8.1, Introduction All modem economic systems make use of money. Prices are quoted in terms of rea ests Incomes are paid and received in the form of money. For this reason, the decision problems ot & ‘economic units (i.e. consumers, firms, the Government, etc.) have a monetary dimension. ; cr ‘instance, the principal aim of a business firm is to earn maximum profits. These profits are aan __EXmonetarytterms. Hence, the real quantity of profits would depend on the value of money. For ise Fessons the discussion of money is important in Economics. In this chapter, we shall also discuss the __ banking system of any country. The banking system plays an important role in determining the supply of money in an economy. 8.2. Definition of money Eaeeemition of money | ‘The definition of money is not given directly, It is given indirectly. We have described the main functions of money. Now, anything which performs these functions will be called money. Thus, in any | Sate Biven time, the goods which acts as the medium of exchange, the measure of value, the ‘standard to deferred payment and as the store of value is defined to be “money’ In this connection, we can refer to the definition of money given by Prof, “Money is what money does”. But this is considered tobe a vague definiti ‘Performs various functions, but this definition does not specify any si other definitions of money given by Prof. Robertson, P Walker. According to him, ion of money. In fact, money ignificant function of money. rof. Cole, and Prof. Kent. These given by Robertson : “Anything which is widel ge of other kinds of business obligations”, joney. on Biven by G. D. H. Cole: “Money is anything which is habitual, i ly and widely Pted in the settlement of debts’, “Sedas #*Money is anything which is commonly used ana Z reer nenis Yused and generally accepted considered tobe the narrow definitions of money because each oft i b 7 hese defini {ons or two functions of money. But an appropriate definition of ees ant functions of money, but also its basic feature, viz, the general ly accepted in Payments for goods or “can be termed as mi .% Money and Banking 185 Functions of money What are the functions of money ? Prof. Kinley has classified the funetions of money into three groups : (i) primary functions, (ii) secondary funetions, and (ii) contingent functions. (1) Primary functions : The most essential functions that money should perform in every economy, are regarded as primary functions of money, Ps (a) Medium of exchange: Money acts as the medium of exchange, The major funetion of money 's to facilitate the process of exchange by removing the defects of the barter system. (b) Measure of value or the unit of account : Money is the measure of ualue, The price of any one gooxt has to be expressed in terms of another. If, under the barter system, it is possible to get 2 Kilogram of potatoes for a piece of cloth, the price of cloth in terms of potatoes will be 2, ie. obtaining 1 unit (or one piece) of cloth requires giving up 2 units (here, two kilograms) of potatoes. The price of potatoes in terms of cloth is half since to get 1 unit of potatoes we have to give up half unit of cloth, Thus, what we understand by the price of a good is its price in terms of another good. Now, like other goods, money is also a good. Hence, the price of cloth can be expressed in terms of money just as it can be expressed in terms of potatoes. When we say that the price of a piece of cloth is 15, we mean that in order to obtain one piece of cloth we have to give up 15 units of money. This is the price of cloth in terms of money. The good, in terms of the prices of all other goods are expressed, is called the measure of value (or the unit of. ) or the numeraire. In modern economies it is money which acts as the numeraire, Le., prices of all goods are expressed in terms of money. (2) Secondary functions : The functions of money which are derived from its primary functions, regarded as its secondary functions. (@) Standard of deferred payment : Credit is given in terms of money. If a person needs 10 kilograms of rice but does not have the required amount of money with him at the time, he borrows this amount. Ifthe price of rice is ® 5 per kilogram, he has to borrow € 50. Hie has to return £50 (plus interest) to the lender at the end of the agreed period. Notice that the person ied rice. But he borrowed money. He did not borrow rice. The interest also is calculated ney terms. The additional amount that has to be returned if € 100 is borrowed for 1 year is called the money rate of interest or simply, the rate of interest. We do not calculate interest by specifying how much additional rice is to be retumed if 1 kilogram of rice is borrowed for one year. [In economic theory, however, even this type of interest ratehas been given a name. It is called the real rate of interest.