000. Therefore in the above equation demand deposits are in fact the
loans.
5) We can thus say that when cash reserves with the bank are Rs 1000, it is creating credit
worth Rs 10,000 in the form of demand deposits. Accordingly,

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 Credit Multiplier or Money Multiplier = Demand Deposits/ Liquidity Reserve Ratio =
10,000/1000 = 10
Or
Credit Multiplier or Money Multiplier = 1 / LRR = 1 / 10% = 10

Reflecting the Credit created by a bank in the Balance Sheet

(Example)
Let us assume that –
i) There is a single banking system in the economy.
ii) LRR = 10% and it does not change
iii) X deposits Rs 1000 with the bank and this is reflected as the demand deposits of the
bank in the form of primary deposits. (Cash deposits with the commercial banks by the
people. They are reflected as part of demand deposits of the banks)

Bank’s Balance Sheet on the initial cash deposit of Rs 1000

(Before it offers loans)
Liabilities Assets
Demand Deposits Rs 1000 Cash Rs 1000
(Primary Deposits)
Total Rs 1000 Total Rs 1000

Because LRR = 10%, the bank requires to hold reserves of Rs 100 only against the deposits of Rs
1000.
Rs 1000/10 = Rs 100

Accordingly bank has an excess cash reserve of Rs 900 (Rs1000 – Rs100 = Rs 900)

The bank would desire to convert its excess reserves of Rs 900 into assets offering returns. The
bank can comfortably offer a loan of Rs 900 without any undue risk. When excess reserves are
converted into loans, the bank’s balance sheet will look as follows -

Bank’s Balance Sheet

(When initial excess reserves are converted into loans)
Liabilities Assets
(i) Demand Deposits Rs (i) Cash Rs 1000
1000
(Primary Deposits)
(ii) Demand Deposits Rs (ii) Loans Rs 900
900
(Secondary Deposits)
Total Rs 1,900 Total Rs 1,900

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If the borrower Y issues a cheque for Rs 900 in favour of X, then the money comes back to the
bank. Accordingly, cash reserves of the bank of Rs 1000 remain undisturbed.

However now it has demand deposits of Rs 1,900, for which the bank requires to hold reserves
of -
10/100 x 1,900 = Rs 190.
The bank continues to have excess reserves of Rs 1000 – Rs 190 = Rs 810

It can convert Rs 810 into loan once again. Now bank’s secondary deposits would increase to
Rs 900 + Rs 810 = Rs 1710
And the demand deposits of the bank would be
Rs 1000+ Rs900+ Rs 810 = Rs 2,710

Bank’s cash reserves of Rs 1000 would remain undisturbed if a cheque of Rs 810 issued to the
borrower is once again deposited in the bank.

The required reserves are 10% of demand deposits

= 10% of Rs 2710
= Rs 271
Excess reserves = Rs 1000 – Rs 271 = Rs 729

Again loans would be offered and demand deposits would increase. This process would
continue till all excess reserves are exhausted.
The bank’s final balance sheet would be as under

Bank’s Balance Sheet

(When excess reserves are totally exhausted)
Liabilities Assets
(i) Demand Deposits Rs 1000 (i)Cash Rs 1000
(Primary Deposits)
(i) Demand Deposits Rs (ii) Loans Rs 900
900 Rs 810
(Secondary Deposits) Rs 729
Rs810 --------
Rs
729
-----
---
(and so on till excess reserves are totally exhausted)
Total Total Rs
Rs 10,000 10,000
Thus against the cash reserves of Rs 1000, the bank creates demand deposits of Rs 10,000. This
amount is the credit created by the banking system. This is how commercial banks contribute to
the supply of money in the economy.
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Condensed Notes for credit creation by commercial banks
How do commercial banks create credit? (4marks)
Commercial banks are an important source of money supply in the economy. They contribute to
money supply by creating credit. They create credit in the form of Demand Deposits. The money
(or deposit or credit) creation by commercial bank is determined by the amount of initial
deposit and the Legal Reserve Ratio (LRR).

