NCERT Class 12 Economics Part 2 Chapter 3: Money and Banking YouTube Lecture Handouts

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NCERT Class 12 Economics Part 2 Chapter 3: Money and Banking

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Money

  • Medium of exchange

  • No use in an island

  • With 1 economic agent – transaction begins

  • Barter – without money

  • Money – intermediate good acceptable to both parties (one wants cloth, other sells rice)

  • Facilitates exchange

  • Opportunity cost (rather than cash – in FD you get interest)

  • individuals can then sell their produces for money and use this money to purchase the commodities they need. Though facilitation of exchanges is considered to be the principal role of money

Functions of Money

  • Medium of exchange (barter becomes difficult in large economy)

  • Convenient unit of account (relative price can be calculated)

  • Store of value for individuals

  • Digital transactions – less cash (Jan Dhan, e-wallet, National Financial Switch) – financial inclusion

  • Thus if prices of all commodities increase in terms of money i.e., there is a general increase in the price level, the value of money in terms of any commodity must have decreased – in the sense

  • that a unit of money can now purchase less of any commodity. We call it a deterioration in the purchasing power of money

  • Drawbacks of Barter – hold commodity like rice which is perishable, has lot of space

  • To perform this function well, the value of money must be sufficiently stable. A rising price level may erode the purchasing power of money – gold, property, house, bonds

Demand for Money

  • What makes people desire certain amount of money

  • Larger the transactions, larger the quantity demanded (depends on income)

  • When interest rates go up, people become less interested in holding money

Supply of Money

  • Central Bank: India – RBI in 1935 – issue currency, controls supply, bank rate, open market operations and reserve ratio, banker to govt., and custodian of foreign exchange

  • Commercial Banks: accept deposit from public and lend it out to those who want to borrow. Mediate between individual firm with excess fund and those who need funds.

  • The currency issued by the central bank can be held by public or by the commercial banks, and is called the ‘high-powered money’ or ‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.

  • The interest rate paid by the banks to depositors is lower than the rate charged from the borrowers. This difference between these two types of interest rates, called the ‘spread’ is the profit appropriated by the bank.

  • Assuming that not everyone who has deposited funds with it will ask for their funds back at the same time, the bank can loan these funds to someone who needs the funds at interest

  • Since banks earn interest from loans they make, any bank would like to lend the maximum possible. Depositors would keep money only if they feel confident on bank

  • A bank must therefore, balance its lending activities so as to ensure that sufficient funds are available to repay any depositor on demand.

Money Creation by Banking System

  • Balance sheet is a record of assets (LHS) and liabilities (RHS) of any firm

  • Asset = Reserve + Loan

  • Liability = Deposits

  • Net Worth = Asset – Liability

  • M1= Currency + Deposits

  • When the banks lend to any person, a new deposit is opened in that person’s name. Thus money supply increases to old deposits plus new deposit (plus currency.

  • As per accounting, both sides of the balance sheet must be equal or total assets must be equal to the total liabilities

  • Assets are things a firm owns or what a firm can claim from others. For bank –building, furniture, loans

  • Reserves (cash or bond or treasury bills) are deposits which commercial banks keep with the Central bank, Reserve Bank of India (RBI) and its cash

  • Liabilities for any firm are its debts or what it owes to others. For a bank, the main liability is the deposits which people keep with it.

  • Ms. Fernandes has deposited Rs 100 in the bank. Let this bank deposit the same amount with RBI as reserves (Fictional Balance Sheet)

SLR, CRR

  • CRR (Cash Reserve Ratio) = % deposits which bank must keep as cash reserves with itself.

  • SLR (Statutory Liquidity Ratio) – bank keeps some reserve as liquid in short term

  • Money Multiplier = (for 20% CRR creates 5 times or reserve of 100 creates deposits of 500)

  • The RBI decides a certain percentage of deposits which every bank must keep as reserves. This is done to ensure that no bank is ‘over lending’. This is a legal requirement and is binding on the banks. This is called the ‘Required Reserve Ratio’ or the ‘Reserve Ratio’ or ‘Cash Reserve Ratio’ (CRR).

