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$\text{Deposit creation} = \text{initial deposit}\times\frac{1}{\text{LRR}}.$
Money is anything that can serve as a medium of exchange. All types of things like animals, agricultural produce, metals had been used as a medium for exchange. The commodities served well as long as the volume of trade was small. Later on metals like gold and silver were used as money. They were durable, they could be divided into monetary units and they were limited in supply. The inconvenience of metals in handling large transactions, lack of safety during transportation, etc. Were the main problems faced. This lead to use of paper currency as a medium of exchange. With further increase in volume of transactions bank money in the form of Cheques, Credit Cards, etc. is now also used as money.
Components:
Money is define as something that serves as a medium of exchange, a unit of accounting, and a store of value.
Medium of exchange function:
Money came into use to remove the inconveniences of barter as money has separated the act of purchase from sale. Medium of exchange is the basic or primary function of money.
Deferred payments are payments which are made some time in the future. Debts are usually expressed in terms of the money of account. Loans are taken and repaid in terms of money.The use of money as the standard of deterred or delayed payments immensely simplifies borrowing and lending operations because money generally maintains a constant value through time.
A commercial bank is a financial institution which performs the functions of accepting deposits from the general public and giving loans for investment with the aim of earning profit.
Functions of commercial banks:
The second major function of a commercial bank is to give loans and advances particularly to businessmen and entrepreneurs and thereby earn interest. This is, in fact, the main source of income of the bank. A bank keeps a certain portion of the deposits with itself as reserve and gives (lends) the balance to the borrowers as loans and advances in the form of cash credit, demand loans, short-run loans, overdraft as explained under.
An eligible borrower is first sanctioned a credit limit and within that limit he is allowed to withdraw a certain amount on a given security. The withdrawing power depends upon the borrower’s current assets, the stock statement of which is submitted by him to the bank as the basis of security. Interest is charged by the bank on the drawn or utilised portion of credit (loan).
A loan which can be recalled on demand is called demand loan. There is no stated maturity. The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower. Those like security brokers whose credit needs fluctuate generally, take such loans on personal security and financial assets.
Short-term loans are given against some security as personal loans to finance working capital or as priority sector advances. The entire amount is repaid either in one instalment or in a number of instalments over the period of loan.
Double coincidence of wants means what one person wants to sell and buy must coincide with what some other person wants to buy and sell. ‘Simultaneous fulfilment of mutual wants by buyers and sellers’ is known as double coincidence of wants.
There is lack of double coincidence in the wants of buyers and sellers in barter exchange. The producer of jute may want shoes in exchange for his jute. But he may find it difficult to get a shoe-maker who is also willing to exchange his shoes for Jute.
Thus, a seller has to find out a person who wants to buy seller’s good and at the same time who must have what the seller wants. This is called double coincidence of wants which is the main drawback of the barter exchange.
Money as medium of exchange solves the barter’s problem of lack of double coincidence of wants as money has separated the acts of sale and purchase. You can sell goods for money to whosoever wants it and with this money you can buy goods from whosoever wants to sell them.
Money is accepted as medium of exchange. People exchange goods and services through medium of money when they buy goods or sell goods. Thus, money becoming intermediary solves barter’s problem of double coincidence of wants.
Explanation:
Medium of exchange: Buying and selling is done with money. It has facilitated trade.
Standard of Deferred Payment:
Deferred payments mean those payments which are to be made in the future. If a loan is taken today, it would be paid back after a period of time.
The amount of loan is measured in terms of money and it is paid back in money. A large number of credit transactions involving huge future payments are made daily. Money performs this function of standard for deferred payments because its value remains more or less stable.
Store of value: Money is the most liquid asset (Liquidity measures how easily assets can be spent to buy goods and services). Money’s value can be retained over time. It is a convenient way to store wealth. Storage of value is one of the three generally accepted functions of money. The other functions are the medium of exchange, which is used as an intermediary to avoid the inconveniences of the coincidence of wants, and the unit of account, which allows the value of various goods, services, assets and liabilities to be rendered in multiples of the same unit.
