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A bank is information which deals in money. We can say that, bank draw surplus money from the people, who are not using it at the time, and lend to those who in a position to use it for productive purposes. Modern banks have developed from very small beginnings. The earlier bankers were goldsmiths.

Functions of commercial banks

There are three principal functions of banks.(other than central banks)


Receiving Deposits Advancing loans Discounting bills

Receiving Deposits- Mostly this is important, because banks mainly depend on the funds
deposited with them by the public. Deposits are of three kinds. (a)- Current or demand deposits

- The bank pays practically no interest. They can withdraw

in part or in full at any time by issuing cheque. (b)- Fixed or time deposits- They are left with the bank for a certain fixed period before the expiry of which they cannot be as withdrawn except after giving due notice. (c)- Saving deposits- Only a small percentage of saving is withdrawn at any particular time. But since withdrawals can and do take place the bank to keep a certain proportion of its assets in liquid form.

Advancing Loans- The bank makes profit by advancing loans. But bank deals in other
peoples money. It has, therefore, to keep read cash to meet the depositors demands .Hence the great care has to be exercised in the matter of lending and keeping reserve. The bank can itself create deposits and thus makes advances considerably in excess of the sums deposited with it. After satisfying itself that the purpose for which the loan is required is economically sound and after taking precautions as regards security, the bank gives it client the right draw cheques. The loan thus becomes a deposit to the credit of the customer concerned. If the customer, by a cheque or a series of cheques, withdraws this amount the payment is made to somebody. These

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cheque in their turn, come back either to the same bank or to other banks of the country or locality.

Discounting bills- It is lending for short period. A tender for instance, who does not wish to
lock up large funds in trade credits, may draw a bill exchange on his debtor, and , after it has been accepted by ,or on behalf of, the debtor, he may get it discounted by his banker. This gives the tender immediate possession of the money due to him less a deduction for the loss of interest and for the commission to the bank. These bills are usually for three months, and when they mature, the bank realizes the face value of the bills .Thus the bank earns more profit in addition to facilitating trade. These bills mature after short periods, and if the worst happens, they can be rediscounted at the central bank.

Other Services- The bank perform a number of other services for the consumers. They help in
the transfer of funds from one place to another and from one person to another though the use of cheques some banks accept bills on behalf of their customer and thus make them more easily negotiable.

Creation of credit
It is one of the most important functions of a modern bank. A bank has sometimes been called a factory for the manufacture of credit. Banks create credit in two ways. 1- By advancing loans. 2- By purchasing securities. It is an open secret that the banks do no keep cent percent reserve against in order to meet the demands of depositors the is not a clock room where you can keep currency notes or coins and claim those notes or coin back when you desire. It is generally understood that deposits received by the bank are meant to be advance to others. A depositor has to be content simply with the banks promise or undertaking to pay him whatever he makes a demand. Thus the bank are able to do with a very small reserves, because all depositors do not come to withdraw money simultaneously; some withdraw, while other deposit at the same time. Similarly, the bank buys securities and pays the seller with its own cheque with its again is no cash; It is just a promise to pay cash.The cheque is deposited in some bank and a deposit is created or credit is created for the seller of the securities. This is credit creation. Process of credit creation Suppose a customer deposits RS 1000 in a bank. The bank has to pay him interest; therefore the bank must seek a safe and profitable investment for this amount.
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Suppose the bank in which a depositor has deposited Rs. 1,000 keeps 20 percent cash reserve to meet the demands of depositors. This means that as soon as the bank has received Rs.1000 it will make up its mind to advance loans up to amount of Rs.5, 000 (only one- fifth reserve is kept). When therefore, a businessman comes to the bank with a request for a loan of Rs.5,000 , he may be sure of being granted accommodation to this extent, provided, of course, his credit is good. The bank would have liabilities of Rs.5, 000 although it has only Rs.1, 000 in cash. The second is creation credit is very simple. The bank purchase securities without paying any cash. It issues its own cheque to pay the purchase price. The cheque is deposited in this bank or some other bank and the small cash reserve which the bank keeps is sufficient to meet the obligation arising from this transaction too.

There have three limitations on the power of the bank to create credit. 1- The total amount of cash in the country; 2- The amount of the cash which the public wishes to hold, i.e. the ratio in which the public wishes to hold bank notes and bank deposits; and 3- The minimum percentage of cash to deposits which the banks consider safe i.e., the reserve ratio. The bank cannot create credit without acquiring assets (in this case the borrowers promise to pay of some security). An asset is form of wealth. The essential condition for creation credit are that the bank obtain fresh cash reserves, they should be willing to lend and businessman should be willing to borrow, and borrower should not withdraw amount of the loan but be content to leave it in the form of deposit with the bank .

Investment Policy: Liquidity vs. Profitability

The liquidity and profitability are opposing considerations. There has to be a compromise, but it is an uneasy compromise. Because whatever the form and the quantity in which the banks keep their reserve, they are found to be unnecessary informal times and insufficient when depositors confidence is shaken. The amount of kept reserve kept by a bank is governed, among others, by three factors 1- Day to day fluctuation in the amount of banks deposits 2- The variability of the customers borrowing needs 3- The nature of secondary reserves and the character of reserve organization in the banking system.
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Importance of liquidity The proportions which the various forms of assets are kept vary from country to country, from bank to bank and vary also with the state of trade. The larger the liquidity of the assets, the more confidence will a bank inspire but lower will be its profits. The whole banking business rests on the confidence of the people in the ability of the bank to pay their money back on demand. If such confidence is shaken for any reason, there is a run on the bank. No bank faces a run because all the assets of the bank are not in liquid form.

Utility of Banks
More concretely we may summarize the uses of bank as follows 1- The bank creates purchasing power in the form of bank notes, cheque, bills and drafts. 2- They make money more mobile, by bringing lenders and borrowers together and by helping funds to move from place to place. 3- The bank encourage the habit of saving among the people and enable small savings, which otherwise would have been scattered ineffectively to be accumulated in to large funds and thus made available for investment of various kinds. 4- The banks agency functions are very useful to the customer of the bank. They undertake to make petty payments of various kinds on behalf of their customers and also make several types of collections on their behalf.

Role of Banks in Economic Development

Banks play a vital role in economic development of underDevelopment economics in several ways. a - Banks Promote Capital Formation Avery small trait of an under developed economy is deficiency of capital which is due to small saving made by the community. Backward economy hardly saves 5% of national income, whereas they should invest at least12% in order to secure a reasonable level of development. The role of banks in economic development is to remove the deficiency of capital by stimulating saving and investment. In this connection the banks may perform two important functions. 1- They attract deposits by offering attractive rates of interest, thus converting saving which otherwise would have remained inert in to active capital. 2- They distribute those savings through loans among enterprises which are connected with economic development.
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b- Optimum utilization of resources It is difficult to see haw, in the absence of banks, could small saving of the people be mobilized or even made possible. It is also difficult to see who would distribute these saving among entrepreneurs. We see in India that the period of economic development has coincided with a phenomenal increase in the bank deposits and increasing advances for agricultural and industrial development. c- Banks finance priority sectors In order to meet additional demands arising out of economic development, the banking system has to undergo certain changes in the structure and organization. The bank and other financial institutions must operate in such a manner as to conform to the properties development and not in terms of return on their capital. d- Banks promote balanced regional development By opening branches in backward areas, the banks make credit facilities available there also the funds collected in developed regions through deposits may be channelized for investment in the under developed regions of the country. In this way, they bring about more balanced regional development project. In this way the bank make valuable contribution to the speed and the level of economic development in the country. e- Banks promote growth with stability They can encourage investment when the speed of development has slowed down .In this way the bank promotes growth with stability. In India the primary functions of bank notes and keep adequate reserves to ensure monetary stability. But now it has assumed wider responsibility to help in the task of economic development. In addition to the traditional responsibility of regulating currency and controlling credit, RBI has been playing a vital role in financing and supervision of the development programmes for agricultural, trade, transport and industry. It has created special fund for promoting agricultural credit and it has created special institution for widening facilities for industrial finance. The other to readily fall in line. They open the new branches to top the savings of the people and lend them to entrepreneurs. An increasing degree of control is exercised in respect of management, financing and development of programmes but are made to further these programmes.

