Credit Creation by Commercial Banks

Commercial banks create credit primarily through the process of accepting deposits and lending a portion of
these deposits to borrowers. This process is known as the credit creation or money creation process.

How Credit Creation Works:Deposits: When a customer deposits money in a commercial bank, the bank does
not keep all the money in its vaults. Instead, it keeps a fraction as reserves and lends out the rest._Reserve
Requirement: Banks are required by the central bank to keep a certain percentage of deposits as reserves
(called the reserve ratio). For example, if the reserve ratio is 10%, the bank must keep 10forevery100
deposited._Lending: The bank lends the remaining 90% to borrowers. These borrowers then spend the money,
which eventually gets deposited back into the banking system, either in the same bank or another
bank._Multiple Deposits and Loans: This cycle repeats multiple times, with each bank lending out a portion of
the deposits it receives. This leads to a multiplied increase in the total money supply.

Money Multiplier: The total credit created is a multiple of the original deposit and is calculated as:

Total Credit Created= 1_

Reserve Ratio

×Initial Deposit

For example, if the reserve ratio is 10% (0.1), the money multiplier is 10. So, an initial deposit of
1000cancreateupto10,000 in credit.

Limitations of Credit Creation by Commercial Banks

Reserve Requirements: Banks must keep a minimum reserve, limiting the amount they can lend._Cash Drain: If
depositors withdraw cash instead of redepositing it, the credit creation process is reduced._Demand for Loans:
Credit creation depends on the demand for loans. If businesses and individuals are unwilling or unable to
borrow, credit creation slows down._Bank’s Willingness to Lend: Banks may restrict lending due to risk
concerns or economic conditions._Central Bank Policies: Central banks can influence credit creation by
changing reserve requirements, interest rates, or through open market operations._Legal and Regulatory
Constraints: Other regulations like capital adequacy norms limit the extent of credit creation._Economic
Conditions: During recessions or financial crises, credit creation may be severely limited due to defaults and
lack of confidence.

This process is fundamental to understanding how commercial banks influence the money supply and the
economy through their lending activities.

token money

Introduction:Money is the backbone of a modern economy, enabling smooth exchange of goods and services.
Among its various forms, token money plays a very important role because it is widely used in daily transactions
despite having little intrinsic value.

Definition of Token Money:

According to Alfred Marshall, “Money is anything which is generally accepted as a means of payment.”

According to Crowther, “Money is anything that is generally acceptable as a means of exchange and at the
same time acts as a measure and store of value.”

Token Money refers to money whose face value is greater than its intrinsic value (i.e., the material used to make
it is worth less than its actual value). It is issued by the government and is accepted as legal tender.

Examples: Coins and paper currency.

_Economical to Produce:Token money is made from inexpensive materials such as paper or base metals like
copper and nickel. The cost of producing this money is very low compared to its face value, which reduces the
financial burden on the government. This allows the government to issue large quantities of money without
using valuable resources._Convenience in Use:Token money is light in weight, portable, and easy to handle.
Unlike metallic money made of precious metals, it does not require much space and can be easily carried in
pockets or [Link] convenience makes it highly suitable for everyday transactions._Facilitates Large
Transactions:With the help of high-denomination currency notes, large payments can be made easily without
carrying bulky or heavy items. This simplifies business dealings and supports large-scale trade and
commerce._Government Control Over Money Supply:Token money is issued and regulated by the government
or central bank. This gives authorities the power to control the supply of money in the economy, which is
essential for managing inflation, deflation, and overall economic stability._Promotes Trade and
Commerce:Token money acts as a widely accepted medium of exchange, removing the difficulties of barter
system. It enables quick and smooth transactions, which encourages buying and selling activities and boosts
economic growth._Uniform Acceptability:Since token money is declared legal tender by the government, it is
accepted by all individuals and institutions within the country. This universal acceptance builds trust and
ensures smooth functioning of economic activities._Conservation of Precious Metals:By replacing full-bodied
money (gold and silver coins), token money helps in saving precious metals. These metals can then be used for
industrial, decorative, or strategic purposes instead of being locked in circulation as money._Supports Modern
Banking System:Token money forms the basis for modern financial systems, including banking, credit, and
digital payments. It increases liquidity in the economy and supports financial institutions in their operations.

