Unit – 2

MONEY & BANKING

 portion
• Money - meaning and supply of money - Currency held
by the public and net demand deposits held by
commercial banks.
• Money creation by the commercial banking system.
• Central bank and its functions (example of the Reserve
Bank of India): Bank of issue, Govt. Bank, Banker's
Bank, Control of Credit through Bank Rate, CRR, SLR,
Repo Rate and Reverse Repo Rate, Open Market
Operations, Margin requirement.
MONEY Money is what money
does.

Anything which is used

as a medium of exchange,
store of value, measure of
value and standard of
deferred payments is called
money.
 Barter system is a system in which goods and
services are exchanged for other goods and services.

COMMODITY – COMMODITY ECONOMY

NON MONETARY SYSTEM OF EXCHANGE

 MONEY SUPPLY

Money supply refers to the total amount of

money which is in circulation in an economy at a given point
of time.
 Components of Money Supply
M1 = Currency + Net Demand Deposits with Banks +
Other Deposits with RBI.

M2 = M1 + Post Office Savings Deposits

M3 = M1 + Time Deposits with Commercial Banks

M4 = M3 + Post Office Savings Deposits

 Factors that determine the Money Supply
(i) Monetary Policy: It is one of the most
important determinants of money supply. The dear
money policy leads to the decline in the money supply
and cheap money policy leads to increase in money
supply
 (ii) Policy of commercial Banks
If commercial Banks lend more, it will
lead to increase in money supply. Lending activity of
the Commercial Banks is determined by the cash
reserve ratio.
 (iii) Fiscal Policy of the Government
If the Government spends more, money supply will
increase and vice versa. Deficit financing leads to
increase in money supply.
 COMMERCIAL BANK
A Commercial bank is a financial institution
which performs the functions of accepting deposits from the
public and advancing loans. The Bank acts as an intermediary
between those who have surplus money and those who are in
need of money.
 Difference between commercial banks and other
financial institutions.

* Banks accept demand deposits.

* Banks create money.

Other financial institutions do not have these

functions.
 Types of deposits held by the Commercial Banks
a) Current account deposits: The depositor can withdraw
his money at any time. Cheque facility is provided to
the depositor. The Bank does not pay any interest.
b) Saving Account deposits: The depositor can withdraw
his money at any time. However, the bank may impose
some restrictions on withdrawal. Interest rate is low
when compared to time deposits. The purpose of this
deposit is to encourage small savings.
c) Fixed or Time Deposits: Money is deposited for a
fixed period of time. The depositor can withdraw
money only after completing that term. Interest rate
is high.
d) Recurring Deposit: It aims at encouraging regular
savings by the people. The depositor can deposit
money in installments for a given period of time.
Withdrawal can be done only after completing the
term.
Credit creation by commercial banks
 CREDIT CREATION BY COMMERCIAL BANKS
Assumptions:
• Banking system is considered as one unit, namely
Banks..
• All receipts and payments in the economy are
through the banks.
• All payments are through cheques.
• The one who receives payment deposits the same in
his account.
Explain the credit creation function of commercial banks.
LRR is 10%
Initial amount is 100 Rs.

K = 1/ LRR
K = 1 / 10%
K = 1 x 100 / 10
K = 10
 rounds Initial amount Loan amount reserve

1 100 90 10

2 90 81 9

3 “ “ “

Total 100 x 10 = 1000 90 x 10 = 900 10 x 10 = 100

Explain the table

CENTRAL BANK
 Meaning
Central Bank is an apex bank to carryout monetary policy
of the country in public interest. Through the various functions
assigned to it.
Central Bank is the monetary authority of a country It
controls, regulates and supervises all the monetary
institutions.
The name of the Central bank in India is Reserve Bank
of India (RBI). It was established in 1935.
 Central bank is the apex institution of a country’s monetary
system. The design and he control of the country’s monetary is its
main responsibility.
India’s Central Bank is the Reserve Bank(RBI)which was
established on April 1, 1935.

FUNCTIONS OF CENTRAL BANK

Controller Custodian of
Banker to Banker’s
Currency Money Foreign
the Bank and
Authority Supply and Exchange
Governmen Supervisor
Credit
 CURRENCY AUTHORITY –BANK OF ISSUE
• The Central Bank is the sole authority for the issue of paper currency in the
country.