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Inference to the Chapter

Thus, the banks come to play a dominant and useful role in promoting economic development by mobilizing the financial resources of the community and by making them flow into desired channels.

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The central bank of the country is the Reserve Bank of India (RBI). It was established in April 1935 with a share capital of Rs. 5 crores on the basis of the recommendations of the Hilton Young Commission. The share capital was divided into shares of Rs. 100 each fully paid which was entirely owned by private shareholders in the beginning. The Government held shares of nominal value of Rs. 2, 20,000. Reserve Bank of India was nationalized in the year 1949. The general superintendence and direction of the Bank is entrusted to Central Board of Directors of 20 members, the Governor and four Deputy Governors, one Government official from the Ministry of Finance, ten nominated Directors by the Government to give representation to important elements in the economic life of the country, and four nominated Directors by the Central Government to represent the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New Delhi. Local Boards consist of five members each Central Government appointed for a term of four years to represent territorial and economic interests and the interests of co-operative and indigenous banks. The Reserve Bank of India Act, 1934 was commenced on April 1, 1935. The Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank. The Bank was constituted for the need of following:

To regulate the issue of banknotes To maintain reserves with a view to securing monetary stability and To operate the credit and currency system of the country to its advantage.

Importance of central bank Control of credit: As already pointed out, every commercial banks creates credit during its daily operations. In fact, credit creation is supposed to be the major function of the commercial banks. But this credit creation sometimes poses serious danger for the economy of the credit. Hence, the need arises of institution which can exercise control on credit creation of the commercial banks. This function can be performed by the central bank. The central bank should see to it that the credit created by the commercial banks remains within limits. 1.) Issue of paper currency: A central bank is also required to issue paper currency. The reason is that the note issue by the central bank satisfies the requirement of elasticity. Moreover, the note issue of the central bank is based strictly on economic considerations. As against this, the system of note issue of the government lacks elasticity.

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2.)Economic help to the commercial banks: A central bank is also required to help the commercial bank to tide over economic crisis. In the absence of the central bank, the commercial banks are likely to fail at the slightest crisis in the economy.

3.) Implementation of governments monetary policies:

Since the central bank can exercises full control over the banking system of the country, it is in a position to implement successfully the monetary and financial policies of the government. Principles of central banking Following are the three main principles of central banking: 1) The central bank is always inspired by the spirit of national welfare: The commercial banks are generally guided almost exclusively by the profit motive. As against this, the central bank is always inspired by the spirit of national welfare. It should not consider profit as the primary motive. But it does not mean that the central bank should suffer losses while working in national interest. The profit motive for central bank should only be a secondary consideration. 2) Monetary and financial stability: Another important principle of central banking is that the central bank should help in the maintenance of monetary and financial stability in the country. There are several weapons in the armory of the central bank which it can utilize for the achievement of this objective. 3) Freedom from political influence: The central bank should remain free from all political influence. In other words, it should not allow itself to be dominated by the ideology of a particular political party. It should work strictly in accordance with the well known principles of central banking. It is also necessary that there should be perfect cooperation between the central bank and the government of India. 4) No competition with member banks: The central bank is a parent bank. Just as the parents do not compete with children, the central bank should, under no circumstances, compete with the member banks in receiving deposits from the public or extending loans to the needy borrowers. If it competes with the members banks, this will conflict with its important functions of being a bankers bank, controller of credit and lender of last resort.

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Functions of central banking Note issuing agency: As already pointed out, the commercial banks in the 19th century had the right of note issue, but the notes issued by there was lack of uniformity in the notes issued by the commercial notes. Secondly, every commercial bank was required to issue notes according it its reserves which were bound to be of a limited size. As such, the notes issued by them were in limited quantity. Thirdly, sometimes the commercial banks failed to convert their notes in cash on public demand. Hence, it was realized that the note issued system of the commercial banks was not satisfactory. After sometime, the government took the issue of paper currency in its own hands. But even this system proved unsatisfactory in the long run. The reason was that the system of note issue adopted by government suffered from lack of elasticity. The government was not in the position to estimate accurately the monetary requirements of the economy. Hence, it came to be realized, in the course of time, that the central bank was the most appropriate institution to undertake the issue of paper currency. The following advantages have accrued from the system of note issue by the central bank: a) b) c) d) e) f) Uniformity in the monetary system Greater public confidence Elasticity in the monetary system Control on credit creation Profit for the government Stability in internal and external value of money. The central bank acts as the bankers bank: The central bank acts as the bankers bank in three different capacities: a) It acts as the custodian of the cash reserves of the commercial banks. b) It acts as the lender of last resort. c) It is the bank of central clearance, settlement and transfer. These three functions are discussed one by one below: Lender of last resort: This means that if the commercial banks are not able to secure financial accommodation from other sources, then as a last resort, they can approach the central bank for necessary credit facilities. The central bank in such a case will be prepared to grant accommodation to the commercial banks against eligible securities. The commercial bank can fall back upon the central bank in time of emergency. This results in the following advantages:

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a) Commercial bank can carry on their activities on the basis of smaller cash reserves. They know that they can get their eligible paper rediscounted by the central bank in time of emergency. b) The commercial banks can secure financial help from the central bank at the time of crisis. This strength the public confidence in the banks because the people know that in case of emergency, the central bank will come to the rescue of the commercial banks. c) This system helps the commercial banks to maintain the liquidity of their financial resources. d) This function of central bank as the lender of last resort, offers an opportunity for the central bank to establish its control over the banking system of the country. When the commercial bank applies to the central bank for financial accommodation, the latter automatically acquires the right to examine the financial condition of the former.

Clearing and settlement: Clearing, it must be admitted, is one of the main operations of central banking. The central bank acts as the clearing house for the commercial banks. Since it holds the cash reserves of the commercial banks, it becomes easier and more convenient for it to act as the clearing house of the country. All the commercial bank has their accounts with central banks. Consequently, the central bank can settle the claims and counter claims of the commercial banks with the minimum use of cash. Thus, the clearing house function of the central bank economies the use of cash by the banks. Another advantage accruing from the central bank its capacity as the clearing house is that it helps the commercial banks to create credit on a large scale because the demand for cash is automatically reduced consequent upon the functioning of the functioning of the clearing house system in the country.

Credit control aimed at serving the important points1) Increasing sales by expanding by credit to customers who are deemed a good credit risk. 2) Minimizing the risk of loss from bad debts by restricting or refuse the credit to the customers who are not a good credit risk. The following five steps can help you take control of your credit situation: 1. 2. 3. 4. 5. Get your credit report, determine and understand your credit rating. Understand the risks of credit fraud and how to protect yourself. Understand your rights. Correct any errors. Work toward improving your credit score.
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Objectives of credit control: There are several objectives of credit control which are as follows(a) (b) (c) (d) (e) To safeguard its gold reserves against internal and external drains: To maintain stability of internal prices: To achieve stability of foreign exchanges: To eliminate fluctuations in output and employment: To assist in economic growth:

Safeguarding gold reserves: The necessity of safeguarding gold reserves arises under a gold standard. In a gold standard country, gold can be imported and exported as the currency of country is convertible by law into gold coin or gold bullion. High prices at home first lead to withdrawal of more cash from the bank and then gold from the central bank to carry on transaction at a higher level this is called the internal drain. Secondly, the home price level being higher than the international price level, imports are encourage and exports are discourage. As unfavorable balance of trade is created which has to be met by export of gold is called as external drain. Price stability; Another object of credit control is maintain stability of internal prices. Price instability causes disturbances in economic relations, mal adjustment and serious consequences. External stability: In the interest of smooth flow of a international trade and for settlement of obligations, stability of foreign exchange rate is essential. Instability disturbs international trade and makes the settlement of international obligation difficult. Thus India concentrates more on internal stability. Economic stability: A more recent view held that the central bank should aim at smoothening out the business cycle. The aim should be to maintain a normal study growth of business activity and prevent booms and slums. Its first task should be to prevent the natural instability of a complex credit system and secondly, to attempt deliberately to offset some of the causes of disturbance that are beyond its control.

