Money and Banking

Functions of Money

• Facilitates a medium of exchange
• barter system is more cost incurring, presumes double coincidence of wants
• The perishable things cannot be carry forwarded as an asset for future
• So money can be a store of value or an asset
• Unit of Account : worth of any G&S can be expressed in monetary units i.e. Rupees Dollars etc
• We can even compare worth of one commodity to other when worth explained in monetary units
• Helps us judge increase and decrease of worth of any G&S like internet is now very cheap in monetary units

• Financial Inclusion (What is it?) is a realistic dream because of penetration of the mobile phone and internet in society
• Economic Exchanges without the mediation of money are called Barter Exchanges
• the search cost increase as the number of economic agents increase, diametrically opposite demand is hard to find

Purchasing Power of Money

• Value of money with respect to commodity, a unit of money can buy how many parts or units of commodity
• General rise in price levels decreases the purchasing power of the money

Demand for money

• Directly proportional to
• Quantum size of the transaction
• Income
• Inversely proportional to
• Deposit Interest Rates
• Demand for money answers what make people desire an amount of money [Think]
• The 1st 2 points are the main reason for Money Demand [Hard + On demand cash]
• Transactions : More Income More Demand
• Opportunity cost : More Rate of Interest on Deposits Less Demand

Factor	Change in Factor	Change in Demand
Income	Increase	Increase
Rate of Interest	Increase	Decrease

    1.Transaction Demand for Money

• There are 2 things in it :
• Total value of all transactions (intermediate + final)
• Actual money in circulation
• The actual money in circulation will always be a fraction (K) of total value of transactions
• An economy of 2 : worker and firm
• Worker gets paid Rs 100 at month start from the Firm (W 100, F 0)
• Worker spends money throughout month on Firm's products (W 0, F 100)
• Actually money in circulation is 100 and total transaction value is 200
• Velocity of Circulation (How many hands money crossed in a period) : Total Value of Transactions (T)/ Money Demand
• Transaction Money Demand = K.T
• We need a relation of Transaction Money Demand with GDP(nominal)
• GDP is also a fraction of TVT = (intermediate + final)
• Hence, Transaction Money Demand = K x RealGDP x GDPDeflator

    

    2.Speculative Demand for Money 

• Apart from transactions people will hold money for their selfish reasons i.e. fro gain from capital
• There is a cost for holding money not in savings account i.e. loss of Rate of Interest
• Market Rate of Interest is a key Factor in deciding when to hold money and when to invest
• Story : Now Consider a Scenario where RoI is 5%
• A company offers to pay Rs 1000 after 2 years if you purchase their bond, these bonds can be traded in market
• The Current value of money I should put in bank account to get 1000 after 2 year at 5% rate = Rs 907.03
• Then the value of the bond must not be more than 907.03
• If it is more, then benefit is in holding money in savings
• Now if we purchase it and RoI increase it will incur loss because now the bond value decreases and I have purchased it at higher value
• And if the value RoI decreases I'll be in profit as bond value increased
• Why people will purchase bond at higher cost when market RoI going down ? The bond will assure a return greater than new decreased RoI
• There are 2 extreme scenarios : RoI Max and RoI Min
• Max : People will put money in bonds and wait RoI to fall again, Speculative money Demand = 0
• Min : People will hold all the money and wait till the RoI rises, Speculative money Demand = Infinite
• In this case If extra money pumped into economy with purpose that with extra money people will buy bonds, people will hold that extra money too and economy will fall in the liquidity trap, Best Example to understand the speculative demand for keeping money and not invest
• In general Increase in Income increases demand to purchase bonds and bond prices increases and thus RoI decreases.
• Formula : Speculative money Demand = (Rmax -RoI)/ (RoI -Rmin)

Total Money Demand = Mt + Ms

Supply of Money

• Currency Supply : RBI (Est 1935)
• Money Creation : Commercial Banks
• Indian Banking System = RBI + CB

    1.Money Creation

• Deposits are the fundamental requirement for the money creation
• Money Multiplier = 1/(Cash reserve ratio)
• Credit Lending=  (MM - 1) x Deposit
• Money Supply = MM x Deposit
• Above this limit, to create new Credit, new Deposit is required or CRR must decrease.
• Cash Reserve Ratio : Percentage of deposits which a bank must keep as cash reserve
• Statutory liquidity Ratio : In addition to CRR, banks are required to keep some reserves in liquid form in short term
• Assets = Reserves + Loans
• Liabilities = Deposits
• Net Worth = Assets – Liabilities

    2.Commercial Banks

• Commercial Banks mediate between individuals or firm with excess funds and lend to those who need funds
• The depositors get interest on sum and interest paid to bank on lent money
• Difference between the Rate of Interest @Loan - @Deposits is called Spread and is Earning of Banks for services
• So Commercial Banks are part money creation system

    3.Reserve Bank of India

• Functions of RBI
• Issue Currency [Coins are issued by Govt]
• Controls the supply of money
• Banker to the Govt
• Custodian of Foreign Exchange Reserves of Economy
• Bank for the Commercial Banks [Lender of last resort for Commercial Banks]
• Currency issued by RBI can be held by Public and Commercial Banks and thus called High Powered Money or Monetary Base or Reserve Money

    4.Policy Tools to control Money Supply

• CBs can create more credit by demanding more funds from market or RBI
• RBI controls money Supply via Qualitative and Quantitative tools
• Quantitative tools : Reserve Ratios, Open Market Operations, Bank Rate
• Reserve Ratio : 
• Decrease will increase credit lending power of banks
• Increase will make CBs to call some Loans because the Reserve needed to be increase with bank
• Open Market Operations : Out Right and Repurchase Agreements [Repo]
• Out Right : operations permanent in nature
• Govt issues bonds and has authorized RBI to trade on behave of Govt with these bonds
• RBI when BUYS the bonds : Issues a cheque : Reserves Increase
• RBI when SELLS the bond : Money sucked out of market : Reserves Decreases.
• The resale or repurchase of these bonds is not certain and thus the operations are permanent in nature
• Repurchase Agreements : Most significant monetary tool of RBI
• Repo rate : Rate at which money lent to the market by buying an agreement which gets matured to be resold after a certain period
• Reverse Repo Rate : Rate at which money from the market borrowed by selling the agreement matured to be repurchased after a certain period
• Bank Rate : Rate at which RBI lends loan to CBs
• Increase in Bank Rate decreases the Reserves hold by CBs
• Decrease in Bank Rate can Increase Reserves hold by CBs

Measures of Money

• M1 = Currency + Demand Deposits
• M2 = M1 + Savings Deposits with Post offices
• M3 = M1 + net deposits [public deposits] with CBs
• M4 = M3 + Total Post Offices deposits [ except National Saving Certificates ]
• Liquidity : M1 > M2 > M3 > M4
• M1, M2 Narrow Money
• M3, M4 Broad Money
• M3 is the most commonly used measure of money supply. M3 : aggregate monetary resources