Current Affairs UPSC

Category : UPSC

Introduction

• Money is the commonly accepted medium of exchange. In an economy which consists of only one individual there cannot be any exchange of commodities and hence there is no role for money.
• Even if there are more than one individual but they do not take part in market transactions, such as a family living on an isolated island, money has no function for them.
• However, as soon as there are more than one economic agent who engage themselves in transactions through the market, money becomes an important instrument for facilitating these exchanges.
• Economic exchanges without the mediation of money are referred to as barter exchanges.
• However, they presume the rather improbable double coincidence of wants.
• Consider, for example, an individual who has a surplus of rice which he wishes to exchange for clothing. If he is not lucky enough he may not be able to find another person who has the diametrically opposite demand for rice with a surplus of clothing to offer in exchange. The search costs may become prohibitive as the number of individuals increases.
• Thus, to smoothen the transaction, an intermediate good is necessary which is acceptable to both parties. Such a good is called money.
• The individuals can then sell their produces for money and use this money to purchase the commodities they need. Though facilitation of exchanges is considered to be the principal role of money, it serves other purposes as well.

Functions of Money

• The first and foremost role of money is that it acts as a medium of exchange.
• Barter exchanges become extremely difficult in a large economy because of the high costs people would have to incur looking for suitable persons to exchange their surpluses.
• Money also acts as a convenient unit of account. The value of all goods and services can be expressed in monetary units.
• If prices of all commodities increase in terms of money which, in other words, can be regarded as a general increase in the price level, the value of money in terms of any commodity must have decreased - in the sense that a unit of money can now purchase less of any commodity. We call it a deterioration in the purchasing power of money.
• A barter system has other deficiencies. It is difficult to carry forward one's wealth under the barter system.
• Money is not perishable and its storage costs are also considerably lower. It is also acceptable to anyone at any point of time. Thus money can act as a store of value for individuals.
• Wealth can be stored in the form of money for future use. However, to perform this function well, the value of money must be sufficiently stable.
• A rising price level may erode the purchasing power of money. It may be noted that any asset other than money can also act as a store of value, e.g. gold, landed property, houses or even bonds. However, they may not be easily convertible to other commodities and do not have universal acceptability.

Demand for Money

• Money is the most liquid of all assets in the sense that it is universally acceptable and hence can be exchanged for other commodities very easily. On the other hand, it has an opportunity cost.
• If, instead of holding on to a certain cash balance, we put the money in a fixed deposits in some bank we can earn interest on that money.
• While deciding on how much money to hold at a certain point of time one has to consider the trade off between the advantage of liquidity and the disadvantage of the foregone interest.
• Demand for money balance is thus often referred to as liquidity preference. People desire to hold money balance broadly from two motives.
• The transaction motive
• The principal motive for holding money is to carry out transactions.
• The number of times a unit of money changes hands during the unit period is called the velocity of circulation of money.
• The speculative motive
• An individual may hold his wealth in the form of landed property, bullion, bonds, money etc. For simplicity, let us club all forms of assets other than money together into a single category called 'bonds'.
• Typically, bonds are papers bearing the promise of a future stream of monetary returns over a certain period of time. These papers are issued by governments or firms for borrowing money from the public and they are tradable in the market.
• When the interest rate is very high everyone expects it to fall in future and hence anticipates capital gains from bond-holding. Hence people convert their money into bonds. Thus, speculative demand for money is low.
• When interest rate comes down, more and more people expect it to rise in the future and anticipate capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money. Hence speculative demand for money is inversely related to the rate of interest.

The Supply of Money

• In a modem economy money consists mainly of currency notes and coins issued by the monetary authority of the country. In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India.
• However, coins are issued by the Government of India,
• Apart from currency notes and coins, the balance in savings, or current account deposits, held by the public in commercial banks is also considered money since cheques drawn on these accounts are used to settle transactions.
• Such deposits are called demand deposits as they are payable by the bank on demand from the accountholder. Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits.
• Though a hundred-rupee note can be used to obtain commodities worth Rs. 100 from a shop, the value of the paper itself is negligible - certainly less than Rs. 100. Similarly, the value of the metal in a five-rupee coin is probably not worth Rs. 5.
• Why then do people accept such notes and coins in exchange of goods which are apparently more valuable than these? The value of the currency notes and coins is derived from the guarantee provided by the issuing authority of these items.
• Every currency note bears on its face a promise from the Governor of RBI that if someone produces the note to RBI, or any other commercial bank, RBI will be responsible for giving the person purchasing power equal to the value printed on the note.
• The same is also true of coins. Currency notes and coins are therefore called fiat money. They do not have intrinsic value like a gold or silver coin.
• They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction.
• Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of payment. Hence, demand deposits are not legal tenders.

