Money and Banking

Before money, people exchanged goods directly for goods — the barter system. Barter had serious problems: it needed a double coincidence of wants (each person had to want exactly what the other offered), there was no common measure of value, goods could not be stored easily, and there was no way to make deferred (future) payments. Money was invented to solve all these problems.

Money is anything that is generally accepted as a medium of exchange and in payment of debts. Modern money includes coins, currency notes and bank deposits. Money performs four main functions:

• Medium of exchange — money is accepted in exchange for all goods and services, so we no longer need a double coincidence of wants. (This is the primary function.)
• Measure (or unit) of value — the value of every good is measured and expressed in money (price), giving a common yardstick.
• Store of value — money can be saved and stored for future use, because it does not perish.
• Standard of deferred payments — money allows borrowing and lending, so payments can be made in the future (e.g. paying back a loan).

By performing these functions, money removes the difficulties of barter and makes trade, saving and investment easy — which is why it is one of the most important inventions in economic life.

A commercial bank is a financial institution that accepts deposits from the public and lends money, in order to earn a profit. Banks are the backbone of the modern money system. Their two primary functions are:

• Accepting deposits — people keep their money safely in banks. The main kinds are the current account (for businesses, withdraw any time, no interest), the savings account (small savers, some interest), and the fixed (time) deposit (money kept for a fixed period at higher interest).
• Advancing loans (lending) — banks lend the deposited money to borrowers (as loans, cash credit, overdrafts) and charge interest. The difference between the interest charged on loans and paid on deposits is the bank's profit.

Banks also perform secondary functions — transferring money, issuing cheques and cards, lockers, and so on.

The most remarkable thing banks do is credit creation (money creation). When a bank receives deposits, it keeps only a small fraction as a cash reserve (because not all depositors withdraw at once) and lends out the rest. The borrower spends the money, which comes back to the banking system as a new deposit, part of which is again lent out — and so on. In this way, the banking system as a whole can create deposits (credit) several times the original cash. This is why commercial banks are said to "create money." The amount they can create depends on the reserve ratio — the smaller the fraction kept as reserve, the more credit can be created.

At the top of a country's banking system is the central bank — the apex institution that controls and supervises the whole monetary and banking system. In India the central bank is the Reserve Bank of India (RBI). Unlike commercial banks, the central bank does not aim at profit; its goal is to manage the economy's money and credit in the public interest. Its main functions are:

• Bank of issue — the central bank has the sole right to issue currency notes in the country. This keeps the currency uniform and under control.
• Banker to the government — it keeps the government's accounts, makes its payments and receipts, and advises it on financial matters.
• Bankers' bank — it acts as the banker to all commercial banks: they keep reserves with it, and it lends to them and supervises them.
• Lender of last resort — in a crisis, when commercial banks cannot get money elsewhere, the central bank lends to them, preventing the banking system from collapsing.
• Controller of credit — this is its most important function. The central bank controls the amount of money and credit in the economy (to manage inflation and growth) using tools such as the bank rate (repo rate), cash reserve ratio (CRR) and open market operations (buying/selling government securities).
• Custodian of foreign exchange reserves.

So while commercial banks deal with the public for profit, the central bank stands above them, managing the nation's money supply, guarding the value of the currency, and keeping the financial system stable. Money, commercial banks and the central bank together make up the heart of the monetary system.