Example
Suppose amount of initial deposit is Rs. 10,000 and LRR 20%.The banks will keep 20% i.e.
Rs.2000 as reserve and lend the remaining Rs.8,000. Those who borrow spend this money. It is
assumed that Rs.8,000 comes back to the bank. This raises total deposits to Rs.18,000. Banks
again keep 20% of Rs.8000 i.e. Rs 1600 as reserve and lend Rs.6,400. This further raises the
amount of deposits with the banks. In this way deposits go on increasing at rate of 80% of the
last deposits.
1
Formula: Money Multiplier (credit multiplier)= LRR =1/20%

The total deposits will be:

Total money creation = Initial deposit x Money Multiplier
=10000 x 5
=Rs50000
6m
Explain credit creation function of commercial bank using following info: Initial deposit 1000,
LRR=10%
Commercial banks are an important source of money supply in the economy. They contribute to
money supply by creating credit. They create credit in the form of Demand Deposits. The money
(or deposit or credit) creation by commercial bank is determined by the amount of initial
deposit and the Legal Reserve Ratio (LRR).

Example
Suppose amount of initial deposit is Rs. 1000 and LRR 10%.The banks will keep 10% i.e. Rs.100
as reserve and lend the remaining Rs.900. Those who borrow spend this money. It is assumed
that Rs.900 comes back to the bank. This raises total deposits to Rs.1900. Banks again keep 10%
of Rs.900 i.e. Rs 160 as reserve and lend Rs.640. This further raises the amount of deposits with
the banks. In this way deposits go on increasing at rate of 90% of the last deposits.
1
Formula: Money Multiplier (credit multiplier)= LRR =1/10%

The total deposits will be:

Total money creation = Initial deposit x Money Multiplier
=1000 x 10
=Rs10000
Bank’s Balance Sheet
(When excess reserves are totally exhausted)

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 Liabilities Assets
(ii) Demand Deposits Rs 1000 (i)Cash Rs 1000
(Primary Deposits)
(ii) Demand Deposits Rs (ii) Loans Rs 900
900 Rs 810
(Secondary Deposits) Rs 729
Rs810 --------
Rs
729
-----
---
(and so on till excess reserves are totally exhausted)
Total Total Rs
Rs 10,000 10,000
Thus against the cash reserves of Rs 1000, the bank creates demand deposits of Rs 10,000. This
amount is the credit created by the banking system. This is how commercial banks contribute to
the supply of money in the economy.

1) Explain any two functions of money. (Delhi 2009 AI 2009, Foreign 2009)
2) Describe the evolution of money. (Delhi 2009, Foreign 2009)
3) State any two problems of barter system of exchange. How does money solve them?
(Foreign 2009)
4) State the four functions of money and explain any one of them. (Delhi 2009, Foreign
2009, Foreign 2010)
5) Give the meaning of demand deposits of commercial banks. (Foreign 2009, Foreign 2011
Delhi 2012)
6) State the components of money supply. (Delhi 2010, Foreign 2010)
7) Define money. (AI 2010, AI 2011)
8) How does money overcome the main problem of exchange in the barter system? Explain.
(Foreign 2010)
9) Define money supply. (Delhi 2011)
10) Explain the significance of the “store of value” function of money. (Delhi 2012)
11) What are time deposits? (AI 2012)
12) Explain the “standard of deferred payment” function on money. (AI 2012)
13) What is bank money? (Foreign 2012)
14) Explain the unit of account function of money. (Foreign 2012)
15) Explain the process of credit creation by commercial banks. (Delhi 2010, Delhi 2011, AI
2010, Foreign 2011)

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CHAPTER 6
BANKING

6.1 Differences between a central bank and a commercial bank

There are certain differences between a central bank and a commercial bank. They are as
follows

Basis Central bank Commercial bank

Meaning Central bank is an apex
institution of the monetary
and baking structure of the
country. It regulates the
entire banking system of
the country
Object Its main objective is to
promote social welfare
Ownership Central bank is generally a
government owned
institution
Competition It does not compete with
the commercial banks
Note-Issue It has got the monopoly
right of note issue
Banker It is a banker to
thegovernment. It is also
the banker of the
commercial banks
Commercial bank is a bank
which deals in money and
credit for the purposes of
earning profit. It operates
under guidelines of the
central bank
Its main objective is to earn
profits
Commercial banks may be
both privately owned or
government owned
institutions
There is a sense of
competition among various
commercial banks
Commercial banks do not
have such rights
Commercial bank is a
banker only of the general
public

6.2 FUNCTIONS OF CENTRAL BANK

The central bank is the apex institution of a country’s monetary system. The design and the
control of the country’s monetary policy it is main responsibility. India’s central bank is the
Reserve Bank of India. The central bank performs the following functions:
6.2.1Currency Authority

a) The central bank is the sole authority for the issue of currency in the country

