Money and Banking

UNIT-IV M B ONEY AND ANKING 7 C HAPTER (cid:1) (cid:6) (cid:6)(cid:9) (cid:2)(cid:3)(cid:4)(cid:5) (cid:7)(cid:3)(cid:8) (cid:7)(cid:3)(cid:10)(cid:11)(cid:3)(cid:12) Money plays an important role in the she was most proficient. This economic system — we see the use of specialisation would result in a supply money at every step of life — indeed it of goods and services of the best would be hard to imagine life without possible quality under the money! The main function of money in circumstances. an economic system is to facilitate the The need would then arise for each exchange of goods and services, i.e. to one to exchange his or her good or lessen the time and effort required to service for the goods and services of the carry on trade. others. How would they exchange the Imagine Robinson Crusoe living goods and services? The simplest alone on an island. He produces all the possible method would be to directly goods and services he requires for his exchange one commodity for another. consumption. Of what use is money to This exchange of ‘goods for goods’ is him? He cannot eat it, wear it or use it called barter exchange. In the above to exchange goods and services with limited context of exchange between others — remember he is alone on the only eleven people, barter exchange island. could take place with minimum loss of Now suppose that he is joined on time and effort. Let us call this economy the island by ten of his friends. All eleven the C-C economy, i.e. commodity for of them would be engaged in the commodity exchange economy. production of the goods and services As the group becomes larger and they require for their consumption. It larger, problems begin to emerge with is likely that each one of them would this direct exchange of goods for goods. be proficient in the production of one The larger the group, the greater will particular good and only average in the be the trading costs of barter exchange. production of the others. It would be Trading costs are nothing but the cost advantageous to the group as a whole of engaging in trade. There are two if each one specialised in the production components of trading costs. One is the of the good or service in which he or search cost – the physical cost of MONEY AND BANKING 91 searching for a person willing and as seashells, pearls, precious stones, prepared for the exchange of goods (it livestock, etc. as medium of exchange. can be thought of as the opportunity However, even this system will not cost of not producing more goods in the reduce to the maximum possible extent time spent searching, or it may be the difficulties and costs of commodity thought of as the cost of the exchange. This is because barter has certain inherent deficiencies as will be deterioration in the good and its adverse discussed later in this chapter. effect on its desirability during the time The main purpose of money is then spent searching). The second to enable trade to be carried on as component is the disutility of waiting cheaply as possible in order to enable as perceived by the individual during the maximum degree of specialisation the search period. More time and effort and therefore, the maximum amount will have to be spent in searching for of productivity. Modern economies the person who both needs the good are highly specialised in their respective you have more than anything else and field. There is specialisation of firms, of has the good that you need more than businesses, of regions, of types of anything else, simply because there are capital, etc. Such specialisation allows now more people to canvass. The longer the utilisation of each person to the best you spend searching for such a person, of his or her ability and skill, each the greater will be the search cost. region to the maximum advantage, and A possible solution to this problem the use of large amounts of specialised would be to use a commonly accepted capital to reap economies of scale. The good as the medium of exchange. The fruits of this are high standards of living medium of exchange has to be and productivity. All this specialisation commonly accepted in order to facilitate will not be possible without an equally exchange. This will reduce the trading highly developed system of exchange cost substantially by removing the and trade, i.e. the use of money. necessity of simultaneously finding the Barter Exchange preferred buyer with the preferred commodity. This simultaneous Prior to the introduction of money as fulfilment of mutual wants by buyers it is known today, trade was carried and sellers is known as double out by barter, i.e. exchange of goods coincidence of wants. It is the difficulty for goods1. Due to the wasteful nature of coming across double coincidence of of barter, the amount of trade that wants that makes direct barter (direct could be carried out by this method exchange of goods for goods) inefficient of exchange was limited. The utility in large groups. In the past many gained from trade would be communities have used articles such outweighed by the utility lost in the 1 The following three sections draw on materials from ‘‘The Economics of Money and Banking’’ by Stephen M. Goldfeld and Lester V. Chandler, Harper and Row, 8th Edition, New York, 1981. 92 INTRODUCTORY MACROECONOMICS process of making the trade. The likely have to make some intermediate following will explain the difficulties transactions – cow for horse, horse for involved in barter exchange. boat, boat for sheep and finally sheep The first main drawback of barter for the desired bullock cart; or he would is the absence of a common unit in have to accept something less desirable terms of which can be measured the than the bullock cart. values of goods and services. The value Thirdly, the barter system lacks any of a good or service means the amount satisfactory unit to engage in contracts of other goods and services with which involving future payments. Contracts it can be exchanged for in the market. requiring future payments are The lack of a common unit meant that commonplace in any exchange no proper accounting system was economy – we enter into agreements possible. The value of each good and regarding wages, salaries, interests, service would have to be expressed not rents etc. and other prices extending just as one quantity but in as many over a period of time. In a barter economy future payments would have quantities as there are kinds and to be stated in terms of specific goods qualities of other goods and services in or services. This leads to the following the market. If there were 1000 goods problems: and services in the market, then the (cid:1) There could be disagreement value of each would have to be regarding the quality of the goods expressed in terms of 999 others. or services to be repaid. Secondly, under barter there was (cid:1) There could be disagreement the lack of ‘double coincidence of wants’. regarding which specific commodity It would be a rare occasion when the would be used for repayment. owner of some goods or services could (cid:1) The risk exists that the commodity find someone else who both wanted the to be repaid could increase or former’s good or service more than decrease markedly in value over the anything else and possessed that good duration of the contract, thus or service that our trader wanted more benefiting the creditor or the debtor than anything else. Consider a situation respectively. where a person desires to exchange his Fourthly, the barter system does cow for a bullock cart. His problem is not provide for any method of storing that he has to find a provider of a generalised purchasing power. People bullock cart – either new or pre-existing can store purchasing power for future – that matches the required use by holding stocks of certain specifications, who wants exactly the commodities to be exchanged for other kind of cow that the person is offering. commodities later. This holding of This type of chance, discovery of a stocks of certain commodities is subject bullock cart provider would be a rare to certain problems such as costly occurrence. The person would most storage, deterioration or appreciation in MONEY AND BANKING 93 the value of the stored commodity, or notebook is worth two pens. Further, difficulty in quickly disposing of the accounting is simplified, as all items will commodity without loss if the owner be recorded in terms of monetary units wants to buy something else. that can be added and subtracted. Due to the above four disadvantages Money is a useful measuring rod of of the barter system, the exchange value only if the value of money itself process tends to be highly inefficient. It remains constant. This is similar to was to overcome these difficulties that saying that a scale is a useful measure money, as we understand it today, was of length only if the length of the scale invented by society. This was itself is constant. The value of money is necessitated by the increasing scale of linked to its purchasing power. industrialisation and commercialisation, Purchasing power is the inverse of the which warranted the monetisation average or general level of prices as of transactions. measured