CBSE Class 12 Economics Money And Banking Notes Set 02

BANKING

• Money Creation by the Commercial Banks
• The Central Bank: Meaning and Functions
• Control of Money Supply by the Central Bank (RBI in India)

I. MONEY CREATION BY THE COMMERCIAL BANKS

In the previous chapter, we noted that the commercial banks are an important source of money supply in the economy. Unlike the central bank, the commercial banks do not have the authority of issuing currency: they cannot issue notes or coins. Yet, they are the suppliers of money as they create money by way of demand deposits. In the present chapter, we discuss the process of money creation by the commercial banks: how exactly the commercial banks create money?

Process of Money Creation by the Commercial Banks

Following observations explain the process of money creation by the commercial banks:

(i) Banks receive cash deposits from the people. These are called 'primary deposits'.

(ii) Banks lend money many times more than their cash reserves.

(iii) Money is lent by the commercial banks not in the form of cash, but in the form of 'credit entry' in the accounts of the borrowers. These credit entries are known as secondary deposits.

(iv) The borrowers can issue cheques against 'credit' (loans) in their accounts. The cheques circulate in the economy as money.

(v) Primary deposits + Secondary deposits = Demand deposits held by the people in the commercial banks

(vi) Total demand deposits with the banks are many times more than the cash reserves of the commercial banks. This is because the commercial banks know (by way of their historical experience) that all the depositors would not show up in the banks to withdraw all their deposits by way of cash.

(vii) If experience shows that withdrawals are generally around 10 per cent of demand deposits, the banks need to keep only 10 per cent of deposits as cash reserves.

(viii) All demand deposits (held by the people) serve as money supply in the economy, just like cash held by the people.

(ix) Demand deposits serving as money supply is called bank money. This is money created by the banks. Because this is circulating in the system not in the form of cash, but in the form of cheques issued by the banks to the holders of demand deposits.

Illustration

Let us illustrate the process of credit creation with the help of an example. For the sake of simplicity, we assume that:

• There is a 'single banking system' in the economy and initially, the bank receives deposits of Rs. 1,000.
• CRR = 10% and it does not change. This reflects cash reserves of the commercial banks as a percentage of their demand deposits.

Table 1 shows how the system would work for the creation of money:

Table 1. Creation of Money in a Single Banking System
Rounds | Deposits (Rs.) | Loans (Rs.) | Cash Reserves (Rs.) (CRR = 10%)
1st Round | 1,000 | 900 | 100
2nd Round | 900 | 810 | 90
3rd Round | 810 | 729 | 81
(and so on till all excess reserves are exhausted)
Total | 10,000 | 9,000 | 1,000

• In the first round, bank receives deposits of Rs. 1,000.
• The cash reserves to tackle the liability of Rs. 1,000 is equal to Rs. 100 (because cash reserve ratio is = 10% of total deposits). Implying that the banks have excess reserves = Rs. 1,000 - Rs. 100 = Rs. 900 which they can use for the purpose of lending.
• When these excess reserves are loaned out, deposits of the banks are raised by Rs. 900. The banks need to hold cash reserves as 10% of Rs. 900 or Rs. 90. Now, excess reserves of the bank is Rs. 900 - Rs. 90 = Rs. 810 which can be loaned. This process continues till total demand deposits are Rs. 10,000 and cash reserves are Rs. 1,000.

Thus, if cash reserve ratio is equal to 10%, initial deposits of Rs. 1,000 allows the bank to create demand deposits up to Rs. 10,000. So that,
\( \text{Demand Deposits} = \frac{1}{\text{CRR}} \times \text{Cash Reserves} \)
\( = \frac{1}{10\%} \times \text{Rs. 1,000} \)
\( = 10 \times \text{Rs. 1,000} = \text{Rs. 10,000} \)

Summing up, we can say that money creation by the commercial banks depends on two principal factors, as under:

• Cash Balances with Commercial Banks which they can use as cushion money (emergency fund) for the creation of credit. Higher these cash balances, greater the money creation (or credit creation) capacity of the commercial banks, and
• CRR: Higher the CRR, lower the capacity to create money.

Besides the CRR (cash which the commercial banks ought to keep), the banks may hold excess reserves, as 'vault cash'. Higher the vault cash, lower would be the capacity to create money.