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b) All the currency issued by the central bank is its monetary liability. This means that the
central bank is obliged to back the currency with assets of equal value. These assets
usually consist of gold coins, gold bullions, foreign securities and domestic government’s
local currency securities.
c) The country’s central government is usually authorized to borrow money from the central
bank. The government does this, by selling local currency securities to the central bank
d) The effect of this is to increase the supply of money in the economy. When the central
bank acquires these securities, it issues currency.
e) This authority of the government gives it flexibility to monetize its debt. Monetizing the
government’s debt (called public debt) is the process of converting its debt (whether
existing or new)which is non monetary liability, into central bank currency, which is a
monetary liability
f) Putting and withdrawing currency into and from circulation is also the job of its banking
department.
g) For example, when the government incurs a deficit in its budget, it borrows from the
central bank. This is done by selling treasury bills to the central bank. The Central bank
pays for the bills by drawing down its stock of currency or printing currency against equal
transfer of the said securities. The government spends the new currency and puts it into
circulation.

6.2.2 Banker to the government

Central bank everywhere in the world acts as a banker, fiscal agent and adviser to its respective
government

a) As a banker- As a banker to the government, it performs the following functions:

ii) It receives deposits from the government and collects cheques and drafts deposited in
the government account
iii) It provides cash to the government as required for payments of salaries and wages to
their staff and other cash disbursements.
iv) It makes payments on behalf of the government to meet its budget deficit
v) It also advances short term loans to the government
vi) It supplies foreign exchange to the government for repaying external debt or making
other payments.

b) As a Fiscal agent- As a fiscal agent, it performs the following functions:

i) It manages the public debt
i. It collects taxes and other payments on behalf of the government
ii. It represents the government in the international financial institutions (like World bank,
International Monetary Fund etc) and various conferences.

c) As adviser-

14
The central bank also acts as a financial adviser to the government. It gives advice to the
government on all financial and economic matters such as deficit financing, devaluation of
currency, trade policy, foreign exchange policy etc.

15
6.2.3 Bankers bank and supervisor
Central bank acts as the banker to the banks in the following ways:
1) Custodian of the cash reserves of the commercial banks
2) As the lender of the last resort
3) As clearing agent
4) As supervisor

1) As Custodian of the Cash Reserves of the Commercial Banks-

The central bank maintains the cash reserves of the commercial banks. Every commercial bank
has to keep a certain percent of its cash reserves with the central bank by law.The
centralization of cash reserves in the central bank has the following advantages-

a) It is a source of great strength to the banking system of the country

b) Centralized cash reserves can serve as the basis of a large and more elastic credit
structure than if the same amount were scattered among the individual banks.
c) The centralized cash reserves can be used most effectively during periods of seasonal
strains and in financial crisis or emergencies.
d) By changing these cash reserves, the central bank can control credit
e) The central bank can provide additional funds temporarily to the commercial banks to
overcome their financial difficulties.

2) As lender of the last resort-

As banker to the banks, the central bank acts as the lender of the last resort. In other words, in
case the commercials banks fail to meet their financial requirements from other sources, they
can as a last resort approach the central banks for loans and advances.

a) Any central bank does this by discounting approved securities and bills of exchange
c) RBI ensures that banking system of the country does not suffer any set back
d) It also ensures that money market remains stable.
3) As clearing agent-

As custodian of the cash reserves of the commercial banks, the central bank acts as the clearing
house for these banks. Since all banks have their accounts with the central bank, the central
bank can easily settle the claims of various banks against each other simply by book entries of
transfers from and to their accounts. This method of settling accounts is called clearing house
function of the central bank

4) As supervisor-

The central bank supervises, regulates and controls the commercial banks. This function of the
Central bank relates to:
a) Licensing of the commercial banks

16
 b) Branch expansion of the commercial banks
c) Liquidation of the banks (winding up of banks)
d) Merger of the banks
6.2.4Control of money supply and credit

The principal methods (or instruments) of credit control employed by central bank can broadly
be grouped into the following 2 categories:
A. Quantitative Credit Control or General Methods
B. Qualitative Credit Control or Selective Methods

A. Quantitative Credit Control or General Methods-

Quantitative methods refer to those methods of credit control which are used by the central
bank to influence the total volume of money/credit in the economy without regard for the
purpose for which the credit is put. The important quantitative methods are:
1) Bank rate policy
2) Open market operations
3) Cash reserve ratio
4) Repo Rate and Reverse Repo Rate

