Class 12 Economics Notes Chapter 3 (Money and Banking) – Introduction MacroEconomics Book
Alright class, let's delve into Chapter 3: Money and Banking from your Macroeconomics textbook. This is a crucial chapter, not just for your board exams but also forms the bedrock for understanding economic policies frequently asked in government exams. Pay close attention.
Chapter 3: Money and Banking - Detailed Notes for Government Exam Preparation
1. Introduction: What is Money?
- Barter System: The system of exchange where goods were directly exchanged for other goods without the use of money.
- Major Drawback: Lack of Double Coincidence of Wants. This means finding someone who not only has what you want but also wants what you have, simultaneously, was extremely difficult and inefficient.
- Other difficulties included: Lack of a common measure of value, difficulty in storing wealth, and impossibility of deferred payments.
- 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.
- Legal Tender: Money that cannot be refused by any citizen of the country for settlement of any kind of transaction. (e.g., Currency notes and coins issued by RBI/Govt.). It can be:
- Limited Legal Tender: Can be used for payments up to a certain limit (e.g., coins).
- Unlimited Legal Tender: Can be used for payments of any amount (e.g., currency notes).
- Fiat Money: Money under fiat (order/authority) from the government to act as money (e.g., notes and coins). It does not have intrinsic value like gold or silver coins.
- Fiduciary Money: Money accepted as a medium of exchange because of the trust between the payer and the payee (e.g., cheques, demand drafts). It is not legal tender.
- Legal Tender: Money that cannot be refused by any citizen of the country for settlement of any kind of transaction. (e.g., Currency notes and coins issued by RBI/Govt.). It can be:
2. Functions of Money
Money overcomes the drawbacks of the barter system. Its main functions are:
- (a) Primary Functions:
- Medium of Exchange: Money acts as an intermediary for the exchange of goods and services, eliminating the need for a double coincidence of wants. It separates the act of sale from the act of purchase.
- Measure of Value / Unit of Account: Money serves as a common denominator, expressing the value of all goods and services in monetary terms (e.g., price). This facilitates comparison and accounting.
- (b) Secondary Functions:
- Store of Value: Money allows wealth to be stored conveniently for future use. Unlike perishable goods, money (in its modern form) is durable and easy to store. However, its value can erode due to inflation.
- Standard of Deferred Payments: Money facilitates transactions that involve future payments (e.g., loans, salaries, pensions). It provides a standard unit for borrowing and lending.
3. Demand for Money
People desire to hold money (liquidity preference) for various reasons:
- Transaction Motive: To carry out day-to-day transactions (buying goods and services). Depends primarily on the level of income and the price level.
- Precautionary Motive: To hold money for unforeseen contingencies or emergencies. Depends on income level and uncertainty.
- Speculative Motive (Less emphasis in NCERT, but important): To hold money to take advantage of future changes in interest rates or bond prices. There's an inverse relationship between the market rate of interest and speculative demand for money.
4. Supply of Money
- Definition: The total stock of money (currency + demand deposits) held by the 'public' at a particular point in time. 'Public' excludes the suppliers of money (RBI, Government, Commercial Banks).
- Measures of Money Supply (India):
- M1 (Narrow Money): CU (Currency notes and coins held by the public) + DD (Net Demand Deposits held by commercial banks). This is the most liquid measure.
- M2: M1 + Savings deposits with Post Office savings banks.
- M3 (Broad Money): M1 + Net Time Deposits of commercial banks. Widely used measure.
- M4: M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates).
- (For most exams based on NCERT, focus on understanding M1 and the concept of Narrow vs Broad Money).
- High-Powered Money (H) / Monetary Base / Reserve Money: Currency held by the public (CU) + Cash Reserves of commercial banks (Vault Cash + Deposits with RBI) (R). H = CU + R. This is the money produced by the RBI and the Government, forming the base for credit creation.
5. Banking
A. Commercial Banks
- Definition: Financial institutions that accept deposits from the public and provide loans for consumption and investment purposes, with the aim of earning profit.