Conclusion:Token money is a vital part of the modern monetary system. Its cost-effectiveness, ease of use, and
wide acceptability make it indispensable for economic development and efficient functioning of trade and
commerce.

Supply of Money: Meaning and Components

1. Introduction:Supply of money is a key concept in monetary economics. It plays an important role in

2. Meaning of Supply of Money:Supply of money refers to the total stock of money available in an economy at a
particular point of time for use by the public. It includes currency and bank deposits that can be used for making
payments.

According to Milton Friedman, money supply is “the total stock of money held by the public at a particular time.”

Features of Money Supply:It is a stock concept (measured at a point of time), It includes only money held by the
public, It excludes money held by banks and government, It consists of currency and deposits

3. Components of Money Supply

In India, money supply is measured in different forms such as M1, M2, M3, and M4, based on

liquidity.

(A) M1 – Narrow Money

M1 is the most liquid form of money and is used for day-to-day transactions.

Components:

[Link] with the Public (C):It includes coins and paper notes held by individuals and firms. Currency is
issued by the government and the Reserve Bank of India.

[Link] Deposits with Commercial Banks (DD):These are deposits in current and savings accounts that can
be withdrawn anytime using cheques, ATMs, or online transfers.
[Link] Deposits with RBI (OD):These include deposits of foreign central banks and international institutions
with RBI.

Formula:

M1 = C + DD + OD

(B) M2

M2 is a broader measure than M1.

Components:

•M1

•Savings deposits with post office savings banks

These deposits are less liquid than bank deposits but still easily convertible into cash.

Formula:

M2 = M1 + Post Office Savings Deposits

(C) M3 – Broad Money

M3 is the most commonly used measure of money supply in India for policy formulation.

Components:

M1

Time Deposits with Commercial Banks (TD):

These include fixed deposits and recurring deposits which cannot be withdrawn immediately without penalty.

Formula:

M3 = M1 + TD

(D) M4

M4 is the widest measure of money supply.

Components:

1.M3

[Link] deposits with post office savings institutions (excluding National Savings Certificates) These deposits
are the least liquid among all components.

Formula: M4 = M3 + Total Post Office Deposits

4. Conclusion

The supply of money is crucial for economic stability and growth. Different measures of money supply help in
understanding the liquidity conditions in the economy. Among these, M3 (Broad Money) is widely used in India.
The Reserve Bank of India regulates money supply through various monetary policy tools to control inflation
and ensure sustainable economic development.

Q. What is Supply of Money? State its Components.

Introduction:The concept of money supply is very important in macroeconomics as it influences economic

Definition:According to John Maynard Keynes, money supply includes not only currency but also demand
deposits because both can be used for making payments.

Money Supply refers to the total amount of money available in an economy at a given time. It includes all forms
of money that can be used as a medium of exchange.

Components of Money Supply

The two main components of money supply are:

1. Currency

2. Demand Deposits

1. Currency:Currency refers to coins and paper notes circulating in the economy.

(i) Coins:Coins are issued by the government.

In earlier times, private institutions also issued coins, but governments regulated them to prevent fraud.

Earlier, there were:

- Full-bodied standard coins (made of gold/silver equal to their value)

- Token coins (face value higher than metal value)

At present:

- Full-bodied coins are no longer in use.

- Small coins like 50 paisa, 25 paisa, etc., are token coins.

- These form a very small part of total money supply (about 3.5% in India).

(ii) Currency Notes:Currency notes are the most important part of money supply.

In India:

- One rupee note is issued by the Government.

- Other notes are issued by the Reserve Bank of India.

Methods of Note Issue

Representative System

Notes were backed fully by gold/silver.

Limited flexibility as issue depended on metal reserves.

Proportional Reserve System

A fixed proportion (e.g., 40%) of reserves in gold and foreign assets.

Used in India before 1956.

Minimum Reserve System:RBI maintains minimum reserve (₹200 crore, including ₹115 crore gold).Notes can
be issued beyond this [Link] flexible but risk of over-expansion.

Nature of Modern Currency:Notes are promissory [Link] are not convertible into gold or [Link] system
is now managed and [Link] depends on economic needs, not metal reserves.

2. Demand Deposits:Demand deposits are bank deposits that can be withdrawn anytime using cheques. They
are also called current deposits.

Types of Bank Deposits:

Fixed Deposits

Withdrawable after a fixed period.

Not included in money supply.