  • In our fictional example, suppose CRR = 20 per cent, then with deposits of Rs 100, our bank will need to keep Rs 20 (20 per cent of 100) as cash reserves. Only the remaining amount of deposits, i.e., Rs 80 (100 – 20 = 80) can be used to give loans. The statutory requirement of the reserve ratio acts as a limit to the amount of credit that banks can create

  • Deposit (100); CRR (20) = loan = 80 (thiss adds as deposit)

  • Total deposit =100+80=180 with 20% CRR =36; it can lend only 64 from 100

  • Twenty per cent of the deposits need to be deposited with the RBI as required reserves (column 3). What the bank lends in each round gets added to the deposits with the bank in the

  • next round. Loans made by the banks are explained in last.

  • For Rs. 500 at 20% CRR = loan of 400 Rs can be given (500-100=400)

Control Money Supply

  • RBI – lends banks at all times – lender of last resort; controls money supply

  • Quantitative tools – bank rate, Open market operation, CRR

  • Qualitative tools – persuasion, margin requirement

  • If the Central bank changes the reserve ratio, this would lead to changes in lending by the banks which, in turn, would impact the deposits and hence, the money supply. If CRR changes to 25%, bank can loan only 300 Rs. Money supply would fall.

  • If the RBI increases the reserve ratio to 25 per cent? Notice that in the previous case, Rs 100 in reserves could support deposits of Rs 400. But the banking system would now be able to loan Rs 300 only.

Open Market Operations

  • Buying and selling of bonds issued by Government in the open market

  • Types: Outright & repo

  • Outright OMO – permanent – RBI buys/sells without any promise to sell/buy it later

  • Repurchase or Repo – buy/sell with specification about date and price of resale (interest rate

  • Reverse repo – RBI sell security with details of repurchase (rate at which it is withdrawn is reverse repo rate)

  • Bank Rate – rate at which RBI gives loan to bank

  • This purchase and sale is entrusted to the Central bank on behalf of the Government. When RBI buys a Government bond in the open market, it pays for it by giving a cheque. This cheque increases the total amount of reserves in the economy and thus increases the money supply.

  • Selling of a bond by RBI (to private individuals or institutions) leads to reduction in quantity of reserves and hence the money supply.

  • By increasing the bank rate, loans taken by commercial banks become more expensive; this reduces the reserves held by the commercial bank and hence decreases money supply. A fall in the bank rate can increase the money supply.

Demand for Money = Liquidity Preference

  • People hold money for transaction or speculative motive

  • where T is total value and k is positive fraction

  • where

  • Get income – have expense (transaction motive)

  • Thus your cash balance at the beginning and end of the month are Rs 100 and 0, respectively. Your average cash holding can then be calculated as (Rs 100 + Rs 0) ÷ 2 = Rs 50, with which you are

  • making transactions worth Rs 100 per month. Hence your average transaction demand for money is equal to half your monthly income

  • 2 person economy – firm and worker – starting firm has 0 and worker has 100; at end reverse happens. The average money holding of the firm as well as the worker is equal to Rs 50 each. Thus

  • the total transaction demand for money in this economy is equal to Rs 100. The total volume of monthly transactions in this economy is Rs 200 – the firm has sold its output worth Rs 100 to the worker and the latter has sold her services worth Rs 100 to the firm.

  • each rupee is changing hands twice a month. On the first day, it is being transferred from the employer’s pocket to that of the worker and sometime during the month, it is passing from the

  • worker’s hand to the employer’s. The number of times a unit of money changes hands during the unit period is called the velocity of circulation of money. In the above example, it is 2, inverse of half – the ratio of money balance and the value of transactions

  • The velocity of money, v, however, has a time dimension. It refers to the number of times every unit of stock changes hand during a unit period of time, say, a month or a year

  • In nominal GDP implies an increase in the total value of transactions and hence a greater transaction demand for money

Demand for Money = Liquidity Preference

  • Speculative motive

  • Individual may hold her wealth in the form of landed property, bullion, bonds, money etc.

