MACRO ECONOMICSNOTES - CA Study Web | 25 Aug 2020

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MACRO ECONOMICS NOTES

Chapter 8 – Money & Banking

UNIT 1 - MONEY

DEFINITION OF MONEY

The definition of money is based on the functions of the money. There are many assets, which carry the

attributes of money. Money is what money does (by Walkar) traditionally, money serve the

following functions-

1. General acceptability

2. Medium of exchange

3. Common measure of value

4. Store of values

To modern economists or empiricists, money includes the followings –

1. Currencies and demand deposits of banks

2. Financial assets such as bonds, government securities and equity shares

3. Time deposits with banks

Above categories of money some economist categories as

1. Near money – includes as financial assets

2. Pure money – includes as cash and cheque deposited with commercial banks.

In modern sense, financial assets are also considered as money on the following criteria:

1. Stability of the demand function,

2. High degree of substitutability, and

3. Feasibility of measuring statistical variations.

(A) FUNCTIONS OF MONEY

In a static sense, money serves:

1. As a medium of exchange: The fundamental role of money in as economics system is to

serve as a medium of exchange or as a means of payment.

2. As a unit of account: Money is a common measure of value. The value in exchange of all

goods and services can be expressed in terms of money. In fact, it acts as a means of

calculating the relative prices of goods and services.

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3. As standard of deferred payment: Money is a unit in terms of which debts and future

transactions can be settled. Thus loans are made and future contracts are settled in terms of

money.

4. As store of value: money holds the purchasing power over the goods and services for all the

times – present and future. Money can be exchanged for the required goods and services at any

time. Thus it acts as a store of value.

In dynamic sense, money serves:

1. Directs economic trends: Money directs idle resources into productive channels and

thereby, affects output, employment, consumption and consequently economic, welfare of

the community at large.

2. As encouragement to division of labour: in a money economy, different people tend to

specialize in the different goods and through the marketing process, these goods are bought

and sold for the satisfaction of multiple wants. In this way, occupational specialization and

division of labour are encouraged by the use of money.

3. Smoothens transformation of savings into investments: In a modern economy, savings

done by households and firms are invest it. Financial institutions and banks help in

mobilization of saving into investment with the help of money. Money so borrowed by the

investors when used for buying raw materials, labour, factory.

(B) MONEY STOCK IN INDIA

1979 the RBI classified money stock in India in the following four categories.

M1 = Currency with the public i.e., coins and currency notes + Demand deposits of the public

known as narrow money.

M2 = M1 + Post office saving deposits.

M3 = M1 + Time deposits of the public with banks called broad money.

M4 = M3 + Total post office deposits.

The basic distinction between narrow money (M1) and broad money (M3) is the treatment of

time deposits with banks. In the present context, total Money stock in India refer to M3 only.

The RBI third working group RBI in 1998 redefined its parameters for measuring money supply namely,

new Monetary (NM) Aggregates.

NM1 = Currency + Demand deposits + other deposits with RBI.

NM2 = NM1 + Time Liabilities portion of saving deposits with banks + Certificates of Deposits

(NM1 + TL + CD +TD) Issued by banks + Term Deposits maturing within a year excluding FCNR (B)

Deposits.



NM3 = NM1 + Term Deposits with banks with maturity over one year + call/Term Borrowings of

the banking system. (NM2 + TD + C/TB)

NM4 has been excluded from the scheme of monetary aggregates.

Three liquidity aggregates namely L1, L2, L3 have also been introduced

(C) Demonetization: Demonetization of currency means discontinuity of a particular currency from circulation and replacing it with a new currency. The government of India in November, 2016, demonetized Rs. 500 and Rs. 1000 currency. That means that the legal tender of currency units was declared invalid from the specified date. The move of demonetization has been welcomed on the following grounds:

It would help the government to track unaccounted black money or cash on which income tax has not been paid.

It would help in reducing illegal activity. Banning high- value currency will halt illegal activity as the cash provided for such activities has no value now.

Fake currency circulation would come to a halt in a single shot. Demonetization could help controlling inflation. When there is very high inflation, one solution can be

to completely change the currency and to start afresh. Money deposited in the bank during demonetization can be taxed especially if the affected parties were

trying to evade taxation by keeping hard cash.

