Money and Banking

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Lack of Double Coincidence of Wants: The biggest drawback of the barter system is the need for a double coincidence of wants. This means that for a transaction to occur, each party must have what the other wants and be willing to exchange it. This requirement often makes trading cumbersome and inefficient.

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Difficulty in Storing Value: In the barter system, storing wealth or value is problematic. Goods like perishables cannot be stored for long, and even durable goods may lose value over time or due to changes in demand.

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Problems of Divisibility: Some goods cannot be divided without losing value, making it difficult to conduct transactions for items of different values. For example, if someone wants to trade a cow for several sacks of grain, dividing the cow to match the exact value of the grain is impractical.

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Lack of a Standard Unit of Account: In a barter system, there is no common measure (like money) to express the value of goods and services. This absence makes it hard to compare the value of different items or services, complicating trade and exchange.

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Difficulties in Deferred Payments: Barter does not facilitate deferred payments, as it is challenging to ensure the quality and quantity of goods or services to be exchanged in the future. This limitation hinders the ability to make contracts or loans.

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Medium of Exchange: Money acts as an intermediary in the exchange of goods and services. Its acceptance in trading makes transactions simpler and more efficient compared to the barter system.

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Unit of Account: Money provides a standard measurement of value, making it easier to compare the value of different goods and services. This function simplifies the process of setting prices and making economic decisions.

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Store of Value: Money can store value for future use. Unlike barter goods, which may perish, lose value, or become obsolete, money retains its value over time, allowing savings and the accumulation of wealth.

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Standard of Deferred Payment: Money facilitates transactions over time, making it possible to settle debts in the future. This function is crucial for credit and loans, which are essential for economic growth and investment.

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Eliminates the Double Coincidence of Wants: Money removes the need for a double coincidence of wants by providing a commonly accepted medium of exchange. People can sell their goods or services for money and then use that money to buy what they need.

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Provides a Convenient Store of Value: Money, especially in its modern forms like digital or paper currency, is easy to store and does not lose value due to spoilage or obsolescence, unlike many barter goods.

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Solves the Issue of Divisibility: Money can be divided into smaller units, allowing for precise pricing and trading of goods and services of varying values. This flexibility is not possible in a pure barter system.

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Establishes a Common Measure of Value: As a unit of account, money provides a common denominator to measure and compare the value of a wide range of goods and services, simplifying trade and economic calculation.

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Facilitates Deferred Payments: Money’s durability and general acceptance make it suitable for deferred payments, enabling credit transactions and financial planning over longer periods.

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Direct Proportionality to Transaction Volume: The transaction demand for money is directly proportional to the volume of transactions. Higher transaction volumes in an economy necessitate a greater demand for money to facilitate these transactions.

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Influence of Income and Expenditure: As income levels or GDP in an economy rise, the volume of transactions typically increases, leading to a higher transaction demand for money. More income generally translates to increased spending and the need for more money in circulation for transactional purposes.

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Payment Habits and Technological Factors: The extent of transaction demand also depends on the prevalent payment habits and the technology available for transactions. In economies where cash transactions dominate, the transaction demand for money is higher. In contrast, economies with advanced electronic payment systems may see a reduced need for holding physical cash.

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M₁ (Narrow Money): This is the most liquid form of money supply and includes currency with the public (notes and coins), demand deposits with the banks (deposits that can be withdrawn on demand), and other deposits with the RBI. M₁ is a key indicator of the most readily available money for transactions.

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M₂: M₂ includes M1 and savings deposits with post office savings banks. This aggregate is broader than M₁ as it includes savings deposits, which are not as liquid as demand deposits but still fairly accessible.

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M₃ (Broad Money): M₃ is a broader measure of the money supply. It includes M₁ plus time deposits with the banking system (like fixed deposits, which are less liquid than demand and savings deposits). M₃ is often used as an indicator of the overall money supply in the economy.

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M₄: M₄ includes M₃ and all deposits with post office savings banks (excluding National Savings Certificates). This is the broadest measure of money supply in the Indian context.

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Government Backing: Legal tender is typically issued by a country’s central bank or monetary authority.

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Compulsory Acceptance: Individuals and businesses are legally obliged to accept legal tender for transactions and debt settlements within the country.

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Physical Forms: In most countries, legal tender takes the form of coins and banknotes.

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Government Decree: Fiat money has value because the government maintains its validity for the payment of taxes and mandates its acceptance as legal tender.

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No Intrinsic Value: Unlike commodity-based money, fiat money does not have intrinsic value or use value (like gold or silver coins).

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Control of Money Supply: The supply of fiat money is regulated by the government and its monetary authorities, allowing more flexibility in monetary policy.

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Currency in Circulation (C): This encompasses all coins and paper money issued by the central bank that are in circulation within the economy, outside the banking system.

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Reserves of Commercial Banks (R): These are the deposits that commercial banks hold at the central bank. These reserves are part of High Powered Money because they are the base upon which commercial banks can create additional money. Reserves include both required reserves (mandated by the central bank) and excess reserves.

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Central Bank’s Cash Reserves: This refers to the cash held by the central bank itself, forming a part of the High Powered Money as it represents the most liquid form of assets the central bank can use.