by the consumer price index etc. As the general price level increases, Functions of Money a unit of money can purchase a lesser Money performs four specific functions, amount of goods and services – so the each of which overcomes the difficulties value or purchasing power of money of barter. The functions of money are to declines. So, money will be a useful unit serve as: (1) a unit of value, (2) a of value only as long as its own value medium of exchange, (3) a standard of or purchasing power remains constant. deferred payments and (4) a store of Money as a Medium of Exchange value. Money as a Unit of Value Money also acts as a medium of exchange or as a medium of payments. The first function of money is to be a This function of money is served by unit of value or a unit of account. The anything that is generally accepted by monetary unit is the unit in terms of people in exchange for goods and which the value of all goods and services services. ‘Anything’ has been quite a is measured and expressed. The value variety of things across places and times. of each good or service is expressed as Some of the things that have served as a price, which is the number of money are – clay, cowry shells, tortoise monetary units for which the good or shells, cattle, pigs, horses, sheep, tea, service can be exchanged. If the price tobacco, wool, salt, wine, boats, iron, of a pen is Rs.10 then a pen can be had copper, brass, silver, gold, bronze, in exchange for ten monetary units nickel, paper, leather, playing cards, (where the monetary unit in this case is debts of individuals, debts of banks, the rupee). debts of governments, etc. Measuring values in monetary units Money will then reduce the time and helps in measuring the exchange values of commodities. If a pen is worth Rs.10 energy spent in barter. The person who and a notebook is worth Rs.20 then a owned a cow can now simply sell it to 94 INTRODUCTORY MACROECONOMICS the person who offers the most money Money as a Store of Value for it and then buy the bullock cart from If money becomes a unit of value and a another person who offers him the best means of payment then it may also bargain. Ultimately, all trade may be perform the function of serving as a considered barter – one good or service store of value. The holders of money are is traded for another good or service – holders of generalised purchasing either directly, or indirectly with money power that can be spent through time. acting as the intermediary. However, by They know that it will be accepted at acting as an intermediary, money any time for any good or service and is increases the ease of trade. thus a store of value. This function will Money is also called a bearer of be performed well as long as money options or generalised purchasing retains a constant purchasing power. It may be noted that any asset other power. This indicates the freedom of than money may also perform the choice that the use of money offers. The function of store of value, for example, owner of the cow need not procure bonds, land, houses, etc. These assets goods and services from those to whom have the advantage that, unlike money, he sold his cow. He can use the money they yield income and may appreciate to buy the things he wants most, from in value over time. However, they are those who offer him the best bargain subject to the following: (1) they may (not necessarily those who bought his involve storage costs, (2) they may not cow), at the time he considers most be liquid in the sense that they could advantageous (not necessarily not be quickly converted into money immediately). Again, this function can without loss of value, and (3) they may only be performed properly if the value depreciate in value. A person may of money remains constant. choose to store value in any form depending on considerations of income, Money as a Standard of Deferred safety and liquidity. Payments If money performs the previous two Definitions of Money functions then it may also perform the After considering the functions of function of being the unit in terms of money, we must now decide what which deferred or future payments are things are to be considered as money, stated. Examples of situations where i.e. we must define what money is. The future payments are to be made are various types of definitions of money are pensions, principal and interest on as follows: debt, salaries etc. As long as money Legal Definitions of Money maintains a constant value through time, it will overcome the problems The statement that ‘money is what the associated with making future law says it is’ would sum up such a payments with specific commodities. definition. A thing will have general MONEY AND BANKING 95 acceptability if the law proclaims it as not help narrow down the list of things money. It may be further endowed that are included in money. For with legal tender power, i.e. it has the example, houses could be a unit of legal power to discharge debts, and a value and a standard of deferred creditor who refuses, it is not legally payment, but are houses money? They entitled to receive anything else in are not, because they are not generally payment of an existing debt. acceptable in payment of debt and for Currency, being legal tender, is also goods and services. called fiat money because it serves as It is commonly accepted that money on the fiat (order) of the anything that is generally acceptable in government. This is not true of deposit payment of debt and as payment for money. Demand deposits of banks are goods and services should be included fiduciary money because they are in the money supply. If a good is in fact accepted as money on the basis of the generally acceptable in payment and trust that their issuer commands. A generally used as a medium of person can however legally refuse to payment, it is money, no matter what take payment through cheques its legal status may be. In India, the because there is no guarantee that a money supply includes coins and cheque will be honoured by the issuer’s paper money, which are together bank. A cheque is an instrument that known as currency, and deposit money. instructs the bank to transfer funds Currency is generally acceptable and from the cheque issuer’s account to the is endowed with legal tender status. cheque receiver. Deposits are moneys accepted by However, legal definitions of money various agencies from others to be held are not the only determinants of what under stipulated terms and conditions. things serve as money. For example, The deposits accepted by banks and people may not prefer legal tender in post offices only are considered as payment and refuse to sell goods and constituents of alternative measures of services to those offering it. On the money supply. contrary, things that are not legally Narrow vs. Broad Definitions of Money defined as money for example, cheques may be generally acceptable as a means The narrow definition of money is based of payment. Today, credit cards can upon its medium of payments function. also be placed in this category. The broad definition of money tried to extend the money category to include Functional Definitions of Money some other things that have a high By functional definition, money will degree of ‘moneyness’ and are widely include all things that perform the four used as a store of value. Thus, also functions that money does. Two of the included in broad money would be time functions of money, i.e. a unit of value and savings deposits at banks and post and standard of deferred payment will offices. These financial assets have a 96 INTRODUCTORY MACROECONOMICS high degree of moneyness or liquidity coins in the case of full-bodied money!). but are not generally acceptable in Credit Money: This refers to money, payment. We shall see some examples whose value as money is greater than of narrow and broad definitions of the commodity value of the material money later in the chapter. from in which the money is made. How can it maintain a higher value as money Classifications of Money than its commodity value? This is done Money can be classified based on the by limiting the quantity of money by relationship between the face value of preventing the free and unlimited money and the value of money as a transformation of the commodity into commodity (or intrinsic value). The money. The government will fix the classifications are as follows: quantity of the particular type of money Full-bodied Money: Full-bodied to be issued and buy only as much of money is money whose value as a the money material as needed for the commodity for non-monetary purposes purpose. The remainder of the supply is as great as its face value as money. of that commodity is left for non- Most of the earlier commodity moneys monetary purposes. This remaining for e.g. gold, silver, cattle etc. were as supply may be so large relative to the valuable for non-monetary purposes as demands for non-monetary uses that they were for monetary uses. The main the market value of the commodity will full bodied monies in modern economies fall below the value of the money. have been the coins of the standard metal when the economy was on a Credit