Availability of cheap deposits in financial institutions means that people can borrow money at low interest rates.

Due to low lending rates, improved revenue collection, and growth in savings and deposits, a country that has demonetized is likely to see an improvement in the growth of its GDP. However, demonetization has the following main disadvantages:

Cash crunch due to non-availability of small denominations currency at least in the short run Increase the cost as the government had to bear the cost of printing of new currency and its circulation,

Inconvenience to the public. Economic growth may get affected in the short run due to business disruptions. The normal trading activities may be disrupted by this process since it takes time for consumers and

suppliers to adjust to the new monetary policy.



UNIT 2 – COMMERCIAL BANKS

Commercial Bank:

A commercial bank is an institution that operates for profit. It accepts deposits from the general public

and extends loans to the households, firms and the government. Though borrowing and lending

constitute the main business of banks. Commercial banks perform a variety of functions. Examples of

commercial banks and Punjab National Bank and State Bank of India. Commercial Banks in India include

Scheduled Banks (which have been included in Second schedule of RBI Act, 1934) and Non Scheduled

Banks (which have not included). Scheduled Banks are divided into Public Sector Banks (SBI, PNB),

Private Sector Banks (HDFC, ICICI) and foreign Banks (Citi Bank, Bank of America). Most of the Public

Sector banks are nationalized banks except SBI.

(A) ROLE OF COMMERCIAL BANKS:

1. Encourage the saving and capital formation: The economic development depends upon the rate of

savings. Banks offer facilities for keeping saving and thus encourage the habits of saving in the

society.

2. Mobilization of savings: Banks encourage savings and mobilize savings into productive investments.

Without banks these savings would have remained idle and would not have been utilized for

productive and investment purpose.

3. Optimum utilization of savings: After nationalization, commercial banks also allocate resources in

the way that maximize production or social welfare, such as agriculture, small-scale industries (SSI)

and weaker sections of the society.

4. Increase the rate of investment and credit creation: By encouraging savings and mobilizing them

from public, banks help to increase the aggregate rate of investment in the economy. Banks also

create deposits or credit, which serve as money.

(B) FUNCTIONS OF A BANK

The functions of a bank can be summarized as follows:

1. Receipt of deposits: The most important function of a bank is to accept deposits from the public

(individual, firms and institutions). Such deposits may be different types-

(a) Demand or current deposits- It includes current deposits and saving deposits. Deposits which are

withdraw able on demand are called demand deposits.

(b) Time deposits- Deposits withdraw able after the expiry of I fixed time period called fixed

deposits.

Interest paid by banks is highest for fixed deposits and lowest or even nil for current deposits.

2. Lending of money: Banks lend money mainly for industrial and commercial purposes. This lending

may take the different form like-



(a) Cash credit

(b) Overdrafts

(c) Loans and advances

(d) Discounting of bills of exchange

Interest charged by banks on such lending varies according to the amount and period involved,

social priority-nature of security offered, the standing of the borrower etc.

3. Agency services: A bank renders various services to consumers as an agent, such as

(a) Collection of bills, promissory notes and cheques

(b) Collection of dividends, interests, premiums, etc.

(c) Purchase and sale of share and securities

(d) Acting as trustee or executor when so nominated

(e) Making regular payment such as insurance premium etc.

4. General services: A modern bank performs following general services to the public-

(a) Issue of letters of credit, travelers cheques, bank drafts, circular notes

(b) Safe keeping of valuables in safe deposit vaults (Lockers)

(c) Supplying trade information and statistics

(d) Conducting economic surveys

(e) Preparation of feasibility studies, project reports etc.

(f) Underwriting of shares and make loans for long-term purpose

5. Tools of Modern Banking-

(a) ATM – Automatic Telling Machine – for cash withdrawal etc.

(b) RTGS – Real Time Gross Settlement – for fund transfer on Real Time.

(c) NEFT – National Electronic Fund Transfer – for fund transfer.

(d) ECS – Electronic Clearing Service.

(e) IFSC – Indian Financial System Code for RTGS & NEFT.