| Thus, usually by the rate of interest, we mean the money rate of interest, ic, the calculation of interest on credit is done through ‘money. Credit is needed when we cannot pay now for a commodity (or a service) that we wish to consume now. For this reason, money is called the standard of deferred payment: (b) Store of value : Wealth is usually kept in the form of money because money is the most liquid form of wealth, Since savings is usually done with a view to use the savings for purchasing some commodities or services, it is as if the values of commodities are being stored. Hence, money is called the store of val Transfer of value : Money is also a means for transferring a given value from one individual to another. any person purchases a commodity (say, wheat from the shop-keeper and pays % 10 per kilogram of wheat purchased) then the value of that commodity can easily be transferred from the buyer to the seller through a payment in terms of money. ingent functions : The functions performed by money in assisting various economicagents y consumers and producers) in making economic decisions, are called contingent functions joney. These are noted belowAn Introduction to Elementary Economics +8 {9) Assisting production decisions and employment of factor inputs The principal objective of any producer is to maxim toemploy such an amount ses bales revere ot prot So, the pretueer or the frm wants of ftctors of production (say, labour, capital and other materials) which would help in achieving those goals, While employing any factor, the firm Lp make factor payments (or contractual payments) i.¢,, the firm has to pay wages to of Workers, interest tothe owners of capital ete. All such factor payments are made in terms money. Hence, money: Production decisions (©) Assisting consum his or her utilit prices of those factors help the producer in taking, important \ption decisions : The principal objective of any consumer is to oe through the consumption of various goods, But this consumption depends ‘on the money income of the consumer as Well as the money-prices of the commodities to be consumed. Thus, the consumer has to pay a price for the commodity purchased for his/her ewan consumption. So, the money income of the consumer and the money-prices of these © of capital earn interest, ‘commodities also influence the consumption decisions of different individuals. Assisting distribution of national income : The owners of various factors of production sell their factors at market prices. Thus, the owners of labi our power earn money wages, owners ‘owners of land eam rent and the owners of ‘organising power’ earn Profits. All these factor incomes, taken together, constitute national income of a country. ‘Thus, the distribution of national income among the owners of different factors are also determined by the money prices of those factors, @ Assisting the operation of a credit system : With the gradual expansion of trade and comunerce, the credit system has become very important. However, money forms the basis ‘of such credit operations performed by the business and financial institutions in an economy. For instance, if there is insufficient deposit of money with the commercial banks, itbecomes difficult for those banks to expand credit money by giving loans to several individuals. Functions a Functions of Money Secondly Fantos | I [Contingent Functions | [ \ Measure of| | Standard of || Store of | [Transfer of Value Deferred value value (unit of paymnent count) io te I mi: Assisting Assisting || Assisting Assisting, Production} | Consumption| | distribution | | the Operation| decisions decisions |) of national ofa, income _| | credit system Chart-1 ‘of money as means of payment : Coins and paper notes jofmoney as means of payment. Some of these modern forms are mentioned we speak of money, two ofits special forms come tomind. These ee Notes are t Paper not even note smaller i Paper no Legal ter order of imited denomi ® F% Money and Banking 187 notes are used for larger qua aoa «fr larger quantities. Cos and notes are however of fers ‘valties oF denominations. even notes of higher yor Nga a 2, 5, 10 oF 20 rupee notes in India) and, in some ces, even notes of higher denominations are sd fr rl purchases: However 8 general rule, the paper notes in payments purchase, the greater is the importance of coins and the ‘smaller-valued Legal tender: When the currency note and coins in cieation in county fe backed by the legal onfer ofthe government, Then the eizens exo refuse thee currency le and coins for the sctement of any typeof tasaction, Hates theve cree ote coins are called as legal tender. Honea So ST CRT ‘accepted by the citizens to settle claims of aval a TCE ricksaw fare). Hence, these coins of smaller denominations sidered as Timited legal tender. On the other hand, the coins and currency notes of Se Q beaccepted by all citizens for settling the claims of any value without limit. ae 's and currency notes of higher denominations are considered as unlimited legal der @ Some related concepts : Here, we can also point out some related concepts regarding money (@) Token money: When the face of money exceeds its intrinsic value, itis called token money. For example. a 100 rupee note isa token money since its face value is more than its intrinsic value, viz,, the value of the paper (say, that might cost € 10) used to print this note (b) Fiat