Money and Banking

What money does, the measures M1 to M4, how banks create credit and the money multiplier, and how the RBI controls money supply with the CRR, bank rate, repo rate and open market operations.

Key ideas

• Barter needs a double coincidence of wants; money removes this as a medium of exchange, a unit of account and a store of value.
• Currency notes and coins are legal tender and fiat money; cheques and demand deposits can be refused, so they are not legal tender.
• Banks keep a fraction of deposits as reserves and lend the rest; loans come back as deposits, so deposits grow by a multiple of the first deposit.
• The higher the reserve ratio, the smaller the money multiplier and the less credit banks can create.
• High powered money is currency with the public plus bank reserves, issued by the central bank.
• Raising the CRR, bank rate or repo rate, or selling bonds, lowers money supply; lowering them, or buying bonds, raises it.
• The RBI is the lender of last resort; moral suasion and margin requirements are qualitative tools.

Remember

Watch out

• Taking the multiplier as the reserve ratio itself instead of its reciprocal.
• Building M3 from M2: M3 = M1 + net time deposits, not M2 + time deposits.
• Thinking an open market purchase of bonds by the RBI reduces money supply (it adds reserves).

Worked example