Money and Banking

2.1 Core concepts

• Barter and the need for money. Direct exchange of commodities without money is barter; it presumes the improbable "double coincidence of wants" and search costs rise as the number of agents increases, making an intermediate good — money — necessary (NCERT introduction, p. 36).
• Four functions of money. Medium of exchange (primary), unit of account (values of all goods expressed in monetary units), store of value (money is non-perishable, low storage cost, universally acceptable), and a standard for deferred contracts; a rising price level erodes the purchasing power of money (NCERT §3.1, pp. 36–37).
• Cashless economy and financial inclusion. A cashless society uses digital transfers instead of physical notes/coins; India's Jan Dhan, Aadhaar-enabled payments, e-wallets and NFS have advanced financial inclusion (NCERT §3.1, p. 37).
• Demand for money — transaction motive. Money is held to bridge the gap between receipt of income and expenditure; transaction demand rises with the value of transactions and, via stable links, with nominal GDP: M^d_T = k·P·Y (NCERT §3.2.1 and Box 3.1, pp. 37, 43–45).
• Velocity of circulation. v = 1/k is the number of times a unit of money changes hands in unit time; v·M^d_T = T (NCERT Box 3.1, p. 44).
• Demand for money — speculative motive. Arises from expectations about future interest-rate movements; bond price is inversely related to the rate of interest (PV calculation), so speculative demand is inversely related to interest rate. At r_min the economy is in a liquidity trap — speculative demand is infinitely elastic (NCERT Box 3.1, pp. 45–47).
• Supply of money — institutions. Money supply is created by the central bank (RBI, established 1935) and the commercial banking system; RBI issues currency, controls money supply, is banker to the government, custodian of foreign-exchange reserves and a bank to the banking system (NCERT §3.2.2, p. 38).
• High-powered money / monetary base. Currency issued by the central bank held by the public or commercial banks; it acts as the basis for credit creation (NCERT §3.2.2, p. 38).
• Commercial banks and "spread". Banks accept deposits and lend; the difference between the lending and deposit interest rates is the "spread" — the bank's profit (NCERT §3.2.2, p. 38).
• Balance-sheet view of a bank. Assets = Reserves + Loans; Liabilities = Deposits; Net Worth = Assets − Liabilities. Reserves are deposits banks keep with the RBI plus cash (NCERT §3.3, pp. 39–40).
• Money creation by banks. When a bank lends, a new deposit is created in the borrower's name, so money supply = old deposits + new deposit (+ currency); the goldsmith Lala parable illustrates this (NCERT §3.3, pp. 38–39).
• Reserve Ratio (CRR) limits credit creation. CRR is the percentage of deposits a bank must compulsorily keep as cash reserves with the RBI; banks also keep liquid short-term reserves as SLR (Statutory Liquidity Ratio) (NCERT §3.3.2, p. 40).
• Money multiplier. With CRR = 20%, Rs 100 of reserves can support Rs 500 of deposits; money multiplier = 1/Reserve Ratio = 1/0.20 = 5. Reserves of Rs 100 create deposits of Rs 500 (NCERT §3.3.2 and Table 3.2, pp. 40–42). If RBI raises the reserve ratio to 25%, money supply falls (multiplier becomes 4).
• Quantitative tools of monetary policy. Change in CRR, change in Bank Rate, and Open Market Operations control the extent of money supply (NCERT §3.4, p. 42).
• Qualitative tools. Moral suasion, margin requirement and credit rationing — persuasion-based tools to discourage or encourage particular kinds of lending (NCERT §3.4, p. 42).
• Open Market Operations (OMO). RBI's buying/selling of government bonds in the open market. Buying bonds → reserves and money supply rise; selling bonds → reserves and money supply fall. Two types: outright (permanent, no promise to reverse) and repo/reverse repo (with pre-specified date and price of reversal); repo rate is the rate on RBI's repurchase agreements, reverse repo rate is on reverse repurchase agreements. Repo/reverse repo at various maturities (overnight, 7-day, 14-day) is now the main tool of RBI monetary policy (NCERT §3.4, pp. 42–43).
• Bank Rate. The rate at which RBI lends to commercial banks; raising it makes bank borrowing costlier, reduces their reserves and decreases money supply; lowering it expands money supply (NCERT §3.4, p. 43).
• Lender of last resort. RBI's readiness to lend to banks at all times when they need funds (NCERT §3.4, p. 42).
• Fiat money and legal tender. Currency notes and coins are fiat money — their value derives from the issuing authority's guarantee (RBI for notes, GoI for coins), not from any intrinsic metal value. They are legal tenders and cannot be refused for settlement; cheques on demand deposits are NOT legal tenders (NCERT "Supply of Money: Various Measures", pp. 47–48).
• Measures of money supply. RBI publishes M1, M2, M3, M4. M1 = CU + DD; M2 = M1 + Post Office savings deposits; M3 = M1 + Net time deposits of commercial banks; M4 = M3 + Total Post Office deposits (excluding NSCs). M1 and M2 are narrow money; M3 and M4 are broad money. M1 is most liquid, M4 the least. M3 is the most commonly used measure — also called "aggregate monetary resources" (NCERT "Legal Definitions: Narrow and Broad Money", p. 48).
• Demonetisation (Nov 2016). Old Rs 500 and Rs 1000 notes were demonetised to tackle corruption, black money, terrorism and counterfeit currency; new Rs 500 and Rs 2000 notes were introduced; aimed at tax compliance and shifting transactions to formal payment systems (NCERT Box 3.2, p. 49).