(C) CAUSES OF NATIONALISATION OF COMMERCIAL BANKS;

Government announced the nationalization of 14major commercial banks with effect from July 1969. 6

more banks were nationalized in 1980. Two banks were merged in 1993, so at present there are 19

nationalized banks. The following factor were responsible for nationalization of commercial bank in

India.

1. To remove private ownership of commercial banks and concentration of economic power: At the

time of independence, one or more business houses controlled all major banks.

Thus, private ownership of banks resulted in concentration of income and wealth in few hands. To

remove the private ownership and concentration of economic power nationalization was

compulsory.



2. Urban-bias: Prior to nationalisation, many commercial banks were in urban areas. But after

nationalisation more and more branches were opened in semi-urban and rural areas. This urban

biased nature of commercial banks led to show rate of growth in the rural areas.

3. Neglect of agricultural sector: there was a total neglect of the agricultural sector and its finance

prior to nationalisation of banks. The banks increasingly advanced finances to commerce and

industry 70% in 1951 to 87% in 1968. Agriculture accounted only 2.2% of the total advances.

4. Violation of norms: Private commercial banks often violated the norms and priorities laid down in

the plans and granted loans to even those industries, which figured nowhere in the priority list.

5. Speculative activities: Private commercial banks earned large profits and indulged in speculative

activities. They have given advances to hoarders and black marketers against high rates of interest.

6. Neglect of priority sectors: There was a complete neglect of agricultural sector, export and small-

scale industries (SSI) etc.

In order to discipline the commercial banks so that they do not overlook the national priorities,

nationlisation of banks was undertaken first in 1969 and then in 1980.

Objectives of nationalization: Objectives of nationalisation were as follows-

(i) Removal of control by a few hands;

(ii) Provision of adequate credit for agriculture and small industry and export;

(iii) Giving a professional bent to management;

(iv) Encouragement of a few class of entrepreneurs; and

(v) The provision of adequate training as well as terms of services for bank staff.

(D) PROGRESS OF COMMERCIAL BANKS AFTER

NATIONALISATION (1969 vs. 2013):

After the nationalisation of 14 banks in 1969 and 6 banks in 1980 following development have taken

place-

1. Expansion of branches: There has been a remarkable expansion of branches since nationalization.

Compared to just 8262 branch offices in 1969, the number of branches in 2016 has increased to

134000. As a result, the population per bank office has reduced from 55,000 in 1969 to 10000 in

2016.

2. Branch opening in rural and unbanked areas: Before nationalisation, there was a clear urban bias in

the operations of banks. But after nationlisation they have started moving towards rural and semi

urban areas. Compared to just 22% in 1969 bank branches in rural areas, has increased about 38% in June

2016.



3. Deposit mobilization: There has been a substantial rise in the rate of deposit mobilization since

nationlisation. The aggregate deposits of commercial banks have increased from Rs. 4665 crore in

1969 to more than Rs. 93,27,300 crore in 2015-16. Considering state-wise deposit mobilization, Deposit

mobilization, we find Maharashtra leads all other states and accounts for about 22 per cent of the

aggregate deposits received by the banks. The state Delhi, U.P. West Bengal Tamil Nadu, Karnataka and

A.P. account for 22% of the aggregate deposits.

4. Bank lending: There has been a great rise in the bank lending since nationalisation. It has gone up

from Rs. 3399 crore in June 1969 to about Rs.72,50,000 crore in 2015-16.

The bank have taken special care of the priority sectors like agriculture, small scale industries and

small retail trade accounted for about 15% of the commercial banks credit. This percentage has

gone up to about 34 per cent in 2015-16.

5. Promotion of new entrepreneurship: Banks also promote entrepreneurship with the schemes such as

JRY, NRY etc.

(E) SHORTCOMING OF COMMERCIAL BANKING IN INDIA:

The main drawbacks of commercial banking are as follows-

1. Insufficient branches: The growth of branches in numerical term is insufficient in India. This is

specially so with regard to rural areas have just 38% of the bank branches but more than 48.9%

(exactly in 2011-12) of the population residing there.

2. Regional imbalances: Only few states have well developed banking facilities: Arunachal Pradesh, J & K,

Uttaranchal, Manipur and Tripura on an average have lesser number of banks compared to other

states. Even from the states which are well banked like Maharashtra, West Bengal and Tamil Nadu, if

big metropolitan cities are excluded the population per bank office is larger than the average for

these state.