1) Bank rate policy-

a) The bank rate is the rate at which the central bank lends funds as a lender of last
resort to the banks, against approved securities or eligible bills of exchange.
b) The effect of change in the bank rate is to change the cost of securing funds from the
central bank
c) An increase in the bank rate increases the costs of securing funds and of borrowing
reserves from the central bank
d) This will reduce the ability of banks to create credit and thus to increase the money
supply. A rise in the bank rate will then cause the banks to increase the rates at which
they lend. This will then discourage businessmen and others from taking loans, thus
reducing the volume of credit.
e) A decrease in the bank rate will have the opposite effect
f) The effectiveness of bank rate policy will depend on-
i. The degree of banks dependence on borrowed reserves
ii. The sensitivity of bank’s demand for borrowed funds to the differential between
the banks lending rate and their borrowing rate. Depending on the business
conditions, commercial banks may not be very sensitive to small variations in
bank rates. In such situations, bank rate policy may not succeed.
iii. The extent to which other rates of interest in the market change
iv. The state of supply and demand of funds from other sources. Bank rate policy
may not succeed if non banking sources of funds are of greater importance than
the banking sources.

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2) Open market operations-

a) Under open market operations, the central bank buys and sells government securities
in the open market (e.g. National Saving Certificates- NSCs)
b) When the central bank intends to contract credit it sells government securities which
are usually purchased either by commercial banks or by their customers
c) Consequently cash reserves with the banks and the amount of customers deposits with
the commercial banks are reduced and so their lending power
d) On the other hand when the bank desires to expand credit in the economy, it starts
purchasing such securities
e) When the central bank purchases securities in the open market it makes payments to
the sellerswhich are usually commercial banks or customers of commercial banks. Thus,
there is an increase in the commercial banksreserves and also an increase in the
customers deposits with the commercial banks. As a result lending power of the banks
increases.
f) Therefore, the policy of open market operation brings about a change in the total
volume of credit created by the commercial banks
g) Success of OMO as a tool of monetary policy requires –
i. A well functioning securities market for the sale and purchase of securities
ii. Reserves with the commercial banks should not be in excess. If commercial banks
regularly and routinely tend to keep their own excess reserves with themselves
then they need not buy securities. In such a case the utility of such a policy will be
doubtful.

In developed countries like the US, banks are not affected by the OMO because they buy
securities with excess reserves and when they sell securities, the amount realized is added to
the excess reserves. In such a situation OMO becomes a powerless tool

3) Varying Reserve Requirements-

Banks are obliged to maintain reserves with the central bank on 2 accounts-
a) Cash Reserve Ratio or CRR
b) Statutory Liquidity Ratio or SLR

a) Cash Reserve Ratio –

a) Commercial banks are required under law to keep with Central bank a minimum
percentage or proportion of their deposits as cash reserve. This is called as the Cash
Reserve Ratio.
b) When credit is to be contracted central bank can increase this ratio and thereby the
cash resources of the bank can be reduced. Banks are thus forced to contract credit.
c) Contrary to this is when it intends to expand credit, it reduces this ratio.

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b) Statutory Liquidity Ratio –

a) The Statutory Liquidity Ratio requires the banks to maintain a specified percentage of
their net total demand and time liabilities in the form of designated liquid assets,
which may be –
1) Excess reserves
2) Unencumbered government securities (which are not acting as security for loans
from the central bank) and other approved securities (securities whose repayment
is guaranteed by the government)
3) Current account balances with other banks
b) Varying theStatutory Liquidity Ratio affects the freedom of banks to sell government
securities or borrow against them from the central bank. This affects their freedom to
increase the quantum of credit and therefore the money supply. Increasing the SLR
reduces the ability of the banks to give credit and vice versa.
c) (Simple definition- Every bank is required to maintain a fixed percentage of its assets in
the form of cash or other liquid assets. This is called as SLR)

4) Repo Rate and Reverse Repo Rate

a) Repo Rate
1) Repo rate or repurchase rate is the rate at which banks borrow money from the
central bank (RBI for India) for a short period by selling their securities (financial
assets) to the central bank with an agreement to repurchase it at a future date at
predetermined price.
2) It is similar to borrowing money from a money-lender by selling him something,
and later buying it back at a pre-fixed price.
b) Reverse Repo Rate
a) Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of
India in case of India) borrows money from commercial banks within the country.
b) It is a monetary policy instrument which can be used to control the money supply in the
country
c) An increase in reverse repo rate means that commercial banks will get more incentives
to park their funds with the RBI, thereby decreasing the supply of money in the market
and vice versa

B. Qualitative Credit Control or Selective Methods -

Qualitative methods or selective methods are those methods which are used by the Central
bank to regulate the flow of credit into particular directions of the economy.