Demand Deposits Withdrawable anytime.

Highly liquid like cash.

Included in money supply.

Importance of Demand Deposits:Payments can be made easily through [Link] and convenient
compared to [Link] record of [Link] used in modern economies.

Role in Money Supply:

Demand deposits are included in money supply because:

- They can be used to purchase goods and services.

- They function like money.

Although cheque payment is not legally compulsory, it is widely accepted.

Credit Creation by Banks:Banks keep only a fraction of deposits as [Link] rest is given as [Link]
creates additional deposits in the [Link] process is called Credit [Link] deposits are also part of
money supply.

Conclusion:Money supply consists mainly of currency and demand deposits. While currency forms the
traditional part, demand deposits have become increasingly important due to the development of banking. Both
together determine the liquidity and economic activity in a country.

FEATURES OF STANDARD MONEY:

Introduction:Money is the backbone of a modern economy. Among its various forms, Standard Money is the
most important as it is officially recognized and widely accepted for all transactions.

Definition of Standard Money:Standard Money refers to money which is declared as legal tender by the
government and is universally accepted for making payments within a country.
According to R.G. Hawtrey,:“Standard money is that money in terms of which the value of all other forms of
money is measured.”

Features of Standard Money (Expanded)

1. Legal Tender:Standard money has the legal backing of the government, which means it must be accepted in
settlement of all debts and obligations. No individual or institution can refuse it for payment. This feature builds
trust and ensures smooth functioning of the monetary system.2. General Acceptability:Standard money is
accepted by everyone in the economy—households, firms, and the government. Its wide acceptability removes
the need for double coincidence of wants, which was a major problem in the barter system.3. Issued by
Government:Standard money is issued and regulated by the central monetary authority of the country, such as
the Reserve Bank of India. This ensures proper control over money supply and helps maintain economic
stability.4. Measure of Value:Standard money serves as a common measure in which the value of all goods and
services is expressed. For example, prices of commodities like rice, clothes, or electronics are all quoted in
terms of money, making comparison easy and systematic.5. Medium of Exchange:It acts as an intermediary in
the exchange process. People sell goods and services for money and then use that money to purchase other
goods and services. This eliminates the inefficiencies of the barter system and simplifies transactions.6. Store
of Value:Standard money allows individuals to store their wealth for future use. People can save money and use
it when required. However, its value may be affected by inflation, which can reduce purchasing power over
time.7. Standard of Deferred Payments:It is used for future payments such as loans, salaries, rents, and
contracts. Since its value is relatively stable, it becomes convenient to make agreements involving future
payments.8. Uniformity:Standard money has a uniform appearance, size, and denomination. This uniformity
makes it easily recognizable and prevents confusion in transactions.9. Portability:It is easy to carry and transfer
from one place to another. Large amounts of value can be carried in small physical forms like currency notes or
even digitally, making transactions highly convenient.10. Durability:Standard money is made from materials that
do not easily deteriorate. Currency notes and coins are designed to withstand wear and tear, ensuring a longer
lifespan and reliability in circulation. Conclusion:Thus, standard money, with its legal authority, universal
acceptance, and functional efficiency, plays a vital role in facilitating economic activities and maintaining stability
in the economy.

NEAR MONEY

Introduction:In the modern financial system, money is not limited only to currency notes and coins. There are
several financial assets which are not used directly as money but can be easily converted into cash. These
assets are known as Near Money. They help individuals and institutions maintain liquidity while also earning
returns.

Concept / Meaning of Near Money:Near Money refers to those assets which are not legal tender, but are very
close to money because they can be quickly and easily converted into cash without significant loss of value.

Definitions by Economists (Scientists):According to Paul A. Samuelson,:“Near money consists of those assets

According to R. S. Sayers,:“Near money refers to highly liquid assets which are not money but can be quickly
turned into money.”