3. Increasing over dues: As a result of increasing loans and advances to unemployed and weaker

section, the commercial banks are facing the problem of bad debts and doubtful debts (called NPAs Non Performing Assets). As a percentage of gross advances, they fell from 1.05 per cent in 2001-02 to 3.2 per cent in 2012-13 but increased to 5.43 per cent in 2014-15 and further to 9.83 in 2015-16 due to slow down in the growth of the economy and poor loan recovery.

4. Lower efficiency: The quality of services rendered has deteriorated. This has happened because of staff

indiscipline and absence of the system of accountability, problem of effective management and control.

This has hampered the overall efficiency of the commercial banks.

5. Declining trends in profitability: the absolute profits of the banks are rising but the profitability ratio of

the banks are not improved much. Factors for declining trends in profitability are

a. Lower interest on Government borrowings from banks

b. Subsidization of credit to priority sector

c. Directed credit programmes of the Govt.



d. Lack of competition

e. Increasing expenditure-overstaffing and mushrooming of branches

f. Profitability are declining due to increasing of non-performing assets (NPA), RBI has taken

some steps to reduce NPAs. These include debt restructuring and recovery through Lok

Adalats, civil courts and debts recovery tribunals.

Gross NPAs of public sector banks stood as high as 9.83 per cent of gross advances in 2015-16. The

Insolvency and Bankruptcy Code (IBC) has been enacted and Securitisation and Reconstruction of

Financial Assets and Enforcement of Security Interest Act (SARFAESI) and The Recovery of Debts due to

Banks and Financial Institutions (RDDBFI) Act have been amended to improve resolution/recovery of

bank loans.

6. Professional touch to management: The public sector banks have lack-expertise in merchant

banking and agricultural financing areas. There is a need for professional touch in these areas.

7. Important role of commercial banks after nationlisation: To sum up, although after nationalisation

the commercial banks have played an important role in achieving national goals of the economy yet

there is a need for: -

a. Spreading their activities to the untouched remote areas

b. Keeping up their profitability.

c. Looking after the growing needs of the priority sectors.

d. Improving the performance of rural/semi-urban branches.

e. Improving the quality of loan portfolio.



UNIT 3 – THE RESERVE BANK OF INDIA

(A) MEANING AND FUNCTIONS OF RBI

The reserve bank of India (RBI) is the central bank of the country and it performs all the central

banking functions. A Central Bank is one which constitutes the apex of the monetary and banking

structure of the country and which performs, in the national economic interest, the following

functions:

1. Issue of currency: The RBI is the sole authority for the issue of currency in India other than one

rupee coins and notes and subsidiary coins, the magnitude of which is relative small. The RBI is also

called ‘bank of issue’.

2. Banker to the government: As a banker to the central and state Governments, the RBI performs the

following functions:

(a) It transacts all the banking business. It accepts money, makes payment and also carries out their

exchange and remittances.

(b) It manages public debts, advices the government on the quantum, timing and terms of new

loans.

(c) It also sells Treasury Bills to maintain liquidity in the economy.

(d) It makes advances which are repayable within 90 days.

(e) The RBI is the fiscal agent and adviser to the government in monetary and financial matters in

India. It has a special responsibility in respect of financial policies and measures concerning new

loans, agricultural finance and legislation affecting banking and credit and international finance.

3. Banker’s Bank: The RBI has extensive power to control and supervise commercial banking system

under the RBI Act, 1934 and the Banking Regulation Act, 1949. The scheduled banks are required to

maintain a minimum of cash reserve ratio (CRR) with RBI. RBI controls the credit position of the

country. The RBI provides financial assistance to scheduled banks and calls for returns and other

necessary information from banks.

4. Custodian of Foreign Exchange Reserves: The RBI is the custodian of monetary reserve in India and

RBI also is the custodian of national reserve of international currency. It has to ensure that normal

short-term fluctuations do not affect the exchange rate. When foreign exchange reserves are

inadequate for meeting balance of payment problem, it borrows from the IMF. The RBI has the

authority to enter into exchange transactions on its own account and on account of government. It

also administers exchange control of the country and enforces the provision of Foreign Exchange

Management Act.