Difficulties of credit control:

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1) Bank credit is not the only form of credit. There is commercial credit like book credit, bills of exchange and promissory notes. 2) Even as regards bank credit, all banks of the country do not have direct relations with the central bank. 3) Even if all banks were member-banks, commercial banks may not always co-operate with the central banks and may not follow its lead. Such co-operation, as we shall see, in indispensable for a successful control of credit. 4) The central bank cannot control the ultimate use to which credit may be put. Strictly commercial loans, for instance, may be used for speculative purposes. Methods or Instruments of credit control used by the central bank: 1) Quantitative or General method 2) Qualitative or Selective method 1) Quantitative or General method: These measures are non-discriminatory as between banks and as between the uses to which credit may be given. They aim at regulating only the aggregate volume of money and credit available to the economy. They do not distinguish between the purposes for which borrowers use the loans, or the type of borrowers who are getting the loans. These measures are used on the assumption that there is a free market mechanism in the economy. By implication, any expansion (or contraction) of money supply is expected to spread itself quickly and evenly throughout the economy. The availability or scarcity of credit is experienced throughout the economy and does not remain confined to any segment of it. Therefore, the authorities need not worry about the part of the economy in which they inject additional credit supply, or from which they drain it. It also follows that any effort to selectively influence some parts of the economy is bound to be frustrated. The effect is felt by the entire economy or not at all.This method used by the central bank to influence the total volume of credit in the banking system.The important quantitative methods of credit control are: (a) (b) (c) Bank rate Open market operations Cash-reserve ratio

2) Qualitative or Selective method: These measures are also known as qualitative credit control, though they have also their quantitative impact. By their very nature, these measures are directed at regulating selective segments of the economy. An underdeveloped economy like ours suffers from several rigidities. It does not have a developed market mechanism. It lacks flexibility and ability to adjust quickly and evenly. Some parts of it can suffer from inflationary
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pressures while others may be suffering from a shortage of demand. There can be intersect oral and inter-regional imbalances. It is, therefore, necessary that in such an economy, the central bank should adopt selective regulatory measures so as to encourage or restrict specific categories of economic activities. These measures aim at influencing the allocation of resources. Selective credit control is exercised through issuing specific instructions to the banks. They can be discriminatory as between banks, between borrowers between purposes for which credit is extended and so on. In some cases, the instructions may also cover some additional dimensions of the credit like its maturity and terms and conditions. The central bank may also prescribe credit rationing, that is, absolute limits up to which specified sectors of the economy may be entitled to get credit from the banking system. It need not be emphasized that a developing economy not only needs selective credit control, it is also more effective and useful for it. This method used by central bank to regulate the flows of credit into particular directions of the economy is called qualitative or selective method of credit control. The quantitative which affect the total volume of credit whereas the qualitative method affect the types of credit extended by the commercial banks-they affect the composition rather than the size of credit in the economy. Open market operations: Open market operations (also known as OMO) is the buying and selling of government bonds on the open market by a central bank. It is the primary means of implementing monetary policy by a central bank. The usual aim of open market operations is to control the short term interest rate and the supply of base money in an economy, and thus indirectly the total money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets such as inflation, interest rates or exchange rates are used to guide this implementation. Limitations of open market operations: There are some limitations of the open market operation in a specific situation which are as followsMoney and capital market not developed: The money and capital market in the under developed countries is not organized and well developed. As such the policy of open market operations is not effective. Excessive cash reserves: if the commercial banks have surplus reserves with them and they resort to easy lending policy, the sale of government securities may not have the desired effect or reducing the cash reserves of the commercial banks. Attitude of people: if there is return of notes from circulation and hoards, the sale of securities
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may not be able to reduce the cash reserve of member banks. Similarly if there are withdrawals of notes for increased currency requirements or for hoarding then the purchase of securities may not increase the cash reserves of the banks. Cash ratio: There is no strict enforcement of fixed ratio of cash to credit for the member banks. If the economic and political conditions are favorable the banks may expand credit by multiple with low cash reserves. In case the loan conditions are not favorable the banks may contract credit even though they have sufficient cash reserves with themselves. Bank rate policy: Bank rate is the interest rate at which a central bank provides loans to banks and other borrowers. Corresponding to it is the discount rate, that is, the rate at which the central bank discounts trade bills, and other instruments, which are redeemable at par. In practice, the two rates result in the same cost of borrowing from the central bank so that the two terms can be used interchangeably. The central bank is the lender of the last resort. Therefore, the rate at which it is ready to extend credit has a direct impact upon the level of interest rate in the country. When the market has to pay more for its funds from the central bank, it increases the interest rate charged from the business sector. It is expected that, faced with a demand for increased interest rates, the borrowers curtail their demand for credit and investment activity slows down. Moreover, higher cost of borrowing funds adds to the cost of production and supply, which means that the suppliers must increase prices or bear the extra cost themselves. In the former case, market demand decreases and results in a recession. And in the latter case, there is a dampening effect on fresh investment. In contrast, a reduction in bank rate leads to a fall in the level of interest rate in the market. The cost of borrowing funds comes down resulting in a downward impact on the cost structure of the business sector. Ordinarily, therefore, with an increase in bank rate, the demand for business loans is expected to fall and vice versa.

Theory of bank rate policy:

The theory underlying open market operations is that the purchase or sale of securities by the central bank directly results in increase or decrease in the cash reserves of the commercial banks, leading thereby to an increase or decrease in their ability to create credit. The policy of open market operations, thus, brings about an immediate change in the total volume of credit created by the commercial banks. This, in its run, influences the level of business activity, employment and the internal price level. The process, in which it influences, is as follows: Let us suppose that there is too much expansion of credit going on in the banking system and that the central bank considers this expansion of credit harmful in the larger interests of the economy.
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To control this excessive expansion of credit, the central bank will start selling securities in the open market both to the banks as well as the private individuals. When the banks and the private individuals purchase these securities, they have to make payments for these securities to the central bank. The result is that cash now moves from the commercial banks to the central bank. This results in fall in the cash reserves of the commercial banks, which, in turn, reduces their ability to create credit. With reduced cash reserves, the commercial banks will not be able to create as much as they were doing before. Thus, through the sale of securities, the central bank is able to exercise a check on the expansion of credit in the banking system. Let us now suppose that the economy is confronted with a deflationary situation and that the commercial banks are not creating as much credit as is desirable in the interests of the economy. In such a situation, the central bank will start purchasing securities in the open market from commercial banks and private individuals. The central bank will naturally have to make payments to the commercial banks and private individuals for its purchases of securities from them. Cash will now move from the central bank to the commercial banks. With increased cash reserves, the commercial banks will be in a position to create more credit with the result that the volume of bank credit in the economy will expand. The credit multiplier will now come into operation. A given increase in the cash reserves of the commercial banks will lead to multiple expansions in the total volume of bank credit within the economy. Thus, through purchase of securities, the central bank is able to stimulate the creation of more credit by the commercial banks. Open market operations also influence the interest rates in the market. The reason is that the quantity of money in circulation changes consequent upon the open market operations by the central bank. Bank rate policy under gold standard: The theory of this policy is specially adapted to gold standard. It operated most successfully, therefore, in great Britain before 1914.Under gold standard, an adverse balance of trade is indicated by movement of the exchange rate to the gold export point and outflow of gold. This may be due to excessive. Export of capital or excessive import of merchandise. Conversely, when the balance of payments is favorable, there is an inflow of gold. Limitations of bank rate policy: For a successful working of such a policy, a little reflection will show that a number of conditions have to be satisfied. 1. The expenditure decisions of the business community are not regulated-by the cost of funds alone. It is equally guided by the marginal efficiency of capital that is the expected rate of return on fresh investment expenditure, which, in turn, is deeply influenced by inflationary and deflationary expectations. For example, if the economy is passing through a boom period, an
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increase in bank rate may be more than counterbalanced by an increase in expected rate of return from fresh investment. By implication, depending upon the strength of inflationary expectations, a small increase in bank rate may prove ineffective in reducing demand for credit. In other words, the bank rate will have to be increased substantially enough for successfully counteracting inflationary expectations. However, in theory it is always possible to do so, in practice, it is often difficult to raise the bank rate by more than a small margin. Going by the same logic, the bank rate is to be reduced when the objective of the central bank is to retrieve the economy from the ditches of a depression and accelerate economic activities. However, if deflationary expectations are very strong, even a substantial reduction in bank rate may fail to revive the economy. 2. The effectiveness of bank rate also depends upon the psychological impact that it may be able to create. Experience shows that it does not succeed because of the time lags involved with time lags. It succeeds only if it has a decisive impact on the market interest rates and related credit conditions. 3. The money markets of the country should be well developed, integrated and very sensitive to even small changes bank rate. If these conditions are not satisfied, bank rate fails in influencing short-term rates. If for example, the bill market is underdeveloped, or if there is no market for money on call and short notice, the market will fail to respond td the bank rate changes. 4. Frequently, economic interest of the government of the country clashes with the use of bank rate as an instrument of credit control. Normally, a modern government has a huge amount of outstanding public debt and is in constant need of fresh loans (including short-term loans by means of treasury bills, etc.) Since an increase in bank rate means an added budgetary cost for the government, it exerts pressure upon the central bank to avoid raising bank rate. 5. The very success of bank rate in pulling the market rate of interest in the same direction creates its own problems. For example, suppose the central bank increases bank rate with the idea of curtailing the volume of money and credit in the country, and it succeeds in increasing the market interest rates. This will cause an inflow of foreign capital, add to the foreign exchange assets of the central bank, cause an addition to domestic money supply and defeat the very objective of raising the bank rate. 6. The effectiveness of bank rate as a weapon of monetary policy has decreased over time. A variety of financial instruments has come into existence and business sector has learn to do with more of mutual credit and other means of doing business. As a result, the dependence of the domestic markets over the central bank has decreased.

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The primary objectives of the monetary policy are: a) b) c) d) e) f) The safeguarding of the countrys gold reserves, Price stability, Exchange stability, Elimination of cyclical fluctuations, Achievement of full employment, and In case under-developed economies, accelerating economic growth.

Which particular objective is to be pursued at any given time will depend on the economic situation to be tackled. A focus will be applied whether a country should follow a dear money policy or a cheap money policy or a neutral money policy. We shall also consider a suitable monetary policy for a developing economy.

Dear money v/s Cheap Money

The terms dear or cheap money indicates the price for money. The price for money refers to the rate at which money can be had borrowed. Dear Money means that the borrowing rates or interest rates are high and Cheap Money means that interest rates are low. When Dear Money? When there is a state of extremely high inflation or out of control inflation, when there is a hectic speculative activity, when there is reckless investment by industrialists, when credit creation by the banks has crossed all prudent bounds, when balance of payment is heavily against the country or threatens to continue unfavorable, a dear money policy is indicated. It is a deflationary move. It will apply a break on senseless capital investment; it will check reckless credit creation by the banks; it will stem the rising tide of the prices; it will muzzle (hold) and mad career of speculators; and it will ultimately put the balance of payments position of the country on a stable footing. When Cheap Money? When the business enterprise is groaning under the benumbing and baneful effects of depression, when the banks are shy of lending, when the low price-level is killing the economic incentive, when there is widespread unemployment, and when a comprehensive building programme has to
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be put through, and so on, a cheap money policy or a policy of low interest rates is the best. It will stimulate investment, create employment; it will oil the wheel of the industrial machine; it will, in short, tend to lift the blanket of depression and remove its deadening influences. Thus, Cheap Money policy(i.e. cheapening of credit services) is a tool for combating slump, fighting unemployment and financing development programmes. When a cheap money policy is adopted, the government has to borrow in the open market. In case there is a shortage or lack of credit, the prices of securities will rise and the demand for them will fall. The government will have to rely on institutional investors. Cheap Money policy means the monetization of public debt, i.e. the public debt is turned into liquid cash. If a stage of full employment has already been reached, it will mean an inflationary finance. Feasibility The rate of interest brings about equilibrium between demand for saving and supply thereof. The rate of interest cannot fulfill the function (of equilibrating demand and supply), because capital expenditure brings into existence the very savings necessary to finance it. There is no question of equilibrating the one with the other because, they are kept in equality by changes in the level of income. If there is a low rate of interest, investment is encouraged. It is now in the power of the State to fix and maintain low rate of interest. Lets understand how can the rates of interest be controlled. The interest rate can be controlled through a control over savings. There are four ways in which people hold their savings, viz. cash balances, bank deposits, bills (short term investments) and bonds (long term investments). After analyzing the picture of the economy, the government may decide to fix a particular rate of interest and then leave the saving public to adjust their savings in the desired form, they wish to. The government can however obtain the balance from central bank through Ways and Means advances, in case it is unable to raise the desired amounts at the rates announced. As the government expenditure proceeds, new savings will be created and the cash balances of the bank will go up. The feasibility of fixing the rate of interest is thus beyond question. The government has simply to decide the rate and then offer to the public, what they would wish to hold given this rate.

Neutral Money Policy

The Neutral Money Theory is associated with the name of Prof. F.A. Hayem. The advocates of this theory believe that the most important causes of economic instability lie in the monetary changes. Eliminate them and you shall have a steady and smooth economy. It is a policy which seeks to neutralize or eliminate the dislocating and disturbing influences caused by the creation or expansion of money on one hand, and its destruction or contraction on
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the other hand. The creation or injection of new money is supposed to cause inflation whereas withdrawal or contraction of money produces a deflationary effect. Inflation is associated with dear money and deflation with cheap money. From the economic point of view both inflation and deflation are bad. Money should be neither dear nor cheap. The neutral money policy is thus identified with zero mark of inflation and deflation. It seeks to create a state of affairs if money did not exists, lest it should be inflationary or deflationary. In the pursuit of the neutral money policy, the monetary authority has to regulate the supply of money that the production levels, price level and the volume of transactions are such if the community did not use any money. To achieve the aim of neutral money policy the monetary authority has to keep its eye on the price level rather than keep the supply of money constant so that dangerous turns in prices are avoided