- Primary Functions:
- Accepting Deposits:
- Current Account Deposits (Demand Deposits): Chequable, no interest paid, usually for businesses.
- Savings Account Deposits: Chequable, earn interest, for individuals.
- Fixed Deposits (Time Deposits): Deposited for a fixed period, higher interest rate, not chequable.
- Recurring Deposits: Fixed amount deposited regularly for a specific period.
- Advancing Loans: Providing credit in various forms (cash credit, overdraft, term loans, discounting bills of exchange).
- Accepting Deposits:
- Money Creation / Credit Creation:
- This is a crucial function. Banks create credit (which is a form of money) many times more than their initial cash reserves.
- Process: Based on the assumption that not all depositors will withdraw their entire funds simultaneously.
- Mechanism: Banks keep a certain fraction of their deposits as reserves (Legal Reserve Ratio - LRR) and lend out the rest. The LRR is set by the central bank and has two components:
- CRR (Cash Reserve Ratio): Fraction of net demand and time liabilities (NDTL) that banks must keep as cash reserves with the RBI.
- SLR (Statutory Liquidity Ratio): Fraction of NDTL that banks must maintain with themselves in the form of specified liquid assets (cash, gold, approved securities).
- Money Multiplier (or Deposit Multiplier): Shows the maximum amount of money the commercial banks can create, given the initial deposits and the LRR.
- Money Multiplier = 1 / LRR
- Total Money Creation = Initial Deposit × (1 / LRR)
- Example: If Initial Deposit = ₹1000 and LRR = 20% (0.2), then Money Multiplier = 1 / 0.2 = 5. Total Money Creation = ₹1000 × 5 = ₹5000.
- Limitations: Amount of cash reserves, LRR, banking habits of people, availability of borrowers, monetary policy of the central bank.
B. Central Bank (Reserve Bank of India - RBI)
- Definition: The apex institution of a country's monetary and banking system. It regulates and controls the activities of commercial banks and other financial institutions. RBI was established on April 1, 1935.
- Functions of RBI:
- Currency Authority (Bank of Issue): Sole authority to issue currency notes (except ₹1 notes and coins issued by the Ministry of Finance, though distributed by RBI). Ensures uniformity and control.
- Banker, Agent, and Advisor to the Government: Manages government accounts, provides short-term credit (Ways and Means Advances), manages public debt, buys/sells foreign exchange on behalf of the government, and advises on monetary/financial matters.
- Banker's Bank and Supervisor:
- Holds cash reserves (CRR) of commercial banks.
- Acts as a lender of last resort (provides loans to banks facing liquidity crises).
- Acts as a clearing house for settling inter-bank claims.
- Supervises and regulates commercial banks (licensing, inspection, branch expansion, winding up).
- Controller of Money Supply and Credit (Monetary Policy): This is the most crucial function for managing inflation and economic growth. RBI uses various instruments to control the credit-creating capacity of commercial banks.
- Custodian of Foreign Exchange Reserves: Manages the country's reserves of foreign currencies, gold, and SDRs. Helps stabilise the external value of the rupee and manage balance of payments issues.
6. Monetary Policy Instruments (Control of Credit/Money Supply)
RBI uses these tools to influence the cost and availability of credit:
-
(A) Quantitative Instruments (Affect the overall volume of credit):
- Bank Rate (or Discount Rate): The rate at which RBI lends long-term funds to commercial banks. An increase in Bank Rate makes borrowing expensive for banks, reducing their lending capacity and vice-versa. (Less frequently used now compared to Repo Rate).
- Repo Rate (Repurchase Rate): The rate at which RBI lends short-term funds to commercial banks against government securities. This is the key policy rate. An increase in Repo Rate discourages borrowing by banks, contracting credit, and vice-versa.
- Reverse Repo Rate: The rate at which RBI borrows funds from commercial banks (or banks park their surplus funds with RBI). An increase in Reverse Repo Rate encourages banks to park funds with RBI, reducing funds available for lending, and vice-versa.
- Open Market Operations (OMO): Buying and selling of government securities by RBI in the open market.
- Selling securities: Soaks liquidity from the market, reduces banks' reserves, contracts credit.
