Money and Banking

•Money: Money may be defined as anything which

is generally acceptable as a medium of exchange
and at the same time acts as a measure, store of
value and standard of deferred payment.

•Functions of Money:
•1. Primary Functions
•a. Medium of exchange
•b. Common measure of value or unit of value

•2. Secondary Functions

•a. Standard of deferred payment

•b. Store of value
•c. Transfer of value
• Primary Functions of Commercial Banks
• The primary functions of a commercial bank are as
follows:
• 1. Accepting Deposits
• Commercial banks accept deposits from people,
businesses, and other entities in the form of:
• Savings deposits – The commercial bank accepts small
deposits, from households or persons, in order to
encourage savings in the economy.
• Time deposits – The bank accepts deposits for a fixed
time and carries a higher rate of interest as compared to
savings deposits.
• Current deposits – These accounts do not offer any
interest. Further, most current accounts offer overdrafts
up to a pre-specified limit. The bank, therefore,
undertakes the obligation of paying all cheques against
deposits subject to the availability of sufficient funds in
the account.
• 2. Lending of Funds
• Another important activity is lending funds to customers in the
form of loans and advances, cash credit, overdraft
and discounting of bills, etc.
• Loans are advances that a bank extends to his customers with
or without security for a specified time and at an agreed rate of
interest. Further, the bank credits the loan amount in the
customers’ account which he withdraws as per his needs.
• Under the cash credit facility, the bank offers its customers a
facility to borrow cash up to a certain limit against the security
of goods. Further, an overdraft is an arrangement that a bank
offers to customers wherein a temporary facility is offered to
overdraw from the current account without any security.
• The limit is pre-specified. Additionally, banks also discount and
purchase bills. In both of these cases, a bank credits the amount
of the bill in the customer’s account after deducting discounts
and commissions. Subsequently, this amount is recovered from
the debtors on the maturity of the instrument.
•
• Secondary Functions of Commercial Banks
• The secondary functions of a commercial bank are as
follows:
• Bank as an Agent
• A bank acts as an agent to its customers for various
services like:
• Collecting bills, draft, cheques, etc.
• Paying the insurance premium, rent, loan installments,
etc.
• Working as a representative of a customer for
purchasing or redeeming securities, etc. in the stock
exchange.
• Acting as an executor, administrator, or trustee of the
estate of a customer
• Also, preparing income tax returns, claiming tax refunds,
etc.
• General Utility Services
• There are several general utility services
that commercial banks offer like:
• Issuing traveler cheques
• Offering locker facilities for keeping
valuables in safe custody
• Also, issuing debit cards and credit cards,
etc.
• The two most important aspects of credit creation are:
• Liquidity – The bank must pay cash to its depositors
when they exercise their right to demand cash against
their deposits.
• Profitability – Banks are profit-driven enterprises.
Therefore, a bank must grant loans in a manner which
earns higher interest than what it pays on its deposits.
• The bank’s credit creation process is based on the
assumption that during any time interval, only a
fraction of its customers genuinely need cash. Also,
the bank assumes that all its customers would not turn
up demanding cash against their deposits at one point
in time.
• Basic Concepts of Credit Creation
• Bank as a business institution  – Bank is a business
institution which tries to maximize profits through
loans and advances from the deposits.
• Bank Deposits  – Bank deposits form the basis for
credit creation and are of two types:
–Primary Deposits  – A bank accepts cash from the
customer and opens a deposit in his name. This is a
primary deposit. This does not mean credit creation.
These deposits simply convert currency money into
deposit money. However, these deposits form the basis
for the creation of credit.
–Secondary or Derivative Deposits  – A bank grants loans
and advances and instead of giving cash to the borrower,
opens a deposit account in his name. This is the
secondary or derivative deposit. Every loan crates a
deposit. The creation of a derivative deposit means
the creation of credit.
• 3.Contingent Functions
• a. Basis of credit
• b. Liquidity
• c. Basis of price mechanism
• d. Maximum profit to the producers
• e. Maximum satisfaction to the
consumers
• f. Basis of distribution of income
• Barter Exchange: It implies the direct
exchange of goods for goods without the
use of money.
• Difficulties involved in the Barter Exchange:
• 1. Lack of a common measure of value.
• 2. Lack of double coincidence of wants
• 3. Lacks of standard of deferred payments.
• 4. Lack of store of value.
• 5. Lack of divisibility.
• 6. Difficulty in exchange of services
• Supply of Money: Total stock of money
(currency notes, coins and demand
deposit of banks) in circulation are held by
the public at a given point of time.
• Supply of money does not include cash
balance held by central and state govt.
and stock of money held by banking
system of country as they are not in actual
circulation of the country.
• Measures of Money Supply = Currency held by
Public + Net Demand Deposits held by
commercial banks
• M 
1 = C + DD + OD
• C = Currency and coins with the public
• DD = Demand deposits of the public with the
banks
• OD = Other deposits
• M 
2 =1M + Pos toffice sav i
ng s depo si
ts
• M 
3 =1M + Ti
m edepos i
ts ofco m m erci
a l b
anks
• M=
4 M
3 + Tota lde
p osit
s w i
th the post offi c
e sa v
i
ng
organ i
s ati
on excl
u dingthe d epos i
tso n  
    