Monetary Policy for a Developing Economy

In a developing economy, the monetary policy has a very special role to play. A developing economy has to make a very large scale mobilization of productive resources of all types and has to organize their most efficient allocation. The task of implementing the development plans of sizeable dimensions is a big task and all out effort is required on the part of all the authorities to ensure their successful implementation. The monetary authorities have to play their full part. One important requirement for steady economic growth is the environmental atmosphere of comparative price stability and absence of inflation. For a steady and sound economic advance and for efficient utilization of resources, for avoidance of distortion and dislocation of investment programmes and for the promotion of the objective of greater economic equalities or of lessening inequalities of income and wealth, it is essential that there be an atmosphere of general financial stability in the economy including price and exchange stability. A non inflationary environment is conducive to sustained, continuous and efficient development rather than fulfill uneven and unstable growth. Weapons which can be used to ensure financial and price stability are as under: 1.) Physical or direct controls like price control and rationing of essential commodities in short supply. (Problems associated with it are it is difficult to administer owing to vast number of producers and consumers. It is complicated and difficult to apply in an under developed economy). 2.) Monetary controls are more effective, less complicated and do not raise many administrative problems. 3.) Fiscal instrument or the budgetary action on the part of government involving income and commodity taxes. (Fiscal policy involves a draft on the financial resources and the purchasing power is the hands of public, and with particular classes of producers and
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consumers. Taxes also differentiate between various classes of consumers and producers through reliefs and rebates.) The fact is that all 3 types of weapon viz. physical, monetary and fiscal have to be used in combination with one another to ensure the requisite atmosphere for the successful implementation of the development plans and to promote steady and healthy growth of the economy.

Role of Central Bank in Economic Development

In a developing economy, the central bank has not to be content with merely playing a regulatory role. Its role must be promotional and developmental. The central bank (R.B.I.) can promote economic development in a number of ways. In particular, it can make a satisfactory provision for the following: 1.) Sound Currency System: to cope with the growth under economic development it is essential to maintain the soundness of the currency system. 2.) Regulated and Adequate Money Supply: the money supply should be adequate and properly regulated for the expanded economic activity so that it may not create an inflationary situation and too little result in recession. 3.) Creation of New Financial Institutions: the central banks create s special financial institutions for promoting economic development in different sectors to provide the much needed finance to accelerate development. 4.) Tackling Balance of Payments Problem: in a developing economy, owing to mounting imports of food grains, machinery, capital equipment, essential raw materials etc, the balance of payments turns adverse. The monetary authority tackles the problems by export promotion, import substitution, raising foreign loans so that economic development proceeds on an even keel. 5.) Restraining Inflationary Pressure: It is the responsibility of the monetary authority to restrain inflationary pressures by freezing part of the liquidity thus generated. This can be achieved by the monetary authorities through its pivot tool- the rate of interest. The interest rates are governed by the monetary policy. Thus, the monetary policy consists in central banks action in the sphere of bank credit. The central bank seeks to regulate bank advances leaving the operation of the price mechanism intact and leaving productive enterprises freedom of initiative and autonomous functioning.

Limitations of Monetary Policy

1. There exist a Non-Monetized Sector: In many developing countries, there is an existence of non-monetized economy in large extent. People live in rural areas where many of the transactions are of the barter type and not monetary type. Similarly, due to non-monetized sector
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the progress of commercial banks is not up to the mark. This creates a major bottleneck in the implementation of the monetary policy. 2. Excess Non-Banking Financial Institutions (NBFI): As the economy launch itself into a higher orbit of economic growth and development, the financial sector comes up with great speed. As a result many Non-Banking Financial Institutions (NBFIs) come up. These NBFIs also provide credit in the economy. However, the NBFIs do not come under the purview of a monetary policy and thus nullify the effect of a monetary policy. 3. Existence of Unorganized Financial Markets: The financial markets help in implementing the monetary policy. In many developing countries the financial markets especially the money markets are of an unorganized nature and in backward conditions. In many places people like money lenders, traders, and businessman actively take part in money lending. But unfortunately they do not come under the purview of a monetary policy and creates hurdle in the success of a monetary policy. 4. Higher Liquidity Hinders Monetary Policy: In rapidly growing economy the deposit base of many commercial banks is expanded. This creates excess liquidity in the system. Under this circumstances even if the monetary policy increases the CRR or SLR, it dose not deter commercial banks from credit creation. So the existence of excess liquidity due to high deposit base is a hindrance in the way of successful monetary policy. 5. Money Not Appearing in an Economy: Large percentage of money never come in the mainstream economy. Rich people, traders, businessmen and other people prefer to spend rather than to deposit money in the bank. This shadow money is used for buying precious metals like gold, silver, ornaments, land and in speculation. This type of lavish spending give rise to inflationary trend in mainstream economy and the monetary policy fails to control it. 6. Time Lag Affects Success of Monetary Policy: The success of the monetary policy depends on timely implementation of it. However, in many cases unnecessary delay is found in implementation of the monetary policy. Or many times timely directives are not issued by the central bank, then the impact of the monetary policy is wiped out. 7. Monetary & Fiscal Policy Lacks Coordination: In order to attain a maximum of the above objectives it is unnecessary that both the fiscal and monetary policies should go hand in hand. As both these policies are prepared and implemented by two different authorities, there is a possibility of non-coordination between these two policies. This can harm the interest of the overall economic policy. These are major obstacles in implementation of monetary policy. If these factors are controlled or kept within limit, then the monetary policy can give expected results. Thus though the monetary policy suffers from these limitations, still it has an immense significance in influencing the process of economic growth and development.

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Role of Monetary Policy in Indian Economic Development

During the last 25 years of planning, the Reserve Bank of India has tried to regulate the cost of credit, the quantity of credit and the purpose or use of credit. For regulating the cost and quantity of credit, the RBI has used the weapons of general or quantitative controls; eg: regulating the bank rate and the open market operations and for regulating the purpose or the use of bank credit, the RBI has had resort to what are called the selective credit controls. The selective credit controls have been used primarily for regulating bank advances against food grains and other selected articles or raw materials like sugar or groundnut, temporarily cotton textiles and recently raw jute and jute goods. These measures have been useful in restraining excessive speculative stockpiling of the commodities concerned, though their success is largely due to the fact of their being used in conjunction with measures of general credit control. The efficiency of the selective controls is limited by the fact that they cannot be adopted in advance of future pattern of production; they are adopted when excessive bank lending has already taken place. It is necessary to maintain a framework of selective credit controls because unregulated bank credit for building of stocks is likely to accelerate price fluctuations. As for instruments of general credit control, viz.. the bank rate and open market operations, the later is more continuous and informal market operations have tended to become increasingly one-way traffic, i.e., there has been more and more selling of the government securities to reduce the gap in the budgetary operations. The scope of the open market operations is also limited by the capacity of the market to absorb the stream of Government securities flowing from the RBI pool. In effect the open market operations have become more and more ancillary to government debt management. In India, the use of the bank rate, which is the prime instrument of monetary policy, had neither been frequent nor considerable. The bank rate remained constant since the inception of the Reserve Bank in 1935 to 1951 when it was raised from 3% to 3.5% and to 4% in 1957. But in recent years, the weapon of the bank rate was used quite frequently. The bank rate was raised to 4.5% in 1963 to 5% in 1964 and further to 6% in 1965. In 1968, however there was a reversal of dear money policy in March 1968, the bank rate was cut from 1% to 5%. Considering again the bank credit was showing a tendency of expanding too much, the bank rate was raised to 6% in January 1971, and further to 7% on May 30, 1973. In July 1974, the bank rate was raised to 9% and the minimum lending rate to be charged by the commercial banks was stepped up from 11% to 12.5%. Simultaneously, interest rates on various categories of commercial bank deposits were enhanced. All these measures had the effect of restraining the growth in money expenditures. In 1960, the Reserve Banks introduced a system of graded lending rates with the bank rate remaining unaltered. Under this system, borrowing quotas for scheduled banks were fixed at 50% of their statutory deposits with the Reserve Bank and 1% above the bank rate was charged for any borrowing in excess of the quota up to an amount equal to the basis quota and for further borrowing, above this additional quota, 2% above the bank rate was charged.

