Money

Definition of Money: Money is anything that is generally accepted as a medium of exchange and also acts as a common measure of value, store of value, and standard of deferred payment.

Money Supply: The total money (currency notes, coins, and demand deposits of banks) in circulation held by the public at a given point of time.

Measures of Money Supply: In India, the Reserve Bank of India (RBI) uses four measures of money supply: M₁, M₂, M₃, and M₄.

Narrow Approach of Money Supply: Includes only liquid assets that are easily acceptable for payments, comprising M₁ and M₂.

Broad Approach of Money Supply: Includes currency held by the public, demand deposits, and time deposits, comprising M₃ and M₄.

Components:

• Currency with Public (C): Currency issued by the Government or Central Bank, known as Legal Tender Money.
• Demand Deposits (DD): Public deposits with banks withdrawable on demand.
• Other Deposits (OD): Demand deposits of public financial institutions, international financial institutions, foreign governments, and central banks with the RBI.
• Time Deposits (TD): Deposits withdrawable only after a specified period.

Stock of Money: Money supply at a particular point in time.

Flow of Money: Money supply over a period of time.

High-powered Money or Reserve Money (H): Sum of currency held by the public (C) and cash reserves of banks (R).

\[ H = C + R \]

Functions of Money

• Medium of Exchange: Facilitates buying and selling by being generally acceptable.
• Measure of Value: Acts as a unit of account to measure and express value of goods and services.
• Store of Value: Maintains purchasing power over time, allowing wealth storage.
• Standard of Deferred Payment: Used to settle debts payable in the future.

Factors Affecting Money Supply:

• Central Bank
• Commercial Banks
• Government
• Banking Habits
• Velocity of Circulation
• Volume of Trade
• Amount of Demand Deposits

Supplier of Money: The Central Bank of the country (RBI in India) supplies money; coins are issued by the Government of India.

Mnemonics for Factors Affecting Money Supply

Charles and Carla Bob gave some very good Variety of Antiques

• C: Central Bank
• C: Commercial Banks
• G: Government
• B: Banking Habits
• V: Velocity of Circulation
• V: Volume of Trade
• A: Amount of Demand Deposit

Banking

Money Creation by Commercial Banks: Commercial banks create money by lending more than the initial deposit, based on the Legal Reserve Ratio (LRR).

Money Multiplier Formula:

\[ \text{Money Multiplier} = \frac{1}{\text{LRR}} \]

Total Deposits Formula:

\[ \text{Total Deposits} = \text{Initial Deposit} \times \text{Money Multiplier} \]

Central Bank: The apex institution supervising and regulating commercial banks. In India, it is the Reserve Bank of India (RBI).

Functions of the RBI/Central Bank:

• Monopoly of Note Issue/Bank of Issue
• Banker to the Government
• Bankers’ Bank
• Controller of Credit

Monetary Management: Regulation of money and credit to meet the demand for trade, business, and economic activities.

Methods of Credit Control: Divided into Quantitative and Qualitative tools.

Quantitative Tools

• Cash Reserve Ratio (CRR): Proportion of total deposits commercial banks must keep as cash reserves with the Central Bank.
• Statutory Liquidity Ratio (SLR): Proportion of liquid assets (gold, government securities) banks must maintain daily.
• Repo Rate: Rate at which Central Bank lends short-term loans to commercial banks against securities.
• Reverse Repo Rate: Rate at which Central Bank borrows money from commercial banks.
• Bank Rate: Rate at which Central Bank gives long-term loans to commercial banks without security.
• Open Market Operations: Buying and selling of securities by Central Bank to regulate liquidity.
• Margin Requirements: Difference between market value of securities and loan amount offered by banks.

Mnemonics for Functions of the Central Bank

Maria Blossom Baked Cake

• M: Monopoly of Note Issue/Bank of Issue
• B: Banker to the Government
• B: Bankers’ Bank
• C: Controller of Credit

Example 1: Money Creation by Commercial Banks

If total deposits created by commercial banks are ₹10,000 crores and the legal reserve requirement is 10%, find the amount of initial deposits.

Solution:

Legal Reserve Requirement (LRR) = 10% = 0.1

Money Multiplier = \( \frac{1}{0.1} = 10 \)

Total Deposits = ₹10,000 crores

Initial Deposits = \( \frac{\text{Total Deposits}}{\text{Money Multiplier}} = \frac{10,000}{10} = ₹1,000 \) crores

Practice Set

Level 1 – Easy

• Define money and list its functions.
• What is the difference between narrow and broad money supply?

Level 2 – Moderate

• Explain the process of money creation by commercial banks with a numerical example.
• Describe the functions of the Central Bank with examples.

Level 3 – Challenging

• Discuss the quantitative and qualitative methods of credit control used by the Central Bank.
• Analyze the impact of changing the Cash Reserve Ratio on the money supply in the economy.

Answer Key

Level 1

• Money: Anything generally accepted as a medium of exchange, measure of value, store of value, and standard of deferred payment.
• Functions: Medium of exchange, measure of value, store of value, standard of deferred payment.
• Narrow vs Broad Money: Narrow money includes liquid assets (M₁, M₂); broad money includes currency, demand deposits, and time deposits (M₃, M₄).

Level 2

• Money Creation: Commercial banks create money by lending multiples of initial deposits based on the legal reserve ratio. Example: With LRR 10%, money multiplier is 10, so ₹1,000 crore initial deposit creates ₹10,000 crore total deposits.
• Functions of Central Bank: Monopoly of note issue, banker to government, bankers’ bank, controller of credit. For example, RBI issues currency and regulates banks.

Level 3

• Credit Control Methods: Quantitative tools like CRR, SLR, repo rate control money supply; qualitative tools like credit rationing influence credit distribution.
• Impact of CRR Change: Increasing CRR reduces money available for lending, decreasing money supply; decreasing CRR increases lending capacity and money supply.

Quick Reference

• Money Multiplier = 1 / LRR
• Total Deposits = Initial Deposit × Money Multiplier
• High-powered Money (H) = Currency with Public (C) + Reserves (R)

Glossary

• Legal Tender Money: Currency recognized by law as valid for meeting a financial obligation.
• Cash Reserve Ratio (CRR): Minimum fraction of deposits banks must keep as reserves with the Central Bank.
• Statutory Liquidity Ratio (SLR): Minimum percentage of deposits banks must maintain in liquid assets.
• Repo Rate: Rate at which Central Bank lends short-term funds to banks.
• Reverse Repo Rate: Rate at which Central Bank borrows money from banks.
• Money Multiplier: Factor by which initial deposit is multiplied to get total money supply.