5. Controller of Credit: Credit control is generally considered to be the principal function of central

bank. By making frequent changes in monetary policy, it ensures that the monetary system in the



Economy functions according to the nation’s needs and goals. The RBI uses almost all quantitative and

qualitative methods of credit controls.

6. Lender of the last resort: RBI is the official “lender of the last resort”. Lender of the last resort

means Central bank coming to the rescue of other banks in times of financial crises. Financial crises

might arise due to improvement in lending operation and due to depression in the economy.

7. Central clearance, settlement and transfer of money: Central bank has a special position for

conducting clearinghouse operation, inter-bank transfer of funds and settlement of accounts.

Central bank also give facility for transfer of money at free of charge.

8. Promotional functions: RBI also performs a variety of developmental and promotional functions. It is

responsible for promoting banking habits among people, mobilizing savings, development of the

banking system, and provision of finance for agriculture, foreign trade and small-scale industries.

But later these function were handed over to NABARD, EXIM Bank and SIDBI (Small Industrial

Development Bank of India) respectively.

9. Collection and publication of data: It has also been entrusted with the task of collection and

compilation of statistical information relating and other financial sectors of the economy.

10. Others: The RBI is responsible for overall monetary policy in India like monetary stability, stability of

domestic price levels, maintenance of the international value of the nation’s currency etc.

(B) ROLE OF THE RBI

The Reserve Bank of India (RBI) occupies an important position in the Indian economy. Its role is

summarized in the following point:

1. The RBI is the apex monetary institution of the highest authority in India. It plays an important

role in strengthening, developing and diversifying the country’s economic and financial

structure.

2. It is responsible for the maintenance of economic stability and assisting the growth of the

economy.

3. It is India’s prominent public financial institution given the responsibility for controlling the

country’s monetary policy.

4. It acts as an adviser to the government in its economic and financial policies, and it also

represents the country in the international economic forums.

5. It also acts as a friend, philosophe and guide to commercial banks. In fact, it is responsible for the

development of an adequate and sound-banking system in the country and for the growth of

organized money and capital markets.

6. India being a developing country, the RBI has to keep inflationary trends under control and to see

that main priority sector like agriculture; experts and small-scale industry get credit at cheap rates.

7. It also has to protect the market for government securities and channelize credit in desired

directions.

(C) CENTRAL BANK VS COMMERCIAL BANK



The following difference found between central bank and commercial banks

S. No Commercial Bank Central Bank

1 It is profit-seeking institutions. Its objective is not to make profit.

2 It allows interest on deposits from public. It does not allow interest on deposits from public.

3 Its profits mainly from loans and advances Its profits mainly from Govt. securities, Loans and

from public. Advances to Govt. and commercial

banks

4 Commercial banks have largely public Central bank’s deals with Govt. Central and State

banks and other financial institution.

5 It is part of State Central bank’s role is to ensure that the others

6 Banks mobilize savings and channelize Central bank’s role is to ensure that the others bank

proper use conduct their business in national

economic interest.

7 Functions of commercial banks are

different

Functions of central bank are unique.

Monetary policy is the one employed by the State through its Central Bank, to control the supply of

money as an instrument of achieving the objectives of general economic policy.

Objectives of monetary policy are-

(a) To regulate monetary growth and maintain price stability

(b) To ensure adequate expansion in credit

(c) To assist economic growth;

(d) To encourage the flow of credit into priority and neglected sectors

(e) To strengthen the banking system.

Instruments of credit control- There are two types of instruments-

Quantitative or general measures-

It influence the total volume of credit

Qualitative or selective measures – It influence

the selective or particular use of credit

(a) Bank Rate Policy

(b) Open Market Operations

(c) Variable Reserve Requirements

(i) Cash Reserve Ratio (CRR)

(ii) Statutory Liquidity Ratio (SLR)

(a) Margin requirements

(b) Consumer credit regulation

(c) Issue of directives

(d) Rationing of credit

(e) Moral Suasion



1. Quantitative or General Measures: It is used for changing the total volume of credit in the economy.

Quantitative Controls affect indiscriminately (similarly) all sectors of the economy.

Quantitative measures consist of-

(a) Bank Rate Policy: The Bank Rate is the official interest rate at which the Central Bank rediscounts the

approved bills held by a commercial bank.