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Complementary to these measures, the Reserve Bank issued in September 1960, a directive rising the lending rates of the scheduled banks by minimum of 1/2%. It was followed by a move on the part of the banks directed to an upward shift in the pattern of deposit rates on savings and fixed deposits. Thus, the rate of interest continues to be the core of the monetary policy. A rise in interest rates has important effects, both direct and indirect, upon those who borrow and those who lend and also on the movement of the funds to and from the country. For some enterprises interest costs are a crucial part of the total outlay. A sharp rise in the interest rate is also expected to increase the more desirable kinds of savings. There is another instrument which the Reserve Bank used to restrain expansion of bank credit viz. varying reserve requirements. This instrument is particularly effective in freezing additional liquidity when the banks are acquiring large new resources, correspondingly adding to their lending capacity. 25% (later 50%) of the increase in deposits was frozen in 1960. This method is more appropriate as a temporary expedient to meet the exceptional liquidity situations, while changes in general interest rates are more appropriate for a long term structural adjustment to a situation of steadily improving liquidity. The RBI called upon to use the above weapons of credit control, for a serious inflationary situation which had developed in the country during the last few years. There has been a great increase in the money supply and the liquidity has outrun the pace of growth of real national income. Consequently, prices and cost of living have been rising. A 20% rise in prices from February end 1939 to September end 1979 i.e., since the presentation of the 1979-80 budget made the situation alarming. Among the factors responsible were, a big increase to the money supply of Rs. 1,182 crores during the end April to end August 1979 as against that of only Rs. 158 crores during the corresponding period of 1978. In order to curb the runaway expansion in bank credit and money supply, the RBI in August-September 1979 reduced bank resources under participation certificates, kept down cash credit and bill discounts, curtailed refinance, offered incentive to saying by rising rate of interest on fixed deposits, fixed ceiling rates on short term advances, and so on. Such a strong action on the monetary front was definitely called for to reduce the pressure of growing money supply and liquid funds generated by bank credits. It is good that Reserve Bank adopted various credit freeze measures. It must be said to the credit of the Reserve Bank of India that it has fully risen to the occasion to meet the requirements of the developing economy. Besides, taking monetary measures mentioned above to maintain the general financial stability in the country, and restraining inflationary pressures, it has helped in the creation of specialized institutions so that financial facilities are made available to the agricultural industries. Its development effort is indeed commendable. RBI has made available short term, medium term, and long term finance to agriculture through a hierarchical network of co-creation of two funds, viz., the National Agriculture Credit (Long term Operation) fund and the National Agriculture Credit (stabilization) Fund deserves mention. It has also been instrumental in setting up Agricultural RE-finance and Development
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Cooperation and lately NABARI. It has organized industrial finance so that small and big industries can secure all types of loans, short term, medium term and long term. It has helped in the creation of Industrial Finance Corporation Of India, State Financial Corporations, ReFinance Corporation, National Small Industries Corporations, National Industrial Development Corporations, Industrial Credit and Investment Corporation and the Industrial Development Bank and the Unit Trust. It has introduced a scheme of guarantee of bank loans to small industry.

Conflicting Objectives of the Monetary Policy

The various objectives of the monetary policy includes : 1) 2) 3) 4) 5) Price Stability Exchange Stability Full Employment Economic Growth Balance of Payment Equilibrium

Other Objectives includes:

a) b) c) d) e) f) g) h)

Creation, working and expansion of different Financial institutions Provision of an efficient payment mechanism Proper debt management Evaluation of a rational interest rate structure Operation of credit control measures Income stabilization by preventing or mitigating cyclical situations To ensure neutrality of money To bring about monetary equilibrium in the economy

Compatibility of Objectives: The price stability and economic growth are not compatible objectives. Price stability and full employment are conflicting objectives Full employment and balance of payment are conflicting objectives Full employment and economic growth are again conflicting objectives There is some conflict between exchange stability, price stability and economic growth

Coordination of Objectives
There is no doubt that some objectives of monetary policy are in conflict with others. But they can also be reconciled to some extent. There are two approaches to this reconciliation viz., the optimising approach and the fixed target approach. The authorities may lay down preference pattern regarding the objectives they would like to achieve. They may also select some rate of trade off or substitution between the conflicting objectives. In other words, it may be laid down

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to what extent one objective can be sacrificed for the achievement of another. It is thus possible to indicate the trade off and lay down priorities among objectives. Optimizing Approach The tradeoff between the rate of change of prices and unemployment rate can be illustrated by the following explanation of the curve drawn. The rate of price change is represented on the vertical axis and unemployment percentage on the horizontal axis. PP is the Phillips curve. Point D shows a situation of price stability at employment rate of 7% (OD) a, b, c are the indifference curves representing the policy preferences of the authorities regarding unemployment and inflation. Each of these curve shows equally acceptable combination of unemployment and inflation for example points x, y ,z on the indifference curve a. But the indifference curve near the origin (i.e. a), is preferred to those which are further off from the origin, because on this curve a certain level of unemployment is associated with a smaller rate of inflation as compared with other curves. The authorities will choose a combination which will maximize the social welfare. Obviously they would like to choose point O where there is not only full employment but also price stability. But at this point there is conflict between price stability and full employment. The authorities must therefore choose from the economically possible combinations which lie on the Phillips curve PP. The optimum combination will be where the indifference curve is a tangent to the Phillip curve. This is point Q where 2% inflation and 4% unemployment will maximize social welfare. In case the authorities prefer lower rate of inflation with g=higher rate of unemployment, they may choose R which is a point of tangency between the Phillips curve and the indifference curve a. This means that the authorities regard 5% unemployment and 1% inflation as maximizing social welfare. Thus the actual trade off between unemployment and inflation will be determined by the pattern of the authorities. Fixed Target Approach In this the authorities fix certain desirable targets (say 95% employment and 5% rate of inflation). The Phillips curve is adapted with the help of some policy instruments to achieve these targets. For instance, by the use of income policy, the objectives of price stability and full employment as determined by the targets can be achieved.

Harmonious Adjustments and Judicious Mix

Some conflicting objectives can be reconciled by making a harmonious adjustment and a judicious mix. For example, the conflict between the objectives of exchange stability and price stability can be resolved if the authorities adopt an action which while maintaining exchange rates coincides with the policy of stabilization.

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In the case of conflicting objectives, the authorities should assign priorities, make a choice and try to have optimal combination depending upon the economic and social conditions of the country. For instance, an optional combination between some rate of wild inflation and economic growth may be found out. The best way to coordinate the conflicting objectives is to give priority to the solution of short term problems, but the short term objectives must be subordinated to the long term objectives.

Monetary Policy v/s Fiscal Policy

Monetary policy affects income and expenditure through cost and availability of money, whereas Fiscal policy affects income and spending through government revenues (i.e. Taxes) and government expenditure. Monetarists assign more important role to monetary policy than to fiscal policy.

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A non-bank financial institution (NBFI) is a financial institution that does not have a full banking license or is not supervised by a national or international banking regulatory agency. NBFIs facilitate bank-related financial services, such as investment, risk pooling, contractual savings, and market brokering. Examples of these include insurance firms, pawn shops, cashier's check issuers, check cashing locations, currency exchanges, and microloan organizations. Alan Greenspan has identified the role of NBFIs in strengthening an economy, as they provide "multiple alternatives to transform an economy's savings into capital investment [which] act as backup facilities should the primary form of intermediation fail."

