CBSE Class 12 Economics Chapter 3: Money And Banking Revision Notes

Key Definitions

Money

Anything that is generally accepted as a medium of exchange, a measure of value, a store of value, and a standard for deferred payments.

Barter System

A system of exchange where goods and services are directly exchanged for other goods and services without the use of money. It requires a 'double coincidence of wants'.

Money Supply

The total volume of money held by the public at a particular point in time in an economy. It is a stock concept.

High-Powered Money (Monetary Base)

The total liability of the monetary authority (RBI) of the country. It consists of currency (notes and coins) held by the public and commercial banks, and reserves of commercial banks with the RBI.

Commercial Banks

Financial institutions that accept deposits from the public and grant loans for the purpose of consumption or investment, aiming to earn profits.

Central Bank (Reserve Bank of India - RBI)

The apex financial institution of a country that controls, regulates, and supervises the monetary and banking system, and acts as the banker to the government.

Cash Reserve Ratio (CRR)

The fraction of total deposits that commercial banks are required to keep as reserves with the Central Bank (RBI) in cash.

Statutory Liquidity Ratio (SLR)

The fraction of total deposits that commercial banks are required to maintain with themselves in the form of specified liquid assets (cash, gold, approved securities).

Repo Rate (Repurchase Rate)

The interest rate at which the Central Bank lends money to commercial banks against the pledge of government securities for a short period.

Reverse Repo Rate

The interest rate at which the Central Bank borrows money from commercial banks by selling government securities for a short period.

Open Market Operations (OMO)

The buying and selling of government securities by the Central Bank in the open market to influence the money supply in the economy.

Bank Rate (Discount Rate)

The rate at which the Central Bank provides loans to commercial banks without any collateral for long-term purposes.

Functions of Money and Money Supply

Money plays a pivotal role in a modern economy, overcoming the limitations of the barter system, such as the double coincidence of wants and the lack of a common measure of value. The primary functions of money are:

1. Medium of Exchange: Money simplifies transactions by being universally accepted. Instead of directly exchanging goods, we sell goods for money and use that money to buy other goods.
2. Unit of Account / Measure of Value: Money provides a common denominator for valuing goods and services, making comparisons and accounting easy. For example, a car costs ₹5 lakh, not 500 chairs.
3. Store of Value: Money allows individuals to save purchasing power for future use. While other assets also store value, money is the most liquid and generally stable (though inflation can erode its real value).
4. Standard of Deferred Payment: Money facilitates future payments for current transactions, crucial for credit and loan systems. Debts and future contracts are typically expressed in monetary terms.

Money Supply refers to the total stock of money circulating in an economy at a particular point in time. It is a stock concept. In India, the Reserve Bank of India (RBI) publishes figures for four alternative measures of money supply: M1, M2, M3, and M4. The most commonly used measure for transactional purposes is M1.

• M1 = Currency held by the public (C) + Demand deposits (DD) of commercial banks + Other deposits (OD) with RBI.
• Currency (C): Includes paper notes and coins held by the public. It does not include cash held by banks.
• Demand Deposits (DD): These are deposits that can be withdrawn on demand by cheque or other means. Examples include current and savings accounts in commercial banks.
• Other Deposits (OD): These are demand deposits held by the RBI of various financial institutions like NABARD, international financial institutions, etc., but exclude deposits of the government and commercial banks with the RBI.

• M2 = M1 + Post Office Savings Bank Deposits.
• M3 = M1 + Net Time Deposits of Commercial Banks. (M3 is considered a broad measure of money supply).
• M4 = M3 + Total Deposits with Post Office Savings Organisations (excluding National Savings Certificates).

High-Powered Money (H) or the Monetary Base is the sum of currency held by the public (C) and vault cash and reserves of commercial banks (R) with the RBI. It is the base on which the commercial banks create credit.

Commercial Banks: Functions and Credit Creation

Commercial banks are key financial intermediaries in an economy. Their primary functions can be broadly categorized:

1. Accepting Deposits: They mobilize savings from the public in various forms:

• Demand Deposits: Payable on demand by the depositor (e.g., current accounts, savings accounts).
• Time Deposits (Fixed Deposits): Payable after a fixed period or notice period. They earn higher interest but cannot be withdrawn on demand.

1. Advancing Loans: They provide credit to individuals and businesses for productive purposes, which is their main source of income.

• Cash Credit: Loans granted against the security of goods or other assets.
• Overdraft Facility: Allows current account holders to draw more than the balance in their account, up to a sanctioned limit.
• Demand Loans: Loans that can be called back on demand by the bank.
• Short-term Loans: Personal loans, housing loans, vehicle loans, etc.

Credit Creation (Money Creation) is the most important function of commercial banks. It is the process by which a commercial bank expands its demand deposits through lending, creating a multiple of the initial deposit. This process relies on the fact that people generally prefer to make payments by cheque rather than in cash, and that banks are required to hold only a fraction of their deposits as reserves (CRR and SLR). The money multiplier is a crucial concept here. It indicates the number of times the total deposits would be of the initial primary deposit.

Money Multiplier = 1 / CRR (where CRR is the Cash Reserve Ratio)

Total Credit Creation = Initial Deposit × Money Multiplier

This process assumes that all transactions flow through banks and there are no cash leakages.

Process of Money Creation by Commercial Banks

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Worked Example: Money Multiplier

• Calculating Total Credit Creation If the initial deposit in a bank is ₹10,000 and the Cash Reserve Ratio (CRR) is 10%, calculate the total amount of money created in the economy. Solution: 1. Money Multiplier (MM) = 1 / CRR MM = 1 / 0.10 = 10 2. Total Money Created = Initial Deposit × Money Multiplier Total Money Created = ₹10,000 × 10 = ₹1,00,000 Therefore, a initial deposit of ₹10,000 can lead to a total of ₹1,00,000 money creation in the banking system, assuming no cash leakages.