money is of various forms: metallic standard: gold coins in a gold 1. Token coins: All our coins (Rs.5, Rs.2, standard, silver coins in a silver Re.1, 50p, 25p, 20p, 10p, and 5p) standard and gold as well as silver coins are token coins in the sense that their when the country was on a bimetallic value as money is far above the value standard. of the metal contained in them. If you Representative Full-bodied Money: melt a five rupee coin and sell the This type of money is usually made of metal in the market place you would paper. It is equivalent to a circulating be extremely lucky to get Rs.5 for it! warehouse receipt for full-bodied coins 2. Representative Token Money: This is or their equivalent in bullion. The paper usually of the form of paper, which is money itself has no value as a in effect a circulating warehouse commodity, it is after all just a piece of receipt for token coins or an equivalent paper, but it represents in circulation amount of bullion that is backing it. an amount of money with a commodity The coin or bullion backing the value equal to the value of the money. representative token money is worth The advantage of this type of money is less as a commodity than as money, that it is convenient to engage in trade thus making it credit money. For which requires large sums of money example, if Rs.10000 worth of (imagine carrying huge sacks of gold MONEY AND BANKING 97 representative token money is The term monetary standard refers circulated as paper money in the to the type of standard money used in economy, then Rs.10000 worth of the economy. The standard money is token coins will back it. However, the that legal money in which the commodity value of the token coins government of the country discharges will be less than Rs.10000, and so will its obligations. The monetary standard be the value of the bullion if instead of is thus synonymous with the standard token coins, bullion was backing the money adopted by the country’s representative token money. monetary authority. Since India’s 3. Circulating promissory Currency monetary authority, the Reserve Bank (notes) issued by Central Banks: of India (RBI) has adopted a standard This is the greatest part of modern currency made of paper, India is on a currency, and includes all currency paper currency standard. notes in India issued by the Reserve Paper currency is the main Bank of India. If you look at any currency of the country. It has an note you will see a legend – ‘I unlimited legal tender, i.e. it can be used promise to pay the bearer the sum to settle debts and make payments up of Rs. ‘X’’ — signed by the Governor to an unlimited amount. For making of the RBI. This is nothing but a smaller payments, coins made of cheap circulating promissory note issued and light metals are used. These coins by the RBI. are limited legal tender since they can 4. Deposits at Banks: These deposits be used to make payments and settle in banks e.g. savings deposits, are debts only up to a limited amount. It claims of creditors against banks would be inconvenient to settle a debt which can be transferred from one of Rs.1000 with 50p. coins! person to another by means of RBI has the sole right to issue cheques. Since the bank does not currency notes, other than the one back all the chequable deposits it rupee note in the country. The has with an equivalent amount of Government of India under the Indian financial assets or money, these Coinage Act issues the one rupee note chequable deposits are credit and all coins. Though the Government money. We will study how banks issues the one rupee note and coins, may keep less than 100% reserves the responsibility for putting them in backing their chequable deposits circulation rests with the RBI. later in the chapter. The system governing note issue in Indian Monetary System India is the Minimum Reserve System. India is at present on the paper Paper currency is not convertible into currency standard. This standard is the precious metal (gold) that is backing also referred to as the managed it; hence the currency is said to be currency standard. inconvertible. 98 INTRODUCTORY MACROECONOMICS Money Supply or demanders of it. This separation is required for monetary analysis. Having defined money we may now list out the things that serve as money.2 Measurement of Money Supply Then, the money supply, i.e. the total This is an empirical matter. It involves stock of moneys of various kinds at any defining various measures of money particular point of time can be supply and computing their values. The computed. By repeated measurements Reserve Bank of India has been at different points of time we may get a publishing data on four alternative time series of the total stock of money. measures of money supply namely, By analysing this time series in M1, M2, M3 and M4. These are defined conjunction with time series of other as follows: economic variables such as incomes, M1 = C + DD + OD wages, prices, employment, etc. we can C is currency held by the public. It hope to understand the effect of money consists of paper currency as well as on the other variables in the economy. coins. DD is the ‘demand deposits’ in It is important to note two things banks. Only the net demand deposits regarding any measure of money of banks are included in money supply supply. First, the supply of money is a because the part of demand deposits stock variable, i.e. it does not have any that represents inter-bank deposits time dimension – it refers to the total held by one bank with another does not amount of money at any particular constitute demand deposits held by the point of time. It is not a flow variable in public. Since money supply is defined the sense of income, which refers to a as money held by the public, we must rate per unit time, i.e. so many rupees net out the inter-bank deposits to arrive at net demand deposits in banks. per year. OD is ‘other deposits’ with the RBI. Second, the stock of money always These are the deposits held by the RBI refers to the stock of money held by the of all economic units except the public. This is always smaller than the government and banks. OD includes total stock of money in existence. The demand deposits of Public Financial term ‘public’ includes all economic units Institutions (like IDBI, etc.), foreign — households, firms, etc. except the central banks and governments, the producers of money, i.e. the government IMF, the World Bank, etc. and the banking system. The banking M2 = M1 + savings deposits with post system includes the Reserve Bank of office savings banks India and all the banks that accept M3 = M1 + net time deposits of banks demand deposits. The reason for such a M4 = M3 + total deposits with post office distinction is to separate the producers savings organisation (excluding or suppliers of money from the holders National Savings Certificates) 2 The following sections draw on material from ‘‘Monetary Economics : Institutions, Theory and Policy,’’ by Suraj B. Gupta, 1982. MONEY AND BANKING 99 M1 and M2 are measures of narrow Acceptance of chequable deposits is money. M3 and M4 are measures of a necessary, but not sufficient condition broad money. M3 is most widely used for FI to be a bank. For example, post measure of money supply. It is also office savings banks are not banks in called aggregate monetary resources of this sense of the term even though they the society. accept deposits from the public. This is The RBI views the four measures of because they do not perform the other money stock as representing different essential function of lending. degrees of liquidity, with M1 being the Similarly, lending alone does not most liquid and M4 being the least make FI a bank. For example, many FIs liquid. Liquidity means the ability to like LIC, UTI, and IDBI, etc. lend to others convert an asset into money quickly but they are not banks in this sense of and without loss of value. the term, as they do not accept Having defined the measures of chequable deposits. money supply, we shall investigate The main functions that commercial what determines the actual amount of banks perform are: money stock at any point of time, and changes in the money stock over time. 1. Acceptance of deposits Money supply will change if the The bank accepts three types of magnitude of any of its constituents deposits from the public. changes. Changes in C, DD and net time deposits of banks cause changes in (cid:1) Current Account Deposits: Deposits money stock as measured by M3. We in current accounts are payable on will go into money supply and changes demand. They can be drawn upon in money supply after looking at the by cheque without any restriction. commercial banking system and the These accounts are usually Central Bank, as these two are key maintained by businesses and are players in determining the changes in used for making business payments. the quantum of money supply. No interest is paid on these deposits. BANKING However, the banks offer various services to the account holders for a Commercial Banks nominal charge, the most important Banking is defined as the accepting, for being the cheque facility. Only when the purpose of lending, or investment the ownership of these deposits has of deposits, money from the public, been so transferred, the medium of repayable on demand or otherwise and exchange or means of payment withdrawable by cheque, draft, order function of these deposits gets or otherwise. completed. Banks keep regular Thus the two essential functions accounts of all transactions made in that make banks as Financial Institutions (FIs) are accepting a particular account and submit chequable deposits from the public statements of the same to the and lending. account-holder at regular intervals. 