5.4 THE QUANTITY THEORY OF MONEY The quantity theory of money was formulated by Irving Fisher. In its original form, the quantity theory states, “prices always change in exact proportion to changes in the quantity of money. If the amount of money is doubled, price double. If the amount of money is halved, price falls to half their original level”. The main point about the quantity theory is that price level changes because of changes in the quantity of money. The quantity theory of money (QTM) refers to the proposition that changes in the quantity of money lead to, other factors remaining constant, approximately equal changes in the price level. Usually, the QTM is written as MV = PY, where M is the supply of money; V is the velocity of the circulation of money, that is, the average number of transactions that a unit of money performs within a specified interval of time; P is the price level; and Y is the final output. The quantity theory is derived from an accounting identity according to which the total expenditures in the economy (MV) are identical to total receipts from the sale of final goods and services (PY). This identity is transformed into a behavioural relation once V and Y are assumed as given or known variables. This is known as the equation of exchange. The equation tells when the supply of money increases, other things remaining the same, there will be a rise in the price level. That means a fall in the value of money. For example, when ‘M’ is doubled, ‘P’ will be doubled. Now-a-days, a large proportion of money consists of cheques, bills and other forms of credit instruments. So, some economists are of the opinion that the above types of money should be taken into account while considering the quantity of money. So the equation of exchange has been modified as follows:- PT=MV+M1V1 where M1 is the total amount of all forms of cheque, bills, and other instrument of credit in circulation and V1 is the velocity of circulation of M1. The main criticism against this theory is that it is based on the assumption of full employment. But if full employment is not there and if there are unemployed resources, an increase in the quantity of money will not generally increase prices. Again, during depression, all prices fall. If the quantity of money is increased at that time, price will not rise. In spite of the above criticism, we may note that the quantity theory of money is a statement of tendency and it indicates in a crude way the relationship between prices and the quantity of money. 101 CU IDOL SELF LEARNING MATERIAL (SLM)
5.5 FRIEDMAN’S QUANTITY THEORY OF MONEY In the Restatement of Quantity Theory of Money Friedman has forced that “The Quantity Theory is in the first instance a theory of the demand for money. It is not a theory of output, or of money income, or of the price level.” Money demand from the side of asset holders is formally equal with the demand of a consuming service. He considers the amount of actual cash remaining M/P as a thing which is demanded, because it delivers the services to that person who holds it. Therefore, money is an asset or capital goods. So money demand is a part of capital or asset theory. For final asset holders the actual demand of money can be possible as the function of main following variables: 1. Total Asset: Total wealth is the identical of Budget constraint. Total asset should be divided into different assets. Behaviourally, the estimations of total asset are available on some times. Except it, income works as the indicator of the asset. So according to Friedman income is an agent of wealth. 2. Division of Asset between Human and Non-Human Forms: The main source of asset is the productive capacity of humans which is human asset. But the change of human asset into non- human asset or vice versa, is under Institutional Constraints. It can be done from buying the non-human asset by present earnings or from the use of non-human asset for being the trained by financial management. So the fraction of total asset in the form of non-human asset is a very important variable. Friedman says the ratio of non-human to human asset or the ratio of asset to income as ω (Omega). 3. Expected Rates of Return on Money and Other Assets: These rates of returns are another form of the price of a commodity, it’s substitutes and it’s complementary in Consumer Demand Theory. The printed rate of return can be zero as generally, is on currency, or negative as it mostly on demand accounts on which net service taxes are payable, or positive as on those demand accounts on which interest is payable and generally on time accounts. Two parts are included in the rate of return printed on other assets: first, any presently Payment receipt or cost as interest on bonds, dividend on shares and the storing cost of physical assets; and second, the change in the prices of these assets which become important in the recession or inflation situations. 102 CU IDOL SELF LEARNING MATERIAL (SLM)
4. Other Variables: Other variables except income can affect the importance of money related to services, which determine the actual liquidity. Except liquidity the interest and preference of assets holders are also variables. Another variable is the trade in present capital goods by the final assets holders. These variables also determine the demand function of money along with the other types of securities. These variables are named as μ (Mu). 5.5.1 Demand Function of Money Friedman demonstrates the demand function of money of a personal asset holder by use of following symbols in his new experimental study ‘Monetary Trends in the United States and the United Kingdom (1982)’ somewhat different from his 1956 fundamental study: M/P = f (Y W, Rm, Rb, Re, gp, µ) Where W is the total stock of demanded money; P is the price level; Y is the actual income; W is the part of asset in the non-human form; Rm is the rate of expected money form; Rb is the rate of expected rate of return on the bonds in which the expected change in their prices are included; Re is the rate of expected rate of return on the equities in which the expected change in their prices are included; gp = (1/P)(dP/dt) is the expected rate of the changes in prices of commodity and so is the rate of expected nominal return on physical assets; µ (Mu) is for other variables except income which can affected the importance related to services of money as interests, preferences etc. The demand function of trade is approximately same. Though the division in total asset and human asset is not very beneficial, because one firm can sell and purchase in the market and give its human asset on rent on its own wish. But other components are important. The total demand function of money is the addition of personal demand functions in which M and Y respectively show the holding money per capita and income per capita and W shows the asset in non-human form. The demand function of money reaches on this result that on increment in expected yields (Returns) of different assets, the demand of money of a holder decreases, and the demand of money increases on increment in asset. Income is adjusted with which cash remaining, that is the long timed expected level of income, not the yielding current income. The empirical proof tells that the income flexibility of money-demand is more than unit, which means that the income velocity is felling down in long time. It means that the prolonged demand function of money is constant. In other words, the interest flexibility of prolonged demand function of money is negligible. 103 CU IDOL SELF LEARNING MATERIAL (SLM)
The money supply is independent from demand of money in the Friedman's Restatement of Quantity Theory of Money Friedman. The supply of money is temporary because of works of money holders. On the other side, the demand of money is constant. It means that money, which the people want to keep in the cash or bank deposits form, is related with their permanent income constantly. If central bank on purchasing the securities of money will increase the money supply, then those people who will sell their securities, will see that the holders of their money are increased in the proportion of their income. So, they will spend their excess holdings of money partially on assets and partially on consuming goods and services. Their money remaining will reduce from this expense and at the same time nominal income will be increased. On the other side, when central bank will reduce the money supply from selling the securities, the money holdings of securities buyers will be lesser in the proportion of their permanent income. So, they on partially selling the securities and spending their consumption partially on goods and services will increase their money holdings. The nominal income will be started to reduce from it. Therefore, from both the ways the demand of money is constant. According to Friedman, if there is change in money stock, then there is the change in equal proportion in price level or in income or in both the income and price level. On giving the money demand, then it is possible to forecast the effects of changes in money supply on total expenditure or income. Is economy is on lower level from full employment then increment in money-supply on increasing total expenditure will make an increment in production and employment. But it is only possible in short time period. Fig 5.4 Friedman’s Quantity Theory of Money 104 Source: www.economicshub.org CU IDOL SELF LEARNING MATERIAL (SLM)
In the figure while the X-axis shows the demand and supply of money, Y-axis measures the income level. MD is the demand curve for money which changes along with income. MS is the supply curve for money. These two curves intersect at point E and the equilibrium income level OY is determined. If there is an increase in money supply, the supply curve shifts to M1S1. At this level the supply is greater than demand and a new equilibrium is established at E1. At the new equilibrium level the income increases to OY1. 5.5.2 Criticism The Restatement of Quantity Theory of Money of Friedman has started a heavy debate and empirical investigation if done from Keynesians and monetarists. The discussion of accusations against Friedman’s theory is as follows: 1. Very Broad Definition of Money: One accusation on Friedman is that he has used such broad definition of money in which not only currency and demand deposits (M1) but the term deposits of commercial banks (M2) are also included. The clear conclusion from this definition is found that the interest flexibility of demand of money is negligible. If the interest rate on term deposit increases then their (of M2) demand increases. But the demand of currency and term deposits (M1) falls. So the total effect which will occur on demand of money will approximately negligible. But the weakness of Friedman’s analysis is that it doesn’t differentiate in long term and short term interest rates. Actually, if demand deposits (M1) are used then, short term rate should be preferred, while long term rate is best for term deposits (M2). It is mandatory that the structure of interest rate like this will affect the demand of money. 2. Money not a luxury goods: Because Friedman has included term deposits in money, so he considers money as a luxury goods. On this basis his conclusion is that the natural rate of supply of money is very higher than income in America. But no any ‘luxury effect’ like this is found about England. 3. Much Importance to Wealth Variables: In the Friedman’s function of demand of money, to consider asset variables more eligible for preference instead of income, the together operation of variables of asset and income, is not seemed logical. As Johansson has targeted, whatever return is yielded on wealth, is the income and the current value of income is asset. In demand function of money interest rate and the existence of one out of these variables will be seemed as making failure to other. 105 CU IDOL SELF LEARNING MATERIAL (SLM)
