Money and Banking
"Money is a matter of functions four: a medium, a measure, a standard, a store."
1. Chapter Overview
Money is the LIFEBLOOD of an economy. This chapter covers: what money IS (its functions), how it's MEASURED (money supply: M1, M2, M3, M4), the role of the CENTRAL BANK (RBI) in controlling money supply through repo rate, CRR, SLR, and open market operations, and how COMMERCIAL BANKS CREATE MONEY through the credit multiplier process.
2. Money — Definition and Functions
Functions of Money
| Function | Meaning |
|---|---|
| Medium of Exchange | Money is ACCEPTED as payment for goods and services. Solves the 'double coincidence of wants' problem of barter. |
| Measure of Value / Unit of Account | All goods and services are PRICED in money. 'What is a haircut worth in terms of bread? Money answers this.' |
| Store of Value | Money can be SAVED and used LATER. (NOT perfect — inflation erodes value.) |
| Standard of Deferred Payment | Debts and future payments are denominated in money. |
3. Money Supply — How Much Money Is There?
The RBI publishes FOUR measures of money supply:
| Measure | What It Includes |
|---|---|
| M1 | Currency with the public + Demand deposits (current/savings accounts) + Other deposits with RBI. 'NARROW MONEY.' |
| M2 | M1 + Savings deposits with Post Office savings banks |
| M3 | M1 + Net TIME DEPOSITS with commercial banks. 'BROAD MONEY.' The MOST commonly used measure. |
| M4 | M3 + Total deposits with Post Office savings organisations |
4. The Central Bank — Reserve Bank of India (RBI)
Functions
- Issues currency (except one-rupee note — Ministry of Finance)
- Banker to the government: Manages government's accounts. Handles borrowing.
- Bankers' bank: Commercial banks hold accounts with RBI.
- Controller of money supply and credit: Uses MONETARY POLICY tools.
- Custodian of foreign exchange reserves.
Monetary Policy Tools (Quantitative)
| Tool | What It Is | How It Works |
|---|---|---|
| Repo Rate | Rate at which RBI LENDS to commercial banks | INCREASE repo rate → costlier for banks to borrow → banks lend LESS → money supply CONTRACTS. DECREASE → opposite. |
| Reverse Repo Rate | Rate at which RBI BORROWS from commercial banks | |
| CRR (Cash Reserve Ratio) | % of deposits banks MUST keep with RBI | INCREASE CRR → less money for banks to lend → money supply CONTRACTS |
| SLR (Statutory Liquidity Ratio) | % of deposits banks MUST keep in liquid assets (cash, gold, govt securities) | |
| Open Market Operations (OMO) | RBI BUYS or SELLS government securities | RBI BUYS securities → releases money into the banking system → money supply EXPANDS |
5. How Commercial Banks Create Money — The Credit Multiplier
- Banks don't just LEND depositors' money. They CREATE money through the lending process.
- Suppose: CRR = 10%. Someone deposits ₹1,000. Bank keeps ₹100 (CRR). Lends ₹900. The ₹900 is deposited in another bank → ₹81 kept, ₹810 lent. The process CONTINUES.
- Money Multiplier = 1 / CRR. With CRR = 10%: multiplier = 10. Initial deposit of ₹1,000 → total money created = ₹10,000.
- 'Banks create money by lending. The central bank controls how MUCH they create — through CRR, repo rate, and OMO.'
6. Exam Focus
- Functions of money — 4 (medium, measure, store, standard of deferred payment)
- Money supply measures — M1, M2, M3, M4. M3 = 'Broad Money.'
- RBI functions — 5. Monetary policy tools: repo rate, reverse repo, CRR, SLR, OMO.
- Money/credit multiplier — 1/CRR. How banks create money.
7. Conclusion
Money is what makes modern economies POSSIBLE:
- FUNCTIONS: Medium of exchange. Measure of value. Store. Standard.
- SUPPLY: M1 (narrow) to M4 (broad). RBI publishes.
- RBI: Controls the quantity and cost of money through repo, CRR, OMO. 'The RBI's most important job: keep inflation low while supporting growth.'
- BANKS: Create money through lending. The multiplier amplifies — and the central bank controls the amplification.
'Money is a social convention. It works because we ALL agree it works. The central bank's job is to make sure that agreement holds.'