Acceptance of Deposits:
Accepting deposits is the primary function of a commercial bank mobilise savings of the household sector. Banks generally accept three types of deposits viz., (1) Current Deposits (2) Savings Deposits (3) Fixed Deposits.
These deposits are also known as demand deposits. These deposits can be withdrawn at any time. Generally, no interest is allowed on current deposits, and in case, the customer is required to leave a minimum balance undrawn with the bank. Cheques are used to withdraw the amount. These deposits are kept by businessmen and industrialists who receive and make large payments through banks. The bank levies certain incidental charges on the customer for the services rendered by it.
This is meant mainly for professional men and middle class people to help them deposit their small savings. It can be opened without any introduction. Money can be deposited at any time, but the maximum cannot go beyond a certain limit. There is a restriction on the amount that can be withdrawn at a particular time or during a week. If the customer wishes to withdraw more than the specified amount at any one time, he has to give prior notice. Interest is allowed on the credit balance of this account. The rate of interest is greater than the rate of interest on the current deposits and less than that on fixed deposit. This system greatly encourages the habit of thrift or savings.
These deposits are also known as time deposits. These deposits cannot be withdrawn before the expiry of the period for which they are deposited or without giving a prior notice for withdrawal. If the depositor is in need of money, he has to borrow on the security of this account and pay a slightly higher rate of interest to the bank. They are attracted by the payment of interest which is usually higher for longer period. Fixed deposits are liked by depositors both for their safety and as well as for their interest. In India, they are accepted between three months and ten years.
Acceptance of Deposits:
Accepting deposits is the primary function of a commercial bank mobilise savings of the household sector. Banks generally accept three types of deposits viz., (1) Current Deposits (2) Savings Deposits (3) Fixed Deposits.
These deposits are also known as demand deposits. These deposits can be withdrawn at any time. Generally, no interest is allowed on current deposits, and in case, the customer is required to leave a minimum balance undrawn with the bank. Cheques are used to withdraw the amount. These deposits are kept by businessmen and industrialists who receive and make large payments through banks. The bank levies certain incidental charges on the customer for the services rendered by it.
This is meant mainly for professional men and middle class people to help them deposit their small savings. It can be opened without any introduction. Money can be deposited at any time but the maximum cannot go beyond a certain limit. There is a restriction on the amount that can be withdrawn at a particular time or during a week. If the customer wishes to withdraw more than the specified amount at any one time, he has to give prior notice. Interest is allowed on the credit balance of this account. The rate of interest is greater than the rate of interest on the current deposits and less than that on fixed deposit. This system greatly encourages the habit of thrift or savings.
These deposits are also known as time deposits. These deposits cannot be withdrawn before the expiry of the period for which they are deposited or without giving a prior notice for withdrawal. If the depositor is in need of money, he has to borrow on the security of this account and pay a slightly higher rate of interest to the bank. They are attracted by the payment of interest which is usually higher for longer period. Fixed deposits are liked by depositors both for their safety and as well as for their interest. In India, they are accepted between three months and ten years.
The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the government mint but they are put into circulation through the central bank.
Central banks have been following different methods of note issue in different countries. The central bank is required by law to keep a certain amount of gold and foreign securities against the issue of notes. In some countries, the amount of gold and foreign securities bears a fixed proportion, between 25 to 40 per cent of the total notes issued.
In other countries, a minimum fixed amount of gold and foreign currencies is required to be kept against note issue by the central bank. This system is operative in India whereby the Reserve Bank of India is required to keep Rs 115 crores in gold and Rs 85 crores in foreign securities. There is no limit to the issue of notes after keeping this minimum amount of Rs 200 crores in gold and foreign securities.