Legal definitions : Narrow and broad money

• Money supply, like money demand, is a stock variable. The total stock of money in circulation among the public at a particular point of time is called money supply. RBI publishes figures for four alternative measures of money supply, viz. and .
• They are defined as follows :
• Savings deposits with Post Office savings banks
• Net time deposits of commercial banks
• Total deposits with Post Office savings organisations (excluding National Savings Certificates)
• Where, CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks. The word 'net' implies that only deposits of the public held by the banks are to be included in money supply.
• The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of money supply.
• and  are known as narrow money.  and  are known as broad money.
  • These gradations are in decreasing order of liquidity.
• is most liquid and easiest for transactions whereas  is least liquid of all. is the most commonly used measure of money supply. It is also known as aggregate monetary resources.

Money creation by the banking system

• Money supply will change if the value of any of its components such as CU, DD or Time Deposits changes. Various actions of the monetary authority, RBI, and commercial banks are responsible for changes in the values of these items. The preference of the public for holding cash balances vis-a-vis deposits in banks also affect the money supply.

The currency deposit ratio

• The currency deposit ratio (cdr) is the ratio of money held by the public in currency to that they hold in bank deposits, cdr = CU/DD. It reflects people's preference for liquidity, cdr increases during the festive season as people convert deposits to cash balance for meeting extra expenditure during such periods.

The reserve deposit ratio

• Banks hold a part of the money people keep in their bank deposits as reserve money and loan out the rest to various investment projects.
• Reserve money consists of two things - vault cash in banks and deposits of commercial banks with RBI. Banks use this reserve to meet the demand for cash by account holders.
• Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves.
• Keeping reserves is costly for banks, as, otherwise, they could lend this balance to interest earning investment projects. However, RBI requires commercial banks to keep reserves in order to ensure that banks have a safe cushion of assets to draw on when account holders want to be paid.
• RBI uses various policy instruments to bring forth a healthy rdr in commercial banks. The first instrument is the Cash Reserve Ratio which specifies the fraction of their deposits that banks must keep with RBI.
• There is another tool called Statutory Liquidity Ratio which requires the banks to maintain a given fraction of their total demand and time deposits in the form of specified liquid assets.
• Apart from these ratios RBI uses a certain interest rate called the Bank Rate to control the value of rdr. Commercial banks can borrow money from RBI at the bank rate when they run short of reserves.
• A high bank rate makes such borrowing from RBI costly and, in effect, encourages the commercial banks to maintain a healthy rdr.

Commercial banks

• Commercial banks accept deposits from the public and lend out this money to interest earning investment projects. The rate of interest offered by the bank to deposit holders is called the 'borrowing rate' and the rate at which banks lend out their reserves to investors is called the 'lending rate'.
• The difference between the two rates, called 'spread9, is the profit that is appropriated by the banks.
• Deposits are broadly of two types - demand deposits, payable by the banks on demand from the account holder, e.g. current and savings account deposits, and time deposits, which have a fixed period to maturity, e.g. fixed deposits.
• Lending by commercial banks consists mainly of cash credit, demand and short-term loans to private investors and banks' investments in government securities and other approved bonds.
• The creditworthiness of a person is judged by his current assets or the collateral (a security pledged for the repayment of a loan) he can offer.

High powered money

• The total liability of the monetary authority of the country, RBI, is called the monetary base or high powered money. It consists of currency (notes and coins in circulation with the public and vault cash of commercial banks) and deposits held by the Government of India and commercial banks with RBI.
• If a member of the public produces a currency note to RBI the latter must pay her value equal to the figure printed on the note.
• Similarly, the deposits are also refundable by RBI on demand from deposit-holders.
• These items are claims which the general public, government or banks have on RBI and hence are considered to be the liability of RBI.

• RBI acquires assets against these liabilities.