4. Money Supply not Exogenous: Friedman considered money as constant. In Friedman’s arrangement money holders changes the money from exogenous way. But in America money supply is made from those bank deposits which are produced by the changes in bank-lending donations. Bank lending donation further is based in those reserved funds which then increases or decreases when (a) financial intermediaries deposit or withdraw the currency; (b) commercial bank borrows from federal reserve arrangement; (c) money inflow from foreign and money outflow to foreign occurs; and (d) Federal Reserve Arrangement sells or buys the securities. First three items gives the ingenious element definitely to supply of demand. Therefore, Money supply is not fully exogenous, while Friedman’s consideration considers it as exogenous. Money supply mostly occurs ingenious. 5. Ignores the effect of other variables on money supply: Friedman ignores the effect of other variables on money supply as price, production or the interest rate. But there is empirical evidence that money supply can’t be described in the form of function of above given variables. 6. Does not consider time factor: Friedman tell nothing about adjustment speed and time determination or time duration in which this theory is not applicable. 7. No Positive Relation between Money Supply and Money GNP: It is found in Friedman’s conclusions that Money Supply and Money GNP are positively correlated. But Kaldor’s approach is that in Britten, the best correlation is between the quarter changes in cash amount held in coins and notes by public and according to personal consumption on market prices, not between money supply and Money GNP. 5.6 MONEY Money is an economic unit that functions as a generally recognized medium of exchange for transactional purposes in an economy. Money provides the service of reducing transaction cost, namely the double coincidence of wants. Money originates in the form of a commodity, having a physical property to be adopted by market participants as a medium of exchange. Definition Crowther, has defined money as “anything that is generally acceptable as a means of exchange (i.e., as a means of settling debts) and that at the same time acts as a measure and as a store of value”. 106 CU IDOL SELF LEARNING MATERIAL (SLM)
Walker has said: “Money is that which money does”. 5.6.1 Functions of Money The most important functions of money are given in the form of a coupled quoted below:- “Money is a matter of function four A medium, a measure, a standard, a store”. 1.Medium of exchange: the most important function of money is that it acts as medium of exchange. Money is accepted freely in exchange for all other goods. Barter system is very inconvenient. So, the introduction of money has got over the difficulty of barter. 2.Measure of value: Due to its use as a medium of exchange for both buying and selling and its use to assign prices to all kinds of other goods and services, money can be used to keep track of the money gained or lost across multiple transactions, and to compare money values of various combinations of different quantities of different goods and services mathematically. This makes things such as accounting for profit and loss of a business, balancing a budget, or valuing the total assets of a company all possible. 3. Store of value: Because money's usefulness as a medium of exchange in transactions is inherently future-oriented, it provides a means to store value obtained through current production or trade for use in the future in the form of other goods and services. In particular trading their non-fungible, non-durable, non-portable, non-recognizable, or non-stable goods or services for money here and now, people can store the value of those goods to trade for goods at other times and places. This facilitates saving for the future and engaging in transactions over long distances possible. 4.Standard of Deferred payments: To the extent that money is accepted as a general medium of exchange and serves as a useful store of value, it can be used to transfer value for exchange use at different times between people through the tools of credit and debt. One person can loan a quantity of money to another for a period of time to use, and repay another agreed-upon quantity of money at a future date. The stored value represented by the loaned money is transferred from the lender to the borrower in exchange for an agreed quantity of stored value in the future. The borrower can then use and enjoy the value of other goods and services that they can now purchase in exchange for payment at a later date. The lender in effect is able to loan the current use of real goods and services (which he does not himself originally possess) to the borrower. The sellers of the goods are able to receive payment for 107 CU IDOL SELF LEARNING MATERIAL (SLM)
their goods now, instead of loaning the goods directly to the borrower in hope of future return or repayment. 5.6.2 Role of Money In the economy today money performs several functions. Money serves as a standard of value in which other values are measured. Money is a store of value, that is, the means in which wealth can be held. It acts as a standard for deferred payments. The following are the role of money in the economic development: 1. Money Promotes Productivity and Economic Growth: Barter system was full of difficulties of exchanging goods and services between individuals. In the absence of easy exchange of goods and services the barter system worked as an obstacle to the division of labour and specialisation among individuals which is an important factor for increasing productivity and economic growth. Further, the process of economic growth leads to the expansion of production of goods and services and consequential rise in incomes of the people. As a result, volume of transactions in the developing economy increases. This raises the demand for money to finance the increased transactions brought about by the expanded level of economic activity. Thus, the process of economic growth would be held in check if adequate supply of money is not forthcoming to meet the requirements of increase in the level of economic activity. 2. Money Promotes Investment: From the viewpoint of development another important role of money lies in making the magnitude of investment independent of the current level of savings. In a barter system, the goods not consumed constitute the savings as well as investment. That is, investment is not different from current savings. The greater the current savings, the greater the investment. However, in a modern economy, this is not so. Whereas it is households which save in the form of money, it is the firms which invest money in capital goods. Therefore, investment can differ from saving because investment activity is separated from the act of saving. More importantly, investment in a monetary economy can exceed the current level of savings. This excess of investment over savings is possible because new money can be created by the Government in the form of currency or by banks in the form of bank deposits. And this is what is important for the purpose of economic development. 3. Money and Investment in Quick-Yielding Projects: It is widely believed that any increase in the supply of money in developing countries would lead to the rise in prices or to the emergence of inflationary pressures. However, this is not always true. A reasonable 108 CU IDOL SELF LEARNING MATERIAL (SLM)
amount of newly created money helps the development of the economy by raising the level of investment. In the developing economies a lot of natural and human resources lie un-utilised and underutilized which can be employed for productive purposes. 4. Monetization and Economic Growth: Further, as is well known, most underdeveloped countries have a large non-monetised (i.e., barter) sector where production is for the purpose of subsistence only. To break the subsistence nature of economic activity and thus generate new forces for economic growth, its monetisation is required. The introduction of money helps in bringing it in contact with the modern sector. 5.6.3 Components of Money The two main components of Money Supply are (1) Currency and (2) Bank Deposits. The detailed explanation is as following: 1) Currency The purport from currency is the coins and notes in circulation. (i) Coins: Now a days the coins are released in every country by the government, though in old era private institutions were also using to release the coins. Government used to restrict the private institution coins in the matters of weight of coins and purity of metal used in coins so that people could save from the fraud. There were two types of coins under the value of gold and silver—Full-bodied Standard Coins and Token Coins. But prevalent now a days under the Managed Currency System, there is no importance of Full-bodied Standard Coins. So those are not in circumstances now. Indian Rupee is neither a full-bodied Standard Coins nor a Token Coin. The 50-paisa, 25 paisa, 10 paisa, 5 paisa, 2 paisa and 1 paisa coin are the Token Coins. The Token coins are not important components of money. Though a large quantity of small coins are in circulation because of poverty in India then also this is only 3.5 % part of total money supply. In the developed countries like America, Token coins are lesser than 2 % of total money supply. (ii) Currency Notes: An important part of money supply are the currency notes. Now a days currency notes are released by either Reserve Bank of country or Government itself. The One Rupee note by Indian Government and the all-other notes are released by Reserve Bank of India. There can be many ways to release (issue) the note; as, representation, proportional, minimum fund, variable, constant, etc. In the era of metal value, paper money was the representative. In other words, the metallic base was kept beside these notes. If Central Bank was releasing the notes of one crore, then it had to keep the gold or silver valued one crore in the treasure. The two main objectives to release the currency representation letter was such – 109 CU IDOL SELF LEARNING MATERIAL (SLM)
