currency
currency
In simple terms, an item which is generally accepted as a medium of exchange is called money.
or
Money is defined as an instrument that serves as a medium of exchange, a store of value, a measure of value, and a standard for deferred payments.
Origin of currency
In the beginning of civilization, human needs were simple and limited. People used to exchange goods with each other to fulfill their needs. Such an economy, where there is direct exchange of goods and services, was called 'barter economy'
Drawbacks of Barter Economy
1. The difficulty of double coincidence
2. Difficulty in measuring the value of the commodity
3. Future savings are not possible
4. Difficulty in exchange of indivisible goods
5. Difficulty in uncovering
Evolution of currency
Due to the multiplicity of needs, the barter system proved to be an inefficient system of exchange. Then money was invented as a common medium of exchange. No longer were goods sold for goods. Instead, goods were sold for money.
Currency changed its form over time like –
The evolution of money is related to the need to facilitate exchange.
Metal currency (gold and silver) 👉 Alloy with paper currency 👉 Plastic money (credit/debit) 👉 E-money
Basic functions of money
1. Primary function
1. Medium of exchange
In an exchange economy, money plays the role of an intermediary. It makes the exchange system smooth and convenient.
2. Measure of value
The value of a product or service is determined based on the money required to acquire it. This helps make the exchange a mutually beneficial activity.
2. Secondary functions
1. Standard of deferred payment
Money plays an important role in lending and borrowing. Money is taken as a loan and is repaid after a time interval.
2. Storage of value
We can store the purchasing power of money and keep a part of it for future use which is called monetary savings
Types of currency
1. Order currency
Order money is the money which is issued by order (authority) of the government.
2. Trust seal
Trust currency is a currency that is accepted as a medium of exchange because of the trust between the payer and receiver.
3. Full body pose
- Money value in full form of money = commodity value of money.
- Credit money : Money value of coins and notes > Commodity value of coins and notes.
money supply
Money supply is a stock concept. It refers to the total money stock held by the people of a country at a given point in time.
It is important to note that the money supply does not include the money stock held by the government, and the money stock held by the banking system of a country.
Measures of Money Supply
In India, there are four alternative measures of money supply, popularly known as M1, M2, M3 and M4.
M1 = C + DD + OD
Who supplies money?
Suppliers of currency include:
1. Central Bank of the country (RBI in India) :- In India, RBI is the major supplier of currency. RBI issues currency on the basis of minimum reserve system. Under this system, the Reserve Bank maintains a minimum reserve of 200 crores in the form of gold and foreign securities. In this reserve, the value of gold should be 115 crores.
2. Commercial Banks :- Commercial banks are the suppliers of money as they create money through demand deposits. These deposits serve as the supply of money as these are checkable deposits. People can withdraw or transfer money by writing a check. The money created by commercial banks through demand deposits is called bank money.
3. Government :- Government is the third source of money supply in the country. In India, the Finance Ministry issues one rupee notes and coins.
Banking
Banking
A bank is an institution that provides its customers with the facility of all money related transactions. In India, this work is done by commercial banks.
Commercial Banks
- Commercial banks are the primary unit of the Indian banking system. Like other businesses, commercial banks also aim to earn profits and for this they provide a variety of services to their customers.
- Such as accepting deposits, giving loans and investing.
- State Bank of India (SBI), Punjab National Bank (PNB), Allahabad Bank, Canara Bank are some examples of commercial banks in India.
The process of money creation by commercial banks
1. Commercial banks create credit in the form of demand deposits (DD).
2. Bank deposits are available in two forms
- Primary Deposit:- Depositing in the form of cash is called primary deposit.
- Secondary Deposit:- Instead of taking the loan from bank in cash, opening a demand deposit account in the bank and depositing the loan amount is called secondary deposit.
Statutory Fund Ratio (LRR)
Broadly speaking, when a bank receives cash deposit from public, it keeps a part of the deposit with itself as LRR (Statutory Fund Ratio) and lends the remaining amount to others to earn interest. These are of two types.
1. Cash Reserve Ratio (CRR): It is the minimum percentage of a bank's total deposits that it is required to keep with the RBI.
2. Statutory Liquidity Ratio (SLR) : Every bank is required to maintain a certain percentage of its assets as liquid assets, called SLR. Liquid assets include cash, gold, unencumbered approved securities.
👉During the process of giving loan, the bank creates credit many times more than the primary deposits in the form of secondary deposits.
Formula for building credit: -
Central bank
- The Reserve Bank of India (RBI) is the central bank of India.
- The central bank is the apex bank that controls the entire banking system of the country. It is the only agency to issue notes and controls the supply of money in the economy.
- It acts as a banker to the government and manages the country's foreign exchange reserves.
Functions of the Central Bank
1. Issue of notes
- The central bank of a country has the exclusive right (monopoly right) to issue notes.
- This is called the monetary authorization function of the central bank.
- Notes issued by the central bank are unlimited legal tender.
2. Financial Adviser to the Government
- As the banker to the government, it manages the accounts of the government.
- As an agent of the government, it buys and sells securities on behalf of the government.
- As an advisor to the government, it formulates policies to regulate the currency market.
3. As a bankers bank
- It has almost the same relationship with other banks in the country as a commercial bank has with its customers.
- The central bank accepts deposits from commercial banks, and provides loans to them.