- Buying securities: Injects liquidity into the market, increases banks' reserves, expands credit.
- Legal Reserve Requirements (LRR):
- CRR: Raising CRR reduces the funds available with banks for lending, contracting credit. Lowering CRR expands credit.
- SLR: Raising SLR reduces funds available for lending (as more needs to be kept in liquid assets). Lowering SLR expands credit.
- Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow overnight funds from RBI against approved government securities, at a rate higher than the Repo Rate. Acts as a safety valve against unexpected liquidity shocks.
-
(B) Qualitative Instruments (Selective Credit Controls - Affect the direction of credit):
- Margin Requirements: The difference between the market value of the security offered for a loan and the amount of loan granted. Raising margin requirements discourages borrowing against specific securities (e.g., to curb speculation).
- Moral Suasion: Persuasion, advice, and requests made by RBI to commercial banks to follow certain lending policies in the interest of the economy.
- Selective Credit Controls / Direct Action: RBI directives to banks regarding lending for specific purposes or sectors. Can include rationing of credit or taking direct action against banks not complying with directives.
Key Terms Recap:
- Money Supply: Stock of money held by the public.
- High-Powered Money (H): Currency with public + Reserves of banks.
- LRR: CRR + SLR. The fraction of deposits banks must keep as reserves.
- Money Multiplier: 1 / LRR. Determines the extent of credit creation.
- Monetary Policy: Actions by the central bank (RBI) to control money supply and credit.
- Repo Rate: Key rate at which RBI lends short-term funds to banks.
- OMO: Buying/selling of government securities by RBI.
Multiple Choice Questions (MCQs)
-
The primary difficulty of the Barter System was:
a) Lack of storage facility
b) Lack of double coincidence of wants
c) Difficulty in transporting goods
d) Absence of a government -
Which of the following is NOT a primary function of money?
a) Medium of Exchange
b) Measure of Value
c) Store of Value
d) Unit of Account -
In India, M1 measure of money supply includes:
a) Currency with Public + Time Deposits
b) Currency with Public + Demand Deposits + Other Deposits with RBI
c) Currency with Public + Demand Deposits with Commercial Banks
d) M3 + Post Office Savings Deposits -
Credit Creation by commercial banks is determined by:
a) Initial Deposits and CRR only
b) Initial Deposits and SLR only
c) Initial Deposits and LRR (CRR + SLR)
d) The amount of High-Powered Money only -
If the Legal Reserve Ratio (LRR) is 25%, the value of the money multiplier is:
a) 2
b) 4
c) 5
d) 0.25 -
Which institution has the sole authority to issue currency notes (except one rupee note) in India?
a) Ministry of Finance
b) State Bank of India
c) Reserve Bank of India
d) Planning Commission (NITI Aayog) -
When the RBI wants to decrease the money supply in the economy, it will typically:
a) Buy government securities in the open market
b) Decrease the Repo Rate
c) Increase the Cash Reserve Ratio (CRR)
d) Decrease the Bank Rate -
The rate at which the Reserve Bank of India lends money to commercial banks for short-term needs against securities is known as:
a) Bank Rate
b) Repo Rate
c) Reverse Repo Rate
d) Marginal Standing Facility Rate -
'Lender of Last Resort' function of the Central Bank implies:
a) Lending to the general public
b) Lending to the government
c) Providing liquidity to commercial banks in times of crisis
d) Managing foreign exchange reserves -
Open Market Operations (OMO) refers to:
a) Lending by commercial banks to the public
b) Borrowing by commercial banks from the RBI
c) Buying and selling of government securities by the RBI
d) Regulation of interest rates by the RBI
Answer Key for MCQs:
- b
- c (Store of Value is often considered secondary, though essential)
- c (NCERT focuses on CU+DD for M1)
- c
- b (Multiplier = 1 / 0.25 = 4)
- c
- c (Increasing CRR reduces banks' lending capacity)
- b
- c
- c
Revise these notes thoroughly. Understand the concepts, especially the functions of money, the process of credit creation, and the role and tools of the RBI. These are frequently tested areas. Good luck!