100 INTRODUCTORY MACROECONOMICS (cid:1) Fixed/Term Deposits: These are other deposits that are not payable on deposits for a fixed term (period of demand are called time deposits. time) varying from a few days to a All current account deposits are few years. They are not payable on demand deposits and all term deposits demand and do not enjoy chequing are time deposits. The classification of facilities. The moneys deposited in savings deposits is not as such accounts become payable only straightforward because they combine on the maturity of the fixed period features of both demand and time for which the deposit was initially deposits. The Reserve Bank of India made. Interest is paid on these distinguishes between the demand deposits and the rate of interest liability portion of savings deposits rises with the term of the deposits. (which are included under demand A variant of fixed deposits are deposits) and the time liability portion recurring deposits. In these of savings deposits (that are included accounts, a depositor makes a under time deposits). The rule to decide regular deposit of an agreed sum which part of the savings deposits over an agreed period e.g. Rs.100 comes under which category is: ‘the per month for 5 years. Interest is average of the monthly minimum paid on the deposits in these balances in the savings accounts on accounts. which interest is being paid shall be (cid:1) Savings Account Deposits: These regarded as a time liability and the deposits combine the features of excess over the said amount shall be both current account deposits and regarded as a demand liability.’ fixed deposits. They are payable on 2. Giving Loans demand and also withdrawable by cheque, but with certain restrictions The deposits received by the bank are on the number of cheques issued not allowed to lie idle by the bank. After in a period of time. Interest is paid keeping a certain portion of the on the deposits in these accounts deposits as reserves, the bank gives the but the interest paid on savings balance to borrowers in the form of account deposits is less than that loans and advances. The different types of the fixed deposits. of loans and advances made by banks In monetary analysis deposits are are as follows: classified into two types: demand (cid:1) Cash Credit – In this arrangement, deposits and time deposits. Demand an eligible borrower is first deposits are payable on demand either sanctioned a credit limit upto which through cheque or otherwise. Only he may borrow from the bank. This demand deposits may serve as a credit limit is determined by the medium of exchange, because their bank’s estimation of the borrower’s ownership can be transferred from creditworthiness. However, actual person to person through cheques. All utilisation of credit by the customer MONEY AND BANKING 101 depends upon his withdrawing repayment is made as scheduled, power. The withdrawing power either in one instalment at the end depends on the value of the of the loan, or in a number borrower’s current assets, which of instalments over the period of comprise mainly stocks of goods – the loan. raw materials, semi-manufactured In addition, commercial banks or finished goods, and bills extend the following facilities when they receivable (dues) from others. The are requested by their customers. borrower has to submit a stock 3. Overdrafts statement of his assets to the bank showing evidence of on-going trade An overdraft is an advance given by and production activity; and acting allowing a customer to overdraw his as a legal document in possession current account upto an agreed limit. of the bank, to be used in case of The security for overdrafts is usually default. The borrower has to pay financial assets of the account holder interest on the ‘drawn’ or utilised such as shares, debentures, life portion of the credit only. insurance policies etc. Overdraft is a (cid:1) Demand Loans - A demand loan is temporary facility and the rate of one that can be recalled on demand. interest charged on the amount of credit It has no stated maturity. The entire used is lower than that on cash credit loan amount is paid in lump sum because the risk involved and service by crediting it to the loan account of cost of such credit is less – it is easier to the borrower. Thus, the entire loan liquify financial assets than amount becomes chargeable to physical assets. interest. Security brokers and others whose credit needs fluctuate day to 4. Discounting Bills of Exchange day usually take these loans. The A bill of exchange is a document security against these loans may be acknowledging an amount of money personal, financial assets or goods. owed in consideration for goods (cid:1) Short-term Loans – Short-term received. For example, if A buys goods loans may be given as personal from B, he may not pay B immediately. loans, loans to finance working He may give B a bill of exchange, stating capital or as priority sector the amount of money owed and the time advances. These loans are secured when the debt has to be settled. If B loans, i.e. they are loans made wants the money immediately, he will against some security. The whole amount of the term loan sanctioned present the bill of exchange to the bank is paid in lump sum by crediting it for discounting. The bank will deduct a to the loan account of the borrower. commission and pay the present value Thus, the entire loan amount of the bill to B. Upon maturity of the bill; becomes chargeable to interest. The the bank will secure payment from A. 102 INTRODUCTORY MACROECONOMICS 5. Investment of funds such as the demand drafts, mail transfers, telegraphic transfers, The banks invest their surplus funds etc. in three types of securities – (ii) Collection of funds – the bank Government securities, other approved undertakes to collect funds on securities, and other securities. behalf of its customers through Government securities are instruments such as cheques, securities of both the Central and State demand drafts, bills, hundis, etc. governments such as treasury bills, (iii) Purchase and sale of shares and national savings certificates etc. securities on behalf of customers. Other approved securities are (iv) Collection of dividends and securities approved under the interest on shares and provisions of the Banking Regulation debentures on behalf of Act, 1949. These include securities of customers. State sponsored bodies like electricity (v) Payment of bills and insurance boards, housing boards, debentures of premia as per customer’s Land Development Banks, units of UTI, directions. (vi) Acting as executors and trustees shares of Regional Rural Banks etc. of wills. Part of the banks’ investment in (vii) Provision of income tax government securities and other consultancy and acceptance of approved securities are mandatory income tax payments of under the provisions of the Statutory customers. Liquidity Ratio requirement of the RBI. (viii) Acting as correspondent, agent or However, banks hold excess investments representative of customers as in these securities because banks can well as securing documentation borrow against these securities from for air and sea passage. RBI and others, or sell these securities in the open market to meet their need 7. Miscellaneous Functions for cash. Banks hold them even though (i) Purchase and sale of foreign the return from them is lower than that exchange. on loans and advances because they (ii) Issuance of travellers’ cheques are more liquid. and gift cheques. (iii) Safe custody of valuable goods in 6. Agency Functions of the Bank lockers. The bank performs certain agency (iv) Underwriting activities (agreeing functions for its customers in return for to partly or fully purchase the a commission. The agency services whole or the unsold portion provided by the banks are: respectively of new issue of (i) Transfer of funds – the bank securities) and private placement provides facility for cheap and of securities (selling securities not easy remittance of funds from through the open market, but place to place via instruments privately to selected entities). MONEY AND BANKING 103 Commercial banks Scheduled Non-scheduled commercial banks commercial banks Public sector banks Private sector banks Foreign banks SBI and its Subsidiaries Other nationalized banks Fig. 7.1: Schematic Classification of Commercial Banks As is evident from the above list, 1. Currency Authority banks provide a wide range of services The Central Bank is the sole authority to their customers. for the issue of currency in the country. Under the present economic All the currency issued by the Central