FOCUS ZONE

Primary and Secondary Deposits

Primary deposits are cash deposits with the commercial banks by the people. These are a part of total demand deposits of the banks.
Secondary deposits are those deposits which arise on account of loans by the banks to the people. These are also a part of total demand deposits of the banks.
Important to note it is, that while primary deposits indicate savings of the depositors with the banks, secondary deposits indicate borrowings of the depositors from the banks. Secondary deposits are also called Derivative Deposits.
Total Demand Deposits of the Commercial Banks = Primary Deposits of the Commercial Banks + Secondary Deposits of the Commercial Banks.

CRR and Credit Multiplier

In India, CRR is determined not by the commercial banks themselves but by the RBI (Reserve Bank of India). Therefore, it is also called LRR (Legal Reserve Ratio).
Also, the commercial banks are required to keep the stipulated (legally required) cash reserves not with themselves, but with the RBI (of course, the banks can keep excess reserves as 'vault cash' with themselves).
Once CRR is known (as fixed by the RBI), we can find out 'credit multiplier', or the number of times the commercial banks can create credit, per unit of their cash reserves with the RBI.

Credit multiplier is found in terms of the following equation:
\( k = \frac{1}{\text{CRR}} \)
Here, k = Credit multiplier.
CRR = Cash reserve ratio.
Example: If CRR = 10%, then
\( k = \frac{1}{10\%} = \frac{100}{10} = 10 \)
It implies that if CRR = 10% then the commercial banks can credit money 10 times of their cash reserves with the central bank. Thus:
if cash reserves are = Rs. 10,000, the commercial banks can create credit, as per the following equation:
\( \text{Credit Creation or Money Creation} = \text{Rs. 10,000} \times \frac{1}{10\%} \)
\( = \text{Rs. 10,000} \times \frac{100}{10} = \text{Rs. 1,00,000} \)
Note that this is the maximum amount of money (credit) that the commercial banks can create given their cash reserves. This is because CRR is legally determined by the RBI, and the commercial banks must comply with it.

FOCUS ZONE

Credit Multiplier
\( k = \frac{1}{\text{CRR}} \)
Here, k = Credit multiplier, CRR = Cash reserve ratio.
In India, CRR is fixed by the RBI. Accordingly, credit multiplier indicates the maximum amount of money that the commercial banks can create, given their cash reserves with the RBI.

2. THE CENTRAL BANK

The central bank is an apex bank that controls the entire banking system of a country. It is the sole agency of note issuing and controls the supply of money in the economy. It serves as a banker to the government and manages forex (foreign exchange) reserves of the country. Reserve Bank of India (RBI) is the central bank of India.

Functions of the Central Bank

Principal functions of the central bank are as under:

• Bank of Issuing Notes: Central bank of a country has the exclusive right (monopoly right) of issuing notes. This is called Currency Authority function of the central bank. The notes issued by the central bank are an unlimited legal tender.
• Banker to the Government: Central bank is a banker, agent, and financial advisor to the government.
  • As a banker to the government, it manages accounts of the government.
  • As an agent to the government, it buys and sells securities on behalf of the government.
  • As an advisor to the government, it frames policies to regulate the money market.
• Bankers' Bank and Supervisory Role: As a Bankers' Bank, it has almost the same relation with other banks in the country as a commercial bank has with its customers. Three observations need to be noted in this context:
  • (i) The central bank accepts deposits from the commercial banks, and offers them loan.
  • (ii) The central bank provides 'Clearing House' facility to the commercial banks. It is a cheque clearing facility provided at one centre to all the banks.
  • (iii) In its supervisory role, the central bank ensures that the commercial banks show compliance to its directives, particularly relating to CRR and SLR. The central bank changes CRR, SLR as and when required. It ensures that the commercial banks show compliance to these changes so that the desired targets are achieved.
• Lender of the Last Resort: It means that if a commercial bank fails to get financial accommodation from anywhere, it approaches the central bank as a last resort. Central bank advances loan to such a bank against approved securities. By offering loans to the commercial banks in situations of emergency, the central bank ensures: (i) that the banking system of the country does not suffer any set-back, and (ii) that money market remains stable.
• Custodian of Foreign Exchange: Central bank is the custodian of nation's foreign exchange reserves. It also exercises 'managed floating' to ensure stability of exchange rate in the international money market. Managed floating refers to the sale and purchase of foreign exchange with a view to achieving stability of exchange rate for the domestic currency.
• Clearing House Function: Central bank performs the function of a clearing house. Let us take an example to understand this function. Supposing, Bank A receives a cheque of Rs. 10,000 drawn on Bank B, and Bank B receives a cheque of Rs. 15,000 drawn on Bank A. Both, Banks A and B have their accounts with the central bank. The cheques of both the banks are cleared through their accounts with the central bank. This is how the central bank acts as a clearing house. It avoids transfer of cash between the banks and reduces requirement of cash.
• Control of Credit: The principal function of the central bank is to control the supply of credit in the economy. It implies increase or decrease in the supply of money in the economy by regulating the 'creation of credit' by the commercial banks. The central bank needs to control the supply of money to cope with the situations of inflation and deflation. During inflation, the supply of money is reduced and during deflation, it is increased. Section 3 of the chapter gives a detailed description of how the central bank controls supply of money in the economy.