Examples of Near Money:Savings bank deposits, Fixed deposits, Treasury bills, Government securities,
Commercial papers, Money market instruments

Advantages of Near Money (Expanded Points)

1. High Liquidity:Near money assets can be converted into cash quickly and easily. For example, a fixed deposit
can be withdrawn or a treasury bill can be sold in the market within a short time. This ensures that individuals
and businesses can meet their financial needs without delay.2. Safety of Investment:Most near money
instruments, especially government securities and bank deposits, are very safe. They involve low risk
compared to shares or other speculative investments. This makes them suitable for risk-averse investors.3.
Earning of Regular Income:Unlike cash, which does not earn any return, near money assets provide interest or
income. For instance, fixed deposits earn interest and treasury bills are issued at a discount, giving returns to
investors. Thus, near money increases the earning capacity of funds.4. Helpful in Financial Planning:Near
money helps individuals and firms manage their finances efficiently. It allows them to keep funds in a liquid form
while also earning returns. This balance between liquidity and profitability is very important in financial
planning.5. Useful During Emergencies:In times of emergency, near money assets can be quickly converted
into cash. For example, a person can withdraw savings deposits or encash short-term securities to meet urgent
expenses such as medical needs or business payments.6. Stability of Value:Near money instruments generally
maintain stable value. Unlike shares and other market-linked investments, their value does not fluctuate widely.
This stability makes them reliable for short-term financial management.7. Encourages Savings Habit:Since near
money assets are safe, liquid, and income-generating, they encourage people to save more. Individuals prefer
keeping their surplus funds in such instruments rather than holding idle cash.8. Promotes Economic
Stability:Near money increases liquidity in the financial system. It ensures smooth flow of funds in the economy,
supports banking operations, and helps in maintaining economic stability by making funds readily available.
Conclusion:Near money is an important component of the modern financial system. Though it is not used
directly as a medium of exchange, its high liquidity, safety, and earning capacity make it extremely useful. It
helps individuals, businesses, and the economy maintain a proper balance between cash availability and
income generation.
High Powered Money (HPM) - Definition and Components

High Powered Money (HPM), also known as Reserve Money or Monetary Base, refers to the total amount of
money created and controlled by the central bank of a country. It is called "high powered because it forms the
foundation of the entire money supply and has the ability to generate multiple expansions of credit through the
banking system. In other words, it is the base upon which the total money supply in the economy is built.

High Powered Money is of great importance in monetary economics because the central bank directly controls
it, and through it, influences credit creation, inflation, and overall economic activity.

Components of High Powered Money

High Powered Money consists of two main components: Currency with the Public (Cp) and Cash Reserves of
Commercial Banks (R).

1. Currency with the Public (Cp)

Currency with the public includes all the paper notes and coins held by individuals, households, and business
firms in the economy.

This component represents the money that is directly available for spending and daily transactions. It is
considered the most liquid form of money since it can be used immediately without any delay or conversion.
People prefer to hold a certain amount of cash for meeting routine expenses such as purchasing goods and
services, paying wages, and settling small debts.

The level of currency with the public depends on factors such as income levels, payment habits, availability of
banking facilities, and the degree of economic development. In developing economies, people tend to hold
more cash due to limited banking access and a higher reliance on cash transactions.

The central bank has full control over this component as it is the sole authority responsible for issuing currency
in the economy.

2. Cash Reserves of Commercial Banks (R)

Cash reserves of commercial banks refer to the reserves that banks maintain to meet customer withdrawals
and legal requirements. These reserves are essential for ensuring liquidity and stability in the banking system.

Cash reserves are further divided into two parts:

(a) Cash in Hand with Banks

This includes the physical cash (notes and coins) that banks keep in their vaults.

Banks maintain this cash to meet the day-to-day withdrawal needs of their customers. It ensures

smooth banking operations and helps maintain public confidence in the banking system. Although this cash
does not earn any interest, it is necessary for maintaining liquidity and preventing bank failures during sudden
withdrawals.

(b) Cash with Central Bank

This refers to the deposits that commercial banks maintain with the central bank. In India, this is maintained with
the Reserve Bank of India in the form of the Cash Reserve Ratio (CRR).

These reserves are mandatory and cannot be used by banks for lending purposes. The central bank uses this
component as a tool to control credit and regulate the money supply in the economy. By increasing or
decreasing the CRR, the central bank can control the availability of funds for lending, thereby influencing
inflation and economic growth.

Formula of High Powered Money

Where:

H = High Powered Money

Cp = Currency with the Public

R= Cash Reserves of Banks

Conclusion:High Powered Money plays a crucial role in the functioning of an economy. It serves as the base for
the money supply and enables the process of credit creation by commercial banks. By controlling high powered
money, the central bank can effectively regulate inflation, ensure financial stability, and promote economic
growth.