Role and Function of NBFI

The role and importance of non-bank financial intermediaries is clear from the various functions performed by these institutions. Major functions of the NBFIs are as follows:
1. Financial Intermediation:

The most important function of the non-bank financial intermediaries is the transfer of funds from the savers to the investors. Financial intermediation is economical and less expensive to both small businesses and small savers, (a) It provides funds to small businesses for which it is difficult to sell stocks and bonds because of high transaction costs, (b) It also benefits the small savers by pooling their funds and diversifying their investments.
2. Economic Basis of Financial Intermediation:

Handling of funds by financial intermediaries is more economical and more efficient than that by the individual wealth owners because of the fact that financial intermediation is based on (a) the law of large numbers, and (b) economies of scale in portfolio management. (i) Law of Large Numbers: Financial intermediaries operate on the basis of the statistical law of large numbers. According to this law not all the creditors will withdraw their funds from these institutions. Moreover, if some
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creditors are withdrawing cash, some others may be depositing cash. Again, the financial intermediaries also receive regular interest payments on loans or investments made by them. All these factors enable the financial intermediaries to keep in cash only a small fraction of the funds provided by the creditors and lend or invest the rest. (ii) Economies of Scale: Large size of the asset portfolios enables the financial intermediaries to reap various economies of scale in portfolio management. The main economies are: (a) reduction of risk through portfolio diversification: (b)employment of efficient and professional managers; and (c) low administrative cost of large loans and (d) low costs of establishment, information and transactions.
3. Inducement to Save:

Non-bank financial intermediaries play an important role in promoting savings in the country. Savers need stores of value to hold their savings in. These institutions provide a wide range of financial assets as store of value and make available expert financial services to the savers. As stores of value, the financial assets have certain special advantages over the tangible assets (such as, physical capital, inventories of goods, etc.). They are easily storable, more liquid, more easily divisible, and less risky. In fact, saving- income ratio is positively related to both financial institutions and financial assets; financial progress . induces larger savings out of the same level of real income.
4. Mobilisation of Saving:

Mobilisation of savings takes place when the savers hold savings in the form of currency, bank deposits, post office savings deposits, life insurance policies, bills, bond's equity shares, etc. NBFI provides highly efficient mechanism for mobilising savings. There are two types of NBFTs involved in the mobilisation of savings; (a) Depository Intermediaries, such as savings and loan associations, credit unions, mutual saving banks etc. These institutions mobilise small savings and provide high liquidity of funds. (b) Contractual Intermediaries, such as life insurance companies, public provident funds, pension funds, etc. These institutions enter into contract with savers and provide them various types of benefits over the long periods.

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5. Investment of Funds:

The main objective of NBFIs is to earn profits by investing the mobilised savings. For this purpose, these institutions follow different investment policies. For example, savings and loan associations, mutual saving banks invest in mortgages, while insurance companies invest in bonds and securities.

Difference between Bank and NBFI

The difference between a bank and a non-banking financial institution (NBFI) is that: (a) A bank interacts directly with customers while an NBFI interacts with banks and governments; (b) A bank indulges in a number of activities relating to finance with a range of customers, while an NBFI is mainly concerned with the term loan needs of large enterprises; (c) A bank deals with both internal and international customers while an NBFI is mainly concerned with the finances of foreign companies; (d) A banks main interest is to help in business transactions and savings/ investment activities while an NBFIs main interest is in the stabilization of the currency.

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Dr. D. Subbarao today took over as the 22nd Governor of the Reserve Bank of India. Dr. Subbarao has been appointed for a three-year term. Prior to this appointment, Dr. Subbarao was the Finance Secretary in the Ministry of Finance, Government of India. Dr. Subbarao has earlier been Secretary to the Prime Minister's Economic Advisory Council (2005-2007), lead economist in the World Bank (1999-2004), Finance Secretary to the Government of Andhra Pradesh (199398) and Joint Secretary in the Department of Economic Affairs, Ministry of Finance, Government of India (1988-1993). Dr. Subbarao has wide experience in public finance. In the World Bank, he worked on issues of public finance in countries of Africa and East Asia. He managed a flagship study on decentralisation across major countries of East Asia including China, Indonesia, Vietnam, Philippines and Cambodia. Dr. Subbarao was also involved in initiation of fiscal reforms at the state level. Dr. Subbarao has written extensively on issues in public finance, decentralisation and political economy of reforms. List of Governors of RBI since its establishment: Sir Osborne Smith Sir James Taylor Sir C D Deshmukh Sir Benegal Rama Rau K G Ambegaonkar H V R Iengar P C Bhattacharya L K Jha B N Adarkar R N Malhotra S Jagannathan S Venkitaramanan N C Sen Gupta Dr. C Rangarajan K R Puri Dr. Bimal Jalan M Narasimham Dr. I G Patel Dr. D. Subbarao Dr. Manmohan Singh A Ghosh Dr. Y V Reddy

I have tried to analyse RBIS monetary policy Here it goes: In its annual monetary policy review for 2010-11, RBI increased its policy rates.

Repo rate and Reverse repo rate increased by 25 bps to 5.25% and 3.75% respectively, with immediate effect. Impact: Repo is the rate at which banks borrow from RBI and Reverse Repo is the rate at which banks deploy their surplus funds with RBI. Both these rates are used by financial system for overnight lending and borrowing purposes. An
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increase in these policy rates imply borrowing and lending costs for banks would increase and this should lead to overall increase in interest rates like credit, deposit etc. The higher interest rates will in turn lead to lower demand and thereby lower inflation. The move was in line with market expectations. Cash reserve ratio (CRR) increased by 25 bps to 6.00%, to apply from fortnight beginning from 24 April 2010. Impact: When banks raise demand and time deposits, they are required to keep a certain percent with RBI. This percent is called CRR. An increase in CRR implies banks would be required to keep higher percentage of fresh deposits with RBI. This will lead to lower liquidity in the system. Higher liquidity leads to asset price inflation and also leads to build up of inflationary expectations. Before the policy, market participants were divided over CRR. Some felt CRR should not be raised as liquidity would be needed to manage the government borrowing program, 3-G auctions and credit growth. Others felt CRR should be increased to check excess liquidity into the system which was feeding into asset price inflation and general inflationary expectations. Some in the second group even advocated a 50 bps hike in CRR. By increasing the rate by 25 bps, RBI has signalled that though it wants to tighten liquidity it also wants to keep ample liquidity to meet the outflows. Governors statement added that in 2010-11, despite lower budgeted borrowings, fresh issuance will be around Rs 342300 cr compared to Rs 251000 cr last year. RBIs Domestic Outlook for 2010-11 Table 1: RBIs Indicative Projections (All Fig In %, YoY) 2009-10 targets 2009-10 2010-11 targets (Jan 10 Policy) Actual Numbers (Apr 10 Policy) GDP 7.5 Expected at 7.2 8 with an by CSO upward bias Inflation (based on 8.5 9.9 5.5 WPI, for March end) Money Supply (March 16.5 17.3 17 end) Credit (March end) 16 17 20 Deposit (March end) 17 17.1 18 Source: RBI

Growth: RBI revised its growth forecast upwards for 2010-11 at 8% with an upward bias compared to 2009-10 figure of 7.5%. It said Indian economy is firmly on the recovery path. RBIs business outlook survey shows corporate are optimistic over the business environment. Growth in industrial sector and services has picked up in second half of 2009-10 and is expected to continue. The exports and import sector has also registered a strong growth. It is important to note that RBI has placed the growth under the assumption of a normal monsoon. India could have achieved a near 8% growth in 2009Page | 36

10 itself, if monsoons were better. Table 2 looks at growth forecasts of Indian economy for 2010-11 by various agencies. Table 2:Projections of GDP Growth by various agencies for 201011 (in %, YoY) 2009-10 2010-11 RBI 7.5 with an 8 with an upward upward bias bias PMs Economic Advisory 7.2 8.2 Council Ministry of Finance 7.2 8.5 (+/- 0.25) IMF 6.7 8 Asian Development Bank 7.2 8.2 OECD 6.1 7.3 RBIs Survey of Professional 7.2 8.5 Forecasters