(i) Saving of the cost of minting coins, (ii) protection from the loss from rubbing the metal. But this system of note release was inflexible because the supply of currency letter was dependent on metal stock. It could not be more than metal stock. For removing the weaknesses of currency representation letter Proportional Method was adopted. Reserve Bank was releasing the Notes on the base of Proportional Reserve System, till 1956 A.D. According to this system the 40 % of the value of Entire Notes was kept in gold, silver, foreign assets and foreign currencies. After 1956 A.D., Minimum Reserve System was adopted. According to this method, it is compulsory that Reserve Bank has to keep the minimum fund of 200 crores in reserves, in which the gold should be of 115 crores. There on the base of minimum fund of 200 crores Reserve Bank can release the notes until any limit. This system is very flexible but the fear of expansion of many notes occurs. Currency notes can be variable or constant. Under the variable currery exchange monetary authorities have to change the currency note with metal. Under the constant currency paper, Reserve bank (Monetary Authorities) gives the guarantee to change the paper notes into token coins or other notes, but not to change in gold or silver. Currently, the unchangeable method to release the notes is circulated in all the countries of the world. Notes are actually promissory notes. Monetary authority promises to give coins or other notes in exchange of it. In resulting of this method, the importance of Monetary paper policy and Monetary management has very increased. Now note release does not depend upon the stock of gold or silver. The monetary authority on keeping in the mind the needs of economy do the supply or determination. 2) Demand Deposits The people in all the countries deposit their money in banks. Bank Deposits are of two types— (i) Fixed Deposits and (ii) Demand or Current Deposits. Fixed Deposits are of a definite time period. The cheque cannot withdraw these Deposits. But the amount of Demand Deposits can ever be withdrawn by the depositor. So the cash in demand deposit form is as liquid as money. In western countries, 90 % payments are done by the banks. The importance of demand or current deposits is continuously increasing in India. It is very safe and convenient to make the payment by the cheque from current or demand deposit account. The payment by cheque is so convenient because however amount of cash can be withdrawn by the cheques. The use of high value notes can be unsafe. Banks have the evidence of payments by cheques because these are noted in the bank accounts. If there would be a problem related to payment then it can be solved by the investigations. Keynes has included the demand deposits in supply of money in his book “A Treatise on Money” (1930 AD). At that time, the economists as Parker 110 CU IDOL SELF LEARNING MATERIAL (SLM)
Wills had objected on it. But currently the demand deposits are started to be include in supply of money in every country approximately because goods and services can also be purchased by demand deposits. But this thing is remarkable that it is not compulsory by the law to accept the payment by cheque. Any of the person can deny accepting the cheque. But to pay in cash form is a legal obligation Banks give the loan on the basis of money deposited to them. For own experiences, Banks have the knowledge of this thing that all the depositors never withdraw their entire deposits at the same time. So, if they keep in them a definite proportion of total deposits and give the remaining amount as credit then they can fulfil the needs of depositors. This is the reason that banks are in the situation that however totals deposit they are having many times greater than that they can credit to people. This activity of banks is called as ‘Credit Creation’. The credit created by banks is also included in supply of money because it is a part of demand deposits. 5.6.4 Money Supply Measures in India Reserve Bank of India had propounded four new measures of money supply; these are M1, M2, M3 and M4. The detailed description is as following: M1 money supply includes coins and currency in circulation— the coins and bills that circulate in an economy that the U.S. Treasury does not hold at the Federal Reserve Bank, or in bank vaults. Closely related to currency are checkable deposits, also known as demand deposits. These are the amounts held in checking accounts. They are called demand deposits or checkable deposits because the banking institution must give the deposit holder his money “on demand” when the customer writes a check or uses a debit card. These items together— currency, and checking accounts in banks—comprise the definition of money known as M1, which the Federal Reserve System measures daily. In simple, M1 = Currency of public + Demand Deposit of Banks + Other Deposits of RBI. M2 includes everything in M1 but also adds other types of deposits. For example, M2 includes savings deposits in banks, which are bank accounts on which you cannot write a check directly, but from which you can easily withdraw the money at an automatic teller machine or bank. Many banks and other financial institutions also offer a chance to invest in money market funds, where they pool together the deposits of many individual investors and invest them in a safe way, such as short-term government bonds. Another ingredient of M2 are the relatively small (that is, less than about $100,000) certificates of deposit (CDs) or time deposits, which are accounts that the depositor has committed to leaving in the bank for a 111 CU IDOL SELF LEARNING MATERIAL (SLM)
certain period of time, ranging from a few months to a few years, in exchange for a higher interest rate. In short, all these types of M2 are money that you can withdraw and spend, but which require a greater effort to do so than the items in M1. In short, M2 = Currency of public + Demand Deposit of Banks + Other Deposits of RBI + Deposits in Saving Plans of Post Office M3 includes a) M1, and (b) Net time deposits of all commercial banks and co-operative banks. Net time deposits of the banking institutions are not as liquid as their demand deposits are. Time deposits have a fixed maturity term. These cannot be withdrawn before maturity without loss of value. These are not payable on as the demand and do not enjoy cheque facilities. M3 measure of money supply is relevant for policy formulation to the extent that through the working of money multiplier it affects the supply of money. M3 = Currency of public + Demand Deposit of Banks + Other Deposits of RBI + Term Deposits of Banks M4 includes (a) M3, and (b) Total deposits with post office saving organisation (excluding National Saving Certificates). M4 measure of money supply which is the least liquid is not used for policy formulation because the total deposits with post office saving organisation do not come under the purview of the Reserve Bank. M4 = Currency of public + Demand Deposit of Banks + Other Deposits of RBI + Term Deposits of Banks + Total Deposit of Post Office (Except NSC) In 1998 A.D., the Executive Committee of RBI advised two new measures as NM2 and NM3. Beside this committee also advised for three liquidity measures as L1, L2 and L3. These three are called as Monetary and Liquidity Aggregates. The detailed explanations of these measures are as following: 1. NM2 = Currency of public + Demand Deposit + Other Deposits of RBI + Short Term Deposits 2. NM3 = NM2 + Long term Deposits + Short Term Fund of Financial Institutions 3. L1 = NM2 + Deposits of Post Offices 4. L2 = Term Monetary Receipts + Certificate of Deposits + Term Deposits 5. L3 = L2 + Social Deposits of Non-Banking Financial Institutions. 5.6.5 Determinants of Money Supply in India There are two theories of the determination of the money supply. According to the first view, the money supply is determined exogenously by the central bank. The second view holds that 112 CU IDOL SELF LEARNING MATERIAL (SLM)
the money supply is determined endogenously by changes in the economic activities which affect people’s desire to hold currency relative to deposits, the rate of interest, etc. Thus, the determinants of money supply are both exogenous and endogenous which can be de- scribed broadly as: the minimum cash reserve ratio, the level of bank reserves, and the desire of the people to hold currency relative to deposits. The last two determinants together are called the monetary base or the high-powered money. 1. The Required Reserve Ratio: The required reserve ratio (or the minimum cash reserve ratio or the reserve deposit ratio) is an important determinant of the money supply. An increase in the required reserve ratio reduces the supply of money with commercial banks and a decrease in required reserve ratio increases the money supply. The RRr is the ratio of cash to current and time deposit liabilities which is determined by law. Every commercial bank is required to keep a certain percentage of these liabilities in the form of deposits with the central bank of the country. But notes or cash held by commercial banks in their tills are not included in the minimum required reserve ratio. But the short-term assets along with the cash are regarded as the liquid assets of a commercial bank. In India the statutory liquidity ratio (SLR) has been fixed by law as an additional measure to determine the money supply. The SLR is called secondary reserve ratio in other countries while the required reserve ratio is referred to as the primary ratio. The raising of the SLR has the effect of reducing the money supply with commercial banks for lending purposes, and the lowering of the SLR tends to increase the money supply with banks for advances. 2. The Level of Bank Reserves: The level of bank reserves is another determinant of the money supply. Commercial bank reserves consist of reserves on deposits with the central bank and currency in their tills or vaults. It is the central bank of the country that influences the reserves of commercial banks in order to determine the supply of money. The central bank requires all commercial banks to hold reserves equal to a fixed percentage of both time and demand deposits. These are legal minimum or required reserves. Required reserves (RR) are determined by the required reserve ratio (RRr) and the level of deposits (D) of a commercial bank RR=RR r× D. If deposits are Rs 80 lakhs and required reserve ratio is 20 percent, then the required reserves 113 CU IDOL SELF LEARNING MATERIAL (SLM)
will be 20% x 80=Rs 16 lakhs. If the reserve ratio is reduced to 10 per cent, the required reserves will also be reduced to Rs 8 lakhs. Thus, the higher the reserve ratio, the higher the required reserves to be kept by a bank, and vice versa. But it is the excess reserves (ER) which are important for the determination of the money supply. Excess reserves are the difference between total reserves (TR) and required reserves (RR) ER=TR-RR. If total reserves are Rs 80 lakhs and required reserves are Rs 16 lakhs, then the excess reserves are Rs 64 lakhs (Rs 80 Lakhs – 16 lakhs). When required reserves are reduced to Rs 8 lakhs, the excess reserves increase to Rs 72 lakhs. It is the excess reserves of a commercial bank which influence the size of its deposit liabilities. A commercial bank advances loans equal to its excess reserves which are an important component of the money supply. To determine the supply of money with a commercial bank, the central bank influences its reserves by adopting open market operations and discount rate policy. Open market operations refer to the purchase and sale of government securities and other types of assets like bills, securities, bonds, etc., both government and private in the open market. When the central bank buys or sells securities in the open market, the level of bank reserves expands or contracts. The purchase of securities by the central bank is paid for with cheques to the holders of securities who, in turn, deposit them in commercial banks, thereby increasing the level of bank reserves. The opposite is the case when the central bank sells securities to the public and banks which make payments to the central bank through cash and cheques, thereby reducing the level of bank reserves. The discount rate policy affects the money supply by influencing the cost and supply of bank credit to commercial banks. The discount rate, known as the bank rate in India, is the interest rate at which commercial banks borrow from the central bank. A high discount rate means that commercial banks get less amount by selling securities to the central bank. The commercial banks, in turn, raise their lending rates to the public, thereby making advances dearer for them. Thus there will be contraction of credit and the level of commercial bank reserves. Opposite is the case when the bank rate is lowered. It tends to expand credit and the consequent bank reserves. 114 CU IDOL SELF LEARNING MATERIAL (SLM)
