Need for Money

In a varied economy, producers will specialise in production

of certain goods, yet consume a diverse set of goods.
There are three basic solutions-
Barter – difficult to overcome double coincidence of wants
– difficult to equate the values of goods exchanged
because of indivisibility of goods
Government Allocation – inefficient use of information
and incentives
Money – solves all the problems of barter system and
removes inefficiency in government allocation
 Money
Money is whatever is generally
accepted in exchange for goods and
services – accepted not as an object to
be consumed but as an object that
represents a temporary room of
purchasing power to be used for buying
still other goods and services
- Milton Friedman
 Evolution of Definitive Money
• In 1400 BC precious metals emerged as
money
• The non-monetary use of commodity
money makes it difficult to continue as
money particularly when intrinsic value of
money is more than its face value
• Gresham’s Law ‘Bad money drives out
good’
 Evolution of Definitive Money
• In 600 AD China used paper money.
• In Europe paper money first came into use when
merchants issued receipts for the gold and other
precious things left with them for safekeeping.
• Fiat money intrinsically worthless item that can
be used as money by government declaration
that it is a legal tender, not to be converted into
any other precious metal.
 Evolution of Definitive Money
• Definitive Money – Money that can be
used immediately for transactions without
conversion to more basic form of money
• Currency
• Demand Deposits
 Functions of Money
• Money is the grease that lubricates the
economic machinery of the world. It
reduces the friction of the voluntary
exchange. Too little oil can leave some
parts cracking; too much oil can gum up
the works. Similarly, too little or too much
money in circulation makes exchange
more difficult and creates economic
problem.
 Functions of Money
• Money is the only commodity that is good
for nothing but to be gotten rid of. It will not
feed you, cloth you, shelter you or amuse
you unless you spend it or invest it.
People will do almost anything for money
and money will do almost anything for
people.
 Functions of Money
• Medium of exchange – avoids double
coincidence of wants – needs to be liquid,
portable and divisible.
• Unit of account – measures relative values of
goods – a yardstick – makes accounting easy –
lowers information costs
• Store of value – storing wealth from one point in
time to another – ability to hold value over time –
durable – fiat money is threatened by inflation as
a store of value
• Standard of differed payment – debt is
denominated in money terms
 Credit card and debit card as
money
• Credit card does function as store of value
if the company that issued it goes
bankrupt
• Debit card is money just like demand
deposits are treated as money
 Measures of Money Supply
• M1 = Currency with public+
Demand deposits with banks+
Other Deposits with RBI
• M2 = M1+ Post Office Deposits
• M3 = M1+ Time Deposits with Banks
• M4 = M3+ Total Post Office Deposits
• M1 is narrow money
• M4 is broad money
• M1 to M4 reduction in the extent of liquidity
 Reserve Bank of India
• Established on April 1, 1935 in accordance with
RBI Act 1934. Fully owned by GOI with a share
capital of Rs 5 crore.
• The preamble prescribes the objectives as “… to
regulate the issue of bank notes, keeping of
reserves with a view to securing monetary
stability in India and generally to operate the
currency and credit system of the country to its
advantage.”
 Functions of RBI
• Supervisory and Regulatory
Functions
• Promotional and Developmental
Functions
• Refinance Activities
 Functions of RBI
• Supervisory and Regulatory
• Issuance of currency notes based on minimum
reserve system
• Credit control – controlling the credit creating
abilities of the commercial banks CRR and SLR
• Exchange control – maintaining exchange rate
for smooth functioning of international trade
• Transfer of funds
 Functions of RBI
• Promotional and Developmental
• Banker to the government – collection and
disbursement of funds – management of
public debt and issues of new loans and
treasury bills – temporary advance to
government under ways and means
account – government’s financial agent –
advisor to government on fiscal and
monetary policies
 Functions of RBI
• Banker to banks
• Holds the reserves of the banks and acts
as a bank for central clearance
• Development finance
• Agriculture, NABARD
• industry IDBI, ICICI, IFCI etc
• Exports – EXIM Bank
• Priority sector lending
 Functions of RBI
• Training
• Banker’s Training College (BTC) Mumbai
• Reserve Bank Staff College (RSBC)
Madras
• College of Agricultural Banking (CAB)
Pune
• Zonal Training Centres
• Indira Gandhi Institute of Development
Research
 Functions of RBI
• Refinance activities
• Lender of last resort and other refinance
operations – repo and bank rate
 Monetary Policy
• Monetary policy refers to actions taken by RBI to
effect monetary magnitudes like money supply,
interest rate and credit availability and other
financial conditions
• Objectives of Monetary policy are price stability,
stable growth and higher employment
• Objectives are inter-related and trade-off is
essential. Price stability is most suited in current
situation
 Transmission Channels
• Quantitative channel – through money
supply and credit
• Interest rate channel
• Exchange rate channel
• Asset price channel
• Channels interact and provide feedback
on each other
 Impossible trinity
• Exchange rate, interest rate and inflation
are three target variables for Monetary
Policy
• Targeting all the three variable
simultaneously is called impossible trinity
• If inflation is targeted, then interest rate
and exchange management become
difficult
 Instruments of Monetary Policy
• Quantitative and Qualitative instruments
• Quantitative instruments include, Bank
Rate, Reserve Ratios, Repos, Open
Market Operations
• Qualitative instruments include Regulation
of credit, margin requirements and moral
suasion
 Bank Rate
• Bank rate or discount rate is the rate at which
the RBI rediscounts first class bills or
government securities
• If Bank rate declines then borrowing is cheaper
for banks
• Banks lend at lower interest rate to firms
• Firms increase production and income increases
• Increased income increase demand and then
the price level
 Repo Rate
• Repo is a repurchase agreement, wherein banks sell
approved securities to RBI with an agreement to buy the
same within one to fourteen days.
• The difference between the sale and purchase prices is
the repo rate.
• It is a short term loan provided by RBI to commercial
banks.
• Usually the repo rate is slightly below the overnight call
rate in the money market
• Repo rate is an instrument for short term liquidity
management
• The reverse transaction is called reverse repo
 Open Market Operations
• This refers to the sale and purchase of
securities like bills and bonds of the
government as well as private financial
institutions by the RBI
• The motive is to affect both interest rate
and availability of liquidity for credit
creation by commercial banks
 Qualitative Instruments
• Whenever commercial banks invests in
securities like equities, then the margin
money should be provided so that in the
event reduced return the loss can be
made good.
• Amount of credit to each sector can also
be fixed
• All these along with moral suasion will be
used to reduce credit creation