Money and Banking

Money is anything generally accepted as a medium of exchange and in the settlement of debts. It evolved through stages — from barter to commodity money, metallic money, paper money, and today bank money and digital money — each stage making exchange easier.

Money performs four functions: it is a medium of exchange (the primary function — it removes the barter problem of a double coincidence of wants), a measure of value (prices express value in money), a store of value (it can be saved), and a standard of deferred payments (it lets borrowing and lending happen). People hold money for two main reasons (the demand for money): the transactions motive (to make everyday payments) and the precautionary and speculative motives (for emergencies and to take advantage of future opportunities).

The supply of money is the total stock of money held by the public at a point of time (it is a stock, and it excludes money held by the government and banks themselves). The Reserve Bank measures it in several monetary aggregates, the most-quoted being:

• M1 = currency (notes and coins) with the public + demand deposits in banks + other deposits with the RBI. M1 is the most liquid measure, also called narrow money.
• Wider measures M2, M3 and M4 add less-liquid deposits (like savings and time deposits); M3 (M1 + time deposits) is called broad money and is the most commonly used aggregate.

So money is what oils the whole economy — and how much of it there is (the money supply) is a key macroeconomic variable that the central bank controls.

A commercial bank accepts deposits from the public and lends money to earn profit. Its two primary functions are accepting deposits (current, savings and fixed deposits) and advancing loans (loans, cash credit, overdrafts). The gap between interest charged on loans and paid on deposits is the bank's profit.

The most important macroeconomic role of banks is credit creation (money creation). Banks know that not all depositors withdraw at once, so they keep only a small fraction of deposits as a cash reserve and lend out the rest. The borrowed money is spent and returns to the banking system as a fresh deposit, of which a fraction is again kept and the rest re-lent — and so on. In this way the banking system as a whole creates total deposits that are a multiple of the original cash.

The size of this multiple is the money (credit) multiplier, which depends on the reserve ratio (the fraction of deposits kept as reserves):

Money Multiplier = 1 ÷ LRR  (LRR = legal reserve ratio)

So if banks must keep 20% (0.2) as reserves, the multiplier is 1 ÷ 0.2 = 5: an initial deposit of ₹1,000 can support total deposits of ₹1,000 × 5 = ₹5,000. The smaller the reserve ratio, the larger the credit a given cash base can create. This is why the central bank controls the reserve ratio to control the money supply — the subject of monetary policy.

The Reserve Bank of India (RBI) is the central bank — the apex institution that controls the country's money and banking system in the public interest (not for profit). Its main functions are: currency authority (sole right to issue notes), banker to the government, bankers' bank (banks keep reserves with it), lender of last resort, custodian of foreign exchange reserves, and — most important — controller of credit.

The RBI controls the money supply and credit in the economy through its monetary policy. The instruments are of two kinds. The quantitative measures (which affect the total volume of credit) are:

• Repo rate — the rate at which the RBI lends to commercial banks. Raising it makes borrowing costlier, reducing credit.
• Reverse repo rate — the rate at which the RBI borrows from banks (absorbing their funds).
• Bank rate — the rate at which the RBI lends to banks for the long term.
• Cash Reserve Ratio (CRR) — the fraction of deposits banks must keep as cash with the RBI. Raising the CRR leaves banks less to lend, reducing credit.
• Statutory Liquidity Ratio (SLR) — the fraction of deposits banks must keep in safe assets (cash, gold, government securities).
• Open Market Operations (OMO) — the RBI buying or selling government securities to inject or absorb money.

The qualitative measures (which affect the direction/use of credit) include margin requirements, moral suasion and selective credit controls. To fight inflation, the RBI tightens (raises repo rate, CRR, SLR; sells securities) to reduce the money supply; to fight a slowdown, it eases (lowers them; buys securities) to increase the money supply. Monetary policy is therefore one of the government's two great tools (with fiscal policy) for managing the whole economy.