money : When the value of the currency notes and coins is derived from the guarantes provided by the issuing authority (say, the Reserve Bank of india), then those currency notes and coins are called as ‘fiat’ money. (© Deposit money : The demand deposits with the commercial banks (which can be withdrawn on aeeos aos considered as deposit money since the cheques drawn on these deposits act like money. The supply of money We have already shown that ‘money’ in any modem economy constitutes currency NOt and coins iasued by the monetary authority of the country. The supply of money in any country refers to the sek of money held by the public at any particular point of time. So, money ‘supply is a stock concept. Thetotal amount of money in an economy consists of various COmpanaiis “CA TA demand deposits sree oraial banks, time deposits of commercial banks and other types o! deposits in the economy. We get different definitions ofthe supply of money depending on. which particular components are included and which are left out. In India, coins and one-rupee notes are issued by the Government of India, while other paper notes are issued by the Reserve Bank of India (RB). ‘All notes and coins together constitute currency. However, by money we do not mean cash only. Demand deposits in commercial banks, ie., those deposits which can be withdrawn at any ‘time (consisting of both savings account and current account deposits) should also be counted as money, especially Aes people can purchase goods and services in fra market by drawing cheques on such deposits, Curran, plus demand deposits plus certain other deposits (e-g, those held by commercial banks in the central bank) is called M; in India. This is one measure of money supply Currency plus demand deposits another measure of money su taken against fixed deposits an toad also be included in the supply of money. Inasimilar way, we get another measure of money Supply: plus (net) time deposits (ie, fixed deposits) of commercial banks constitute ppl. Some economists believe that since in certain es Joans can be ced for purchasing goods and services in themarket these deposits ifwe include deposits in post offices II wre inelude deposits in the various non-banking financial) Cass > An Introduction to Elementary Economics + CO), ;rshtutions, we get yet another measure of money supply. However, currency plus demand deposits 's the most widely accepted measure of money supply. Some of the measures of the supply of money are mentioned below : (1) Mo= Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other’ deposits with the RBI = Net RBI credit (o the Government + RBI credit to the commercial sector + RBI's ms on banks + RBI's net foreign assets + Government's currency liabilities to the public ~ RBI's net non-monetary liabilities ‘Bankers’ deposits with the Reserve Bank’ represent balances maintained by banks in the current account with the Reserve Bank mainly for maintaining Cash Reserve Ratio (CRR) and as working, funds for clearing adjustments. ‘Other’ Deposits with the Reserve Bank, for the purpose of monetary compilation, include deposits from foreign central banks, multilateral institutions, financial institutions and sundry deposits net of International Monetary Fund (IMF) Account ‘Net Reserve Bank of India (RBI) credit to Government’ includes the Reserve Bank’s credit to Central as well as State Governments. It includes ways and means advances and overdrafts to the Governments (to overcome the short-term budgetary deficits), the Reserve Bank’s holdings of Government securities, and the Reserve Bank's holdings of rupee coins less deposits of the concerned Government with the Reserve Bank. The Reserve Bank’s claims on banks include Joans to the banks including National Bank for Agriculture and Rural development (NABARD). ‘The ‘Reserve Bank's credit to the commercial sector’ represents investments in bonds/shares of financial institutions, loans to them and holdings of internal bills purchased and discounted. ‘Government's currency liabilities to the public’ comprise rupee coins and small coins. The Reserve Bank's net foreign assets are its holdings of foreign currency assets and gold. This ‘reserve money’ is also known as ‘high powered money’. Our subsequent section will focus on this concept. | (2) M, = Rupee notes and coins with the public (C) + demand deposits with the commercial banks (DD) + other deposits with the Reserve Bank (OD). Here, C= Rupee notes and coins held by the public at a particular point of time (say, as on 30th iP P vy, June, 2010) ; ! DD = The amount of demand deposits (viz., the deposits in savings account and current account) with the commercial banks ; and ‘OD = These other deposits include ) Demand deposits of some foreign central banks and foreign govemmments with the Reserve Bank @ ign of India (RBI) ; (i) Demand deposits of some Development financial institutions (say, Industrial Development Bank of India, Industrial Finance Corporation of India, etc) with the RBI; and (iii) Demand deposits of some international financial institutions (eg, Intemational Monetary Fund (IMF), World Bank, Asian