Money and Banking

Module-4
Meaning ;-
• Money is anything which is generally accepted
as a medium of exchange.
• It must be noted that money can be any
commodity chosen by common consent, as an
instrument of exchange of goods and services.
• Robertson, “anything which is widely accepted
in payment for goods or in discharge of other
kinds of business obligations.”
• Walker, "Money is what money does."
Evolution of money-
Barter system Gold Metal coins Paper
money Plastic cards(ATM) Electronic
money
Functions of money-

• Medium of exchange: It is the most important

and unique function of money which
separates it from near-money assets. The use
of money as a common medium of exchange
has greatly facilitated the activity of buying
and selling goods and services.
• Measure of value: Money serves as a yardstick
to measure values of all other goods and
services in terms of their money price. In the
absence of money, value of one commodity
could be expressed only in terms of the other
goods and services.
There are goods which are expressed in
different physical units, e.g. a meter of cloth,
a kilogram of wheat, a liter of milk, etc.
• Standard of deferred payments: Money
facilitates not only the current transactions of
gods and services but also their credit
transactions. It facilitates credit transactions
when present goods are exchanged against
future payments.
• Store of value: People can hold a part of their
present earnings in the form of money to be
spent in future. Money represents generalised
purchasing power and is a perfectly liquid
asset as well. Besides, it is durable and more
stable in its value.
• Transfer of value: Money as a means of
transferring purchasing power. It is the most
convenient form in which value can be
transferred from one person to another and
also from one place to another. It is because
money is readily accepted by all and its cost of
transfer from one place to another is very low
 Quantity theory of money-
• Irving Fisher developed this theory in his well-
known work entitled 'The Purchasing Power of
Money' published in 1911.
• In this theory, Fisher primarily emphasized the
role of money as the medium of exchange and
ignored the function of money as a store of value.
• According to this theory, the value of money in a
given period depends upon the quantity of
money in circulation in the economy.
• The quantity of money affects the price level
and value of money.
• Price level changes directly and value of
money changes inversely in the same
proportion as the change in supply of money,
other things remaining the same.
• If the quantity of money in circulation is
doubled, the price level will also become
double and value of money will be halved and
vice-versa.
 Fisher’s equation of exchange-
• MV= PT
Where,
M- Total quantity of money
V- velocity of money
P- Price Level
T- Total amount of goods and services
exchanged for money
• MV represents the total supply of money in
the economy and PT represents the total
demand for money to buy the goods and
services in the economy.
P=MV/T
• Thus, price level is determined by the total
quantity of money alone when V and T are
constant. Earlier credit money and its velocity
of circulation was not taken into consideration
but later it was considered by Fisher and new
equation became
MV+M’V’=PT
M' stands for credit money and V' stands for
velocity of circulation of credit money. Other
things remaining constant, price level changes
in the same proportion as the changes in the
supply of money.
• So doubling the quantity of money will double
the price level and value of money will fall.
• Price level and money supply move in the
same direction and value of money moves in
the opposite direction.
• Assumptions of the theory Fisher’s quantity
theory of money is based on the following
assumptions:
[Link] change in the volume of transactions.
2. No change in the velocity of circulation of
money.
3. No Hoarding of money.
4. Constancy in the ratio of credit money to legal
tender money.
5. No barter system. Money is used to buy
everything.
• 6. Price level is a passive factor.
It is assumed that P is affected by all other
factors but P itself is inactive and does not
influence any factor. P is only the result and
not a cause.
 Central bank