   
 
 
NS C
• Banks:
• Commercial Banks: Commercial Banks are
financial institution who accepts deposits
from the public and provide loans facilities
for investment with the aim of earning profit.
• Functions of Commercial Banks
• 1. Primary functions:-
• (a) Accepting deposits
• (b) Advancing loans
• (c) Discounting bill of exchange.
• 2. Secondary functions:-
• 1. Agency function
• (a) Transfer of fund
• (b) Collection of funds
• (c) Purchase and sale of shares and securities
on behalf of the customers
• (d) Collection of dividend and interest
• (e) Payment of bills and insurance premium on
behalf of customers
• (f) Acting as executor and trustee of will
• (g) Acting as correspondent and
representative of customer and provide letter
of credit to the         customer.
• 2. General utility function
• (a) Purchase and sell of foreign exchange.
• (b) Issuance of travelers cheque.
• (c) Safe custody of valuable goods in lockers.
• (d) Underwriting of securities.
• Central Banks: The central Bank is the apex
institution of monetary and financial system
of a country. It makes monetary policy of the
country in public interest. It manages,
supervises and facilitates the banking system
of the country.
• Functions of Central Banks
• 1. Bank of Issue
• 2. Banker to the Government
• 3. Banker’s Bank and Supervisor.
• 4. Controller of credit.
• 5. Lender of last resort
• 6. Custodian of foreign exchange reserves
• MONEY CREATION OR CREDIT CREATION BY
COMMERCIAL BANKS
• CREDIT is defined as finance made available
by one party to another party on a certain
rate of exchange.
• The capacity of banks to create money or
credit depends on (i) Amount of primary
deposits and (ii) Legal reserve ratio(LRR).
•  Legal Reserve Ratio(LRR):- is fixed by the
central bank of a country and it is the
minimum ratio of deposit legally required to
be kept as cash by banks.
• Cash Reserve Ratio(CRR):- It is a part of LRR which is
to be kept with the central bank.
• Statutory Liquidity Ratio(SLR):- It is a part of LRR
which is to be kept with the bank themselves.
• Commercial bank’s demand deposits are a part of
money supply. Commercial banks lend money to the
borrowers by opening demand deposit account in
their names. The borrowers are free to use this
money by writing cheques. According to definition
demand deposits are a part of money supply.
Therefore, by creating additional demand deposits
bank create money. Money creation depends upon
two factor: Primary deposits and Legal Reserve
Ratio (LRR). Deposit Multiplier = 1/LRR Total Deposit
creation = Initial deposit X 1/LRR.
• Repo rate : Repo rate is the rate at which the
central bank of a country (Reserve Bank of
India in case of India) lends money to
commercial banks in the event of any
shortfall of funds. Repo rate is used by
monetary authorities to control inflation.
• Description: In the event of inflation, central
banks increase repo rate as this acts as a
disincentive for banks to borrow from the
central bank. This ultimately reduces the
money supply in the economy and thus
helps in arresting inflation.
• Reverse repo rate : Reverse repo rate is the rate at which the
central bank of a country (Reserve Bank of India in case of India)
borrows money from commercial banks within the country. It is a
monetary policy instrument which can be used to control the
money supply in the country.
• Description: An increase in the reverse repo rate will decrease the
money supply and vice-versa, other things remaining constant. An
increase in reverse repo rate means that commercial banks will
get more incentives to park their funds with the RBI, thereby
decreasing the supply of money in the market.    
• Reverse repo rate : Reverse repo rate is the rate at which the
central bank of a country (Reserve Bank of India in case of India)
borrows money from commercial banks within the country. It is a
monetary policy instrument which can be used to control the
money supply in the country.
• Description: An increase in the reverse repo rate will decrease the
money supply and vice-versa, other things remaining constant. An
increase in reverse repo rate means that commercial banks will
get more incentives to park their funds with the RBI, thereby
decreasing the supply of money in the market.    
• The Central Bank
• The primary function of the central bank is to control
the money supply in the economy. It is responsible for
issuing currency on behalf of the government. In
addition to this primary function, the central bank
performs the following duties:
• It receives the state revenues, keeps deposits of
various departments and makes payments on behalf