Development Bank etc.) with the RBI Here, OD does not, however, include (i) the statutory deposits of the commercial banks with the RBI and (ii) the government deposits with the RBI. {important to note that while measuring the M,, the net demand deposits (or the net demand es) with the commercial banks are to be considered. demand deposits = gross demand deposits (-) inter-bank claims. inter-bank claims do not enter into the demand deposits of the people with the commercial this portion is subtracted from the gross demand deposits. “GS * Money and Banking Other measures of money supply (3) My = M, + Postal savings bank deposit, TRA ; i Se the deposits of the people with postal savings banks are also included in bank deposits on demand ose the People can withdraw money from their postal savings @) My =M, + (Ne 189 *) Time deposits with the commercial banks. In this measure, which is sup Pposed to be much broader than My-measure of mi the et time deposits or term de} an My woney supply, the aot tine chanics posits of the public with the commercial banks are also treated a8 8 rent of the money supply in an economy, This is becaus 01 commercial banks against such term deposit, a oe Here, the time deposits are considered in the ‘net’ sense because only the term deposits of the People with the commercial banks are included in the ‘The inter-bank term deposits are deducted from th decal GN ae Rd oar coal we gross term deposits to determine th the seea cae posits to determine the net term deposits with LANs Sime deposits = Gross time deposits () interbank time deposits with the commercial banks. (S)_M, = Ms + Total deposits with the postal savings organisations (excluding National Savings Certificates) In this measure of money supply, both demand and time deposits of the public (except National Savings Certificates) with the postal savings organisations are included in the money supply in addition to Ms In India, M, and M, are considered as Narrow Money, while Ms and M, are treated as Broad Money. Since M, and M; include lesser constituents of money supply, they are considered as Narrow Money. On the other hand, Ms and M, include greater number of the constituents of money supply, and hence, they are considered as Broad Money. Generally, My is used to measure the ‘Aggregate supply of monetary resources’ of a country. However, from the view point of liquidity of an asset, M, is supposed to be most liquid and M, is supposed to be least liquid. The ease with which any asset can be converted into cash, is considered as the liquidity of that asset. Thus, cash is the most liquid asset. eo e [me] [ vt ae 4] MG I 1 od. 1 deh i aa = Demand |( omnes | [Mi] [poet ) Lo] | Stns | EST Gala banks banks. organisations| Chart-2( 190 ‘An Introduction to Elementary Economics #% @. 8.2.4. Concept of High-powered Money or Base Money (Mo) The High-powered money refers to the total liability of the Monetary Authority (say, the Reserve dank of India of the country. In India, this High-powered money (which is denoted by Mo) or the Monetary base or the Reserve money of the economy is estimated as follows Reserve Money (Mg) = Currency in circulation + Bankers’ deposits with the Central Bank + “Other deposits with the Central Bank. This is also estimated follows My = Net Central Bank credit to the Government + Central Bank credit to the commercial sector + Central Bank’s claims on banks + Central Bank’s net foreign assets + Government's currency liabilities to the public — Central Bank’s net non-monetary liabilities. In India, ‘Currency in circulation’ includes notes in circulation, rupee coins and small coins. ‘Currency with the public (as a component of M,) is arrived at after deducting cash with banks from total currency in circulation, as reported by Reserve Bank on India (RBD). “*Bankers’ deposits with the Reserve Bank’ represent balances maintained by banks in the current account with the Reserve Bank mainly for mainly for maintaining Cash Reserve Radio (CRR) and as working funds for clearing adjustments. ‘Other’ Deposits with the Reserve Bank’, for the purpose of monetary compilation, include deposits from foreign central banks, multilateral institutions, financial institutions and sundry deposits net of the quota subscription in IMF Account (India being a member of the International Monetary Fund hhas to contribute some fund to IMF according to its quota). *Net Central Bank credit to Government’ includes the Central Bank’s credit to Union as well as State ‘Governments. Let us take the case of Reserve Bank of India (RBI) whieh is the ‘Central Bank’ in our ‘country. In case of India, it includes ways and means advances and overdrafts to the Governments by the RBI, the Reserve Bank's holdings of Government Securities, and the Reserve Bank's holdings of ‘mupee coins less deposits of the concerned Government with the Reserve Bank. The Reserve Bank's claims on banks include loans to the banks including National Bank for Agricultural and Rural development (NABARD). ‘The ‘Reserve Bank's credit to the commercial sector’ represents investments in bonds/shares of financial institutions, loans