It should be noted that commercial bank reserves are affected significantly only when open market operations and discount rate policy supplement each other. Otherwise, their effectiveness as determinants of bank reserves and consequently of money supply is limited. 3. Public’s Desire to Hold Currency and Deposits: People’s desire to hold currency (or cash) relative to deposit in commercial banks also determines the money supply. If people are in the habit of keeping less in cash and more in deposits with the commercial banks, the money supply will be large. This is because banks can create more money with larger deposits. On the contrary, if people do not have banking habits and prefers to keep their money holdings in cash, credit creation by banks will be less and the money supply will be at a low level. 4. High Powered Money and the Money Multiplier: The current practice is to explain the determinants of the money supply in terms of the monetary base or high-powered money. High-powered money is the sum of commercial bank reserves and currency (notes and coins) held by the public. High-powered money is the base for the expansion of bank deposits and creation of the money supply. The supply of money varies directly with changes in the monetary base, and inversely with the currency and reserve ratios. 5. Other Factors: The money supply is a function not only of the high-powered money determined by the monetary authorities, but of interest rates, income and other factors. The latter factors change the proportion of money balances that the public holds as cash. Changes in business activity can change the behaviour of banks and the public and thus affect the money supply. Hence the money supply is not only an exogenous controllable item but also an endogenously determined item. 5.7 MONEY MARKET Money market consists of negotiable instruments such as treasury bills, commercial papers. and certificates of deposit. It is used by many participants, including companies, to raise funds by selling commercial papers in the market. Money market is considered a safe place to invest due to the high liquidity of securities. It has certain risks which investors should be aware of, one of them being default on securities such as commercial papers. Money market consists of 115 CU IDOL SELF LEARNING MATERIAL (SLM)
various financial institutions and dealers, who seek to borrow or loan securities. It is the best source to invest in liquid assets. The money market is an unregulated and informal market and not structured like the capital markets, where things are organised in a formal way. Money market gives lesser return to investors who invest in it but provides a variety of products. 5.7.1 Meaning & Definition Money market basically refers to a section of the financial market where financial instruments with high liquidity and short-term maturities are traded. Money market has become a component of the financial market for buying and selling of securities of short-term maturities, of one year or less, such as treasury bills and commercial papers. According to the RBI, \"The money market is the centre for dealing mainly of short character, in monetary assets; it meets the short-term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also by the government.\" According to Crowther, \"The money market is a name given to the various firms and institutions that deal in the various grades of near money.\" 5.7.2 Importance of Money Market The money market is a market for short term transactions. Hence it is responsible for the liquidity in the market. Following are the reasons why the money market is essential: • The money market maintains a balance between the supply of and demand for the monetary transactions done in the market within a period of 6 months to one year. • It enables funds for businesses to grow and hence is responsible for the growth and development of the economy. • The money market aids in the implementation of monetary policies. • The money market helps develop trade and industry in the country. Through various money market instruments, it finances working capital requirements. It helps develop the trade in and out of the country. • The short-term interest rates influence long term interest rates. The money market mobilises the resources to the capital markets by way of interest rate control. • The money market helps in the functioning of the banks. It sets the cash reserve ratio and statutory liquid ratio for the banks. It also engages their surplus funds towards short term assets to maintain money supply in the market. 116 CU IDOL SELF LEARNING MATERIAL (SLM)
• The current money market conditions are the result of previous monetary policies. Hence it acts as a guide for devising new policies regarding short term money supply. • Money market instruments like T-bills help the government raise short term funds. Otherwise, to fund projects, the government will have to print more currency or take loans leading to inflation in the economy. Hence the money market is also responsible for controlling inflation. 5.7.3 Functions of Money Market The major functions of money market are given below: • To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money for short term monetary transactions. • To promote economic growth. Money market can do this by making funds available to various units in the economy such as agriculture, small scale industries, etc. • To provide help to Trade and Industry. Money market provides adequate finance to trade and industry. Similarly, it also provides facility of discounting bills of exchange for trade and industry. • To help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the monetary policy. • To help in Capital Formation. Money market makes available investment avenues for short term period. It helps in generating savings and investments in the economy. • Money market provides non-inflationary sources of finance to government. It is possible by issuing treasury bills in order to raise short loans. However, this does not lead to increases in the prices. 117 CU IDOL SELF LEARNING MATERIAL (SLM)
5.7.4 Instruments of Money Market treasury bills call and promissory notice notes money Money market instruments certificate commercial of deposits papers Fig 5.5 Money Market Instruments 1.Treasury Bills: Treasury Bills are the preeminent instrument of the Money Market which are issued for less than 1 year, i.e., for 91,182,360 days. The Central Government issues them for providing short-term capital to the market. It can be issued as ordinary or ad hoc treasury bills and by any individual who is a resident of India can purchase such bills. 2. Promissory notes: The promissory note is the earliest types of bill. It is a written promise on the part of a businessman today to another a certain sum of money at an agreed future data. Usually, a promissory note falls due for payment after 90 days with three days of grace. A promissory note is drawn by the debtor and has to be accepted by the bank in which the debtor has his account, to be valid. The creditor can get it discounted from his bank till the date of recovery. Promissory notes are rarely used in business these days, except in the USA. 3. Commercial papers: Commercial bills, also a money market instrument, works more like the bill of exchange. Businesses issue them to meet their short-term money requirements. These instruments provide much better liquidity. As the same can be transferred from one person to another in case of immediate cash requirements. 4. Certificate of deposit: Certificates of deposits are issued by commercial banks at a discount on face value. The discount rate is determined by the market. In India the minimum 118 CU IDOL SELF LEARNING MATERIAL (SLM)
size of the issue is Rs.25 lakhs with the minimum subscription of Rs.5 lakhs. The maturity period is between 3 months and 12 months. 5. Call and notice money: There is the call money market in which funds are borrowed and lent for one day. In the notice market, they are borrowed and lent up to 14 days without any collateral security. But deposit receipt is issued to the lender by the borrower who repays the borrowed amount with interest on call. In India, commercial banks and cooperative banks borrow and lend funds in this market but mutual funds and all-India financial institutions participate only as lenders of funds. 5.8 CAPITAL MARKET Capital market consists of primary markets and secondary markets. Primary markets deal with trade of new issues of stocks and other securities, whereas secondary market deals with the exchange of existing or previously-issued securities. Another important division in the capital market is made on the basis of the nature of security traded, i.e. stock market and bond market. 5.8.1 Meaning & Definition Capital market is a market where buyers and sellers engage in trade of financial securities like bonds, stocks, etc. The buying/selling is undertaken by participants such as individuals and institutions. Capital Market, is used to mean the market for long term investments, that have explicit or implicit claims to capital. Long term investments refer to those investments whose lock-in period is greater than one year. 5.8.2 Importance of Capital Market 1. It is only with the help of capital market, long-term funds are raised by the business community. 2. It provides opportunity for the public to invest their savings in attractive securities which provide a higher return. 3. A well-developed capital market is capable of attracting funds even from foreign country. Thus, foreign capital flows into the country through foreign investments. 4. Capital market provides an opportunity for the investing public to know the trend of different securities and the conditions prevailing in the economy. 5. It enables the country to achieve economic growth as capital formation is promoted through the capital market. 119 CU IDOL SELF LEARNING MATERIAL (SLM)
6. Existing companies, because of their performance will be able to expand their industries and also go in for diversification of business due to the capital market. 7. Capital market is the barometer of the economy by which you are able to study the economic conditions of the country and it enables the government to take suitable action. 8. Through the Press and different media, the public are informed about the prices of different securities. This enables the public to take necessary investment decisions. 9. Capital market provides opportunities for different institutions such as commercial banks, mutual funds, investment trust; etc., to earn a good return on the investing funds. They employ financial experts who are able to predict the changes in the market and accordingly undertake suitable portfolio investments. 5.8.3 Functions of Capital Market • Mobilization of savings to finance long term investments. • Facilitates trading of securities. • Minimization of transaction and information cost. • Encourage wide range of ownership of productive assets. • Quick valuation of financial instruments like shares and debentures. • Facilitates transaction settlement, as per the definite time schedules. • Offering insurance against market or price risk, through derivative trading. • Improvement in the effectiveness of capital allocation, with the help of competitive price mechanism. • Capital market is a measure of inherent strength of the economy. It is one of the best sources of finance, for the companies, and offers a spectrum of investment avenues to the investors, which in turn encourages capital creation in the economy. 120 CU IDOL SELF LEARNING MATERIAL (SLM)
