CHAPTER THREE
03
Money and Banking
What money really is, why people hold it, and how
the Reserve Bank and commercial banks together
create and control it.
CHAPTER OVERVIEW
Money is so familiar that we rarely stop to think about what it really is. This chapter
asks those basic questions and takes them further - how do banks create money
legally, and how does the Reserve Bank of India control how much money exists in
the economy?
What is money and what problems did it solve?
Why do people hold money? (Two motives: transaction and speculative)
How do banks create money - the money multiplier.
How does RBI control money supply - quantitative and qualitative tools.
Measures of money supply: M1 to M4.
WHAT IS MONEY AND WHY DOES IT
EXIST?
The Problem with Barter
Before money, people used barter - they
swapped goods directly. If you grew rice
and needed shoes, you had to find a
shoemaker who also happened to need
rice. This is called the double
coincidence of wants, and it made
trade extremely difficult.
Limitations of Barter Exchange
• Double coincidence of wants
• Lack of common unit to measure
• Problem in deferred payment
, • Problem in storing wealth
Imagine trying to pay your school fees in 50 kg of potatoes. That is the barter
problem.
How Money Solved the Problem
Money is simply anything that is commonly accepted as a medium of exchange. It
stepped in as the middleman in every transaction. Instead of swapping rice for shoes
directly, you sell rice for money, then buy shoes with that money.
The four functions of money:
Medium of Exchange: Removes the need for
double coincidence. Anyone accepts it for
anything.
Unit of Account: Everything gets a price tag in
money. Now you can compare values easily.
Store of Value: Save money for future use.
Unlike rice, money does not rot. But inflation
erodes its purchasing power.
Standard of Deferred Payment: Loans and
debts are made in money. Borrow Rs.10,000
today, repay Rs.11,000 next year.
▶ Purchasing power: When prices rise (inflation),
your money buys less - its purchasing power has
fallen.
DEMAND FOR MONEY
People hold money in their wallets and bank accounts instead of investing it all. Why?
Economists identify two main reasons.
Transaction Motive - For Daily Use
You need cash to buy things every day. Your income arrives monthly but your
expenses happen daily. So, you keep some cash on hand to bridge the gap.
• Transaction demand for money rises when income rises - more income means
more spending means more cash needed.
• It also rises when the price level rises - the same number of transactions cost
more in rupee terms.
▶ Formula: Transaction Demand = k x P x Y, where Y = real income, P = price
level, k = fraction held as cash
▶ Velocity of Circulation: = How many times Rs.1 changes hands per year.
Higher velocity means economy needs less money for same transactions.
Speculative Motive - As an Asset
People also hold money as a financial asset - a safe place to park wealth, especially
when they expect interest rates to rise. Bond prices and interest rates move in opposite
directions. When interest rates rise, bond prices fall - capital loss for bond holders.
03
Money and Banking
What money really is, why people hold it, and how
the Reserve Bank and commercial banks together
create and control it.
CHAPTER OVERVIEW
Money is so familiar that we rarely stop to think about what it really is. This chapter
asks those basic questions and takes them further - how do banks create money
legally, and how does the Reserve Bank of India control how much money exists in
the economy?
What is money and what problems did it solve?
Why do people hold money? (Two motives: transaction and speculative)
How do banks create money - the money multiplier.
How does RBI control money supply - quantitative and qualitative tools.
Measures of money supply: M1 to M4.
WHAT IS MONEY AND WHY DOES IT
EXIST?
The Problem with Barter
Before money, people used barter - they
swapped goods directly. If you grew rice
and needed shoes, you had to find a
shoemaker who also happened to need
rice. This is called the double
coincidence of wants, and it made
trade extremely difficult.
Limitations of Barter Exchange
• Double coincidence of wants
• Lack of common unit to measure
• Problem in deferred payment
, • Problem in storing wealth
Imagine trying to pay your school fees in 50 kg of potatoes. That is the barter
problem.
How Money Solved the Problem
Money is simply anything that is commonly accepted as a medium of exchange. It
stepped in as the middleman in every transaction. Instead of swapping rice for shoes
directly, you sell rice for money, then buy shoes with that money.
The four functions of money:
Medium of Exchange: Removes the need for
double coincidence. Anyone accepts it for
anything.
Unit of Account: Everything gets a price tag in
money. Now you can compare values easily.
Store of Value: Save money for future use.
Unlike rice, money does not rot. But inflation
erodes its purchasing power.
Standard of Deferred Payment: Loans and
debts are made in money. Borrow Rs.10,000
today, repay Rs.11,000 next year.
▶ Purchasing power: When prices rise (inflation),
your money buys less - its purchasing power has
fallen.
DEMAND FOR MONEY
People hold money in their wallets and bank accounts instead of investing it all. Why?
Economists identify two main reasons.
Transaction Motive - For Daily Use
You need cash to buy things every day. Your income arrives monthly but your
expenses happen daily. So, you keep some cash on hand to bridge the gap.
• Transaction demand for money rises when income rises - more income means
more spending means more cash needed.
• It also rises when the price level rises - the same number of transactions cost
more in rupee terms.
▶ Formula: Transaction Demand = k x P x Y, where Y = real income, P = price
level, k = fraction held as cash
▶ Velocity of Circulation: = How many times Rs.1 changes hands per year.
Higher velocity means economy needs less money for same transactions.
Speculative Motive - As an Asset
People also hold money as a financial asset - a safe place to park wealth, especially
when they expect interest rates to rise. Bond prices and interest rates move in opposite
directions. When interest rates rise, bond prices fall - capital loss for bond holders.