BANKER TO THE GOVERNMENT

• It acts as a banker, agent and a financial advisor to both central and state government
• As a banker, It provides a large number of routine banking functions like maintaining
the balances, arranging and managing funds of the government and so on.
• It accepts receipts and makes payments for the government.
• It woks as agent of the government in matters of collection of taxes, etc.
• It manages public debt.
• As a financial advisor, it advises the government on economic, financial and
monetary matters
BANKER’S BANK AND SUPERVISOR
• Custodian of Cash Reserves: Commercial banks are required to keep a
certain proportion of their deposits with the Central Bank. It acts as a
custodian of cash reserves(known as CRR) of commercial banks.
• Lender of the Last Resort: Commercial banks, if they are not able to meet
their financial needs through other sources, especially when a bank is faced
with unanticipated server financial crisis, they finally approach Central Bank.
• Clearing House: As central Bank holds cash reserves of all the commercial
banks. And all banks have accounts with central bank. So it can easily settle
claims of various commercial banks against each other.
AS A SUPERVISOR
Central Bank regulates and controls issues related to licensing, branch
expansion, liquidity of assets, management, merging, winding up, etc. through
periodic inspection and the returns filed by banks.
CONTROLLER OF MONEY SUPPLY AND CREDIT
• ‘Credit control’ is the most crucial function played by any Central Bank. The
Primary objective of credit control is to remove the causes for price fluctuations
which in turn are related to the supply of money.
• By controlling credit, the Central Bank can exercise an effective control over
economic activity and mobilize it in desired direction.
Tools used by Central Bank to control money supply
Quantitative Measures Qualitative Measures
Bank Rate
Repo rate Margin
Reverse Repo rate Requirement
Open Market Operations Moral Suasion
Legal Reserve Requirements
Selective credit
Statutory Liquidity Ratio control
Cash Reserve Ratio (CRR)
(SLR)
Custodian of foreign exchange reserves
1.Bank Rate:
It is the rate at which the central bank lends
money to commercial bank to meet their long- tem
needs.
→ increase in bank rate →increases the cost of
borrowing from central bank →Commercial banks
increases lending rate →discourages public borrowing
→reduces the ability of commercial banks to create
credit
2. Repo rate:
It is the rate at which the central bank lends
money to commercial bank to meet their Short-
tem needs.
Central Bank → increases repo rate →increases the
cost of borrowing from central bank →Commercial
banks increases lending rate →discourages public
borrowing.
• A decrease in Repo rate will have the opposite effect.
3. Reverse Repo rate:
When the commercial banks have surplus
funds, they can deposit the same with Central
Bank and earn interest. The rate of interest on
such deposits is called Reverse Repo rate.
Central bank commercial banks
4.Open Market Operations:
It refers to the sale and purchase of securities in the
open market by the central Bank to public and
commercial bank.
sale of securities→ reduces the reserves of commercial bank
and ability to create credit →decreases the money supply in
the market
Purchase of securities → increases the reserves and raises the
bank ability to give credit.
5. Legal Reserve Requirements: Commercial Banks are obliged to maintain
legal reserves. It is a direct method to control the credit creating power of
banks.
Two components of legal reserve:

1.Cash Reserve Ratio (CRR): It is the minimum percentage of net demand and
time liabilities, to be kept by commercial banks with the central bank.
2.Statutory Liquidity Ratio (SLR): SLR is the fraction of net total demand and
time deposits that commercial banks must keep with themselves in the form of
liquid assets.
• A change in CRR or SLR affect the ability of the commercial banks to create credit
→increase in CRR or SLR or both → reduces excess credit →limits their credit
creating power.
• Decrease in CRR and SLR →increases money with commercial bank →lending
increases →money supply increases.
6. Custodian of Foreign Exchange Reserve
Central Bank acts as the custodian of the country’s stock of
gold and reserves of foreign exchange. All the foreign
exchange transactions must be routed through RBI →enables
stabilizing external value of currency
2. Qualitative instrument
1. Increase in Margin Requirement:
It refers to the difference between the market value
of security offered and the value of amount lent.
• An increase in margin reduces the borrowing capacity
• A fall in margin encourages people to borrow more.
 2. Moral Suasion(Advise to Discourage Lending):
This is a combination of persuasion and pressure on
other banks in order to follow the policy of CB. It is
exercised through discussions, letters, speeches and
hints to banks.
Generally RBI succeeds in convincing the banks as it acts as
their lender of last resort.
3. Selective credit control(Introduce Credit Rationing):
It is a method in which the central bank directs other
banks to give or not to give credit for certain purposes
or to particular sector.
 Difference between commercial bank and central bank

Commercial Bank Central Bank

Governed by both by government and Central bank is governed by the people
RBI. connected with government.
Maximization of profit. Public welfare

Do ordinary banking activities. Does not do ordinary banking works

Creats money by creating deposits. Supply money by printing .

 CREDIT CREATION BY COMMERCIAL BANKS
Assumptions:
• Banking system is considered as one unit, namely
Banks..
• All receipts and payments in the economy are
through the banks.
• All payments are through cheques.
• The one who receives payment, deposits the same in
his account.
 Suppose, Bank receives a deposit of Rs 1000. A part
of this deposit Bank keeps as Statutory Liquidity Ratio
(CRR and SLR). Suppose LRR is 20%. The Bank
keeps Rs.200 as reserve and gives Rs. 800 as loans.
The borrower is asked to open an account with the
Bank and the loan amount is credited in his account.
So, Bank receives a deposit of Rs. 800. Suppose,
the man who takes loan withdraws the money, he pays
it to another man and the other person will deposit that
amount in the Bank. Every loan creates a deposit.
 Now the Bank has Rs. 800 as deposit, it can keep
20% of the amount as reserve and lend the
remaining Rs. 640. The deposit creation continues in
the above manner. So, Bank can lend several times
more than the amount that it receives as deposit.
How many times more than the initial deposit can
the Bank lend? It depends on the LRR.
Money Multiplier =
Money Created = Initial deposit x Multiplier
= 1000 x
= 1000 x = 5000