Money and Banking
This textbook covers monetary economics, Fisher's MV=PT quantity theory, Cambridge M=kPY cash balance approach, commercial bank credit creation multipliers, RBI quantitative/qualitative monetary policy instruments, M1-M4 aggregates, banking sector reforms, NPAs, and IBC 2016.
Money and Quantity Theories
Money eliminates the double coincidence of wants inherent in barter trade. Its functions are categorized into Primary, Secondary, and Contingent functions:
Classification of Money Functions:
- Primary Functions: Medium of Exchange (facilitates market transactions) and Unit of Account (common denominator for pricing).
- Secondary Functions: Standard of Deferred Payments (facilitates credit contracts) and Store of Value (liquid wealth accumulation).
- Contingent Functions: Distribution of national income, equalization of marginal utilities, and basis of credit system.
Where: $M = \text{Primary Currency}$, $V = \text{Velocity of Currency}$, $M' = \text{Bank Credit Money}$, $V' = \text{Velocity of Credit}$, $P = \text{Price Level}$, $T = \text{Volume of Transactions}$.
Solved Numerical Example:
Problem: Given currency supply $M = \$1,000$, velocity $V = 5$, credit money $M' = \$500$, velocity $V' = 4$, and transaction volume $T = 1,400$ units. Calculate price level ($P$).
Solution:
$MV + M'V' = PT \implies (1000 \times 5) + (500 \times 4) = P \times 1400$
$5000 + 2000 = 1400P \implies 7000 = 1400P \implies P = 7000 / 1400 = 5$.
Answer: The General Price Level ($P$) is 5.
Cambridge economists (Alfred Marshall, A.C. Pigou, D.H. Robertson, J.M. Keynes) focused on the demand for money to hold as liquid cash balances:
Where: $M = \text{Money Supply}$, $k = \text{Fraction of real national income held in liquid cash}$, $P = \text{Price Level}$, $Y = \text{Real National Income}$.
Credit Creation and Central Banking
Commercial banks expand credit through derivative deposits. Given an initial primary deposit ($D$) and Cash Reserve Ratio ($\text{CRR}$), total credit created ($K$) is:
Step-by-Step Credit Expansion Round Table (Initial Deposit = $1,000, CRR = 10%):
| Banking Round | Primary Deposit ($) | Required Reserve (10%) ($) | Derivative Loan ($) |
|---|---|---|---|
| Bank A (Round 1) | 1,000.00 | 100.00 | 900.00 |
| Bank B (Round 2) | 900.00 | 90.00 | 810.00 |
| Bank C (Round 3) | 810.00 | 81.00 | 729.00 |
| Total System Output | $10,000.00 | $1,000.00 | $9,000.00 |
| Tool Category | Policy Instrument | Operational Mechanism |
|---|---|---|
| Quantitative (General) | Repo Rate | Short-term rate at which RBI lends money to commercial banks against government securities. |
| Quantitative (General) | Cash Reserve Ratio (CRR) | Percentage of Net Demand and Time Liabilities (NDTL) banks must park as cash with RBI. |
| Quantitative (General) | Statutory Liquidity Ratio (SLR) | Percentage of NDTL banks must maintain in liquid assets (gold, government bonds). |
| Quantitative (General) | Open Market Operations (OMO) | Sale/Purchase of government securities in open market to regulate systemic liquidity. |
| Qualitative (Selective) | Margin Requirements & Credit Rationing | Directing credit flow to specific priority sectors and setting loan-to-value caps. |