Central Bank (RBI) and Monetary Policy

The Reserve Bank of India (RBI) is the central bank of India, established in 1935. It is the apex monetary institution and plays a crucial role in maintaining economic stability. Its key functions include:

1. Issue of Currency (Sole Authority): RBI is the sole authority for issuing currency notes (except one-rupee notes and coins, which are issued by the Ministry of Finance, GoI, but circulated by RBI).
2. Banker to the Government: It acts as a banker, agent, and financial advisor to the Central and State Governments, managing their public debt, accepting receipts, and making payments.
3. Banker's Bank and Supervisor: RBI maintains accounts of all commercial banks, lends to them as a 'lender of last resort' during crises, and supervises their functioning.
4. Controller of Money Supply and Credit: This is the most significant function, managed through its monetary policy.
5. Custodian of Foreign Exchange Reserves: It manages the country's foreign exchange reserves and facilitates external trade and payments.
6. Clearing House Function: It facilitates inter-bank transactions and settlements.

Monetary Policy refers to the measures taken by the Central Bank to control and regulate the supply of money and credit in the economy. Its objectives typically include price stability, full employment, and economic growth. RBI uses various instruments to achieve these objectives:

A. Quantitative Instruments (General Credit Controls): Affect the overall volume of credit.

• Cash Reserve Ratio (CRR): The percentage of demand and time deposits that commercial banks must keep with the RBI. Increase in CRR reduces banks' lending capacity, thus decreasing money supply. Decrease in CRR increases lending capacity and money supply.
• Statutory Liquidity Ratio (SLR): The percentage of deposits banks must maintain in liquid assets (cash, gold, approved securities) with themselves. Increase in SLR restricts credit creation, decrease in SLR expands it.
• Repo Rate: The rate at which RBI lends short-term money to commercial banks. Increase in Repo Rate makes borrowing costlier for banks, leading to higher lending rates for customers, thus reducing money supply. Decrease in Repo Rate stimulates borrowing and increases money supply.
• Reverse Repo Rate: The rate at which RBI borrows short-term money from commercial banks. An increase in Reverse Repo Rate encourages banks to park funds with RBI, reducing money supply. A decrease has the opposite effect.
• Bank Rate: The rate at which RBI lends long-term to commercial banks without collateral. Higher Bank Rate discourages borrowing, decreasing money supply, and vice-versa.
• Open Market Operations (OMO): Buying and selling of government securities by RBI. Selling securities by RBI absorbs liquidity from the market, reducing money supply. Buying securities injects liquidity, increasing money supply.

B. Qualitative Instruments (Selective Credit Controls): Influence the direction of credit to specific sectors.

• Margin Requirements: The difference between the market value of a security and the loan granted against it. Higher margin requirements reduce the loan amount, discouraging speculation.
• Moral Suasion: Persuading commercial banks to follow RBI's directives and guidelines.
• Selective Credit Controls: Directives to discourage or encourage lending to particular sectors.

Key Points to Remember

• Double Coincidence of Wants is the main limitation of the Barter System.
• Money Supply is a stock concept, measured at a specific point in time.
• M1 is the most liquid measure of money supply, comprising Currency, Demand Deposits, and Other Deposits with RBI.
• M3 is a broad measure of money supply, including M1 and Net Time Deposits.
• High-Powered Money (H) = Currency with public + Reserves of commercial banks with RBI.
• Commercial banks' primary function is credit creation, based on the money multiplier.
• Money Multiplier = 1 / CRR.
• Central Bank (RBI) is the apex financial institution, responsible for monetary policy and regulating banks.
• Quantitative tools (CRR, SLR, Repo, Reverse Repo, Bank Rate, OMO) affect the volume of credit.
• Qualitative tools (Margin Requirements, Moral Suasion, Selective Credit Controls) affect the direction of credit.
• An increase in CRR/SLR/Repo Rate/Bank Rate leads to a decrease in money supply, and vice-versa.

Exam Tip: Mastering Monetary Policy Tools

When answering questions about the Central Bank's monetary policy tools, always clearly state what the tool is, how it works (mechanism), and its impact on money supply/credit availability in the economy (e.g., 'An increase in Repo Rate makes borrowing costlier for commercial banks, leading to higher interest rates for consumers and thus reducing the overall money supply.'). Pay special attention to the difference between Repo Rate and Bank Rate (short-term vs. long-term, collateral vs. no collateral). Also, practice numerical problems on the money multiplier. Differentiating between CRR and SLR is a common trap.

Practice Questions with Solutions

• Q: What is the main problem associated with the Barter System that money helps overcome? A: The main problem is the 'double coincidence of wants', where both parties must simultaneously desire what the other has to offer.
• Q: If CRR is 5% and the initial deposit is ₹50,000, what is the maximum amount of money the banking system can create? A: Money Multiplier = 1 / 0.05 = 20. Maximum money created = ₹50,000 * 20 = ₹10,00,000.
• Q: How does an increase in the Repo Rate affect the money supply in the economy? A: An increase in the Repo Rate makes borrowing from the RBI more expensive for commercial banks, leading them to raise their lending rates. This discourages borrowing by businesses and individuals, thereby reducing the money supply in the economy.
• Q: Distinguish between CRR and SLR. A: CRR (Cash Reserve Ratio) is the fraction of deposits banks must keep with the Central Bank in cash, while SLR (Statutory Liquidity Ratio) is the fraction banks must maintain with themselves in liquid assets like cash, gold, or approved securities.

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