liberalisation, commercial banks are Bank is its monetary liability. This urged to assume certain roles which are means that the Central Bank is obliged usually outside the purview of typical to back the currency with assets of commercial banking such as equal value. These assets usually development banking, insurance in consist of gold coin, gold bullion, addition to commercial banking foreign securities, and the domestic practices. government’s local currency securities. Figure 7.1 gives a schematic The country’s Central Government classification of commercial banks. is usually authorized to borrow money The Central Bank from the Central Bank. The government The central bank is the apex institution does this, by selling local currency of a country’s monetary system. The securities to the Central Bank. The effect design and the control of the country’s of this is to increase the supply of money monetary policy is its main responsibility. in the economy. When the Central Bank As pointed out earlier, India’s central acquires these securities, it issues bank is the Reserve Bank of India. currency. This authority of the The Central Bank performs the government gives it flexibility to monetize following functions: its debt. Monetizing the government’s 104 INTRODUCTORY MACROECONOMICS debt (called public debt) is the process As the government’s banker, of converting its debt (whether existing the Central Bank also has the or new), which is a non-monetary responsibility of managing the public liability, into Central Bank currency, debt. This means that the Central Bank which is a monetary liability. has to manage all new issues of government loans (by advising the Putting and withdrawing currency government on the quantum, timing into and from circulation are also the job and terms of such loans), services the of its banking department. For example, public debt outstanding (by making when the government incurs a deficit in sure that interest is paid on time and its budget, it borrows from the Central maturing bills are retired by repaying Bank. This is done by selling treasury the principal) and nurtures the market bills to the Central Bank, the latter paying for government securities (by ensuring for the bills by drawing down its stock of that the market functions smoothly, currency or printing currency against with adequate supply of all maturities equal transfer of the said securities. The of existing bills and has enough government spends the new currency liquidity to pick up the new issues and puts it into circulation. of bills). The Central Bank also advises the 2. Banker to the Government government on banking and financial The Central Bank acts as a banker to matters. the government – both Central as well 3. Bankers’ Bank and Supervisor as State governments. It carries out all the banking business of the (Lender of the last report) As the government, and the government keeps banker to banks, the Central Bank its cash balances on current account holds a part of the cash reserves of with the Central Bank. banks, lends them short-term funds As the banker to the government, and provides them with centralised clearing and remittance facilities. The the Central Bank accepts receipts and banks are required to deposit a makes payments for the government, stipulated ratio of their net total and carries out exchange, remittance liabilities (the CRR) with the Central and other banking operations. The Bank. The purpose of this stipulation Central Bank also provides short-term is to use these reserves as an credit to the government, so that the instrument of monetary and credit government can meet any shortfalls in control. In addition to this, the bank receipts over disbursements. The holds excess reserves with the Central government borrows money by selling Bank to meet any clearing drains due treasury bills to the Central Bank. The to settlement with other banks or net government carries on short term withdrawals by their account holders. borrowing by selling ad-hoc treasury The pool of funds with the Central bills to the Central Bank. Bank serves as a source from which it MONEY AND BANKING 105 can make advances to banks funds and of borrowing reserves temporarily in need of funds, acting in from the central bank. This will its capacity as lender of last resort. reduce the ability of banks to create However, the banks in temporary need credit and thus to increase the of funds are supposed to approach money supply. A rise in the bank other sources first like the call money rate will then cause the banks to market and then only approach the increase the rates at which they Central Bank. lend. This will then discourage The Central Bank supervises, businessmen and others from regulates and controls the commercial taking loans, thus reducing the banks. The regulation of banks may be volume of credit. A decrease in the related to their licensing, branch bank rate will have the opposite expansion, liquidity of assets, effect. In actual practise however, management, amalgamation (merging the effectiveness of bank rate policy of banks) and liquidation (the winding will depend on (a) the degree of up of banks). The control is exercised banks’ dependence on borrowed by periodic inspection of banks and the reserves (positive relationship), returns filed by them. (b) the sensitivity of banks’ demand for borrowed funds to the differential 4. Controller of Money Supply and between the banks lending rate and Credit their borrowing rate (positive The Central Bank controls the money relationship), (c) the extent to which supply and credit in the best interests other rates of interest in the of the economy. The bank does this by market change and (d) the state of taking recourse to various instruments. supply of and demand for funds Generally they are categorised as from other sources. quantitative and qualitative 2. Open Market Operations: OMO is instruments. Let us first deal with the the buying and selling of instruments of quantitative control, i.e. government securities by the those that affect only the quantity of the Central Bank from/to the public particular variable: and banks on its own account. It 1. Bank Rate Policy: The bank rate is does not matter whether the the rate at which the central bank securities are bought from or sold lends funds as a ‘lender of last to the public or banks because resort’ to banks, against approved ultimately the amounts will be securities or eligible bills of deposited in or transferred from exchange. The effect of a change in some bank. The sale of government the bank rate is to change the cost securities to banks will have the of securing funds from the central effect of reducing their reserves. bank. An increase in the bank rate When the bank gives the Central increases the costs of securing Bank a cheque for the securities, the 106 INTRODUCTORY MACROECONOMICS Central Bank collects the amount credit control. An increase in the by reducing the bank’s reserves by CRR has the effect of reducing the the particular amount. This directly banks excess reserves and thus reduces the bank’s ability to give curtails their ability to give credit. credit and therefore decrease the Reducing the CRR has the effect of money supply in the economy. increasing the bank’s excess When the Central Bank buys reserves, which increases its power securities from the banks it gives the to give credit. banks a cheque drawn on itself in The SLR requires the banks to payment for the securities. When maintain a specified percentage of their the cheque clears, the Central Bank net total demand and time liabilities in increases the reserves of the bank the form of designated liquid assets by the particular amount. This which may be (a) excess reserves directly increases the bank’s ability (b) unencumbered (are not acting as to give credit and thus increase the security for loans from the Central money supply. Successful conduct Bank) government and other approved of OMO as a tool of monetary policy securities (securities whose repayment requires first that a well functioning is guaranteed by the government) and securities market exists. If banks (c) current account balances with other regularly and routinely resort to banks. Varying the SLR affects the keeping excess reserves then the freedom of banks to sell government utility of such a policy will be securities or borrow against them from doubtful. In developed countries the Central Bank. This affects their like the US, banks are not affected freedom to increase the quantum of by the OMO because they buy credit and therefore the money supply. securities with excess reserves and Increasing the SLR reduces the ability when they sell securities, the of banks to give credit and vice versa. amount realised is added to the We now deal with instruments of excess reserves. In such a situation, qualitative credit control, which deal OMO becomes a ineffective tool. with the allocation of credit between 3. Varying Reserve Requirements: alternative uses. Banks are obliged to maintain 1. Imposing margin requirement on reserves with the Central Bank on secured loans: A margin is the two accounts. One is the Cash difference between the amount