Performing all these functions, the central bank focuses on growth with stability. (Growth refers to a sustained rise in GDP. Stability refers to the elimination of inflationary and deflationary situations in the economy.)

FOCUS ZONE

The Central Bank and A Commercial Bank—The Difference

The Central Bank
(i) The central bank is the apex bank—the bank of all banks in the country. All commercial banks function under the control of the central bank. It accepts deposits from the commercial banks and advances loans to them. But, it does not deal with the general public.
(ii) The central bank regulates the supply of money, besides being the principal source of money supply in the economy.
(iii) The central bank is a custodian of forex reserves of the country. It conducts 'managed floating' to regulate exchange rate of the domestic currency.
(iv) The central bank is a note issuing authority. It is a currency authority of the country.
(v) The central bank focuses on growth and stability of the economy.

A Commercial Bank
(i) A commercial bank is that financial institution which accepts deposits from the general public and offers loans to the people for purpose of consumption and investment.
(ii) A commercial bank only contributes to the supply of money by way of credit creation.
(iii) A commercial bank is not a custodian of forex reserves of the country. However, it deals in the sale and purchase of foreign exchange for purpose of profit.
(iv) A commercial bank is not a note issuing authority. It is not a currency authority.
(v) A commercial bank focuses on profit maximisation.

HOTS

Question. What is the significance of centralised cash reserves with central bank?
Answer: Two observations need to be noted in this context:
(i) Centralised cash reserves enable the RBI to offer financial help to the commercial banks during emergencies. It is called 'financial accommodation' by the RBI. Banks get financial accommodation (or financial help) in times of emergency.
(ii) Centralised cash reserves enable the RBI to exercise control over the commercial banks. Because these reserves depend on CRR (fixed by RBI in India) and by varying the CRR, the RBI can increase or decrease the credit creation capacity of the commercial banks. Accordingly, money supply in the economy is regulated.

3. CONTROL OF MONEY SUPPLY (OR CREDIT SUPPLY) BY THE CENTRAL BANK (RBI IN INDIA)

The central bank adopts various measures to control the supply of money in the economy. Largely, these measures relate to credit supply by the commercial banks. These are broadly classified as:

• Quantitative Instruments, and
• Qualitative Instruments.

Following is a brief description of these instruments. It may be noted that these instruments are used to decrease the supply of money when there is inflationary spiral in the economy and to increase the supply of money when there is deflationary spiral in the economy.

(A) Quantitative Instruments of Credit Control

Quantitative instruments are those instruments of credit control which focus on the overall supply of money in the economy. Supply of money is lowered to tackle inflation, and it is raised to tackle deflation. Following is a brief description of these instruments:

(1) Bank Rate: Bank rate refers to the rate of interest at which the RBI lends money to the commercial banks. It relates to instant (immediate) loan requirement of the commercial banks. The increase (or decrease) in bank rate is often followed by increase (or decrease) in the market rate of interest (the interest rate charged by the commercial banks from the general public). Accordingly, the cost of credit (also called the cost of capital) changes in the market. When bank rate is increased, market rate of interest is also increased. Accordingly, the cost of capital increases. This lowers the demand for credit and therefore, the supply of money tends to fall. Accordingly, inflation is corrected. On the other hand, when bank rate is decreased, market rate of interest is also decreased. Accordingly, the cost of capital decreases. This increases demand for credit and therefore, supply of money tends to rise. Accordingly, deflation is corrected.

Rise in Bank Rate
\( \implies \) Rise in market rate of interest
\( \implies \) Rise in cost of capital
\( \implies \) Fall in demand for credit
\( \implies \) Fall in the supply of money
\( \implies \) Inflation is controlled.

Fall in Bank Rate
\( \implies \) Fall in market rate of interest
\( \implies \) Fall in cost of capital
\( \implies \) Rise in demand for credit
\( \implies \) Rise in the supply of money
\( \implies \) Deflation is controlled.

