Chapter 3: Money and Banking

• Role: Money becomes useful when economic agents exchange goods and services through markets; it has no role in a single-person economy or where people do not engage in market transactions.
• Barter exchange: Goods or services are exchanged directly without using money.
• Double coincidence of wants: Barter requires each person to want what the other offers at the same time.
• Search costs: Finding a suitable trading partner can become difficult and costly, especially as the number of people increases.
• Need for money: An accepted intermediate good lets people sell what they have for money and use it to buy what they need.
• Example: A rice seller can sell rice for money, then use that money to buy clothing.

Value and Purchasing Power

• Relative price: Compare prices in money to find how much of one good equals another; for example, a pen at Rs 10 equals five pencils at Rs 2 each.
• Value of money: It is the quantity of goods that one unit of money can buy; at the given prices, Re 1 buys 0.5 pencil or 0.1 pen.
• Purchasing power: A general rise in the price level means one unit of money buys less, so money’s purchasing power falls.
• Store-of-value limit: Rising prices can erode money’s purchasing power and weaken its ability to preserve wealth.
• Other assets: Gold, land, houses and bonds can also store value, but may be less easily converted into goods and lack money’s universal acceptability.

India’s Move Towards Cashless Transactions

• Aim: Use fewer cash payments and more digital transactions while widening financial inclusion.
• Initiatives: Jan Dhan accounts, Aadhaar-enabled payment systems, e-Wallets and the National Financial Switch (NFS) support this shift.
• Enabler: Wider access to mobile phones and smartphones has made financial inclusion a more realistic goal.

Money-creating institutions

• Central bank: Issues currency and influences the money supply.
• Commercial banks: Accept public deposits and create credit by lending part of those funds.

Functions and importance

• Currency issue: Issues the country's currency.
• Money-supply control: Uses tools such as the bank rate, open market operations and changes in reserve ratios.
• Other functions: Acts as banker to the government, custodian of foreign exchange reserves and bank to the banking system.
• India: The Reserve Bank of India (RBI) is the central bank.

Why it is called high-powered

• Basis for credit: Central-bank-issued currency acts as the basis for credit creation.

Banking, deposits and lending

• Spread: The difference between the interest rate charged to borrowers and the lower rate paid to depositors; this is the bank's profit.
• Why deposit: People may choose banks for interest, safer storage and the convenience of demand deposits, cheques and debit cards.
• Demand deposits: Make transactions convenient and safe, even when the deposits earn no interest.
• Lending balance: Banks retain some funds for withdrawals and lend the rest; they must be able to repay depositors on demand.

Bank Lending and Money Supply

• Lending creates deposits: When a bank gives someone a loan, it opens a new deposit in that person’s name.
• Why banks can lend: Banks do not expect all depositors to withdraw their deposits at the same time.
• Effect: New loan-created deposits add to existing deposits and currency, increasing the money supply.
• Example: A loan of Rs 100 is recorded as the bank’s claim on the borrower, while the borrower receives a new deposit.

Assets and Reserves

• Assets: Things a firm owns or claims from others. A bank’s assets include buildings, furniture, loans and reserves.
• Loans: A loan is an asset because it is a claim the bank can recover from the borrower.
• Reserves: Commercial bank deposits held with the RBI, along with the bank’s cash. They are kept partly as cash and partly in RBI-issued financial instruments such as bonds and treasury bills.
• Example: A bank loan of Rs 100 is recorded as a Rs 100 asset.

Balancing the Accounts

• Accounting rule: The two sides of a balance sheet must be equal.
• Net worth: If assets exceed liabilities, the difference is recorded as net worth on the liabilities side.

Starting balance sheet

• Assets are what the bank owns or is owed; liabilities are what it owes to depositors.
• With deposits of Rs 100 and the full amount held as reserves, the bank has Rs 100 in assets and Rs 100 in liabilities.
• Net worth is zero here because assets equal deposits.

How reserve requirements limit lending

• RBI sets the CRR to ensure banks do not lend out all their deposits; this legal requirement limits credit creation.
• At a CRR of 20%, a bank must keep Rs 20 from each Rs 100 of deposits as reserves; the remaining Rs 80 can be lent.
• As loans are redeposited, deposits increase and banks must hold additional reserves against them.

Repo Operations

• Maturities: RBI conducts repo and reverse repo operations for periods such as overnight, 7 days and 14 days.
• Policy role: These operations have become the RBI’s main monetary policy tool.

Transaction demand and nominal GDP

• GDP link: Total transactions include intermediate goods and are greater than GDP, but transaction value is positively related to nominal GDP.
• Income and prices: Higher real GDP or a higher general price level raises nominal GDP and transaction demand for money.
• Variables: $Y$ is real GDP and $P$ is the general price level, measured by the GDP deflator.

Interest rate and speculative money demand

• High interest rate: People expect it to fall, anticipate bond-price gains and shift money into bonds; speculative money demand is low.
• Low interest rate: People expect it to rise, anticipate bond-price losses and shift from bonds to money; speculative money demand is high.
• Limits: At $r_{max}$, speculative money demand is zero; as the rate falls toward $r_{min}$, it rises without limit.