The monopoly of issuing notes vested in the central bank ensures uniformity in the notes issued which helps in facilitating exchange and trade within the country. It brings stability in the monetary system and creates confidence among the public. The central bank can restrict or expand the supply of cash according to the requirements of the economy. Thus it provides elasticity to the monetary system. By having a monopoly of note issue, the central bank also controls the banking system by being the ultimate source of cash. Last but not the least, by entrusting the monopoly of note issue to the central bank, the government is able to earn profits from printing notes whose cost is very low as compared with their face value.
De Kock regards this function as a sine qua non of central banking. By granting accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and dealers, or other financial institutions, the central bank acts as the lender of the last resort.
The central bank lends to such institutions in order to help them in times of stress so as to save the financial structure of the country from collapse. It acts as lender of the last resort through discount house on the basis of treasury bills, government securities and bonds at “the front door”.
The other method is to give temporary accommodation to the commercial banks or discount houses directly through the “back door”. The difference between the two methods is that lending at the front door is at the bank rate and in the second case at the market rate. Thus the central bank as lender of the last resort is a big source of cash and also influences prices and market rates.
Monetary policy refers to the policies and instruments through which the central bank controls the supply of money and credit. These instruments of monetary policy can be broadly classified into the following two categories.
The three instruments of monetary policy include:
Moral Suasion: A persuasion technique followed by the central bank to pressurise the commercial banks to abide by the monetary policy is termed as moral suasion. This involves meetings, seminars, speeches and discussions, which explains the present economic scenario and thereby persuading the commercial banks to adapt the changes needed. In other words, this is an unofficial monetary policy that exercises the power of talk.
Direct Action: The central bank can also take direct action against those commercial banks who do not abide by its directives and policy changes. In this case, the central bank may directly refuse any grant of further funds to such banks.
Cash reserve ratio (CRR): It refers to the minimum proportion of the total deposits that the commercial banks has to maintain with the central bank in form of reserves.
An increase in the CRR, would mean that banks would be required to keep a greater portion in form of deposits with the central bank. This implies that the commercial banks are left with lesser amount of funds to lend out. Hence, the lending capacity of the banks reduces, leading to fall in the money supply. On the contrary, a fall in CRR will lead to an increase in the money supply.
$\text{M}^{\text{D}}_{\text{T}}=\text{K T}$
Or, $\frac{1}{\text{k}}\text{M}^{\text{D}}_{\text{T}}=\text{T}$ Or, $\text{v}\text{M}^{\text{D}}_{\text{T}}=\text{T}$$\text{v}=\frac{1}{\text{k}^{2}}$, represents velocity of circulation of money.
T = Total value of transactions in the economy over a period of time K is a positive fraction$(\text{M}^{\text{D}}_{\text{T}})$ = Stock of money people are willing to hold at a particular point of time.
The transaction demand for money is positively related to the total value of transactions and negatively related to the velocity with which money is circulated.$\text{A}=\text{P}\Big(1 + \frac{\text{r}}{100}\Big)^{\text{n}}$
It is given that A = Rs. 500 r = 5% n = 2 years Substituting the values in the formula$500=\text{P}\Big(1 + \frac{5}{100}\Big)^{2}$
$500=\text{P}\Big(1 + \frac{1}{20}\Big)^{2}$
$500=\text{P}\Big( \frac{21}{20}\Big)^{2}$
$500=\text{P}\Big( \frac{441}{400}\Big)$
$\text{P}= \frac{200000}{441}$
So, P = Rs 453.51 Therefore, Price of the bond is Rs. 453.51.OR
Explain the effect of Cash Reserve Ratio (CRR) on credit creation by commercial banks.OR
What are open market operations? How do these affect availability of credit?OR
How does a central bank influence credit creation by commercial banks by open market operations? Explain.OR
Explain 'banker to the government' function of the Central Bank.| S. No. | Basis | Quantitative Instruments | Qualitative Instruments | ||||||||||||||||||
| 1. | Meaning | These are the instruments of monetary policy that affect overall supply of money credit in the economy. | These instruments are used to regular the direction of credit. | ||||||||||||||||||
| 2. | Alternative Name | Traditional methods of control. | Selective methods of control. | ||||||||||||||||||
| 3. | Instruments |
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