(2) Open Market Operations: Open market operations refer to the sale and purchase of securities in the open market by the RBI on behalf of the government. By selling the securities (like, National Saving Certificates—NSCs) in the open market, the RBI soaks liquidity (cash) from the economy. And, by buying the securities, the RBI releases liquidity. When liquidity is soaked (as during inflation), cash reserves of the commercial banks are squeezed. Implying a cut in their credit creation capacity. On the other hand, when liquidity is released (as during recession/deflation), cash reserves of the banks tend to rise. Implying a rise in credit creation capacity of the commercial banks. Thus, inflation is corrected by selling the securities and soaking liquidity, while deflation is corrected by buying the securities and releasing liquidity.

Sale of Securities by the RBI
\( \implies \) Soaks liquidity and leads to a fall in cash reserves of the commercial banks
\( \implies \) Fall in credit creation capacity of the commercial banks
\( \implies \) Fall in money supply
\( \implies \) Inflation is controlled.

Purchase of Securities by the RBI
\( \implies \) Releases liquidity and leads to a rise in cash reserves of the commercial banks
\( \implies \) Rise in credit creation capacity of the commercial banks
\( \implies \) Rise in money supply
\( \implies \) Deflation is controlled.

Two Types of Open Market Operations

There are two types of open market operations (i) outright, and (ii) repo. Outright open market operations are permanent in nature. These are as discussed above. The other type is known as repo open market operations. In such type of operations, there is a promise of repurchase and resale of securities (unlike in the first type).

(3) Repo Rate: The rate at which the RBI (central bank) offers short period loans to the commercial banks by buying the government securities in the open market is called 'Repo Rate'. In fact, it is a Repurchase Rate. A repurchase agreement is signed by both the parties stating that the securities will be repurchased by the commercial banks on a given date at a predetermined price. In other words, the RBI issues a loan cheque to the commercial banks by buying from them the government securities. But, it carries the agreement of repurchase of securities by the commercial banks at the predetermined date and at a predetermined price. During inflation, the cost of capital is increased by increasing the repo rate. This lowers the demand for credit and accordingly, the supply of money in the economy, as desired. On the other hand, during deflation, the cost of capital is reduced by reducing the repo rate. This increases the demand for credit and accordingly, the supply of money in the economy, as desired.

Rise in Repo Rate
\( \implies \) Rise in cost of capital
\( \implies \) Fall in demand for credit
\( \implies \) Fall in supply of money by the commercial banks
\( \implies \) Inflation is controlled.

Fall in Repo Rate
\( \implies \) Fall in cost of capital
\( \implies \) Rise in demand for credit
\( \implies \) Rise in supply of money by the commercial banks
\( \implies \) Deflation is controlled.

(4) Reverse Repo Rate: The rate at which the RBI (central bank) accepts deposits from the commercial banks (through government securities) is called 'Reverse Repo Rate'. It is also called Reverse Repurchase Rate. In this case, a reverse repurchase agreement is signed by both the parties stating that the securities will be repurchased on a given date at a predetermined price. Reverse repo rate allows the commercial banks to generate interest income. When reverse repo rate is lowered, banks are discouraged to park their surplus funds with the RBI. Instead, the banks may use these funds as CRR-funds with the RBI. This leads to a rise in credit supply (money supply) by the commercial banks. Accordingly, supply of money is enhanced in the economy, as desired to control deflation. On the other hand, a rise in reverse repo rate may induce the commercial banks to park more funds with the RBI to generate interest income. This lowers their capacity to offer CRR-funds to the RBI for the creation of credit. Accordingly, supply of money is reduced in the economy, as desired to control inflation.

Fall in Reverse Repo Rate
\( \implies \) Less funds are parked by the commercial banks with the RBI to generate interest income
\( \implies \) More funds are used as CRR-funds with the RBI, for the creation of credit
\( \implies \) Supply of money increases
\( \implies \) Deflation is controlled.

Rise in Reverse Repo Rate
\( \implies \) More funds are parked by the commercial banks with the RBI to generate interest income
\( \implies \) Less funds are used as CRR-funds with the RBI, for the creation of credit
\( \implies \) Supply of money decreases
\( \implies \) Inflation is controlled.

(5) Cash Reserve Ratio (CRR): It refers to the minimum percentage of a bank's total deposits required to be kept with the RBI. It is fixed by the RBI and is varied from time to time to regulate the supply of money in the economy. When the supply of money is to be increased, CRR is lowered, and when the supply of money is to be reduced, CRR is raised.