  • Bonds are papers bearing the promise of a future stream of monetary returns over a certain period of time (to borrow money from public and are tradable in market)

  • Competitive bidding will raise the price of the bond above its face value, till price of the bond is equal to its Present Value (PV). If price rises above the PV the bond becomes less attractive compared to the savings bank account and people would like to get rid of it. The bond will be in excess supply and there will be downward pressure on the bond-price which will bring it back to the PV

  • It is clear that under

  • competitive assets market condition the price of a bond must always be equal to its present value in equilibrium

  • If you think that the market rate of interest should eventually settle down to 8 per cent per annum, then you may consider the

  • current rate of 5 per cent too low to be sustainable over time. You expect interest rate to rise and consequently bond prices to fall. If you are a bond holder a decrease in bond price means a loss to you – similar to a loss you would suffer if the value of a property held by you suddenly depreciates in the market. Such a loss occurring from a falling bond price is called a capital loss to the bond holder – try to sell bond and hold money

  • When the interest rate is very high everyone expects it to fall in future and hence anticipates capital gains from bond-holding. Hence people convert their money into bonds. Thus, speculative demand for money is low. When interest rate comes down, more and more people expect it to rise in the future and anticipate capital loss.

  • If supply of money in the economy increases and people purchase bonds with this extra money, demand for bonds will go

  • up, bond prices will rise and rate of interest will decline.

  • Speculative demand for money is plotted on the horizontal axis and the rate of interest on the vertical axis. When r = rmax,

  • speculative demand for money is zero. The rate of interest is so high that everyone expects it to fall in future and hence is sure about a future capital gain. Thus everyone has converted the speculative money balance into bonds. When r = rmin, the economy is in the liquidity trap. Everyone is sure of a future rise in interest rate and a fall in bond prices. Everyone puts whatever wealth they acquire in the form of money and the speculative demand for money is infinite.

  • Total demand for money in an economy is, therefore, composed of transaction demand and speculative demand. The former is directly proportional to real GDP and price level, whereas the latter is inversely related to the market rate of interest

Supply of Money

  • Currency notes + coins

  • Currency notes are issued by RBI

  • Coins by GoI

  • balance in savings, or current account deposits, held by the public in commercial banks is also considered money since cheques drawn on these accounts are used to settle transactions. Such deposits are called demand deposits as they are payable by the bank on demand from the account-holder. Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits

  • Currency: value of the currency notes and coins is derived from the guarantee provided by the issuing authority of these items. Every currency note bears on its face a promise from the Governor of RBI that if someone produces the note to RBI, or any other commercial bank

  • RBI will be responsible for giving the person purchasing power equal to the value printed on the note.

  • The same is also true of coins. Currency notes and coins are therefore called fiat money. They do not have intrinsic value like a gold or silver coin. They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction

  • demand deposits are not legal tenders

Narrow & Broad Money

  • M1 = CU (currency – notes and coins with public) + DD (demand deposit by banks)

  • M2 = M1 + Savings deposits with Post Office savings banks

  • M3 = M1 + Net time deposits of commercial banks

  • M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates)

  • Money supply, like money demand, is a stock variable. The total stock of money in circulation among the public at a particular point of time is called money supply

  • M1 and M2 are known as narrow money. M3 and M4 are known as broad money. These measures are in decreasing order of liquidity. M1 is most liquid and easiest for transactions whereas M4 is least liquid of all. M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources.

Demonetization

  • Nov 2016

  • Old Rs 500 and 1000 notes no longer a legal tender

  • Exchange of Rs 4000 old currency the by new currency per person and per day was allowed

  • Tax compliance

  • Channelized savings

  • Bank – more loans at lower rates

  • Curb black money and tax evasion

  • Decrease corruption and shift to formal electronic payment system

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