Inflation: RBIs inflation projection for March 11 is at 5.5% compared to FY March10 estimate of 8.5% with an upward bias (the final figure was at 9.9%). RBI said inflation is no longer driven by supply side factors alone. First WPI non-food manufactured products (weight: 52.2 per cent) inflation, increased sharply from (-) 0.4%in November 2009, to 4.7% in March 2010. Fuel price inflation also surged from (-) 0.7 per cent in November 2009 to 12.7% in March 2010. Further, contribution of non-food items to overall WPI inflation, which was negative at (-) 0.4% in November 2009 rose sharply to 53.3% by March 2010. So, overall demand pressures on inflation are also beginning to show signs. These movements were visible in March 2010 itself, pushing RBI to increase rates before the official policy in April 2010. RBI Policy Rates are as under:
: 6.0% 8.0% 7.0% 9.0%

Bank Rate

Repo Rate : Reverse Repo Rate : Marginal Standing Facility Rate :

RBI Exchange Rates as on 14th September are as under: INR/1 USD: INR/1 EURO: INR/1 JAPAN YEN: 47.8055 Rs. 65.1143 62.1900


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Lending/ Deposit rates: Base rates-: 9.5%-10.75%, Savings Bank Rates-: 4%, Deposit Rate-: 8.5%-9.5%. Reserve Ratio Rate: CRR-:6%, SLR-: 24%

Policy Stance The policy stance remains unchanged from January 2010 policy. Table 3: Comparing RBIs Policy Stance October 2009 Policy January 2010 Policy April 2010 Policy Watch inflation trend Anchor inflation Anchor inflation and be prepared to expectations, while expectations, while respond swiftly and being prepared to being prepared to effectively respond appropriately, respond appropriately, Monitor liquidity to swiftly and effectively swiftly and effectively meet credit demands to further build-up of to further build-up of of productive sectors inflationary pressures. inflationary pressures. while securing price Actively manage Actively manage and financial stability liquidity to ensure that liquidity to ensure that Maintain monetary the growth in demand the growth in demand and interest rate for credit by both the for credit by both the regime consistent with private and public private and public price and financial sectors is satisfied in a sectors is satisfied in a stability, and non-disruptive way. non-disruptive way. supportive of the Maintain an interest Maintain an interest growth process rate regime consistent rate regime consistent with price, output and with price, output and financial stability. financial stability.

Source: RBI Summary: Given the economic outlook, policy ahead is going to remain challenging. There are many trade-offs RBI has to manage. It needs to manage high inflation without impacting the growth process. The recent inflation numbers show rising demand side pressures on inflation. The market participants are already looking at an increase of around 100-150 bps by March 2011 end. The higher interest rates would make it difficult to manage the government borrowing program and also invite more capital flows. High interest rates could also lead to higher lending costs for the corporate sector. The challenges are not limited to domestic factors alone. The concerns remain on future outlook of advanced economies which complicates the policy process further.

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Other Development and Regulatory Policies In its Annual (in April) and Mid-term review (in October) of monetary policy, RBI also covers developments and proposed policy changes in financial system. Some of the developments announced in this policy are: New Products/Changes in guidelines

Currently, Interest rate futures contract is for 10 year security. RBI has proposed to introduce Interest rate futures for 2 year and 5 year maturities as well. RBI has permitted recognised stock exchanges to introduce plain vanilla currency options on spot US Dollar/Rupee exchange rate for residents Final guidelines for regulation of non- convertible debentures of maturity less than one year by end-June 2010 RBI had proposed to introduce plain vanilla Credit Default Swaps in October 2009 policy. RBI would place a draft report on the same by end- July 2010 Earlier, banks could hold infrastructure bonds in either held for trading or available for sale category. This was subject to mark to market requirements. However, most banks hold these bonds for a long period and are not traded. From now on, banks can classify such investments having a minimum maturity of seven years under held to maturity category. This should lead banks to buy higher amount of infrastructure bonds and push infrastructure activity. The activity in Commercial Papers and Certificates of deposit market is high but there is little transparency. FIMMDA has been asked to develop a reporting platform for Commercial Papers and Certificates of deposit.

Setting up New Banks

Finance Minister, in his budget speech on February 26, 2010 announced that RBI was considering giving some additional banking licenses to private sector players. NBFCs could also be considered, if they meet the Reserve Banks eligibility criteria. In line with the above announcement, RBI has decided to prepare a discussion paper on the issues by end-July 2010 for wider comments and feedback. In 2004 seeing the financial health of urban cooperative banks, it was decided not to set up any new UCBs. Since then the performance of these banks has improved. It has been decided to set up a committee to study whether licences for opening new UCBS can be done. In February 2005, the Reserve Bank had released the roadmap for presence of foreign banks in India. The roadmap laid out a two-phase, gradualist approach to increase presence of foreign banks in India. The first phase was between the period March 2005 March 2009, and the second phase after a review of the experience gained in the first phase. In the first phase, foreign banks wishing to establish presence in India for the first time could either choose to operate through branch presence or set up a 100% whollyowned subsidiary (WOS), following the one-mode presence criterion. Foreign banks already operating in India were also allowed to convert their existing branches to WOS
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while following the one-mode presence criterion. However, because of the global crisis the second phase which was due in April 2009, could not be started. The global financial crisis has also thrown some lessons for policymakers. Drawing these lessons RBI would put up a discussion paper on the mode of presence of foreign banks through branch or WOS by September 2010.

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As we conclude with this project work, we can say that our knowledge on the working of the Indian Banking System has increased at par. We are now well aware that how the banking industry operates, how policies are formed, what measure are taken in case of economic disorders so as to bring it back to the equilibrium, how to frame policies, the terms and the jargons of the banking sector etc. Not only this, our study on Central Banking as a whole has helped us a lot to understand the role of the Reserve Bank of India in the economy. The study has given us the in depth knowledge about how the credit creation takes place in the banks, so that we can understand that how the money market is operated. In addition to this we have got some very valuable insight of the monetary policy, its role in the developing economy along with its role in the Indian Economic Development. Also that we have done some study on how and when what policies are made or adopted so that we can understand its impact on the business world and thereby on the economy. We as future managers, have to engage ourselves in decision making. A knowledge of the banking system will contribute a lot to our abilities to make effective decisions. Also that the continual emphasis of the college management on us to read Economic Times has generated our interests in the economy and that we can continuously keep ourselves updated with its help. In depth study of the negotiable instruments, banking system etc in one of or Lab subjects has generated a extreme hunger in us to have more and more knowledge, and that we always have our reputed faculties to assist us with our problems wherever we stuck, and tell us a bulk of knowledgeable things in just a span of a few lecture, which if we would have studied on our own, had taken around 50% of or life in understanding that. We are being empowered with the weapon of KNOWLEDGE. Knowledge is Power, Power is Wisdom and Wisdom is Goal. We just have to inherit it with our constant and sincere efforts, so that we are the Iron force ready to take a plunge in the battle field of the corporate. May God Bless us with our commitments and give us the power to move on the right track without deviating.

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In the making of this project, we have taken the assistance of the following text books: A text book of Modern Economic Theory by Dr. K.K. Dewett, 22nd Diamond Jubilee Edition (2005). Part 3: Money and Banking, Unit 2-: Banking; Pages 619 to 652. A text book of Central Banking for Emerging Market Economics by A Vasudevan, 1st Edition (2003). Central Banking System Pages 115 to 210. A text book of Money, Banking And Trade by Dr. M.L. Seth, Edition of (2008), Pages: 270-280 and 291-297 Other than this, we have used internet to extract out data from the sources:

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