Rise in CRR
\( \implies \) Rise in cash reserves for a given amount of demand deposits
\( \implies \) Fall in money supply of the commercial banks
\( \implies \) Inflation is controlled.

Fall in CRR
\( \implies \) Fall in cash reserves for a given amount of demand deposits
\( \implies \) Rise in money supply of the commercial banks
\( \implies \) Deflation is controlled.

(6) Statutory Liquidity Ratio (SLR): Every bank is required to maintain a fixed percentage of its assets in the form of liquid assets, called SLR. The liquid assets include: (i) cash, (ii) gold, and (iii) unencumbered approved securities. The rate of SLR (like that of CRR) is fixed by the RBI and is varied from time to time. To decrease the supply of money (as during inflation), the central bank increases SLR. Accordingly, funds available for CRR-deposits (for the creation of credit) are reduced. Conversely, SLR is reduced to increase the supply of money (as during deflation) in the economy. Accordingly, funds available for CRR-deposits (for the creation of credit) are increased.

Rise in SLR
\( \implies \) Rise in liquid assets to be held by the commercial banks with themselves
\( \implies \) Fall in the availability of funds for CRR-deposits with the RBI
\( \implies \) Fall in money supply of the commercial banks
\( \implies \) Inflation is controlled.

Fall in SLR
\( \implies \) Fall in liquid assets to be held by the commercial banks with themselves
\( \implies \) Rise in the availability of funds for CRR-deposits with the RBI
\( \implies \) Rise in money supply of the commercial banks
\( \implies \) Deflation is controlled.

(B) Qualitative Instruments of Credit Control

Qualitative instruments are those instruments of credit control which focus on select sectors of the economy. These instruments are used to increase or decrease the supply of money to select sectors of the economy. (These are those sectors which are the principal source of instability in the economy.) Broadly, the qualitative instruments are placed in three categories, as under:

(1) Margin Requirement: The margin requirement refers to the difference between the current value of the security offered for loan (called collateral) and the value of loan granted. Suppose, a person mortgages his house worth Rs. 1 crore with the bank for a loan of Rs. 80 lakh. The margin requirement in this case would be Rs. 20 lakh. The margin requirement is raised when the supply of money needs to be reduced. The margin requirement is lowered when the supply of money is to be increased. Often the margin requirement is kept high for speculative (trading) activities.

Rise in Margin Requirement
\( \implies \) Fall in demand for credit
\( \implies \) Fall in supply of credit by the commercial banks
\( \implies \) Fall in money supply
\( \implies \) Inflation is controlled.

Fall in Margin Requirement
\( \implies \) Rise in demand for credit
\( \implies \) Rise in supply of credit by the commercial banks
\( \implies \) Rise in money supply
\( \implies \) Deflation is controlled.

(2) Rationing of Credit: Rationing of credit refers to fixation of credit quotas for different business activities. Rationing of credit is introduced when the supply of credit is to be checked particularly for speculative activities in the economy. The RBI fixes credit quota for different business activities. The commercial banks cannot exceed the quota limits while granting loans. This restricts the supply of money in the economy, and inflation is controlled. On the other hand, rationing of credit (if already in practice) is withdrawn to increase the supply of money. This controls deflation.

Introduction of Credit Rationing
\( \implies \) Decreases the supply of credit by the commercial banks
\( \implies \) Decreases the supply of money
\( \implies \) Inflation is controlled.

Withdrawal of Credit Rationing
\( \implies \) Increases the supply of credit by the commercial banks
\( \implies \) Increases the supply of money
\( \implies \) Deflation is controlled.

(3) Moral Suasion: It is like rendering an advice to the commercial banks by the RBI to follow its directives. The banks are advised to restrict loans during inflation, and be liberal in lending during deflation.

Instruments of Credit Control Summary

Quantitative Instruments:

• Bank Rate
• Repo Rate
• Reverse Repo Rate
• Cash Reserve Ratio
• Statutory Liquidity Ratio
• Open Market Operations

Qualitative Instruments:

• Margin Requirement
• Rationing of Credit
• Moral Suasion

Did You Know it?

Moral suasion is a combination of both 'persuasion' and 'pressure'. The RBI tries to persuade the commercial banks to follow its directives, but if persuasion does not work, it uses the required pressure as an apex bank of the country. If pressure also does not work, the RBI can use direct action which includes derecognition of the concerned bank. As an instrument of monetary policy, 'moral suasion' works both as a quantitative instrument as well as a qualitative instrument. However, often it is classified as a qualitative instrument.