Instruments of Monetary Policy and the Reserve Bank of India

• It is clear from the above discussion that the total amount of money stock in the economy is much greater than the volume of high powered money.
• Commercial banks create this extra amount of money by giving out a part of then- deposits as loans or investment credits.
• Total amount of deposits held by all commercial banks in the country is much larger than the total size of their reserves.
• If all the account-holders of all commercial banks in the country want their deposits back at the same time, the banks will not have enough means to satisfy the need of every accountholder and there will be bank failures.
• All this is common knowledge to every informed individual in the economy. Why do they still keep their money in bank deposits when they are aware of the possibility of default by their banks in case of a bank run (a situation where everybody wants to take money out of one's bank account before the bank runs out of reserves)?
• The Reserve Bank of India plays a crucial role here. In case of a crisis like the above it stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter. This system of guarantee assures individual account-holders that their banks will be able to pay their money back in case of a crisis and there is no need to panic thus avoiding bank runs. This role of the monetary authority is known as the lender of last resort.
• Apart from acting as a banker to the commercial banks, RBI also acts as a banker to the Government of India, and also, to the state governments.
• It is commonly held that the government, sometimes, 'prints money' in case of a budget deficit, i.e., when it cannot meet its expenses (e.g. salaries to the government employees, purchase of defense equipment from a manufacturer of such goods etc.) from the tax revenue it has earned.
• The government, however, has no legal authority to issue currency in this fashion. So it borrows money by selling treasury bills or government securities to RBI, which issues currency to the government in return.
• The government then pays for its expenses with this money. The money thus ultimately comes into the hands of the general public (in the form of salary or sales proceeds of defense items etc.) and becomes a part of the money supply.
• Financing of budget deficits by the governments in this fashion is called Deficit Financing through Central Bank Borrowing.                                                    
• However, the most important role of RBI is as the controller of money supply and credit creation in the economy. RBI is the independent authority for conducting monetary policy in the best interests of the economy - it increases or decreases the supply of high powered money in the economy and creates incentives or disincentives for the commercial banks to give loans or credits to investors.
• The instruments which RBI uses for conducting monetary policy are as follows:

• Open market operations
• RBI purchases (or sells) government securities to the general public in a bid to increase (or decrease) the stock of high powered money in the economy.
• If RBI wishes to reduce the supply of high powered money it undertakes an open market sale of government securities of its own holding in just the reverse fashion, thereby reducing the monetary base.
• Bank rate policy
• As mentioned earlier, RBI can affect the reserve deposit ratio of commercial banks by adjusting the value of the bank rate - which is the rate of interest commercial banks have to pay RBI - if they borrow money from it in case of shortage of reserves.
• A low (or high) bank rate encourages banks to keep smaller (or greater) proportion of their deposits as reserves, since borrowing from RBI is now less (or more) costly than before.
• As a result banks use a greater (or smaller) proportion of their resources for giving out loans to borrowers or investors, thereby enhancing (or depressing) the multiplier process via assisting (or resisting) secondary money creation.
• In short, a low (or high) bank rate reduces (or increases) rdr and hence increases (or decreases) the value of the money multiplier, which is (1 + cdr)/(cdr + rdr).
• Varying reserve requirements
• Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) also work through the rdr-route. A high (or low) value of CRR or SLR helps increase (or decrease) the value of reserve deposit ratio, thus diminishing (or increasing) the value of the money multiplier and money supply in the economy in a similar fashion.
• Sterilisation by RBI
• RBI often uses its instruments of money creation for stabilising the stock of money in the economy from external shocks.
• Suppose due to future growth prospects in India investors from across the world increase their investments in Indian bonds which under such circumstances, are likely to yield a high rate of return. They will buy these bonds with foreign currency.
• Since one cannot purchase goods in the domestic market wdth foreign currency, a person or a financial institution who sells these bonds to foreign investors will exchange its foreign currency holding into rupee at a commercial bank.
• The bank, in turn, will submit this foreign currency to RBI and its deposits with RBI will be credited with equivalent sum of money.
• What kind of adjustments take place from this entire transaction? The commercial bank's total reserves and deposits remain unchanged (it has purchased the foreign currency from the seller using its vault cash, which, therefore, goes down; but the bank's deposit with RBI goes up by an equivalent amount - leaving its total reserves unchanged).
• There will, however, be increments in the assets and liabilities on the RBI balance RBPs foreign exchange holding goes up. On the other hand, the deposits of commercial banks wdth RBI also increase by an equal amount.
• But that means an increase in the stock of high powered money - which, by definition, is equal to the total liability of RBI. With money multiplier in operation, this, in turn, will result in increased money supply in the economy.
• This increased money supply may not altogether be good for the economy's health. If the volume of goods and services produced in the economy remains unchanged, the extra money will lead to increase in prices of all commodities.
• People have more money in their hands with which they compete each other in the commodities market for buying the same old stock of goods.
• As too much money is now chasing the same old quantities of output, the process ends up in bidding up prices of every commodity - an increase in the general price level, which is also known as inflation.
• RBI often intervenes with its instruments to prevent such an outcome. In the above example, RBI will undertake an open market sale of government securities of an amount equal to the amount of foreign exchange inflow in the economy, thereby keeping the stock of high powered money and total money supply unchanged.
• Thus it sterilises the economy against adverse external shocks. This operation of RBI is known as sterilisation.
• Money supply is, therefore, an important macroeconomic variable. Its overall influence on the values of the equilibrium rate of interest, price level and output of an economy is of great significance.