Money and Banking
Class 12 Economics · Introductory Macroeconomics · Chapter 3
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Summary
Money is anything commonly accepted as a medium of exchange. It overcomes the problems of barter, which requires a double coincidence of wants, and performs four functions: medium of exchange, unit of account, store of value, and standard of deferred payment. The demand for money arises from the transaction motive (money needed to carry out purchases, related to income) and the speculative motive (holding money versus bonds, inversely related to the interest rate). The supply of money consists of currency and bank deposits, measured as \(M_1,M_2,M_3,M_4\), where M1 and M2 are narrow money and M3 and M4 are broad money. Money is created by the banking system. The central bank — the Reserve Bank of India — issues currency (high-powered money), acts as banker to the government and to banks, holds foreign exchange reserves and is the lender of last resort. Commercial banks accept deposits and lend, creating credit. Because banks keep only a fraction of deposits as reserves, an initial deposit multiplies into a larger total through the money multiplier, \(\text{money multiplier}=\dfrac{1}{\text{CRR}}\). The RBI controls money supply using quantitative tools — the cash reserve ratio (CRR), statutory liquidity ratio (SLR), bank rate, repo and reverse repo rates, and open market operations — and qualitative tools such as margin requirements and moral suasion.
Key terms
Barter
Direct exchange of goods for goods, requiring a double coincidence of wants.
Money supply (M1–M4)
Measures of money: M1 and M2 are narrow money, M3 and M4 are broad money.
High-powered money
Currency issued by the central bank that forms the base for credit creation.
Money multiplier
The factor by which deposits expand from reserves, \(\dfrac{1}{\text{CRR}}\).
Cash Reserve Ratio
The fraction of deposits banks must keep as reserves with the central bank.
Repo rate
The rate at which the RBI lends to commercial banks against securities.
Extra questions & answers
Try one from this chapter
The main drawback of the barter system is: