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Lecture Notes

Money and Banking


1 What is money ?

In a very narrow sense, money enables us to buy goods and service in return. There are many definitions of money according to its use.

1.1 Legal definition of money

Money is what the law says it money There are definition of money according to legal definition:

Legal tender money:Money which can be legally used for making payments of debts or other obli- gations is termed as legal tender money. E.g. Indian rupee

Non-legal tender money (Optional money) It refers to the money that generally accepted, but legally,one is not bound to accept it. e.g. Gold.

1.2 Functional definition of money

Money refers to something that performs the four basic functions of money 1) Medium of exchange. 2) Measure of value 3) Standard of deferred payments 4) Store of value

1.3 Definition on the basis of liquidity

Liquid Money:Liquidity we mean that, the lowest cost by which an asset can be converted to money. So, the rupee itself is the most liquid money.

Near money: The financial assets which are not liquid as currency notes and coins, but can be easily converted into money for payments. Example: Certificate od deposits (CD), National saving deposit.

1.4 Definition on the basis of scope

Narrow definition money: It refers to those things which performs basic function of money.

Broad definition of money: In addition to narrow money with time deposits in banks and post offices.

2 Classification of Money:

Money can be classified on the basis of relationship between the value of money as money and the value of the money as commodity. Broadly, money is classified as:

Full bodied money:A unit of money , whose face value and intrinsic value are equal i.e. Money value= Commodity value Example : Gold

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Representative full bodied money: It refers to the money which is generally made up of paper. Its face value is much higher than the value as a commodity. Example: Rs 1000 note.

Credit money: Credit money refers to the money whose intrinsic value is much lower than the face value. Example: Demand deposits, Credit cards.

3 Evolution of Money

The evolution of the money has taken following stages :

Commodity money (Barter system) Metallic money Paper money Credit money Plastic money.

4 Money Supply

Money supply refers to the total volume of money held by the public at particular point of time in an economy. 1) Here, public we mean both individuals and firms. 2) It is a “ Stock ” concept.

5 Measurement of Money Supply

Since 1977, RBI measures the money supply (M 1 , M 2 , M 3 , M 4 )

5.1 M1

It is the first and basic measure of money. It is also known as transaction money.

M1 = Currency and coins with public + Demand deposits of commercial banks + Other deposits with RBI

M1 is the most liquid measure of money supply as all its components are easily used as a medium of exchange.

Currency and coins with public consists of currency notes and coins with the public.

Demand deposits of the commercial banks by the public is also taken here as it is easily converted to money.

Other deposits with RBI includes the deposits held by the RBI on behalf of foreign banks and govern- ments, public financial institutions, World bank, IMF, etc.

High powered money (H):High powered money is produced by the RBI and government. High powered money = Curreny with the public + Cash reserves with banks. ‘H’ is high powered compared to ‘M’ because cash reserve serve as the actual base for the generation of money

5.2 M2

It is a broader concept of money supply as compared to M1. In addition to M1, it includes saving deposits with post office saving account.

M2 = M1 + saving deposits with post office


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5.3 M3

This concepts is broader as compared to M1. In addition to M1, it also includes net time deposits.

M3 = M1 + Net time deposits with bank

5.4 M4

This measure includes total deposits with post office saving bank in addition to M3.

M4 = M3 + Total deposits with post office (Excluding natioanal saving certificate (NSC))

Facts about money supply

They are ordered in terms of liquidity.

M3 is widely used as measure of money supply.

M1 and M2 are generally known as narrow money supply.

6 Theories of Demand for Money

The demand for money arises from two important functions of money. First, money acts as a medium of exchange. Second, it is a store of value. Thus individuals and businesses wish to hold money partly in cash and partly in the form of assets.

What explains changes in the demand for money? There are two views on this issue. The first is the “scale” view which is related to the impact of the income or wealth on the demand for money. The demand for money is directly related to the income level. The higher the income level, the greater will be the demand for money.

The second is the “substitution” view, which is related to relative attractiveness of assets that can be substituted for money. According to this view, when alternative assets like bonds become unattractive due to fall in interest rates, people prefer to keep their assets in cash, and the demand for money increases, and vice versa.

The scale and substitution view combined together have been used to explain the nature of the demand for money which has been split into the transactions demand, the precautionary demand and the speculative demand. There are three approaches to the demand for money: the classical, the Keynesian, and the post-Keynesian. We discuss these approaches below.

