Basics of Money

Money

Refers to any object that is generally accepted as payment for goods & services and repayment of debts.

Functions of Money

• A medium of exchange: An object that is generally accepted as a form of payment.
• A unit of account: A means of keeping track of how much something is worth.
• A store of value: Can be held & exchanged later for goods & services at an approximate value.

Types of Money

1. Animal Money: In ancient India, Go-Dhan (cow wealth) was accepted as a form of money.
2. Commodity Money: Naturally scarce precious metals, conch shells, barley beads etc. Derives its value from the intrinsic value of the commodity.
3. Full bodied money: Any unit of money, whose face value and intrinsic value are equal i.e., Money Value = Commodity Value. 
4. Credit Money: Any unit of money, whose face value is higher than intrinsic value. Ex.: One Rupee Coin.
5. Fiduciary Money: Money which gets accepted due to mutual trust between parties. Ex.: Demand drafts and Cheques.
6. Fiat Money: Money which does not has any intrinsic value of its own (Currency notes). Generally declared as Legal tender for all transactions within a country.

Legal Tender

• Cannot be refused by any citizen of the country for settlement of any kind of transaction.
• Legal tender can be either limited or unlimited. In India, while coins are limited legal tender, currency notes are unlimited legal tender. 

Under Coinage Act, 2011, 50 paise coins can be used as legal tender for dues up to Rs 10. Coins of Rs 1 and above can be used as legal tender for dues up to Rs 1000. While anyone cannot be forced to accept coins beyond the limits mentioned, voluntarily accepting coins for amounts exceeding the limits mentioned above is not prohibited.

Sources of Money Supply

RBI: Sole authority to print currency notes under RBI Act, 1934. Can print notes of different denominations from Rs 2 to up to Rs 10,000. All banknotes issued by RBI are backed by assets such as Gold, Government Securities and Foreign Currency Assets, as defined in Section 33 of RBI Act, 1934.

Bank notes are printed at 4 currency presses. Two owned by GoI through Security Printing & Minting Corporation of India Ltd. (SPMCIL) located at Nasik and Dewas. The other two are owned by RBI’s subsidiary Bhartiya Reserve Bank Note Mudran Private Ltd. (BRBNMPL) at Mysuru & Salboni.

Government: Issues One-Rupee Notes and Coins. Coins can be issued up to the denomination of Rs 1000 under the Coinage Act, 2011. Government decides the quantity of coins to be minted based on indent received from RBI on yearly basis.

Seigniorage

• Profit which accrues to a Central bank due to printing of Currency notes. This profit is because of intrinsic value of the paper currency being much lower than its face value. For example, cost of printing a Rs 500-note may be Rs 3. Hence, printing one such note & putting it into circulation fetches a profit of Rs 497. Usually, central banks ‘earn’ this profit & transfer it to Government.

Components of money supply

Total stock of money in circulation among the public at a particular point of time is called money supply.

M1 & M2 are known as narrow money. M3 & M4 are known as broad money. These gradations are in decreasing order of liquidity. M1 is most liquid & easiest for transactions whereas M4 is least liquid of all. M3 is the most used measure of money supply.

High-powered money

Total liability of RBI is called monetary base or high-powered money. Also, known as Reserve Money or M0.

Calculation of M0: Currency with Public + Currency with banks + Banker's deposits with RBI + ‘Other’ deposits with RBI

Note: As per RBI Act, 1934, RBI needs to maintain minimum reserves of Rs 200 crores (115 Crores- Gold, 85 crores- Foreign Currency Assets) to print currency notes. Based upon maintenance of minimum reserves, RBI can print unlimited currency notes. Thus, there is no statutory limit on printing of currency notes on RBI.

Money multiplier

After keeping aside for reserve requirements, banks lend the money received out of deposits. A part of this money is further deposited in banking system after changing multiple hands in the economy. A part of this deposit is further used for lending. 

This cycle of lending and depositing creates additional money in the economy. The additional money created is calculated by a term called money multiplier. 

Thus, money multiplier tells us by how many times an initial loan will be “multiplied” as it is spent in the economy and then re-deposited in other banks. Money multiplier = 1/r (where r = reserve ratio). Also calculated as (M3/ M0)

Note: Money multiplier is also calculated as (M3/M0). For example, the total Reserve Money (M0) as of April 2021 is Rs 35 lakh crores. The total Broad Money (M3) is around Rs 187 lakh crores. Hence, presently, money multiplier is approximately around 5.34.

Velocity of money

Refers to the frequency with which money changes hand during a unit period of time, say, a month. Calculated as (Nominal GDP/ Money Supply).

Higher Velocity of Money  Greater number of transactions Increase in Nominal GDP growth rate.

Currency Deposit Ratio (CDR)

Ratio of money held by public in currency to that they hold in bank deposits. It reflects people’s preference for liquidity. For ex. CDR increases during festive season as people convert deposits to cash balance for meeting extra expenditure during such periods.

If currency-deposit ratio increases, it means that public is holding more of its money out of Banks rather than depositing it. Hence, money multiplier will go down.

Reserve Deposit Ratio

Proportion of the total deposits commercial banks keep as reserves. Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI. It includes the SLR and CRR.

Liquidity trap

Occurs when a country is trying to recover from a recession (lower/negative rate of inflation) and the government aims to boost investment by reducing interest rates to facilitate borrowing. In a standard economy, such a reduction in interest rates encourages both borrowing and spending levels on part of both producers and consumers. 

However, in case of Liquidity trap, an expansionary monetary policy becomes ineffective. Due to prevailing depressed demand and production levels, individuals prefer storing their money in advent of weakening economic conditions.

Paradox of thrift

Popularized by economist John Keynes. It states that as individuals try to save more, it leads to a fall in aggregate demand and hence fall in economic growth. However, this theory has been criticized on the ground that an increase in savings allows banks to lend more leading to increase in Investment and GDP growth.