- The central bank provides 'clearing house' facility to the commercial banks.
- In its supervisory role, the central bank ensures that commercial banks comply with its instructions, especially those relating to CRR and SLR.
- It makes changes in it as per the need and the commercial banks comply with it so that the desired goals can be achieved.
4. Lender of Last Resort
- If a commercial bank fails to get financial support from anywhere, it approaches the central bank as a last resort.
- The central bank grants loans to such banks against approved securities.
- By lending to commercial banks in emergency situations, the central bank ensures that
- There should be no shock to the country's banking system, and the currency market should remain stable.
5. Custodian of foreign exchange
- The central bank is the custodian of the country's foreign exchange reserves.
- It also uses 'managed floating' to ensure exchange rate stability in the international currency market.
- Managed floating refers to the sale and purchase of foreign currency with the aim of achieving exchange rate stability for the domestic currency.
6. This clearing house
- Commercial banks settle their mutual creditors and liabilities by simply making transfer entries.
- Every bank has an account in the central bank. These banks receive cheques from each other which the central bank pays from their accounts.
- As a result, there is no need for cash transactions.
7. Control over debt
- The main function of the central bank is to control the supply of credit in the economy.
- To increase or decrease the supply of money in the economy by regulating 'credit creation' by commercial banks.
- To deal with situations of inflation and deflation the central bank needs to control the money supply.
- During inflation, the money supply decreases and during deflation, it increases.
Control of money supply by the central bank (RBI)
Central banks adopt various measures to control the supply of money in the economy. Broadly, these measures relate to the supply of credit by commercial banks.
These are classified into two types:
(A) Quantitative Tools
(B) Qualitative tools
These tools are used to decrease the money supply during inflation in the economy and to increase the money supply during deflation in the economy.
(A) Quantitative tools of credit control
Quantitative tools are those tools of credit control that focus on the overall supply of money in the economy.
1. Bank rate
- Bank rate is the rate at which the central bank lends money to commercial banks.
- Bank rate is different from the market interest rate.
- Interest rate is the rate at which commercial banks lend money to the public in the market.
- When the bank rate increases, the interest rate also increases, due to which loans become expensive and the demand for credit by traders decreases.
- Hence, in case of inflation and excess demand, the central bank increases the bank rate and thus directly controls the credit given by commercial banks.
- On the contrary, in a situation of lack of demand and recession, the central bank indirectly increases the availability of credit by reducing the bank rate.
2. Open market processes
- This refers to the buying and selling of government securities in the open market by the central bank.
- When the central bank sells securities to commercial banks, it withdraws cash worth that amount from them.
- Due to which the lending capacity of commercial banks falls. In this way the central bank controls the availability of credit.
- In case of economic recession, the central bank increases the cash reserves of commercial banks by purchasing securities, thereby increasing the availability of credit
3. Repo rate
- The rate at which RBI (central bank) provides short term loans to commercial banks by buying government securities in the open market is called 'repo rate'.
- A repurchase agreement is signed by both the parties. RBI issues loan cheques to the commercial banks by purchasing the government securities from them.
- During inflation, the cost of capital is increased by increasing the repo rate. This reduces the demand for loans and accordingly, the supply of money in the economy, as expected, decreases.
- On the other hand, during deflation, the cost of capital is reduced by lowering the repo rate. This increases the demand for loans and accordingly, the supply of money in the economy increases as desired.
4. Reverse repo rate
- The rate at which commercial banks accept deposits (through government securities) is called the 'reverse repo rate'. It is also called the reverse repurchase rate.
- In this case, a reverse repurchase agreement is signed by both parties stating that the securities will be repurchased on a specified date at a predetermined price.
- The reverse repo rate allows commercial banks to generate interest income.
5. Cash Reserve Ratio (CRR)
- This is the minimum percentage of a bank's total deposits that it is required to keep with the RBI.
- It is decided by the RBI and changed from time to time to regulate the supply of money in the economy.
- When the money supply needs to be increased, the CRR is decreased and when the money supply needs to be decreased, the CRR is increased.
6. Statutory Liquidity Ratio (SLR)
- Every bank is required to maintain a certain percentage of its assets as liquid assets, called SLR. Liquid assets include cash, gold, unencumbered approved securities.
- The rate of SLR is decided by the RBI and changes from time to time. To reduce the money supply, the central bank increases the SLR.
- CRR reduces the money available for deposits. Conversely, SLR is reduced to increase the supply of money in the economy.
- CRR-money available for deposits (for creation of credit) is increased.
B. Qualitative tools of credit control
Qualitative instruments are those instruments of credit control that focus on select sectors of the economy. These instruments are used to increase or decrease the money supply in select sectors of the economy.
1. Moral pressure
- It means persuading and requesting the commercial banks by the central bank to follow the monetary policy of the central bank.
- The central bank can use its moral influence and persuade the banks to restrict the money supply.
- Moral pressure is applied through discussions, letters, speeches, advice etc.
2. Margin requirement
- Margin is the difference between the value of the security and the amount of the loan.
- If the margin requirement increases, lending may decrease. While a decrease in margin requirement leads to expansion of credit.
3. Credit rationing
- Credit rationing means imposing limits and charging high/low rates of interest to selected sectors. Such measures restrict the flow of credit to a particular sector.
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