of Reserve Ratio or CRR and the other the loan and market value of the is the SLR or Statutory Liquidity security offered by the borrower Ratio. Under CRR the banks are against the loan. If the margin required to deposit with the Central imposed by the Central Bank is Bank a percentage of their net 40%, then the bank is allowed to demand and time liabilities. Varying give a loan only up to 60% of the the CRR is a tool of monetary and value of the security. By altering the MONEY AND BANKING 107 margin requirements, the Central programme of the economy has had Bank can alter the amount of loans implications on the monetary policy of made against securities by the the government. One important banks. The advantages of this component of such policy has been the instrument are manifold. High gradual downward adjustment of the margin requirements discourage structure of interest rates in favour of speculative activities with bank a lower interest rate regime. The credit and therefore divert resources apparent reason is that the interest from unproductive speculative rates in India are too high, and given activities to productive investments. the low inflation rate recently, the real By reducing speculative activities, interest rates are therefore too high. The there is reduction in the fluctuation effect of this is to dampen investment. of prices in the market price of One suspects that the real reason for securities. the government’s decision to lower 2. Moral Suasion: This is a combination interest rates is the fact that the interest of persuasion and pressure that the and repayment obligations on Central Bank applies on the other government debt are fast reaching banks in order to get them to fall in unsustainable levels. The government line with its policy. This is exercised is reaching a stage where it has to through discussions, letters, borrow not for productive activities or speeches and hints to banks. The Central Bank frequently announces to finance developmental works, but its policy position and urges the rather to pay off old debts. Where it has banks to fall in line. Moral suasion to borrow to repay past principal is not can be used both for quantitative that dangerous a state of affairs. Where as well as qualitative credit control. it has to borrow to meet interest 3. Selective Credit Controls (SCCs): obligations on past debt is a These can be applied in both a calamitous state of public finances. positive as well as a negative The effect of lower interest rates is manner. Application in a positive beneficial to the state of public finances. manner would mean using The government can ‘retire’ costly old measures to channel credit to debt and replace with cheaper new particular sectors, usually the debt, and it can reduce the interest priority sectors. Application in a burden of its debt. The added negative manner would mean using advantage of low interest rate regime measures to restrict the flow of is that it boosts investment. credit to particular sectors. The Government has also gone in for Banks and Monetary Policy: A reform of the Banking System in a big Recent Scenario way, in line with the structural In the present Indian macroeconomic adjustment programme. The main scenario, structural adjustment thrust of the reforms as per the 108 INTRODUCTORY MACROECONOMICS recommendations of the Narasimhan of the banks to increase their efficiency, Committee Reports, 1991 and 1998 was allow foreign private banks to set up to reduce the excessively high CRR and branches or subsidiaries in India and SLR (to increase the banks capability to reduce the directed, subsidized credit create credit), reduce and ultimately to priority sectors (to allow banks to deregulate the interest rates, give more allocate credit on commercial rather than autonomy to the operational functioning developmental criteria). SUMMARY (cid:1) The main function of money in an economic system is to facilitate the exchange of goods and services, that is, to lessen the time and effort required to carry on trade. (cid:1) The exchange of ‘goods for goods’ is called barter exchange. (cid:1) Barter becomes unwieldy as groups become larger. A possible solution is the use of a commonly accepted good as a medium of exchange. (cid:1) Barter suffers from four main drawbacks, each of which is overcome by a specific function of money. (cid:1) Money may be defined using legal definitions or functional definitions. (cid:1) Money may be classified based on the relationship between the value of the money as money, and the value of money as a commodity. (cid:1) India follows a managed paper currency standard with a minimum reserve system of note issue. (cid:1) Money supply is the total stock of moneys of various kinds at any particular point of time. (cid:1) Banking is defined as the accepting, for the purpose of lending, or investment of deposits, money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise. (cid:1) Two essential functions of a bank are accepting deposits and giving loans. (cid:1) The Central Bank is the apex institution of a country’s monetary system. The design and control of the country’s monetary policy is its main responsibility. EXERCISES 1. What is the main function of money in an economic system? 2. What is barter? 3. What are the drawbacks of barter? 4. How does the use of money overcome the drawbacks of barter? 5. How can money be defined? 6. How can money be classified? 7. What monetary system does India follow? 8. What is money supply? 9. What are the various money stock measures? 10. What is banking? 11. What are the functions of commercial banks? 12. What are the functions of central banks? A 7.1: T L P PPENDIX HEORY OF IQUIDITY REFERENCE In this chapter, we have studied only The amount of transaction balances the supply of money. We may round off a person must hold increases the discussion on money by proportionately with the money volume introducing the theory of demand for of transactions. Among all the money, from the Keynesian perspective. transactions made, only some of them The Keynesian theory of the demand for will be in final goods and services. If we money (liquidity preference) is as assume that the ratio of GNP to the follows. Keynes believed that people volume of all transactions as some demand money for three reasons or constant, then we have the amount of ‘motives’. money balances that the public as a 1. Transactions Motive whole wishes to hold for transactions purposes depending on the level of The reason for transactions demand is income. as follows. Money is needed to carry Further, the amount of transactions out ordinary day-to-day transactions. This is the medium of exchange balances required varies proportionately function of money. The need to hold with the price level P at which the output monetary balances arises because is sold. Twice as much money is people in general do not have required to purchase a commodity that synchronized receipts and costs Rs.100 as was required to expenditures patterns. In other words, purchase the same commodity when its the amount of money individuals price is Rs.50. The same is true for the receive at any point of time may not be economy wide total of purchases PY, equal to the amount of payments that where Y is real GNP. have to be made at that point of time. The transactions demand may be For example, an individual may receive expressed in equation form as a monthly salary but have to pay the milkman every week. As a result he will M = k(PY) t have to hold cash balances in order to Where, pay the milkman every week. If the amount that a person receives at every M =transactions demand for money t point of time equalled the amount that k =constant of proportionality he paid out at each point of time then P =price level there would be no need to hold money balances for transactions. Y =real GNP 110 INTRODUCTORY MACROECONOMICS If we assume that a change in the holding money. In the Keynesian world, price level causes a proportionate a person who buys bonds is change in the quantity of transactions speculating that the interest rate will not balances required, we may rewrite the rise appreciably during the period in equation as: which he intends to hold the bond. The uncertainty regarding the future M = Pk(Y) t interest rate causes people to hold To convert the demand for nominal money for speculative purposes. There balances into real balances we divide is a negative relationship between the throughout by P to get interest rate and the market price of M a bond, or for that matter any t =k(Y) debt security. P People who buy bonds expect the M t where is the demand for real interest rate to fall and the prices of P bonds to rise. In other words, they balances for transactions purposes. regard the present interest rate as ‘high’ 2. Precautionary Motive and the present bond prices as ‘low’. The precautionary demand for money Those who switch from bonds to money arises because of uncertainty regarding have opposite expectations. future receipts and expenditures. Now, people who view the current Precautionary balances enable people interest rate as too ‘high’ or too ‘low’ to meet unanticipated increases in obviously have some