2.2 Definitions to memorise

2.3 Diagrams / processes to remember

• Table 3.1 — Balance Sheet of a Bank (initial): Assets: Reserves Rs 100; Liabilities: Deposits Rs 100; Net Worth Rs 0 (p. 40).
• Table 3.2 — Money Multiplier Process: Round 1 Deposit Rs 100 → Required Reserve Rs 20 → Loan Rs 80; Round 2 Deposit Rs 180 → Required Reserve Rs 36 → Loan Rs 64; ... final round Deposit Rs 500 → Required Reserve Rs 100 → Loan Rs 400 (p. 41).
• Table 3.3 — Final Balance Sheet: Reserves Rs 100 + Loans Rs 400 = Rs 500; Deposits Rs 500 (p. 41).
• Fig. 3.1 — Speculative Demand for Money: Downward-sloping in (M^d_S, r) plane; vertical at r = r_max (M^d_S = 0) and horizontal (infinitely elastic) at r = r_min — the liquidity trap (p. 46).
• Goldsmith Lala parable — illustrates how fractional reserve banking creates "money out of thin air" (pp. 38–39).

2.5 Key formulas

2.4 Common confusions / NTA trap points

• CRR vs SLR. CRR is held as cash reserves with the RBI; SLR is held by the bank in liquid form (cash, gold, approved securities) in the short term. Both limit credit but are distinct.
• Money multiplier = 1/r, not r. Students reflexively multiply by r — the multiplier is the reciprocal of the reserve ratio.
• Narrow vs Broad money ordering. M1 < M2 < M3 < M4 in size (broadly); liquidity decreases in the same order (M1 most liquid, M4 least). M3 — NOT M1 — is the most commonly used measure.
• Coins issuer. Coins are issued by the Government of India, not RBI. Only currency notes are issued by RBI.
• Legal tender scope. Demand deposits / cheques are NOT legal tender — they can be refused.
• OMO direction. RBI buying bonds injects money (expansionary); selling bonds withdraws money (contractionary). Students often flip this.
• Bank Rate vs Repo Rate. Bank Rate is the basic rate at which RBI lends to commercial banks; Repo Rate is the rate on RBI's repurchase agreements — both rate hikes contract money supply.
• Outright OMO vs Repo. Outright is permanent; repo/reverse repo have a pre-specified date and price of reversal.