to them and holdings of internal bills purchased and discounted Government's currency liabilities to the public’ comprise rupee coins and small coins in circulation, we Reserve Bank’s net foreign assets are its holdings of foreign currency assets and gold. The srve Banks's net foreign exchange assets take into account the impact of appreciation in the value ‘of gold following its revaluation close to international market price (since 1990). Such appreciation has a corresponding effect on Reserve Bank’s net non-monetary liabilities ‘Net non-monetary liabilities of the Reserve Bank’ are liabilities which do not have any monetary impact. These comprise items such as the Reserve Bank's paid-up capital and reserves (Paid-uip capital is the amount of money a company receives from its shareholders), contribution to Nationat Funds, RBI employees’ Provident Fund and superannuation funcls, et [The term ‘High powered’ implies that an increase in this base money by & 1 leads to an increase in more than ® 1 in total money supply. This process will be discussed in subsequent sections We know that every commercial bank has to keep certain proportion of its total deposits with the Central Bank. This i called required reserve. For example, the commercial banks may have to keep 10 per cent of their total deposits as cash reserve with the Central Bank (which is known as statutory. ‘eash reserve ratio). The rest 90 per cent can be used by the commercial banks for credit creation ae ‘well as for meeting the regular day-to-day demands of their depositors. This is called as free reserve (or the vault cash).% Money and Banking Both these reserves, viz, cash with commerci , viz, cash with commercial banks (free reserve) and maintained by the commercial banks with the Cental Bank cequred ieenas the commercial banks but liabilities to the Central Bank. These are tank becauise it promises to pay the bearer of these legal tend ency equivalent tothe sum printed on tome GUTeRGy AGI This reserve money plays 4 joney plays an important role for the creation of credit money by the banking system ay the commercial banks as a whole in an economy. Given the required reserve, if the cornmercial banks can borrow fads at lower costs (Le, at lower bank rate vi, the dlaseaag rate at which the Contra Bank lncouts the securities pretuced by the commercial banks while lending to commercial banks] from the Central Bank, their free reserves will rise, Hence, the commercial banks then can give more loans to their clients and more credit money can be created. Thus, reserve money increases when the Central Bank provides more credit or lends to the commercial banks. 8.3. Banks Banks play a most important part in any economy that uses money, For this reason, we must now get into a detailed discussion of banks. 8.3.1. Definition of a bank Briefly, a bank is a business firm whose main function is to give and accept credit, In addition, it has some subsidiary functions. The Indian Banking Regulation Act (1949) defines the activity of a bankas ‘accepting for the purpose of lending or investing of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise”. Now-e-days, banks work under various Governmental restrictions. In our country, the Banking: companies function under the control of the Central Bank or the Government. There are restrictions: on the rates of interest at which the banks can lend or borrow. Besides, banks must be joint stock: companies. In India, there cannot be proprietorship or partnership firms. Moreover, a bank is nationalised as soon as its total deposits exceed a certain limit. 8.3.2. Kinds of banks ;pes of banks in countries like India are described below : Inall countries there is a special bank that looks after the working of other banks. ‘All other banks carry on their business within the restrictions imposed by this bank. This bank fs called the Central Bank. In India the Reserve Bank of India is the Central Bank. It was established in 1935. At first, however, it was not fully under Government control It was The principal () Central bank: nationalised in 1949. (@) Commercial banks : The firms that we usually refer to as ‘banks’ are called commercial banks. ‘Their main function is to accept deposits from the public and lend money to business firms. The argest commercial bank in India is the State Bank of India. ‘A commercial bank must have the following three basic features which distinguish them from any non-banking financial institution (a) A commercial bank accepts deposits the depositors on demand by drawing ch (b) Acommercial bank uses the deposit mone individuals. (©) Commercial banks can ‘create’ money throug! deposit money or credit money. {Any financial institution which may accept public deposits anc engage in lending operations, but Teannot create credit money (like the Life Insurance Corporation of Indlia), should not be treated as mimereial banks. They are regarded as non-banking financial intermediaries, from the public. These deposits can be withdrawn by veques on those deposits. yy for lending to different business institutions or hh their lending operations. This is called