5.8.4 Types of Capital Market Primary market Secondary market Capital market Figure 5.6 Types of capital markets 1. Primary market: Otherwise called as New Issues Market, it is the market for the trading of new securities, for the first time. It embraces both initial public offering and further public offering. In the primary market, the mobilisation of funds takes place through prospectus, right issue and private placement of securities. 2. Secondary market: Secondary Market can be described as the market for old securities, in the sense that securities which are previously issued in the primary market are traded here. The trading takes place between investors, that follows the original issue in the primary market. It covers both stock exchange and over-the-counter market. 5.9 DIFFERENCE BETWEEN MONEY MARKET & CAPITAL MARKET BASIS FOR MONEY MARKET CAPITAL MARKET COMPARISON Meaning A segment of the financial market A section of financial market where lending and borrowing of where long-term securities is short-term securities are done. issued and traded. Nature of Market Informal Formal 121 CU IDOL SELF LEARNING MATERIAL (SLM)
BASIS FOR MONEY MARKET CAPITAL MARKET COMPARISON Treasury Financial Bills, Commercial Papers, Shares, Debentures, Bonds, instruments Certificate of Deposit, Trade Retained Earnings, Asset Credit etc. Securitization, Euro Issues etc. Institutions Central bank, Commercial bank, Commercial banks, Stock non-financial institutions, bill exchange, non-banking brokers, acceptance houses, and so institutions like insurance on. companies etc. Risk Factor Low Comparatively High Liquidity High Low Purpose To fulfil short term credit needs of To fulfil long term credit needs of the business. the business. Time Horizon Within a year More than a year Merit Increases liquidity of funds in the Mobilization of Savings in the economy. economy. Return on Less Comparatively High Investment Table 5.1: Difference between money market and capital market 122 CU IDOL SELF LEARNING MATERIAL (SLM)
5.10 SUMMARY • According to Keynes, the rate of interest is the reward for parting with liquidity for a period. • Liquidity refers to the cash holdings of the people. • The quantity theory of money states that price always change in exact proportion to changes in quantity of money. • The quantity theory of money has been put in a form of equation known as “equation of exchange”. • The direct exchange of goods for goods is called barter system. • Money acts the medium of exchange & help to overcome the difficulties of barter system. • Price is nothing but value expressed in terms of money. • Money acts a store value. • Money plays a vital role in the economic development of the country. • Money market is a market where short-term financial securities are traded. • Capital market is a market where the government and company long securities are traded. 5.11 KEYWORDS • Transaction motive- to meet day to day activities, people prefer to keep cash. • Precautionary motive- to meet unforeseen expenditure. • Speculative motive- to take advantage of market movements of prices of bonds, shares, etc. • Fisher’s equation- MV=PT • M- Amount of money • V- Velocity of circulation of money • P- price level • T- Volume of trade. 5.12 LEARNING ACTIVITY 1. Discuss how money plays a vital role in the day-to-day activities of an individual 123 CU IDOL SELF LEARNING MATERIAL (SLM)
___________________________________________________________________________ ___________________________________________________________________________ 5.13 UNIT END QUESTIONS A. Descriptive Type Questions Short Questions 1. What are the three motives of liquidity preference theory? 2. Write the equation of exchange. 3. Define money. 4. Define money market and write any two importance. 5. What is capital market and write its functions. Long Questions 1. Discuss liquidity preference theory of interest. 2. Discuss the quantity theory of money. 3. Define money and the role of money in economic growth, 4. Write the functions of money. 5. Define money market and what are the instruments of money market. 6. What are the functions of money market? 7. What is capital market and write it types. 8. What is the importance of capital market? 9. Distinguish between money market and capital market. B. Multiple Choice Questions 1. The author of liquidity preference theory is_____ a. Alfred Marshall b. J.M. Keynes c. J.B.Say d. Irving Fisher 2. The direct exchange of goods for goods is called____ a. barter system b. money 124 CU IDOL SELF LEARNING MATERIAL (SLM)
c. money market d. capital market 3. The equation MV= PT was given by____ a. J.M. Keynes b. J.B. Say c. Irving Fisher d. Adam smith 4. _____ market deals with trading of short-term securities. a. perfect market b. imperfect market c. capital market d. money market 5. ____ deals with fresh issue of securities. a. Perfect market b. imperfect market c. money market d. Primary capital market Answer 1 – b, 2 – a, 3 – c, 4 – d, 5 – d. 5.14 REFERENCES Reference books • Baird, C.W. (1977). Elements of Macro Economics, London: West Publishing Company. • Dernburg, T.F.& McDougal, D.M. (1983). Macro Economics. New York: McGraw Hill. • Gardner Ackley, G. (1985). Macro-Economic Theory. New York: McMillan. • Ghuman, R.S. (1998). Antar-RashtriyaArthVigyan, Patiala: Punjabi University. • Harvey, J.&Johnson, M. (1971). Introduction to Macro Economics, London: McMillan Textbooks • Jain, T.R. (1997). Macro Economics, New Delhi: V.K. Publications. 125 CU IDOL SELF LEARNING MATERIAL (SLM)
• Jhingan, M.L. (2003). Macro-Economic Theory, New Delhi: Varinda Publishers. • Sharma, O.P. (2003). Macro Economics, Patiala: Punjabi University. • Vaish, M.C. (2008). Macro-Economic Theory. New Delhi: Oxford University Press. Websites • www.economicdiscussions.net • www.economicshub.in 126 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT – 6 BANKING 127 Structure 6.0 Learning Objectives 6.1 Introduction 6.2Meaning and definitions 6.3 Structure of commercial banks 6.4 Functions of Commercial banks 6.5 Role of commercial banks 6.6 Central Bank 6.7 Meaning and definition 6.8 Functions of central bank 6.9 Role of central bank 6.10 Difference between central bank and commercial bank 6.11 Summary 6.12 Keyword 6.13 Learning activity 6.14 Unit end questions 6.15 References 6.0 LEARNING ACTIVITY After studying this unit, students will be able to: • Define the meaning and definitions. • Have the clear idea about the structure of commercial banks. • Examine and analyse the functions of commercial banks. • Evaluate the role of commercial banks in the economic development. CU IDOL SELF LEARNING MATERIAL (SLM)
6.1 INTRODUCTION Banking is an industry that handles cash, credit, and other financial transactions. Banks provide a Safe place to Store extra cash and credit. They offer savings accounts, Certificates of Deposit, and checking accounts. Banks use these deposits to make loans. These loans include home mortgages, business loans, and car loans. A Bank is a financial institution licensed to receive deposits and make loans. Two of the most common types of banks are commercial/retail and investment banks. Depending on type, a bank may also provide various financial services ranging from providing safe deposit boxes and currency exchange to retirement and wealth management. 6.2 MEANING AND DEFINITION Commercial banks are joint stock companies dealing in money and credit. A commercial bank is nothing but a financial institution that accepts cheque able deposits of money from the public and also uses the money with it for lending. The most distinctive function of a commercial bank is that it accepts deposits called demand deposits from the public which are cheque able, i.e., withdrawable by means of cheques. Acceptance of deposits alone, however, does not give it the status of a bank. It’s another essential function is to make use of these deposits for lending to others. Commercial banks usually give short-term loans and advances. They occupy a dominant place in the money market. They form the biggest component in the banking structure of any country. The commercial banks are governed by the Indian Banking Regulation Act, 1949 with up-to-date amendments. Under the law, commercial banks are not supposed to do any other business except banking. In modern times, they undertake a number of subsidiary functions in order to satisfy the requirements of millions of their customers. DEFINITION According to R.S. Sayers, a bank is defined as “an institution whose debts (bank deposits) are widely accepted in settlement of other peoples’ debts to each other”. In the words of Crowther, “The banker’s business is then, to take debts of other people, to offer his own in exchange and thereby to create money”. He further says that a bank “collects money from those who have it to spare or who are saving it out of their incomes and it lends this money to those who require it”. 128 CU IDOL SELF LEARNING MATERIAL (SLM)
6.3 STRUCTURE OF COMMERCIAL BANKS The commercial banking system consists of scheduled banks and non-scheduled banks. Scheduled Bank: A Scheduled bank is one, which is registered in the Second Schedule of the Reserve Bank of India. The following conditions should be fulfilled by a bank for inclusion in the Schedule. 1. The bank concerned must be carrying on a business of banking in India. 2. The bank must have paid-up capital and reserve of an aggregate value of not less than ` 5 lakhs. 3. It must satisfy the Reserve Bank of India that its affairs are not being conducted in a manner detrimental to the interest of the depositor. Presently, the RBI has prescribed a minimum capital of ` 100 crore for starting a new commercial bank. Non-Scheduled Bank: A Bank which is not included in Second Schedule of the Reserve Bank of India is known as non- scheduled bank. RBI scheduled banks non-scheduled banks commercial banks Co-operative banks public sector regional rural private sector state co- banks bank operative state bank other Indian banks Foreign banks nationalised banks central co- banks operative banks primary credit socities Fig 6.1 Structure of commercial banks 129 CU IDOL SELF LEARNING MATERIAL (SLM)
The scheduled banks come within the direct purview of the credit control measures of the Reserve Bank. They are entitled to borrowings and rediscounting facilities from the Reserve Bank of India. Non-scheduled banks are not entitled to such facilities. 6.4 FUNCTIONS OF COMMERCIAL BANKS In the modern world, commercial banks perform such a variety of crucial functions that it is very difficult to make an all-inclusive list of their functions. However, the several crucial functions performed by them can be classified into two broad heads namely: (a) Primary functions and (b) Secondary functions/Subsidiary functions. Primary Functions of Commercial Banks The primary functions of commercial banks are called traditional functions or core functions. They are the following: (i) Acceptance of deposits from the public. (ii) Creation of credit. (iii) Lending of funds. (iv) Use of cheque system. (v) Remittance of funds. 1. Accepting Deposits: The most important function of commercial banks is to accept deposits from the public. Various sections of society, according to their needs and economic condition, deposit their savings with the banks. For example, fixed and low-income group people deposit their savings in small amounts from the points of view of security, income and saving promotion. On the other hand, traders and businessmen deposit their savings in the banks for the convenience of payment. Therefore, keeping the needs and interests of various sections of society, banks formulate various deposit schemes. Generally, there are three types of deposits which are as follows: (i) Current Deposits: The depositors of such deposits can withdraw and deposit money whenever they desire. Since banks have to keep the deposited amount of such accounts in cash always, they carry either no interest or very low rate of interest. These deposits are called as Demand Deposits because these can be demanded or withdrawn by the depositors at any time 130 CU IDOL SELF LEARNING MATERIAL (SLM)