6.1 The Classical Approach

The classical economists did not explicitly formulate demand for money theory but their views are inherent in the quantity theory of money. They emphasized the transactions demand for money in terms of the velocity of circulation of money. This is because money acts as a medium of exchange and facilitates the exchange of goods and services. In Fisher’s “Equation of Exchange”.


Where ‘M, is the total quantity of money, ‘V’ is its velocity of circulation, P is the price level, and T is the total amount of goods and services exchanged for money.


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The right hand side of this equation ‘PT, represents the demand for money which, in fact, “depends upon the value of the transactions to be undertaken in the economy, and is equal to a constant fraction of those transactions.” MV represents the supply of money which is given and in equilibrium equals the demand for money. Thus the equation becomes

M d = PT

This transactions demand for money, in turn, is determined by the level of full employment income. This is because the classicists believed in Say’s Law whereby supply created its own demand, assuming the full employment level of income. Thus the demand for money in Fisher’s approach is a constant proportion of the level of transactions, which in turn, bears a constant relationship to the level of national income. Further, the demand for money is linked to the volume of trade going on in an economy at any time.

Thus its underlying assumption is that people hold money to buy goods.

But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events. It is therefore, not possible to say that V will remain constant when M is changed. The most important thing about money in Fisher’s theory is that it is transferable. But it does not explain fully why people hold money. It does not clarify whether to include as money such items as time deposits or savings deposits that are not immediately available to pay debts without first being converted into currency.

It was the Cambridge cash balance approach which raised a further question: Why do people actually want to hold their assets in the form of money? With larger incomes, people want to make larger volumes of transactions and that larger cash balances will, therefore, be demanded.

The Cambridge demand equation for money is

M d = kP Y

where M d is the demand for money which must equal the supply to money (Md=Ms) in equilibrium in the economy, k is the fraction of the real money income (PY) which people wish to hold in cash and demand deposits or the ratio of money stock to income, P is the price level, and Y is the aggregate real in- come. This equation tells us that “other things being equal, the demand for money in normal terms would be proportional to the nominal level of income for each individual, and hence for the aggregate economy as well.”

Its Critical Evaluation:

This approach includes time and saving deposits and other convertible funds in the demand for money. It also stresses the importance of factors that make money more or less useful, such as the costs of holding it, uncertainty about the future and so on. But it says little about the nature of the relationship that one expects to prevail between its variables, and it does not say too much about which ones might be important.

The classicists emphasized only the medium of exchange function of money which simply acted as a go-between to facilitate buying and selling. For them, money performed a neutral role in the economy. It was barren and would not multiply, if stored in the form of wealth. It ignores the store value of money.

This was an erroneous view because money performed the “asset” function when it is transformed into other forms of assets like bills, equities, debentures, real assets (houses, cars, TVs, and so on), etc. Thus the neglect of the asset function of money was the major weakness of classical approach to the demand for money which Keynes remade.

6.2 The Keynesian Approach: Liquidity preference theory

Keynes in his General Theory used a new term “liquidity preference” for the demand for money. Keynes suggested three motives which led to the demand for money in an economy:

(1) the transactions demand,


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(2) the precautionary demand, and (3) the speculative demand.

The Transactions Demand for Money:

The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. According to Keynes, it relates to “the need of cash for the current transactions of personal and business exchange” It is further divided into income and business motives. The income motive is meant “to bridge the interval between the receipt of income and its disbursement.” Similarly, the business motive is meant “to bridge the interval between the time of incurring business costs and that of the receipt of the sale proceeds.” If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa. The transaction demand for money is a positive function of the level of income.

Precautionary demand for money: The money people demand for financing unforeseen events in their day-to-day life is known as precautionary demand for money. It has been advocated by many economists that it depends upon the level income positively.

L 1 = kY

Where L 1 is the transactions and precautionary demand for money, ‘k’ is the proportion of income which is kept for transaction and precautionary purposes, and ‘Y ’ is the income.

