Class 12 Economics - Chapter 3: Money and Banking

Introduction to Money

Money is the commonly accepted medium of exchange in an economy. Its importance emerges when:

• There is more than one economic agent
• These agents engage in market transactions

Economic exchanges without money are called barter exchanges, which suffer from:

• The problem of double coincidence of wants
• High search costs for matching needs
• Difficulty in storing wealth

3.1 Functions of Money

1. Medium of exchange: Facilitates transactions by eliminating the need for double coincidence of wants
2. Unit of account: Provides a common measure for valuing goods and services
   Relative price = Price of good A / Price of good B
3. Store of value: Allows wealth to be stored for future use (though inflation can erode purchasing power)

3.2 Demand for Money and Supply of Money

3.2.1 Demand for Money

Factors affecting money demand:

• Transaction demand: Increases with income level (more transactions)
• Interest rates: Higher rates reduce money demand as people prefer interest-bearing deposits

3.2.2 Supply of Money

In modern economies, money consists of:

• Cash (currency notes and coins)
• Bank deposits

Central Bank (Reserve Bank of India)

Key functions:

• Issues currency
• Controls money supply (bank rate, open market operations, reserve ratios)
• Banker to government and commercial banks
• Custodian of foreign exchange reserves

Currency issued by RBI is called high-powered money, reserve money, or monetary base.

Commercial Banks

Functions:

• Accept deposits from public
• Provide loans to borrowers
• Profit from interest rate spread (difference between lending and deposit rates)

3.3 Money Creation by Banking System

Banks create money through fractional reserve banking - they don't keep 100% of deposits as reserves.

Balance Sheet of a Bank

3.3.1 Limits to Credit Creation and Money Multiplier

The Cash Reserve Ratio (CRR) sets the limit to credit creation:

Example: With CRR = 20%, Money Multiplier = 1/0.20 = 5

3.4 Policy Tools to Control Money Supply

RBI uses various instruments to regulate money supply:

Quantitative Tools

1. Cash Reserve Ratio (CRR): Percentage of deposits banks must keep with RBI
2. Open Market Operations:
   • Buying/selling government securities
   • Repo rate: Rate at which RBI lends to banks
   • Reverse repo rate: Rate at which RBI borrows from banks
3. Bank Rate: Rate at which RBI lends to commercial banks (long-term)

Qualitative Tools

• Moral suasion (persuasion)
• Margin requirements
• Selective credit control

Detailed Discussion: Demand and Supply for Money

Demand for Money (Liquidity Preference)

People hold money balancing liquidity needs against opportunity cost (foregone interest).

Transaction Motive

Money held for daily transactions, related to income level:

Where:
k = fraction of nominal income held as money
P = price level
Y = real GDP

Velocity of money (V): Number of times money changes hands per period

Speculative Motive

Money held based on interest rate expectations:

• When interest rates are high: People expect them to fall (bond prices to rise), so hold less money
• When interest rates are low: People expect them to rise (bond prices to fall), so hold more money

At very low rates, economy enters a liquidity trap where money demand becomes infinitely elastic.

Supply of Money

Components of money supply in India:

• M1 (Narrow Money): Currency + Demand Deposits
• M2: M1 + Post Office Savings
• M3 (Broad Money): M1 + Time Deposits
• M4: M3 + All Post Office Deposits

Fiat money: Currency without intrinsic value, backed by government guarantee

Legal tender: Money that cannot be refused for payment of debts

Suggested Readings

• Dornbusch, R. and S. Fischer. 1990. Macroeconomics, (fifth edition) pages 345–427, McGraw Hill, Paris.
• Sikdar, S., 2006. Principles of Macroeconomics, pages 77–89, Oxford University Press, New Delhi.