they want. Such deposit accounts are highly useful for traders and big business firms because they have to make payments and accept payments many times in a day. (ii) Fixed Deposits: These are the deposits which are deposited for a definite period of time. This period is generally not less than one year and, therefore, these are called as long term deposits. These deposits cannot be withdrawn before the expiry of the stipulated time and, therefore, these are also called as time deposits. (iii) Saving Deposits: In such deposits, money up to a certain limit can be deposited and withdrawn once or twice in a week. On such deposits, the rate of interest is very less. As is evident from the name of such deposits their main objective is to mobilize small savings in the form of deposits. These deposits are generally done by salaried people and the people who have fixed and less income. 2. Giving Loans: The second important function of commercial banks is to advance loans to its customers. Banks charge interest from the borrowers and this is the main source of their income. Banks advance loans not only on the basis of the deposits of the public rather they also advance loans on the basis of depositing the money in the accounts of borrowers. In other words, they create loans out of deposits and deposits out of loans. This is called as credit creation by commercial banks. (i) Cash Credit: In this type of credit scheme, banks advance loans to its customers on the basis of bonds, inventories and other approved securities. Under this scheme, banks enter into an agreement with its customers to which money can be withdrawn many times during a year. Under this set up banks open accounts of their customers and deposit the loan money. With this type of loan, credit is created. (iii) Demand loans: These are such loans that can be recalled on demand by the banks. The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower, and thus entire loan becomes chargeable to interest with immediate effect. (iv) Short-term loan: These loans may be given as personal loans, loans to finance working capital or as priority sector advances. These are made against some security and entire loan amount is transferred to the loan account of the borrower. 3.Over-Draft: Banks advance loans to its customer’s up to a certain amount through over- drafts, if there are no deposits in the current account. For this, banks demand a security from the customers and charge very high rate of interest. 131 CU IDOL SELF LEARNING MATERIAL (SLM)
4. Discounting of Bills of Exchange: This is the most prevalent and important method of advancing loans to the traders for short term purposes. Under this system, banks advance loans to the traders and business firms by discounting their bills. In this way, businessmen get loans on the basis of their bills of exchange before the time of their maturity. 5. Investment of Funds: The banks invest their surplus funds in three types of securities— Government securities, other approved securities and other securities. Government securities include both, central and state governments, such as treasury bills, national savings certificate etc. Other securities include securities of state associated bodies like electricity boards, housing boards, debentures of Land Development Banks units of UTI, shares of Regional Rural banks etc. Secondary Functions of Commercial Banks Modern commercial banks, besides performing the main functions, viz., accepting deposits and lending money, cover a wide range of financial and non-financial services to customers and general public. The bank services are steadily increasing to meet the growing needs of the community. The secondary functions of a modern banker may be classified into two as: (i) Agency Functions. (ii) Miscellaneous Services or General Utility Functions. (i) Agency Functions: Banks function in the form of agents and representatives of their customers. Customers give their consent for performing such functions. The important functions of these types are as follows: (i) Banks collect cheques, drafts, bills of exchange and dividends of the shares for their customers. (ii) Banks make payment for their clients and at times accept the bills of exchange: of their customers for which payment is made at the fixed time. (ii) Miscellaneous Functions: Besides the functions mentioned above, banks perform many other functions of general utility which are as follows: (i) Banks make arrangement of lockers for the safe custody of valuable assets of their customers such as gold, silver, legal documents etc. (ii) Banks give reference for their customers. (iii) Banks collect necessary and useful statistics relating to trade and industry. (iv) For facilitating foreign trade, banks undertake to sell and purchase foreign exchange. (v) Banks advise their clients relating to investment decisions as specialist. (vi) Bank does the under-writing of shares and debentures also. (vii) Banks issue letters of credit. (viii) During natural calamities, banks are highly useful in mobilizing funds and donations. (ix) Banks provide loans for consumer durables like Car, Air- conditioner, and Fridge etc. 132 CU IDOL SELF LEARNING MATERIAL (SLM)
BANK SUBSIDIARIES • Bank Controls One or More Subsidiaries • Subsidiaries Offer Other Services Such as Insurance and Security Brokerage Services • Profits and Losses of Each Subsidiary Impact Parent Bank AGENCY SERVICES OF COMMERCIAL BANKS Agency Services or Agency functions of commercial banks are elaborated in detail below 1. Collection of Cheques, Dividends, Interests etc: Collecting cheques, drafts, bill of exchange, dividends, interests etc. on behalf of its customers and credit the amount in their account is one of the most important agency services rendered by the banks. Banker accepts standing instructions from the customers and arranges to collect dividend, interest, pension, salaries, bills etc. on behalf of his customers. 2. Payment of Subscription, Rent, Insurance Premium etc: Banks undertake the payment of subscriptions, rent, insurance premium etc. on behalf of the customers and debit the account with the amount. It accepts the standing instructions of the customer and arranges for. The payment of such expenses on their behalf. It charges a small amount by way of commission for these services. 3. Conduct of Stock Exchange Transactions: Banks’s purchase and sell various securities such as shares, debentures, bonds etc. of joint stock companies both private and Government on behalf of their customers. 4. Acting as Executor, Trustees, Attorneys etc.: Banks act as executors of will, trustees, attorneys and administrators. As an executor it preserves the ―Wills‖ of the customers and executes them after their death. As a trustee, it takes care of the funds of the customers. As an attorney, it signs transfer forms and documents on behalf of the customer. 5. Preparation of Income Tax Returns: Banks prepare income tax returns for their customers through their tax service departments. 6. Conducting Foreign Exchange Transactions: Commercial banks purchase and sell foreign exchange for their customers. 7. Banker acts as an agent to the customer: When a customer deposits cheque, drafts, bills or any other promissory notes, the banker collects them and on realization credits the account of the customer. For this activity, the banker is given commission. Banks also act as a 133 CU IDOL SELF LEARNING MATERIAL (SLM)
correspondent, representative of their customers. Some banks may even get the travellers’ tickets, passport etc. for their customers. 6.5 ROLE OF COMMERCIAL BANKS Commercial Banks have always played an important position in the country’s economy. They play a decisive role in the development of the industry and trade. They are acting not only as the custodian of the wealth of the country but also as resources of the country, which are necessary for the economic development of a nation. The following are the roles of commercial bank in the economic development of the country. 1. Capital Formation Banks play an important role in capital formation, which is essential for the economic development of a country. They mobilize the small savings of the people scattered over a wide area through their network of branches all over the country and make it available for productive purposes. Now-a-days, banks offer very attractive schemes to attract the people to save their money with them and bring the savings mobilized to the organized money market. If the banks do not perform this function, savings either remains idle or used in creating assets, which are low in scale of plan priorities. 2. Creation of Credit Banks create credit for the purpose of providing more funds for development projects. Credit creation leads to increased production, employment, sales and prices and thereby they cause faster economic development. 3. Channelizing the Funds to Productive Investment Banks invest the savings mobilized by them for productive purposes. Capital formation is not the only function of commercial banks. Pooled savings should be distributed to various sectors of the economy with a view to increase the productivity of the nation. Then only it can be said to have performed an important role in the economic development of the nation. Commercial Banks aid the economic development of the nation through the capital formed by them. In India, loan lending operation of commercial banks subject to the control of the RBI. So our banks cannot lend loan, as they like. 4. Fuller Utilization of Resources 134 CU IDOL SELF LEARNING MATERIAL (SLM)
Savings pooled by banks are utilized to a greater extent for development purposes of various regions in the country. It ensures fuller utilization of resources. 5. Encouraging Right Type of Industries The banks help in the development of the right type of industries by extending loan to right type of persons. In this way, they help not only for industrialization of the country but also for the economic development of the country. They grant loans and advances to manufacturers whose products are in great demand. The manufacturers in turn increase their products by introducing new methods of production and assist in raising the national income of the country. 6. Bank Rate Policy Economists are of the view that by changing the bank rates, changes can be made in the money supply of a country. In our country, the RBI regulates the rate of interest to be paid by banks for the deposits accepted by them and also the rate of interest to be charged by them on the loans granted by them. 7. Bank Monetize Debt Commercial banks transform the loan to be repaid after a certain period into cash, which can be immediately used for business activities. Manufacturers and wholesale traders cannot increase their sales without selling goods on credit basis. But credit sales may lead to locking up of capital. As a result, production may also be reduced. As banks are lending money by discounting bills of exchange, business concerns are able to carry out the economic activities without any interruption. 8. Finance to Government Government is acting as the promoter of industries in underdeveloped countries for which finance is needed for it. Banks provide long-term credit to Government by investing their funds in Government securities and short-term finance by purchasing Treasury Bills. 9. Bankers as Employers After the nationalization of big banks, banking industry has grown to a great extent. Bank’s branches are opened in almost all the villages, which leads to the creation of new employment opportunities. Banks are also improving people for occupying various posts in their office. 10. Banks are Entrepreneurs 135 CU IDOL SELF LEARNING MATERIAL (SLM)