notion in their expenditures or unanticipated minds of the ‘normal’ rate of interest, reductions or delays in receipts. with which they compare the current Demand for precautionary balances rate of interest. Given this notion of the varies directly with income. An ‘normal’ rate of interest, at any point of individual can and will need to time people will decide that the current keep aside more money for this purpose rate of interest is higher than, lower as his income increases. Since than or equal to the normal rate of both transactions demand and interest. precautionary demand are functions of If people view the current rate of income, they may be combined so that interest as too high, they will expect the M the equation t =k(Y) can be used to rate to drop as it returns to the normal P rate. At the current high rate, people denote the demand for both (real) will therefore, hold bonds instead of transactions and precautionary money. They will therefore, not only balances. currently enjoy the high rate of return 3. Speculative Motive provided by the bonds, but will also The speculative demand for money expect capital gains as the bond prices arises from the speculative motive for rise and the interest rate falls to normal. MONEY AND BANKING 111 On the other hand if people view the current interest rate as low, then they will expect it to rise and bond prices to r fall, as the interest rate returns to the 0 normal rate. They will therefore hold money rather than bonds. The interest lost as a result of holding money will be small in comparison to the prospective capital losses if the interest rate does indeed rise. Thus, holding idle r 1 msp money is the safer policy. m Thus, we can conclude that the sp demand for speculative balances varies Fig A7.1: Relationship between Interest inversely with the interest rate. We may Rate and Real Balances write the equation for speculative demand for money as: no one prefers money to bonds. M = P.h(r) sp At the other end of the curve, Where, speculative demand becomes perfectly M = demand for nominal speculative elastic with respect to interest rate (the sp balances curve becomes parallel to the X-axis), P = price level i.e. a small proportional change in the h(r) = function of r (M is an inverse interest rate causes an infinitely sp function of r) larger change (in the opposite direction) in the quantum of speculative Dividing throughout by P we get the balances demanded. demand for real speculative balances: This is because all people believe M sp that the interest rate is so low that it m = = h(r) sp P cannot go any lower – it can only rise. We may show the relationship To hold bonds at this interest rate is to between m and r in diagrammatically take the almost certain risk of a capital sp in Fig. A7.1. loss as the interest rates rise and the The higher the market interest rate, bond prices fall. Thus, all people hold the lower will be the amount of real money, and no bonds at this interest balances that people will maintain for rate. This section of the curve (where it speculative purposes. At some high becomes perfectly interest elastic) is interest rate r , the curve shows that called the liquidity trap. It is in this 0 people will hold no money in speculative section of the curve that increases in balances. This is because all people money supply, since it goes entirely into believe that the interest rate is so high speculative balances, cannot affect the that it can only fall. At this interest rate, interest rate. 112 INTRODUCTORY MACROECONOMICS The Total Demand for Money (liquidity preference) r The total demand for money expressed in real terms is the sum of the transactions demand, the precautionary demand and the speculative demand. It r may be written as: 0 m m = k(Y) + h(r) d d For any given price level, we know from k what m will be for every level of t Y; and we know from h what m will be m (cid:2) m (cid:1) m sp t sp d for every level of r. Fig A7.2 : Liquidity Preference Curve. From k and h we know what the total demand for money will be for every combination of Y and r. This may for money at different rates of interest. be represented diagrammatically At the rate of interest r the demand for 0 in Fig A7.2. transactions and precautionary The curve m is the liquidity balances is m and the demand for d t preference curve. It shows the demand speculative balances is m . sp A 7.2 : M E I R PPENDIX ONETARY QUILIBRIUM AND THE NTEREST ATE The equilibrium interest rate is equilibrium with the supply of money determined by the interaction of the (m ) being equal to the demand for s curves representing the supply of money. This may be represented money and the demand for money. diagrammatically in Fig A7.3 below : Assume the supply of money, i.e. the r money stock to be some given constant amount. Given the money supply and the income level, there will be some interest rate at which the sum of the r transactions, precautionary and e speculative demands for money will be just equal to the supply of money. The m d interest rate that equates the supply of money with the demand for money is m(cid:1) m m ,m called the equilibrium interest rate. At d s d s that rate, there will be monetary Fig A7.3 : Equilibrium Rate of Interest MONEY AND BANKING 113 The supply of money curve is a r m m s s1 vertical straight line because it is a constant, and is independent of the rate of interest. The money market is in r equilibrium at interest rate r because 0 the supply of money equals the e demand r 1 for money. m Altering the money supply will affect d the interest rate. Consider the effect of an increase in the money supply from m,m d s m to m . We can portray the effect of s s1 Fig A7.4 :Rate of Interest and Changes in this diagrammatically in fig A7.4. The Money Supply effect of an increase in the money supply is to cause a decrease in the interest rates from r to r . However this will occur only supply increase is ‘trapped’ in the 0 1 if the money supply increase takes place speculative balances and does not affect the region of the demand for money interest rate. curve that does not correspond to the Decreasing the money supply liquidity trap. If money supply increases will have the opposite effect of over the section of the curve where the increasing the rate of interest. This can liquidity trap operates, then all the happen when the economy is not in the additional liquidity created by the money liquidity trap as well. A 7.3 : B S C B PPENDIX ALANCE HEET OF OMMERCIAL ANKS Commercial banks are financial explanation of the assets and liabilities intermediaries. They deal in financial of banks follows: assets and money. A look at the Liabilities consolidated balance sheet for all commercial banks reflects their heavy 1. Capital and Reserves: Capital and involvement in dealing with financial reserves constitute the owned funds of assets. the banks. Paid up capital is the amount A glance at the table shows that of share capital contributed by the banks raise the bulk of their funds by owners, i.e. the shareholders of selling deposits, and their assets the banks. Reserves are the retained comprise mainly of: (a) bank credit earnings or undistributed profits of the consisting of loans, advances, and bills banks. The purpose of accumulating discounted and purchased, (b) reserves is to improve the banks’ capital investments and (c) cash. A brief position so as to better meet unforeseen 114 INTRODUCTORY MACROECONOMICS Table A.7.1 Consolidated Balance Sheet of Indian Commercial Banks as on March 31, 2002 Item Amount % to Total (Rs. in Crores) Liabilities 1.Capital 21497.18 1.40 2. Reserves and surplus 62648.94 4.08 3.Deposits 1202767.43 78.33 4.Borrowings 107178.82 6.98 5.Other liabilities 141420.76 9.21 Total Liabilities 1535513.13 100.00 Assets 1.Cash and balances with RBI 86760.51 5.65 2.Balances with banks and 117518.25 7.65 money at call and short notice 3.Investments 588058.29 38.30 4.Loans and advances 645743.04 42.05 5.Fixed assets 20083.30 1.31 6.Other assets 77349.74 5.04 Total Assets 1535513.13 100.00 liabilities and unexpected losses. The from each other, from the call money owned funds of banks usually market and from other sources also. constitute a small source of their funds. Assets This is because their business is in 1. Cash: This item includes cash in hand other peoples’ money! and balances with other banks including 2. Borrowings: Banks as a whole the RBI. Banks hold balances with the borrow from the RBI, IDBI, NABARD RBI under the cash reserve ratio, which and from other Non-Banking Financial is a mandatory requirement. Such Institutions like UTI, GIC and its reserves are called statutory reserves. subsidiaries, and the ICICI, which are Besides these, banks voluntarily hold allowed to lend in the inter bank call extra reserves to meet daily withdrawals money market. Individual banks borrow of cash by their account holders. MONEY AND BANKING 115 2. Money at call at short notice: This time for goods received. The person who consists of money lent to other banks, issues the bill is the debtor and the stock brokers and other financial person who accepts the bill is the institutions for short periods of time creditor. If