Speculative demand for money:

Speculative demand for money is the amount of money individuals or firms need to exploit short term opportunities in fluctuations of commodities and asset prices. Demand for this component will depend on the opportunity cost of holding idle money vis-a-vis investing in commodities or assets. Given that return from any assets is related to benchmark real interest rate. The demand of money for speculative purpose will depend on real interest rate and will be negatively related. The speculative demand for money can be written mathematically as:

L 2 = f(r) ,

f r < 0

The total real demand for money is given by

M d



kY + f (r)

M d


= L 1 + L 2


7 Monetarist View

Monetarists believed that money is the most important factor in different economic activities with a slogan “”. They believed that changes in money supply completely pass through to the economy through prices. That is change in money supply will always be equal to inflation in long run. Taking the exchange equation



= kY

, the long run output will always be equal to full employment level of output. Therefore the real money demand will always remain constant. Therefore,



= dP


= Inflation


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8 Commercial Banking

Commercial banking is a primary unit of the Indian banking system. Commercial banking is an institution which performs the functions of accepting deposits, granting loans and making investments, with aim of earning profits, Example: State Bank of India and its associate banks, Punjab National Bank.

Commercial Banks: Backbone of an economy

It can be very well assumed that the household sectors saves a part of its income which is made available to the productive sector for further investment

Commercial banks work as financial intermediaries .

It borrows from public at a rate known as “borrowing rate”, and it lends money a rate called “"lending rate". The difference between lending rate and borrowing rate is called "net interest margin (NIM)" for the bank .

9 Functions of Commercial Banks

It can be broadly categorized as two function:

1. Primary function

2. Secondary function.

9.1 Primary function

Accepting deposits: It is the most important function of the commercial banks.The main kinds of deposits are

– Current Account Deposits

– Saving Account Deposits

– Fixed Account Deposits

Advancing Loans:The deposits made by the public not allowed to remain idle. So, after keeping the certain reserves the balance is given to certain needy borrowers and interest is charged. Different types of loans and advances made by the commercial banks are:

– Cash Credit

– Demand Loans

– Short-term Loans

– Long-term Loans

9.2 Seconadary function:

Overdraft Facility

Discounting Bills of Exchange

Agency functions

1. Transfer of funds

2. Collection of payments of various items.

3. Purchase and sale of foreign exchange.


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General utility function

1. Locker facility.

2. Traveller’s cheques.

3. Letter of credit.

4. Collection of statistics

10 Credit Creation Mechanism

Banking system as a whole facilitates creation of money through credit function. The structure of banking system enables creation of credit in excess of the deposits in the banking system as a whole. This is called the credit multiplier. The credit multiplier is possible because, the deposits in the banking system as a whole need not be in cash. Banks through the historical experience, understands that, they only to need a keep a fraction of their money in liquid cash to satisfy the needs of depositors at any point of time. To understand this let us define some terminologies in the banking system. Legal Reserve Ratio (LRR): It is legally reserve for the banks to keep a certain minimum fraction of their deposits as reserve. This fraction is called LRR. In India, we have 1.Cash reserve ratio (CRR) 2.Statutory liquidity ratio (SLR) Thus it is


Assuming there are infinity number of banks. Arranged in


B 1 , B 2 , B 3 ,

LRR = r


Let ‘D’ amount of deposit made by a customer in B 1 .

B 1 :




(1 r)D to B 2

B 2 :


r(1 r)D



(1 r) 2 D to B 3

B 3 :


r(1 r) 2 D

(1 r) 3 D to B 4

Now total money(M) created is

M = D 1 + (1 r) + (1 r) 2 + (1 r) 3 +


M = D





multiplier =



Exercise: If a person deposited Rs200 in a bank. And the SLR and CRR for a bank is 20% and 5% respectively. How much money get created in the economy ? Exercise: Deposited increased by Rs 10 in an economy. And the SLR and CRR for a bank is 15% and 5% respectively. How much money get created in the economy ?


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11 Equilibrium in Money Market

In the section 4 we discussed about the money supply measurements and in section 4 discussed about real money demand. We say, money market will be in equilibrium if real money demand is equal to real money supply. That is

M d


= M s


⇐⇒ M d = M s

The interest rate at which the demand for money becomes equal to supply of money, we call that interest rate to equilibrium interest rate.

Case - I (M d > M s ) In this case, people demand more money than supply. This means people expect that that financial asset price may decrease in future. Since the prices of these assets are inversely related to the expected real interest rate in future (term structure), thus expected real interest rate increases and market reaches equilibrium. That is, if

M d > M s =r

Case - II (M d < M s ) In this case people demand less money than current supply. This means, people have found that holding financial asset is more profitable that holding money (opportunity cost increases). Thus people will try to reallocate their portfolio and which ultimately will lead to higher demand for financial assets. This will lead to increase in asset price and thus decrease in real expected interest rate. That is

M d < M s =r

The End.