of the government.
• It keeps the cash reserves of the commercial banks,
acts as a clearing-house for the inter-bank transactions
and as a lender of last resort. It supervises the
commercial banking system and ensures its smooth
running.
• It controls the money and capital markets by changing
the supply of money and thereby the rate of interest.
The objective is to keep equilibrium in these markets.
• It is the custodian of the foreign exchange.
It has to keep a closer check on the
external value of the domestic currency
and prevent its deterioration.
• It is the adviser to the government in all
the monetary affairs. It is responsible for
the formulation and implementation of the
monetary policy.
• Quantitative Measures or Instruments of Credit
Control:
• These measures directly affect the quantity of
money supply in the economy:
• Open market operations: This is the most frequently
used instrument or the routine practice to control
the money supply. However, its effectiveness
depends on the perfection of the capital and money
markets. The central bank sells government
securities (called treasury bills) to the general public
if a contractionary policy is desired. In contrast, it
buys back these bonds and diffuses extra money
into the economy if an expansionary policy is to
follow. This is the medium of government borrowing
at the market rate of interest.
• The bank rate policy: The rate of interest at which the
central bank offers loans to commercial banks or
discounts their bills is called ‘Bank Rate’ and the rate
at which the commercial banks extend loans to the
general public is called the ‘Market Rate’. A change in
the bank rate is followed by a corresponding change
in the market rate. Thus it is another powerful
instrument of credit control; however, it is rarely used.
• Variation in Capital Reserves: All commercial Banks
are required (by law) to keep a fixed proportion of
deposits as reserves with the central banks. This is
known as a reserve ratio; the power of the
commercial banks to extend loans is reduced. This
instrument is also rarely used.
• Variation in Cash Reserves: The commercial
Banks are also required to keep a fixed
proportion of their total deposits in cash form,
standing ready to honor the Checks of
customers and to avoid solvency problem. By
increasing this cash-reserve proportion, the
central bank can limit the autonomy of the
commercial banks to credit. However, the
banks may not strictly follow the advice of the
central bank in this case.
• These measures do not affect the quantity of money/
credit percent, rather these can redirect the flow of
credit to particular purposes/ channels. These
include:
• Moral Persuasion:  The central bank can advise the
commercial banks to follow either a loose or tight
credit policy, i.e. to extend loans on easy terms for
one purchase/time and on tight terms for some other
purchase/time. However, the commercial banks are
not obliged to follow such instructions very strictly. If
this is the case, then credit rationing may be applied.
• Direct Action: The central bank may take a direct
action in case the commercial banks do not respond
to its instructions carefully. It may refuse to discount
the bills of a particular bank or even may blacklist it /
debar it from the business.
• Difference and Comparison

BASIS CENTRAL BANK COMMERCIAL BANK

Meaning The apex body A financial

which regulates institution which
the supply of initiate deposits,
money in the provide loans and
economy and invest the public's
administers the money to earn
banking system profits
operations in a
country
Ownership Public Public or private
Banking System Apex Institute Constituent Unit
Bank Chief Governor Chairman
Number of Banks Single Many
Customers Other banks and General public
government
Motive or Controlling credit Profit earning
Objective system
Foreign Currency Guardian of Dealer of foreign
Function foreign currency currency
Loans Lender of the last Lending commercial
resort for commercial loans, personal loans,
banks housing loans, trade
finance, vehicle loans
and mortgage loans

Other Functions Issuing government Safe deposits service,

bonds, formulates foreign exchange
banking regulations provision and letter of
and fund clearance credit
among member
banks
Note Printing Yes No
Authority

Monetary Authority Yes No

Monetary Supply Yes No
Function
Monopoly Yes No

Example with Reserve Bank of State Bank of India (SBI), Central Bank of
Reference to India India (RBI) India (CBI), Canara Bank, etc.
Governing Body in Reserve Bank of Banking Regulation Act 1949
India India Act 1934