the creditor wants the varying from 1 day to 14 days. Banks amount immediately he may get the bill lend their surplus cash in such a discounted by a bank, i.e. the bank manner in order to earn interest without deducts a commission and pays the putting undue strain on their liquidity creditor the amount. Thereafter the position. bank collects the amount from the 3. Bills: These may be inland or foreign, debtor. Thus, during the pendency of depending upon where the party is, the bill, it is an asset of the bank. from whom the bank has to collect The table illustrates the nature of payment. In business, it is customary business turned out by the scheduled to make payments through a bill, commercial banks and this will make which is nothing but a document us understand the relative positions of acknowledging that payment has to be liabilities and assets in banking made of a certain amount at a certain business. A 7.4 : C C M E PPENDIX REDIT REATION AND ULTIPLE XPANSION D OF EPOSITS We are now in a position to look at 4. The public do not alter its currency increases in the supply of money as a holdings, i.e. there is no extra- result of the increase in one of the normal cash drain from the components of money, namely, deposits banking system due to net with the bank. Increases in deposits withdrawals by account holders. with the bank, i.e. DD happens through These four assumptions would the process of credit creation and multiple expansion of deposits. explain the link between the quantity To analyse the basic economics of of bank deposits and the quantity of credit creation, we may make some reserves. As we will see, the volume of simplifying assumptions. This will help deposits can change only if the volume in understanding the process without of reserves held by banks change. getting too mired in detail. The key The RBI determines the quantity of simplifying assumptions are as follows: reserves, specifically by two policies. 1. Banks accept targeting the demand The first policy is for RBI to lend deposits. reserves to the banks. These reserves 2. All banks face the same cash reserve are called borrowed reserves or requirement of nearly 10%. borrowings. When the RBI increases 3. Banks have no desire to hold excess its loans to banks then reserves reserves. 116 INTRODUCTORY MACROECONOMICS increase, and when RBI reduces the cheque drawn on the RBI to the RBI, loans, reserves decrease. bank A will be credited with Rs.1000 The second way the RBI can alter of reserves. This will cause an alteration the quantity of reserves is through open of the T-account (an account showing market operations. Open market changes in the balance sheet) as below: operations is the buying and selling of The bank has to keep 10% of securities by the RBI in the open Rs.1000, i.e. Rs.100 as reserves under market. When RBI purchases securities cash reserve requirement. The it does so by writing a cheque on itself. remaining Rs.900 is excess reserves, The seller of the security deposits the which the bank does not want by cheque with a bank and the bank assumption. The bank would like to passes along with the cheque to the RBI convert these excess reserves into an for payment. Payment is made by earning asset. It may do this by adding the amount to the banks reserve purchasing securities or by making a account at the RBI. In other words, by loan. Let us suppose that the bank purchasing securities the RBI simply chooses to make a loan. When the bank create reserves. The RBI can reduce makes a loan, it opens an account in reserves by simply selling securities. The the name of the borrower for the amount RBI, as the seller of the securities of the loan. Thus, when the bank lends, receives a cheque drawn on some bank. it creates a demand deposit. Since When it clears the cheque it reduces the demand deposits are included in the reserve account of the bank by the definition of money, the bank is creating cheque amount, thus reducing total money. reserves. The amount of money the bank can Consider now that the RBI safely lend is the amount of its excess purchases securities from an individual reserves. This means that bank A can worth Rs.1000 and the individual lend Rs.900 and create an equivalent deposits the cheque with bank A. We amount of deposits. The recipient of the will now trace the effects of this action. loan will most likely spend it and the funds will ultimately get deposited in Deposit Expansion at the First Bank another bank. This will affect its T- As a result of RBI’s security purchase, account as follows. bank A finds itself with an additional Thus, bank A has adjusted to its Rs.1000 of demand deposits. original Rs.1000 deposit by adding Furthermore, after it has presented the Rs.100 to reserves and Rs.900 to Bank A Change in Assets Change in Liabilities Cash reserves +Rs.1000 Demand deposits +Rs.1000 Required reserves +Rs.100 Excess reserves +Rs.900 MONEY AND BANKING 117 earning assets in the form of loans. The The loans made by bank B were bank’s excess reserves have been made to someone, and that someone eliminated and the bank is satisfied. spent the amount and it ultimately got Have all the effects of the initial deposited in a demand deposit account deposit worked themselves out? in another bank. That bank would then Definitely not! There is still the matter have a deposit of Rs.810, required of the Rs.900 deposited in another bank reserves of Rs.81 (being 10% of Rs.810) by the borrower. We have to trace the and excess reserves of Rs.729. This effects of this deposit. Following exactly Rs.729 can be used to acquire the same steps and same logic as before, earning assets simply continuing this we have: Bank A Change in Assets Change in Liabilities Cash reserves +Rs.100 Demand deposits +Rs.1000 Loans +Rs.900 Required reserves +Rs.100 Excess reserves Rs.0 Assume that he borrower deposited sequence. the Rs.900 in bank B. then bank B’s The pattern of the sequence is as T-account will alter as follows. follows. At each step the bank sets aside Bank B will want to make profitable 10% of the newly acquired deposits in use of its excess reserves and decides the form of required reserves and uses Bank B Change in Assets Change in Liabilities Cash reserves +Rs.900 Demand deposits +Rs.900 Required reserves +Rs.90 Excess reserves + Rs.810 to make loans worth Rs.810. After it the remaining 90%, its excess reserves makes the loan, it will have converted to acquire earning assets. As the Rs.810 of excess reserves into earning number of such cycles increases, the assets. The T-account will now be as total quantity of assets and demand follows. deposit accounts in the banking system Bank B Change in assets Change in Liabilities Cash reserves +Rs.90 Demand deposits +Rs.900 Loans +Rs.810 Required reserves +Rs.90 Excess reserves Rs.0 118 INTRODUCTORY MACROECONOMICS increase, although it is evident that at cycles. That is, we have to add 1000 + each succeeding cycle, the increase is 900 + 810 + … where each term is 0.9 10% smaller than in the previous one. times the preceding term. This amounts The need to set aside 10% of each to finding the sum of a geometric series addition to deposits in the form of of the form a + ar+ ar2 + ar3 + … where required reserves ultimately limits the in our example, a = 1000 and r = 0.9. size of the expansion. The formula for the sum of a geometric The deposit expansion process can progression is a/(1–r). Computing is summarised in Table A7.2. the value for our example we get The cycles cease when all excess 1000/(1 – 0.9) = 10000, as shown in reserves have been converted into the table. required reserves. At that point, as per As we can see, demand deposits the table, demand deposits (and have increased by a tenfold multiple of therefore money) have increased by the initial increase in reserves. Rs.10000, required reserves have The transfer of funds between increased by Rs.1000 and loans (credit banks that goes on in each cycle helps created) has increased by Rs.9000. explain why banks try to attract Note that the total increase in deposits away from other banks. The demand deposits is the sum of the bank that succeeds in drawing reserves increases in each of the individual away from other banks can increase Table A7.2 : The process of Credit Creation and Deposit Expansion (All figures are in rupees) Bank name Additional Additional Additional required deposits (Rs.) loans (Rs.) reserves (Rs.) (money increase) (credit increase) A 1000.00 900.00 100.00 B 900.00 810.00 90.00 C 810.00 729.00 81.00 D 729.00 656.10 72.90 E 656.10 590.49 65.61 F 590.49 531.44 59.05 G 531.44 478.30 53.14 – – – – – – – – and so on – – – Total 10000.00 9000.00 1000.00 MONEY AND BANKING 119 its own lending power. An important reserves, it may create deposits and point to be noted is that the terms loans only with the remaining amount, ‘multiple deposit expansion’ and which is a sub multiple of the initial ‘credit creation’ refer to the banking deposit. In other words, all the banks system as a whole and not to an taken together are able to create individual bank. For an individual demand deposits and credit several bank, after setting aside the required times larger than the initial deposit.