In recent days, banks have assumed the role of developing entrepreneurship particularly in developing countries like India. Developing of entrepreneurship is a complex process. It includes the formation of project ideas, identification of specific projects suitable to local conditions, inducing new entrepreneurs to take up these well-formulated projects and provision of counselling services like technical and managerial guidance. Banks provide 100% credit for worthwhile projects, which is also technically feasible and economically viable. Thus, commercial banks help for the development of entrepreneurship in the country. 6.6 CENTRAL BANK A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services including economic research. Its goals are to stabilize the nation's currency, keep unemployment low, and prevent inflation. Most central banks are governed by a board consisting of its member banks. The country's chief elected official appoints the director. The national legislative body approves him or her. That keeps the central bank aligned with the nation's long-term policy goals. At the same time, it's free of political influence in its day-to-day operations. The Bank of England first established that model. Conspiracy theories to the contrary, that's also who owns the U.S. Federal Reserve. 6.7 MEANING AND DEFINITIONS The Reserve Bank of India (RBI) is India's central banking and monetary authority. RBI regulates loans offered by banks and non-banking financial institutions to government entities, businesses, and consumers and controls the availability of funds in the financial system for credit. RBI sets the direction for interest rates and price stability and conducts fund raising activities for the central and the state governments through the auction of government securities. Reserve Bank is also responsible for monitoring the foreign exchange flows into the Indian economy, managing currency exchange rates and supervising how banks and non-banking financial institution’s function. In the words of Decock, “The central bank is a banking system in which a single bank has either a complete or a residuary monopoly of note issue.” 136 CU IDOL SELF LEARNING MATERIAL (SLM)
Professor Hatley says, “Central Bank is the lender of the last resort.” 6.8 FUNCTIONS OF CENTRAL BANK The functions of central bank are different from other banks. The following functions of central bank are stated below: A. Traditional or general functions: 1. Issue of notes and coins: The first and foremost function of central bank is to issue notes and coins as per needs of the public and requirement of business and commerce. As per rules, notes are issued against gold, silver and foreign currency. Bangladesh Bank (Central Bank) keeps foreign currency reserves as security against issuance of notes. Bangladesh Bank unilaterally reserves the right to issue notes. The arguments in its favour are as follows: (a) To maintain equilibrium in quality between notes and currency issue (b) To maintain equilibrium in size, types and values of notes and currency © To maintain stability in rates of exchange both inland and foreign (d) To create confidence on the people (d) To control money market. 2. Government Bank: Central Bank acts as banker and economic adviser of the Government. The central bank conducts and maintains Government accounts for all Government receipts and payments. 3. Banker’s Bank: Central Bank acts as banker’s bank. As a rule, all scheduled and commercial banks have to maintain Statutory Liquidity Reserve (SLR) 18% with Bangladesh Bank (CRR: 5% and Bonds & Securities 13%). 4. Lender of the last Resort: In case of financial crisis of the commercial banks, central bank acts as a lender of the last resort through lending against first class securities, bill of exchange etc. 5. Reservoir of foreign currency: Central Bank maintains Foreign Currency Reserve. For the purpose of control of foreign currency, the following factors are responsible: (a) For issuance of notes (b) For payments of liabilities (c) For payments of debts. 6. Clearing House: Central Bank acts as a Clearing House for settlement of inter-bank transactions. 7. Credit Control: Credit Control is one of the major functions of central bank. The following are the ways of controlling credit: (a) Change in bank rates (b) Open market operation © 137 CU IDOL SELF LEARNING MATERIAL (SLM)
Change (increase or decrease) in reserve- ratio. (d) Selective credit (e) Direct influence (f) Moral suasion (g) propaganda. B. Purposeful functions: • Control Currency Market: Central Bank acts as a controller and guardian of the currency market. For the purpose of formation, control and maintenance of currency market and for its overall development, central bank is the pioneer. • Stabilize Exchange Rate: Central Bank maintains stability of the foreign currency exchange rates by means of controlling credit. Stable exchange rates position helps create favourable balance of trade and acceptability of stable currency gets momentum in the international market. • Maintain Gold Standard: Central Bank is responsible for maintenance and control of gold reserve. • Stabilize Price-Level: Fluctuations and frequent changes of price-level affect economic growth. With a view to making good of the economic imbalances and crisis situations, central bank takes necessary measures for stabilizing price-level. • Stabilize business activities: Central Bank formulates credit policy and with this spirit, central bank takes necessary steps to protect economic depression for stabilizing business activities. • Employment opportunities: Central Bank takes initiatives for creating employment opportunities by means of credit-control mechanism. C. Expansion and Development Functions: • Development of Agriculture Sector: Central Bank formulates policy for expansion of Agri-sector for the purpose of economic up liftmen in the country. • Development of Industry Sector • Development of natural resources: Central Bank plays vital role for tapping natural resources which may lead to economic growth. D. Other Functions: • Adviser and Representative of Government: 10 Central Bank advises Government on economic issues and sometimes acts as a representative of the Government. 138 CU IDOL SELF LEARNING MATERIAL (SLM)
• Economic Research: Central Bank conducts various economic research works and formulates policies for economic development. Central Bank conducts survey on different economic issues for the knowledge of the general public of the country. 6.9 ROLE OF CENTRAL BANK The central bank in a developing country aims at the promotion and maintenance of a rising level of production, employment and real income in the country. The central banks in the majority of underdeveloped countries have been given wide powers to promote the growth of such economies. They, therefore, perform the following functions towards this end. 1. Expanding currency supply for financing development plans: A developing country like India is to undertake massive development plans and programmes for accelerating the pace of development. The government requires a vast amount of finance for this purpose, for which the country is to rely on the method of deficit financing (i.e., the issue of new paper-notes) in addition to using other methods. The banking sector is to provide adequate finance for this purpose. The central bank, being the sole note-issuing authority can assist the government by expanding the supply of currency to enable the government to finance its massive plan outlays. Actually the Reserve Bank of India has been assisting the Government of India by expanding the supply of currency. But, the supply of currency (and credit) is to be properly regulated for enabling the economy achieve faster growth with reasonable price stability. 2. Resource mobilisation and supply of adequate credit: The mobilisation of resources for development purposes is an essential requirement in a developing economy. In such an economy, the central bank can assist the government in mobilising domestic resources for financing the development plans through such activities as the floating of new loans of the government, strengthening the banking structure for mobilising resources even from the rural areas, and so on. Apart from these the central banks to make necessary arrangements for the supply of adequate bank credit which is so essential for developmental activities. 3. Increasing the flow of bank credit to the priority sectors: The formulation of development priorities is an essential characteristic of development planning. The central bank of a developing country is to frame its monetary and credit policy 139 CU IDOL SELF LEARNING MATERIAL (SLM)
in such a fashion that larger and desired quantities of bank credit go to the priority sectors, such as agriculture, cooperatives, small industries and export trade. Furthermore, for social and economic along with economic growth achieving, it has to formulate a policy for extending liberal bank credit to the weaker and hitherto neglected sections of the community. At the same time it can follow the policy of credit restraint for maintaining price stability and for ensuring proper use of bank credit. For this reason the Reserve Bank of India has been following a monetary and credit policy what is known as the policy of controlled expansion of bank credit. Through it the R.B.I. can undertake the direct financing of development projects by lending liberally to those institutions which provide development finance. 4. Controlling inflation and containing cost escalation: The rising price level is regarded as a concomitant of economic development. The central bank in a developing economy is required to take necessary steps in holding the price line at a desired level so that plan-estimates are not totally upset due to cost-escalation. In a developing economy various traditional and new measures of monetary controls, especially selective credit controls, are used to check the inflationary rise in prices. The measures like higher margin requirements for speculative bank advances, higher CRR and incremental CRR, higher statutory liquidity ratios, penal rates of interest on excessive borrowings differential interest rate policy, higher bank rates and lending rates, etc. may be adopted by the central bank, as done by the Reserve Bank of India, for controlling inflation and for containing, or at least moderating, cost escalations of development projects. 5. Creation of a strong infrastructure and expansion of institutional facilities for agricultural and industrial finance: For creating a strong and integrated infra-structure a developing economy is to extend institutional facilities for agriculture and industry, as such facilities are grossly inadequate. The central bank in such a country can take some positive steps for extending the institutional facilities for agricultural and industrial finance. Thus, the Reserve Bank of India has taken active steps in reorganising the rural credit structure through co-operatives, the National Bank for Agriculture and Rural Development (NABARD), regional rural banks, lead banks. 140 CU IDOL SELF LEARNING MATERIAL (SLM)
