Chapter 3 — Money and Banking

Barter exchange is the exchange of commodities without the mediation of money. It requires a double coincidence of wants — both parties must have exactly what the other needs. In a large economy the search costs of finding such a match become prohibitive, making barter impractical.

Money acts as (1) a medium of exchange — universally acceptable in transactions; (2) a unit of account — all goods and services can be expressed in monetary units; and (3) a store of value — wealth can be held as money for future use, since it is not perishable and has low storage costs.

Transaction demand arises because people need money to carry out purchases. It is given by MdT = kPY, where Y is real GDP and P is the price level. It is positively related to both real income and the price level — a higher income or higher prices means more money is needed for transactions.

Speculative demand arises from uncertainty about future interest rate movements. When interest rates are high, people expect them to fall, anticipating capital gains on bonds, so they hold bonds rather than money — speculative demand is low. When rates are low, people expect them to rise, fear capital losses on bonds, and prefer to hold money — speculative demand is high. Thus speculative demand for money is inversely related to the market rate of interest.

A liquidity trap occurs when the market interest rate is so low that everyone expects it to rise in the future, making bond-holding unattractive (expected capital loss). In this situation everyone holds all additional money as cash balances and the speculative demand for money becomes infinitely elastic — injecting more money does not lower the interest rate further.

Currency issued by the central bank — which can be held by the public or by commercial banks as reserves — is called high-powered money, reserve money, or the monetary base. It is so named because it acts as the basis for credit creation by the banking system.

Banks lend out a portion of deposits, and the borrowed amounts return to the bank as new deposits, enabling further lending. This multiplies the original deposit into a larger money supply. The limit is set by the Cash Reserve Ratio (CRR) — the percentage of deposits that every bank must keep as reserves with the RBI. With a 20% CRR, an initial Rs 100 deposit ultimately generates Rs 500 in total deposits.

The money multiplier is the ratio of total deposits (money supply) to the initial reserves. It equals 1/CRR. In the textbook example, with a CRR of 20% (0.20), the money multiplier is 1/0.20 = 5, so Rs 100 in reserves creates Rs 500 in deposits.

CRR is the percentage of a bank's total deposits that it must keep as cash reserves with the RBI. It is a legal requirement set by the RBI. In the chapter's example, a CRR of 20% means a bank with Rs 100 in deposits must keep Rs 20 as reserves and can lend only Rs 80.

SLR is the ratio of deposits that banks are required to hold in liquid form (such as government securities) in the short term, in addition to the CRR. Both CRR and SLR act as limits on the amount of credit banks can create.

Open market operations (OMO) involve the RBI buying or selling government bonds in the open market. When RBI buys bonds it pays by cheque, increasing total reserves and expanding money supply. When it sells bonds, reserves fall and money supply contracts. There are two types: outright (permanent) and repo/reverse repo (temporary, with a buyback agreement).

A repo (repurchase agreement) is when the central bank buys securities from commercial banks with an agreement to sell them back at a specified price and date — the rate of interest in this arrangement is the repo rate (money injected into system). A reverse repo is when the central bank sells securities with an agreement to buy them back — the rate is the reverse repo rate (money withdrawn from system).

The bank rate is the rate at which the RBI lends to commercial banks. Increasing the bank rate makes borrowing more expensive for commercial banks, reducing their reserves and decreasing money supply. A fall in the bank rate has the opposite effect and can increase money supply.

M1 = currency (notes + coins) held by public + net demand deposits in commercial banks. M2 = M1 + savings deposits with Post Office savings banks. M3 = M1 + net time deposits of commercial banks. M4 = M3 + total deposits with Post Office savings organisations (excluding NSCs). M1 and M2 are narrow money; M3 and M4 are broad money in decreasing order of liquidity. M3 is the most commonly used measure and is also called aggregate monetary resources.

Fiat money is currency (notes and coins) that does not have intrinsic value — the paper or metal is worth less than the face value. Its value comes from the guarantee of the issuing authority (the RBI Governor promises to honour the face value). Legal tender is money that cannot be refused by any citizen for settling any transaction. Currency notes and coins are legal tenders; cheques drawn on demand deposits are not, as they can be refused.

When commercial banks need more funds to create credit, they can approach the RBI, which is always ready to lend to them. This role of being the ultimate source of funds for the banking system is what makes the RBI the lender of last resort.

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