16. Money and Banking
Money is a legally recognized medium of exchange used for transactions, consisting of physical cash and negotiable instruments. It serves four primary functions: as a medium of exchange, a store of value, a unit of account, and a standard of deferred payment. Commercial banks provide services like accepting deposits, giving loans, and creating credit. They also handle foreign exchange and manage securities. The central bank, which regulates commercial banks, issues currency, and implements monetary policy to control inflation and ensure financial stability. The independence of central banks helps in avoiding political influence, ensuring transparency, and promoting stable economic policies.
What is Money?
- Definition:
Money is an officially-issued legal tender, typically consisting of paper notes and coins. It is used as a medium of exchange and is generally acceptable in the settlement of debts and transactions. - Forms: Includes physical cash and negotiable instruments such as cheques.
- Purpose: Facilitates exchange, assigns value to goods/services, enables savings, and supports credit transactions.
Functions of Money
- Medium of Exchange
- Most vital function; money allows goods and services to be exchanged easily.
- Eliminates the limitations of the barter system, especially the double coincidence of wants—the need for both parties to have what the other wants.
- Universally accepted in exchange for goods/services.
- Store of Value
- Money holds its value over time, enabling people to save and use it later.
- Unlike some assets (e.g., perishable goods), money remains useful for future transactions.
- However, inflation can reduce the value of money over time.
- Unit of Account
- Money provides a common standard to measure the value of goods and services.
- Helps in comparing prices, maintaining records, and making financial decisions.
- Standard of Deferred Payment
- Money is used in credit transactions to make payments in the future.
- Loans, bonds, and installments are possible because money provides a standard means for future payments.
Important Financial Concepts
- Near Money:
Assets that are not cash but can quickly be converted to cash (e.g., treasury bills, bonds). - Liquidity:
The ability of an asset or business to be easily converted into cash to meet short-term obligations. High liquidity = quicker conversion to cash. - Liabilities:
These are debts or financial obligations a person or institution must pay. Examples include loans, bills payable, or bonds.
Commercial Banks
Definition
A commercial bank is a financial institution that offers banking services such as accepting deposits, giving loans, and investment products to individuals and businesses.
Primary Functions
- Accepting Deposits:
- Savings Deposits: For small savers with interest benefits.
- Fixed Deposits (Time Deposits): Locked for a set time period with higher interest rates.
- Current Deposits: For frequent transactions; mostly used by businesses. May offer overdraft facilities.
- Providing Loans:
- Banks issue loans to individuals and businesses and earn interest.
- Loan types: short-term, long-term, overdraft, housing loans, etc.
- Credit Creation:
- Unique to banks.
- Banks don’t lend out all deposited cash—they create new credit through deposits and loans, increasing the money supply in the economy.
Secondary Functions
- Providing Locker Facilities:
- For safekeeping of valuables like documents, jewelry, etc.
- Dealing in Foreign Exchange:
- Helps in import/export by facilitating currency exchange. Only authorized banks can offer this service.
- Exchange of Securities:
- Buy and sell government or private securities on behalf of customers.
- Discounting Bills of Exchange:
- Banks buy commercial bills before maturity at a discounted value, ensuring liquidity for businesses.
- Acting as an Agent:
- Pays utility bills, insurance premiums, taxes on behalf of customers.
- Offers other services like managing investments, estate handling, and electronic transactions.
Central Bank
Definition
A central bank is a national authority that regulates the banking system, controls the money supply, and implements the country’s monetary policy. It also issues currency.
Functions
- Issuing Currency:
- Sole authority to issue legal tender notes in the country.
- Regulating Commercial Banks:
- Sets rules and monitors all other banks to ensure financial stability.
- Maintaining Financial Stability:
- Prevents banking failures, manages crises, and supports economic growth.
- Acting as a Banker to the Government:
- Manages government accounts, public debt, and foreign reserves.
- Monetary Policy Implementation:
- Controls inflation, interest rates, and money supply through tools like repo rate, reverse repo rate, and cash reserve ratio (CRR).
Independence of Central Bank
- In many countries, the central bank operates independently from the government in setting interest rates.
- Example: The Bank of England is independent in deciding interest rates to keep inflation around a 2% target.
- Benefits of independence:
- Avoids political pressure
- Promotes transparency and professionalism
- Ensures more stable economic policy
Functions of Money
Medium of exchange, store of value, unit of account, and standard of deferred payment.
Liquidity
The ease with which an asset can be converted into cash to meet short-term obligations.
Credit Creation by Commercial Banks
The process by which banks lend more than the actual cash they hold by using deposits to create loans.