• The central Bank of India was established on 1

April 1935, on the recommendation of ‘Hilton
Young Commission’.
• Also known as reserve bank of India.
• The Central Office of RBI was initially
established in Calcutta and then permanently
moved to Mumbai in 1937.
• RBI is controlled by a central board of
directors.
• the RBI was nationalized on 1 ST January
1949.
 Functions of central Bank-
1. Issue of Bank Notes: The Reserve Bank of India
has the sole right to issue currency notes except
one rupee notes which are issued by the Ministry
of Finance.
• Currency notes issued by the Reserve Bank. It
issues notes of every denomination, except one-
rupee note and coins and small coins, through
the Issue Department of the Bank.
• One- rupee notes and coins and small coins are
issued by the Government of India.
2. Banker to the Government: The RBI acts as
the banker to the government of India and
State Governments .
• As such it transacts all banking business of
these Governments.
• As the Government’s banker, the RBI provides
short-term credit to the Government of India.
• RBI act as an agent by sale and purchase of
securities on the behalf of govt.
3. Banker’s Bank:
• As bankers’ bank, the RBI holds a part of the
cash reserves of commercial banks and lends
them funds for short periods. All banks are
required to maintain a certain percentage
• The main objective of changing this cash
reserve ratio by the RBI is to control credit.
4. Lender of Last Resort: The commercial banks
approach the Reserve Bank in times of
emergency to tide over financial difficulties,
and no other banks are providing them
finance then the Reserve bank comes to their
rescue though it might charge a higher rate of
interest, that rate is called Marginal standard
facility(MSF)
[Link] of Credit: The RBI controls the total
supply of money and bank credit in the
country’s interest. The RBI controls credit to
ensure price and exchange rate stability.
• To achieve this, the RBI uses all types of credit
control instruments, quantitative, qualitative
and selective. The most extensively used
credit instrument of the RBI is the bank rate.
 Commercial bank
• A commercial bank is a financial institution
which performs the functions of accepting
deposits from the general public and giving
loans for investment with the aim of earning
profit.
• Commercial banks are accept deposits and
advances loans to the public.
• Commercial banks in India are largely Indian
public sector and private sector with a few
foreign banks.
 Functions of commercial Bank-
Accepting deposits-
Deposits - [Link]
[Link] deposits
[Link] deposits
Granting loans and advances-
 Agency functions
 Transfer of funds
 Collection of payment of funds
 Purchase and sale of securities and foreign
exchange
Investment of funds-
• Investment surplus funds in government
securities or other approved ecuities
Credit creation-
• Credit creation is the most significant function
of the commercial banks.
• Commercial banks accept deposits and lend
loans and advances.
• In this process they create two types of
deposits, namely primary deposits and
secondary deposits.
Other functions-
• Issuing traveler's cheque
• Provides locker facility
 Fiscal policy and Monetary policy
• When policymakers seek to influence the
economy, they have two main tools at their
disposal—i.e.-
• Monetary policy-Central banks indirectly target
activity by influencing the money supply through
adjustments to interest rates, bank reserve
requirements, and the purchase and sale of
government securities and foreign exchange.
• Fiscal policy-Governments influence the
economy by changing the level and types of
taxes, the extent and composition of spending,
and the degree and form of borrowing.
 Fiscal policy
• Fiscal Policy refers to government policy in
respect of public expenditure, taxation and public
debt. It is the means by which the government
adjusts its spending levels and tax rates to
monitor and influence a nation’s economy.
• It is based on the principles of Keynesian
economics, which basically states that
governments can influence macroeconomic
productivity levels by increasing or decreasing tax
levels and public spending.
Objectives -
• To mobilise additional resources into socially necessary
lines of development
• To achieve and maintain economic stability
• To stabilize the price level.
• To maintain the growth rate of the economy.
• To maintain equilibrium in the balance of payments.
• To raise standard of living of the citizens of the country.
• To reduce extreme inequality in income and wealth
• To provide the necessary incentives to the private
sector for its healthy growth. etc
 Tools of fiscal policy-
• Public Expenditure
• It includes subsidies, transfer payments
including welfare programs, public works
projects and government salaries. By
increasing or decreasing its spending, the
government can directly influence economic
activity. For example, more government
spending can increase demand, leading to
higher output and employment.
• Taxation
• The government can influence economic
activity through its taxation policy. By reducing
taxes, the government leaves individuals and
businesses with more income to spend and
invest, which can boost economic growth.
Conversely, increasing taxes can help cool
down an overheated economy by reducing the
amount of disposable income available.
• Public Borrowing
• Public borrowing refers to the means by which
governments finance their expenditures that
exceed tax revenues.
• Under it, the government raises money from the
domestic population or from abroad through
instruments such as bonds, NSC, Kisan Vikas
Patra, etc.
• Public borrowing is a common practice used to
fund public services, infrastructure projects,
welfare programs, and to manage the country’s
fiscal policy.
• Other Measures
• Other fiscal measures adopted by the
government include:
• Rationing and price control
• Regulation of wages
• Increase the production of goods and services.
 Types of fiscal policy-
• Contractionary fiscal policy-
• Fiscal policy that reduces demand via lower
spending is called contractionary or tight.
• The objective of Contractionary Fiscal Policy is
to reduce inflation.
• This type of policy is usually undertaken
during inflationary periods to control excess
money supply.
• It can trigger some unemployment.
• Expantionary-
• Fiscal policy that increases aggregate demand
directly through an increase in government
spending is called expansionary.
• The objective of Expansionary Fiscal Policy is to
reduce unemployment and also results in better
GDP.
• This type of policy is usually undertaken during
recessions to increase the level of economic
activity.
• It can cause some inflation.
 Monetary policy-
• Monetary policy is an economic policy that manages
the size and growth rate of the money supply in an
economy. It is a powerful tool to regulate
macroeconomic variables such as inflation and
unemployment.
• These policies are implemented through different
tools, including the adjustment of the interest rates,
purchase or sale of government securities, and
changing the amount of cash circulating in the
economy. The central bank or a similar regulatory
organization is responsible for formulating these
policies.
 Difference between fiscal and
monetary policy
Fiscal policy Monetary policy
• It is a macro-economic policy • it is a macro-economic policy
used by the government to used by the Central Bank to
adjust its spending levels and influence money supply and
tax rates to monitor and a interest rates.
nation’s economy..
• Controlled by the • Controlled by the Central
Government. Bank.
• To influence the economic
condition. • To influence the money supply
• Public Expenditure, Taxation, and interest rates.
Public Borrowing etc • Bank Rate, Cash Reserve Ratio,
Statutory Liquidity Ratio etc.
Objectives-
The primary objectives of monetary policies are
the management of inflation or
unemployment and maintenance of currency
exchange rates.
• 1. Inflation
• Monetary policies can target inflation levels. A
low level of inflation is considered to be
healthy for the economy. If inflation is high, a
contractionary policy can address this issue.
• 2. Unemployment
• Monetary policies can influence the level of
unemployment in the economy. For example,
an expansionary monetary policy generally
decreases unemployment because the higher
money supply stimulates business activities
that lead to the expansion of the job market.
• 3. Currency exchange rates
• Using its fiscal authority, a central bank can
regulate the exchange rates between
domestic and foreign currencies. For example,
the central bank may increase the money
supply by issuing more currency. In such a
case, the domestic currency becomes cheaper
relative to its foreign counterparts.