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We use money and banking in our daily lives very often. The world on a global scale is stabilised by capitalist exchanges, mostly involving money. There are numerous functions of money in a society that keep up the demand for money, and the need for resources keeps up the supply of money. Money is defined as a standard of deferred payment that is acknowledged as a means of exchange and has some value.
Money
Money is either an item or a verifiable record, accepted widely in a society or a country, that is given in exchange for goods and services mainly. Money has some value, decided by the legal systems of a country, and its identity is upheld by legal tender.
Money provides a method of exchange that lets us buy or sell things according to our needs, take or repay a debt according to financial needs, etc. Money can be stored, purchased, sold, and even multiplied according to the person.
Functions of Money
There are numerous functions of money, including but not limited to being a medium of exchange, a store of value, a deferred payment standard, a unit of account, etc. Primarily, the functions of money are divided into three types:
Barter System
A barter system is one in which products and services are exchanged directly without the use of money.
For example, if A wishes to buy a car from B, B offers his television to A in exchange for the car. In this scenario, commodities and services are exchanged without the use of money. The part where money is exchanged for goods or services is annulled. Instead, some goods needed by person A are taken in exchange for something B needs and A has.
This was a common practice in ancient civilisations where the demands of people were limited and few. The economy where the barter system is prevalent is called the ‘Barter economy’ or ‘C-C economy’, where C stands for commodity.
Supply of Money
The entire total of all the currency and other liquid instruments in an economy at any particular time is known as the money supply. Money supply can, in other words, be defined as the sum total of the money held by the whole public in an economy at a particular time.
The supply of money is calculated as the sum of currency held by the public and net demand deposits held by commercial banks.
Money in a modern economy consists mainly of currency notes and coins issued by the country’s monetary authority. The Reserve Bank of India (RBI), the country’s monetary authority, issues currency notes in India.
Coins, on the other hand, are issued by the Indian government. Apart from currency notes and coins, the public’s savings or current account deposits in commercial banks are also considered money because cheques drawn on these accounts are used to pay transactions. These deposits are known as demand deposits because the bank pays them out to the account holder on demand. Other types of deposits, such as fixed deposits, have a set maturity date and are referred to as time deposits.
Measurement of Supply of Money
M1 = money in circulation + public demand deposits with banks + other deposits
This is also known as transaction money, which can be directly used in transactions.
M2 = M1 + savings deposits at the post office
These savings at the post office cannot be withdrawn by cheque and are classified under demand deposits.
M3 = M1 + commercial bank time deposits
It includes a net time deposit in addition to the transaction money.
M4= M3 + the sum of all post office savings and loan organisation deposits, excluding NSC deposits.
Features of supply of money
The following are the key elements of the supply of money:
The money supply is calculated using the stock concept, which determines the amount of money held by the public at any one time
Any money held by governments, commercial banks, or central banks is excluded
Bank
A bank is a financial institution that takes and creates credit from the general public. Lending can be done in two ways: directly or indirectly through capital markets. They are heavily regulated in most states due to their relevance to a country’s financial stability. In most countries, a system known as fractional reserve banking has been institutionalised, in which banks keep liquid assets equivalent to only a portion of their current liabilities. Banks are often subjected to minimum capital requirements and additional rules aimed at ensuring liquidity.
Commercial Banks
Commercial banks are described as financial institutions that accept deposits from the general public and then use that money to provide advance loans for a variety of purposes in order to maximise profits.
Commercial Banks’ Functions
The major and secondary roles of commercial banks that we will learn about in Money and Banking are as follows:
Primary Purposes:
Deposits are accepted
Bill of Exchange Discounting
Loans that are being advanced
Secondary Purposes: Commercial banks’ secondary functions are further divided into two categories:
Agency function:
Collection of funds
Transfer of funds
Collection of interest and dividend
Purchasing and selling shares on behalf of their customers
Paying insurance and payment bills on behalf of their customer’s
Consultations regarding income tax
Collecting statistics
Trustee and executor
General utility functions:
Underwriting securities
Issuing travel cheques
Selling and purchasing foreign exchange
Safety of goods kept in custody in lockers
Overdraft facility: discounting bills of exchange
Central Banks
The Central banks are the apex financial entities in charge of money creation and distribution and the generation of credit. According to the Money and Financial research notes, central banks are in charge of administering the country’s banking sector as well as developing monetary policy.
Money Creation
Money creation, or in other words, demand for money, is one of the significantly important activities of commercial banks. Through this process of money creation, the commercial banks then create credit in excess of the initial deposits.
As previously stated, banks accept deposits and use these deposits to issue loans for various reasons to maximise profits. Credit Creation is the process of making loans to the general population.
The monetary basis, often known as high-powered money, is the whole liabilities of the country’s monetary authority, the RBI. It comprises money (publicly circulated notes and coins and vault cash held by commercial banks) and deposits held by the Government of India and commercial banks with the Reserve Bank of India. If a member of the public hands over a currency note to the RBI, the latter is required to pay her the amount indicated on the note. Similarly, the deposits are refundable by the RBI if depositors request them. These are claims made against RBI by the general people, the government, or banks and are thus considered RBI’s obligation. RBI buys assets to cover these liabilities.
Commercial banks’ credit/money production process is influenced by the following two factors:
1- The size of the major deposits
2- Legal reserve ratio
The legal reserve ratio is the minimum percentage of deposits that banks are required by law to retain in cash
The legal reserve ratio can be further divided into two subcategories:
i. The cash reserve ratio is the portion of the legal reserve ratio that banks are required to keep with the central bank.
ii. The statutory liquidity ratio is the portion of the legal reserve ratio that banks are required to hold within their own bank.
Demand for Money
The desire to hold financial assets in the form of money, such as cash or bank accounts, is known as the demand for money. Investments are not included under these financial assets of demand for money. It can relate to the demand for money in a restricted sense (M1) or in a broader sense (M2 or M3).
Interest-bearing assets dominate money in the sense of M1 as a store of value (even if only temporarily).
M1, on the other hand, is required to conduct trades; in other words, it offers liquidity.
This results in a trade-off between the liquidity benefit of storing money for near-term spending and the interest benefit of temporarily holding other assets.
The desire for M1 is a result of this trade-off over how a person’s money should be held.
The transaction motive and the precautionary motive are the two main reasons why people keep their money in the form of M1 in macroeconomics.
The asset demand is based on the demand for those components of the broader money concept M2 that bear a non-trivial interest rate.
LM Curve
The nominal quantity of money required divided by the price level represents the real demand for money. The LM curve is the location of income-interest rate pairs where money demand equals money supply for a given money supply.
This demonstrates that money demand is inversely connected to interest rates.
People prefer to hold bonds when interest rates are high (which give a high-interest payment).
When interest rates fall, bondholders earn a smaller return. Therefore, they prefer to keep their money in cash.
Types of Demand for Money
Transaction demand, or the amount of money required to purchase products, is linked to income
Precautionary demand is money required in the event of a financial emergency
When consumers prefer to keep their money rather than buy assets/bonds/risky investments, this is known as the asset motive or speculative demand
Conclusion
The value of money in today’s economy is of utmost importance with regard to the functions of money, demand for money and the supply of money.