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Accepting Deposits: Commercial banks accept various types of deposits from the public, including savings accounts, current accounts, and fixed or term deposits. These deposits are a major source of funds for the bank.

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Lending Money: Banks provide loans and advances in various forms such as overdrafts, term loans, cash credits, and discounting of bills. This is a crucial function as it facilitates business activities and personal finance needs.

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Credit Creation: This is a fundamental function of commercial banks. Through the process of accepting deposits and lending money, banks create additional credit in the economy. This function is vital for economic growth and development, as it significantly increases the money supply within an economy.

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Overdraft Facilities: Banks offer overdraft facilities to their customers, allowing them to withdraw more than their account balance, which is particularly useful for businesses.

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Discounting of Bills of Exchange: Banks provide immediate funds against bills of exchange, which are instrumental for the smooth functioning of the business sector.

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Investment of Funds: Banks invest surplus funds in various securities, including government bonds, shares, and debentures, to earn returns.

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Agency Functions: Banks act as agents for their customers, undertaking activities like collecting cheques, dividends, paying insurance premiums, and handling other financial transactions.

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General Utility Services: These include locker facilities, underwriting services, dealing in foreign exchange, issuing letters of credit and guarantees, and offering financial advice.

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Facilitating Transactions: Banks provide facilities like cheques, debit and credit cards, and online banking services, making transactions convenient for customers.

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Promoting Economic Growth: By providing credit and other financial services, banks play a significant role in the economic development of a country.

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Reserve Ratio (RR): A key determinant, where a lower reserve ratio means banks can lend more, increasing the money multiplier.

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Currency Drain Ratio (CDR): A higher currency drain ratio, where the public prefers holding cash, reduces the money multiplier.

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Banking Habits of the Public: More deposits and less cash holding by the public lead to a higher money multiplier.

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Policies of the Central Bank: Central bank policies that influence reserve requirements or currency circulation can affect the money multiplier.

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Economic and Financial Stability: In stable economic conditions, the money multiplier tends to be higher due to increased confidence in the banking system.

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Open Market Operations (OMO): OMO involves the buying and selling of government securities by the RBI in the open market. When the RBI buys securities, it injects liquidity into the banking system, and selling securities absorbs excess liquidity.

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Bank Rate: This is the rate at which the RBI lends money to commercial banks for the long term. A higher bank rate results in higher lending rates by banks, reducing borrowing and spending.

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Margin Requirements: This refers to the difference between the loan amount and the value of the collateral. Adjusting margin requirements can control the amount of credit banks can extend.

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Credit Rationing: The RBI can limit the amount of credit for certain purposes or sectors, controlling the flow of credit to specific areas of the economy.

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Moral Suasion: This involves persuasive tactics by the RBI to encourage or discourage certain activities by banks. It’s more of a psychological approach than a direct policy tool.

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Directives: The RBI may issue specific instructions to banks to control certain aspects of their lending or investment activities.

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Deposit Multiplication: When a bank receives deposits, it keeps a portion as reserves (as per the reserve ratio requirements) and lends out the rest. The money lent out eventually finds its way back into the banking system as deposits, which can then be lent out again, minus the required reserves. This cycle continues, and with each iteration, new deposits are created, effectively increasing the total money supply in the economy.

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Credit Creation: The process of lending more than the initial deposits received is known as credit creation. It is this ability to create credit that essentially equates to creating money. For example, if a bank receives a deposit of ₹ 1,000 and the reserve ratio is 10%, the bank can lend out ₹ 900. If this ₹ 900 is deposited into another bank, that bank can lend out ₹ 810 (assuming the same reserve ratio), and so on. This process multiplies the initial deposit, increasing the money supply.

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Impact on Money Supply: The total increase in the money supply is a multiple of the original deposit, a phenomenon governed by the money multiplier. The money multiplier effect shows how an initial deposit can lead to a much larger increase in the total money supply.

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Regulatory Constraints: While banks have the ability to create money, this process is not limitless. It is constrained by the reserve requirements set by the central bank, the demand for loans, the willingness of people to borrow, and the overall economic conditions.

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Providing Liquidity to Banks: As the lender of last resort, the RBI provides emergency funds to commercial banks and other financial institutions that are facing financial difficulty and cannot obtain funds from any other source. This role is crucial in preventing a liquidity crisis in the banking system.

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Preventing Bank Failures: By providing liquidity support, the RBI helps to prevent bank failures that could have severe repercussions on the economy. This support is essential in maintaining public confidence in the banking system.

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Stabilizing Financial Markets: The RBI’s role as the lender of last resort helps stabilize financial markets during periods of extreme volatility or crisis. By assuring banks and financial institutions that emergency funding is available, the RBI plays a key role in mitigating panic and preventing a systemic collapse.

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Terms and Conditions: The RBI provides this emergency funding typically at a higher interest rate than the market rate. This is to discourage banks from relying on the RBI for funding except in genuine emergencies and to encourage them to manage their risks more effectively.

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Regulatory Oversight: Alongside providing emergency funds, the RBI also exercises regulatory oversight to ensure that banks operate in a prudent and stable manner. This oversight is crucial to prevent situations where banks might need to seek emergency funding.