Unlike Quantitative methods, these methods affect the type of credit given by the commercial
banks. It is because of this specific use of credit that they are called ‘selective controls’.

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The important qualitative methods of credit control are:
1) Imposing Margin Requirements on secured loans
2) Moral Suasion
3) Selective Credit Controls

1) Imposing Margin Requirements on secured loans -

a) A margin is the difference between the amount of the loan and the market value of
the security offered by the borrower against the loan
b) If the margin imposed by the Central bank is 40% then the bank is allowed to give a loan
only up to 60% of the value of security
c) By altering the margin requirements, the Central bank can alter the amount of loans
made against the securities by the banks
d) The advantages of this instrument are manifold. High margin requirements discourage
speculative activities with bank credit and therefore divert resources from
unproductive speculative activities to productive investments.
e) By reducing speculative activities, there will be reduction in the fluctuation of market
prices of securities.

2) Moral Suasion –
a) This is a combination of persuasion and pressure that the Central bank applies on the
other banks in order to get them fall in line with its policy.
b) This is exercised through discussions, letters, speeches and hints to the banks
c) The Central bank frequently announces its policy position and urges the banks to fall in
line.
d) Moral Suasion can be used both for quantitative as well as qualitative credit control

3) Selective Credit Control –

a) This can be applied both in positive as well as negative manner
b) Application in a positive manner would mean using measures to channel credit to
particular sectors, usually the priority sectors.
c) Application in a negative manner would mean using measures to restrict the flow of
credit to particular sectors.

6.2.5 Custodian of foreign exchange: Central bank is the custodian of foreign nation’s foreign
exchange reserve. It also exercises ‘managed floating’ to ensure stability of exchange rate in the
international money market.

6.3 Differentiate between Demand Deposits and Fixed Deposits

Demand Deposits Fixed Deposits

1) Demand Deposits can be withdrawn by 1) These deposits can be withdrawn only
their depositors at any time without notice after the expiry of a certain fixed period

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 2) They are chequable i.e. they can be
withdrawn through cheques
3) No interest is paid on these deposits.
Rather depositors have to pay something
to the bank for its services
4) These deposits constitute a part of
money supply
2) They are not chequable.
3) These deposits carry high rates of
interest
4) They fall under the category of near
money

Distinguish between Bank rate and Repo rate.

Bank Rate Repo Rate

The bank rate is the rate at which the
central bank lends funds as a lender of last
resort to the banks, against approved
securities or eligible bills of exchange
Repo rate or repurchase rate is the rate
at which banks borrow money from the
central bank (RBI for India) for
a shortperiod by selling their securities
(financial assets) to the central bank with
an agreement to repurchase it at a future
date at predetermined price.

Bank rate relates to borrowings by the Repo rate relates to short-term

commercial banks to cope with their borrowings by the commercial banks.
immediate cash-crunch

1) Define bank rate. (Delhi 2009)

2) State any three points of distinction between central bank and commercial banks. (Delhi
2009)
3) Define cash reserve ratio. (AI 2009, Delhi 2011)
4) Explain any 2 functions of a central bank. (AI 2009, Foreign 2009)
5) Explain any 2 functions of a commercial bank. (Foreign 2009)
6) Explain the central bank’s function as a currency authority. (Delhi 2010, Foreign 2012)
7) How do changes in the bank rate affect money creation by commercial banks? (Delhi 2010)
8) Explain the government’s banker function of central bank. (Delhi 2010, AI 2010, AI 2012)
9) Explain the lender of last resort function of the central bank. (Delhi 2010, AI 2010, 2012)
10) Explain the meaning of CRR and SLR. (AI 2010)
11) Explain how open market operations by the central bank affect money creation by
commercial banks. (AI 2010)
12) Define legal reserve ratio. Explain its components. (Foreign 2011, Delhi 2012)
13) Explain the banker’s bank function of the central bank. (Delhi 2012)
14) Distinguish between CRR and LRR (Foreign 2012)
15) Distinguish between CRR and SLR. (Foreign 2010)

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