Similarly, in developing institutional facilities for industrial finance it played a very significant role by establishing some specialised institutions like the Industrial Finance Corporation, the Industrial Development Bank, etc. The central bank in a developing economy usually sponsors the establishment of these institutions by subscribing to their shares and debentures by a large amount. 6. Operating exchange control: Foreign exchange constraint is often found to be a serious obstacle to the growth of a developing economy. Accordingly, the central bank in such an economy can serve the best cause of growth by making proper arrangement for the judicious use of the country’s scarce foreign exchange, as had been done by the Reserve Bank of India at the early years of planning. 7. Development oriented monetary policy: The central bank in a developing economy can formulate a development-oriented monetary and credit policy like the policy of controlled expansion of bank credit as followed by the Reserve Bank of India for promoting economic growth with stability. Through this monetary policy the central bank can bring about a desired allocation of resources especially capital. 8. Developing sound banking structure: The central bank in a developing economy can also take various positive steps and adopt various measures such as deposit insurance, nationalisation of banks, creation of a suitable bill market scheme and so on for building a sound banking structure, or financial infrastructure which is essential for achieving faster economic growth. 9. Advising government on plan matters: The central bank in a developing economy like India, can also advise the government not only on banking and financial matters but also on a wide range of economic issues related to national economic planning and resource mobilisation. Besides, a central bank should keep a strict watch over any possible sign of misdirection of the economy and accordingly it should give timely and proper advice to the government. 10. Economic surveys and collecting basic statistics: Finally, the central bank in a developing economy like the R.B.I, often conduct surveys on various uncovered sectors and supply valuable data on national economic plans and policies to the government for formulating development plans. 141 CU IDOL SELF LEARNING MATERIAL (SLM)
6.10 DIFFERENCE BETWEEN CENTRAL BANK AND COMMERCIAL BANK Points of distinction Central Bank Commercial bank Formation Central Bank is the sole Commercial Bank is formed Ownership Purpose banking Institution which is on the basis of Banking Number established through ordinance Company Laws. Control Government Influence or special law of the Currency Market Government. Central Bank is established Commercial Bank is under Government established under both govt. ownership. and private Ownership To earn profit is not the main The main purpose of purpose of central bank. Its commercial bank is to earn main purpose is to control profit. Recovery of loan is the credit system and money main stay for generation of market. profit In a country there is only one In a country there may be Central Bank. more number of commercial banks. Central Bank is Conducted Commercial Bank is Exclusively Under Conducted under Central Government Control. bank’s control. Government has direct Government has indirect influence on Central Bank. influence On Commercial Bank through Central Bank Central Bank organizes, Commercial Banks are the controls and administers members of the currency 142 CU IDOL SELF LEARNING MATERIAL (SLM)
currency market. market Competition Central Bank does not Commercial Bank has to face Representative compete with other banks. to face lot of competition Foreign Branch Note issue Central Bank represents the Commercial Bank represents Credit control country or state. the Customers Clearing House Central Bank has no branch Commercial Bank may have Lender of abroad. many Branches abroad. Nature Of work Note issue is the primary Commercial Bank cannot function of central bank. issue notes. Foreign Exchange Central Bank controls credit Commercial Bank assists central bank In controlling credit. Central Bank acts as a Commercial banks are the clearing house for settlement members of the clearing of inter-bank transactions. house. They settle transactions through clearing house. In case of any crisis, central Commercial Bank gets bank Last resort lends assistance from central bank commercial bank as a last in case of need. resort. Central bank is not engaged Commercial bank is engaged in general banking activities in receiving deposits, paying i.e. to receive deposits, to money, creating loan etc. lend, to create loan etc. Central Bank controls foreign Commercial bank helps exchange. central bank in controlling 143 CU IDOL SELF LEARNING MATERIAL (SLM)
foreign exchange. Investments Central bank does not Make Commercial bank makes Refinance Facility any investment for investments in various sectors Development work profitability purpose. for the purpose of profitability Central bank refinances Commercial bank takes commercial bank against first refinance facility from the class securities, bill of central bank. exchange Central Bank formulates Commercial bank participates policy on development Work. in the development program Initiated by the central bank. 6.11 SUMMARY • Commercial banks generally grant short-term loans and advances and promote trade and industry. • The Indian commercial banking system consists of mainly scheduled banks including cooperative banks. • Modern banks perform a variety of functions which may be broadly classified into primary functions and secondary functions. • The important functions like receiving of deposits, lending of money, creation of credit, remittance of funds, etc. are called primary functions. • All other functions come under the category of secondary functions which may again be classified into agency functions and general utility functions • Banks play a dynamic role in the economic development of a nation by assuming different roles and acting in different capacities. 6.12 KEYWORDS 144 CU IDOL SELF LEARNING MATERIAL (SLM)
• Bank: Financial institution which receives deposits from public and lends the same to promote trade and industry. • Scheduled Bank: A bank registered in the second schedule of the Reserve Bank of India. Fixed Deposit: Deposit repayable after a predetermined period. • Credit Creation: Simply crediting a customer’s account instead of giving liquid cash while granting loans and advances. • Letter of Credit: Document issued by banks to promote foreign trade and travel. • Merchant Banking: Offering financial, technical and managerial services under one roof to industrial customers. • Factoring: Purchase of book debts or receivables of customers by banks. • Credit Card: Document issued by banks to facilitate credit purchases. 6.13 LEARNING ACTIVITY 1. Find the commercial bank in your area and discuss its functions. _________________________________________________________________________ _________________________________________________________________________ 6.14 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define bank. 2. What are the types of deposits? 3. What are the types of deposits? 4. Write the agency functions of commercial bank. 5. Banker acts an agent to the customer-explain. 6. Define central bank 7. What is the role of central bank in Indian economy? Long Questions 145 CU IDOL SELF LEARNING MATERIAL (SLM)
1. Define bank and write the structure of commercial banks. 146 2. What are the primary functions of commercial banks? 3. Write the secondary functions of commercial banks? 4. What is the role of banks in economic development of the country? 5. Write the functions of Central bank. 6. What are the differences between central banks and commercial banks? B. Multiple Choice Questions 1. Purchase and sale of security is an______ service. a. agency b. principal c. creditor d. debtor 2. The person who holds the property for the beneficiaries is known as______ a. Agency b. trustee c. principal d. debtor 3.The letter of credit facilitate_____ a. internal trade b. barter system c. foreign trade d. trade CU IDOL SELF LEARNING MATERIAL (SLM)
4. Money can be withdrawn any number of times from_____ account. a. saving b. recurring deposit c. fixed deposit d. current 5. A scheduled bank is registered in the____ schedule of the RBI. a. I b. III c. IV d. II Answers 1-a, 2-b, 3-c, 4-d, 5-d 6.15 REFERENCES Reference books • Baird, C.W. (1977). Elements of Macro Economics, London: West Publishing Company. • Dernburg, T.F.& McDougal, D.M. (1983). Macro Economics. New York: McGraw Hill. • Gardner Ackley, G. (1985). Macro-Economic Theory. New York: McMillan. • Ghuman, R.S. (1998). Antar-RashtriyaArthVigyan, Patiala: Punjabi University. • Harvey, J.&Johnson, M. (1971). Introduction to Macro Economics, London: McMillan Textbooks • Jain, T.R. (1997). Macro Economics, New Delhi: V.K. Publications. • Jhingan, M.L. (2003). Macro-Economic Theory, New Delhi: Varinda Publishers. • Sharma, O.P. (2003). Macro Economics, Patiala: Punjabi University. • Vaish, M.C. (2008). Macro-Economic Theory. New Delhi: Oxford University Press. Websites 147 CU IDOL SELF LEARNING MATERIAL (SLM)
• Economictimes.indiatimes.com • Theinvestorsbook.com • www.economictimes.com • www.techykushi.medium.com 148 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT- 7 CREDIT CREATION AND CREDIT 149 CONTROL Structure 7.0 Learning objective 7.1 Introduction 7.2Money multiplier 7.3 Credit creation 7.4 Some basic concepts 7.5 process of credit creation 7.6 Limitations of credit creation 7.7 competitive banking and credit creation 7.8 Do banks really create credit? 7.9 Methods to control credit 7.10 Summary 7.11Keywords 7.12 Learning activity 7.13 Unit end questions 7.14 References 7.0 LEARNING OBJECTIVES After studying this unit, students will be able to: • Define the meaning of Money multiplier. • List some of the basic concepts. • Explain the process of credit creation. • Examine the limitations of credit creation. • Analyze the methods to control credit. CU IDOL SELF LEARNING MATERIAL (SLM)
7.1 INTRODUCTION Through credit creation, banks increase the supply of money in the economy which has a direct impact on production, consumption and level of investment and along with it process of development and prosperity is influenced. 7.2 MONEY MULTIPLIER The Money Multiplier refers to how an initial deposit can lead to a bigger final increase in the total money supply. it represents the largest degree to which the money supply is influenced by changes in the quantity of deposits. It identifies the ratio of decrease and/or increase in the money supply in relation to the commensurate decrease and/or increase in deposits. Money Multiplier = Money Supply /High Powered Money OR m= H/M .... (i) (Here, m = Money Multiplier, M = Supply of Money (currency in circulation and bank’s demand deposits), H = High power money) Total Supply of money is the sum of currency and demand deposits. M = C + D …(ii) (Here C = Currency, D= Demand Deposits) Money multiplier in real world The equation above does not account for all of the factors that subtly and not-so-subtly influence the way that the money multiplier effect behaves in the real world. Here are a few of those factors: • Taxes: A certain fraction of all income is lost to taxes. • Savings: People don’t spend all their money at all times—they typically save some of it, and often quite a lot of it. • Bad loans: If a bank lends out money to a company and then that company is forced to file for bankruptcy, that loaned money never returns back to circulation in the banking system. • Import spending: Money spent on imported products exits the national economy to circulate in other countries. 150 CU IDOL SELF LEARNING MATERIAL (SLM)
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