If Central Bank wish to control credit and inflation and wishes to discourage investment at that time, it

will increase the bank rate, If Central Bank wish to control deflation or wishes to boost production and

investment that time, - it will decrease the bank rate. Bank rate was 9% in Sept., 2014 In India. At

present, it is 6.25% (August, 2017) the bank rate once used to be the policy rate in India i.e. the key

interest rate based on which all other short term interest rates move. Discounting/rediscounting of bills

of exchange by the Reserve Bank has been discontinued on introduction of Liquidity Adjustment Facility

(LAF). As a result, the bank rate has become dormant as an instrument of monetary management. The

bank rate has been aligned to the Marginal Standing Facility (MSF) rate and, therefore, as and when the

MSF rate changes alongside policy repo rate changes, the bank rate also changes automatically.

(b) Open market operations (OMO): OMO imply deliberate and direct sales and purchases of securities and

bills in the open market by the Central Bank to control the volume of credit.

If it wish to control credit and inflation- then Central Bank sells securities in the open market

If Central Bank wish expansion of credit at the time of deflation- them in purchase the securities

(c) Variable reserve requirements: The Central Bank also uses the method of variable reserve

requirements to control credit. There are two types of reserves, which the commercial banks are

generally required to maintain :

1. Cash Reserve Ratio (CRR)

2. Statutory Liquidity Ratio (SLR)

1. CRR refers to that portion of total deposits; which a commercial bank has to keep with RBI in the form of

Cash Reserve. Cash Reserve Ratio at present, (August, 2017) cash reserve ratio is 4% and SLR is

20% for entire net demand and time liabilities of the Schedule commercial banks.

2. Statutory Liquidity Ratio refer to that portion of total of deposits of a commercial bank, which it has to

keep with itself in the form of liquid assets viz-cash, gold or approved Govt. securities.

Conclusions-

During inflation, to control inflation and to discourage investment – it is advisable to

(i) Increase the bank rate

(ii) Sale of securities in the open market

(iii) Increase the CRR and SLR

During deflation, to control deflation and to encourage investment, it is advisable to



(i) Decrease the bank rate

(ii) Buying of securities in open market

(iii) Decrease the CRR and SLR

But effect of increase in CRR or SLR will be reduced or nullified if Bank rate is reduced; so all things

should be in the same direction.

(d) Repo Rate & Reverse Repo Rate:

Repo rate is rate at which our banks borrow from RBI. Reverse Repo Rate is at which RBI borrows from RBI. At present, repo rate is 6 per cent. (August 2017).

At present Reverse Repo rate is 5.75 per cent. (August 2017).

2. Qualitative or selective measures: It regulates credit for specific purposes. The Central Bank may use the following

forms of credit control-

(a) Margin requirements: Margin requirements is the difference between securities offered and

amount borrowed from banks. Increase in margin reduce the borrowing capacity and decrease the

margin increase the borrowing capacity. To control credit in selective areas, bank should

increase the margin requirements and vice versa.

(b) Consumer credit regulation: The regulation of consumer credit consists of laying down rules

regarding down payments and maximum maturities of installment credit for the purchase of

specified consumer durable goods. Raising the required down payment limits and shortening of

maximum period tend to reduce the demand for such loans and thereby check consumer credit.

(c) Issue of directives: The Central Bank may also use directives to various commercial banks, in

the form of oral or written statements, appeals or warnings, to various commercial banks for

credit control.

(d) Rationing of credit: Rationing of credit is a selective method adopted by the Central Bank for

controlling and regulating the purpose for which credit is granted or allocated by commercial

banks.

(e) Moral suasion: Moral suasion implies persuasion and request made by the Central Bank to the

commercial banks to co-operate with the general monetary policy of the former.

(f) Direct Action: The Central Bank may take direct action against the erring commercial banks. It

may refuse to rediscount their papers, and give excess credit, or it may charge a penal rate of

interest over and above the Bank Rate, for the credit demanded beyond a prescribed limit.

By making frequent changes in monetary policy, The Central bank ensure that the monetary system in

the economy functions in the national economic interest.


MACRO ECONOMICSNOTES - CA Study Web | 25 Aug 2020

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