Money and Banking

Barter System: A system of direct exchange where goods are directly exchanged for other goods without the mediation of money (C-C Economy: Commodity-for-Commodity).

The 4 Inherent Defects of Barter:

1. 1. Lack of Double Coincidence of Wants: Exchange requires that what person A wants to sell is precisely what person B wants to buy, and vice versa. Finding such a mutual match is extraordinarily difficult.
2. 2. Lack of a Common Unit of Value: In the absence of a common monetary denominator (like the Rupee), there was no common measure to price goods (e.g., how many cows equal one horse?).
3. 3. Difficulty of Deferred Payments: Future contractual payments (credit, pensions, salaries) were impossible to negotiate because commodities deteriorate, change quality, and fluctuate violently in value.
4. 4. Difficulty in Storing Value: Storing wealth in perishable physical commodities (cattle, wheat, milk) incurred massive storage costs, deterioration, and risk of loss.

Functions of Money:

• Primary Functions:
  • Medium of Exchange: Money acts as an intermediary in transactions, eliminating the need for double coincidence of wants.
  • Unit of Value (Measure of Value): Serves as a common measuring rod in which prices of all goods and services are expressed.
• Secondary Functions:
  • Standard of Deferred Payments: Facilitates future contractual debts, loans, and interest payments.
  • Store of Value: Liquid, non-perishable store of purchasing power for future consumption.

Money Supply: The total stock of money (currency and demand deposits) held by the public at a specific point in time in an economy (a stock concept). Does not include cash held by commercial banks or the government/RBI (the suppliers of money):

The 4 Official RBI Monetary Measures:

• $M_1$ (Narrow Money / Most Liquid): $$M_1 = C + DD + OD$$ Where:
  • $C$ = Currency notes and coins held by the general public.
  • $DD$ = Net Demand Deposits held by commercial banks (savings and current accounts withdrawable by cheque).
  • $OD$ = Other deposits held with the Reserve Bank of India (foreign central banks, IMF).
• $M_2$: $M_1 + \text{Savings deposits with Post Office Savings Banks}$.
• $M_3$ (Broad Money / Aggregate Monetary Resources): $$M_3 = M_1 + \text{Net Time (Fixed) Deposits with Commercial Banks}$$
• $M_4$: $M_3 + \text{Total Deposits with Post Office Savings Organisation (excluding NSC)}$.

Commercial banks generate credit through the fractional reserve banking process:

• Two Core Assumptions:
  • 1. The entire commercial banking system is treated as a single unified entity ("Banks").
  • 2. All transactions are routed through the banking system (all payments made via cheques/transfers).
• Legal Reserve Ratio (LRR): The minimum percentage of deposits that banks are legally mandated to keep as liquid reserves: $$\text{LRR} = \text{Cash Reserve Ratio (CRR)} + \text{Statutory Liquidity Ratio (SLR)}$$
• Money Multiplier Formula ($k$): $$k = \frac{1}{\text{LRR}}$$
• Total Deposit / Credit Creation: $$\text{Total Deposits Created} = \text{Primary (Initial) Cash Deposit} \times \frac{1}{\text{LRR}}$$ Numerical Proof: If Initial Deposit = ₹1,000 and $\text{LRR} = 20\% = 0.20$: $$\text{Total Deposits} = 1,000 \times \frac{1}{0.20} = 1,000 \times 5 = \mathbf{₹5,000}$$ The banking system creates ₹4,000 of fresh secondary credit on top of the ₹1,000 primary cash!

The Reserve Bank of India (RBI), established on 1 April 1935, is the apex monetary authority controlling currency, credit, and commercial banks:

Functions of the Central Bank:

• 1. Bank of Issue: Sole legal monopoly to issue currency notes (except ₹1 note/coins issued by Ministry of Finance).
• 2. Banker to the Government: Manages public debt and government treasury accounts.
• 3. Banker's Bank & Supervisor: Custodian of cash reserves of commercial banks.
• 4. Lender of the Last Resort: Provides emergency liquidity to solvent banks facing liquidity crises.

Monetary Policy Instruments to Control Inflation & Deflation: