THE NATIONAL LAW INSTITUTE

UNIVERSITY, BHOPAL

I YEAR, 2nd TRIMESTER

SUBJECT: ECONOMICS II

TOPIC:- RBI, MONEY SUPPLY AND RELATED ASPECTS

1| NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 Table of Contents
CERTIFICATE ........................................................................................................ Error! Bookmark not defined.
ACKNOWLEDGEMENT ......................................................................................... Error! Bookmark not defined.
REVIEW OF LITERATURE..................................................................................................................................... 3
RESEARCH METHODOLOGY ............................................................................................................................... 4
OBJECTIVES ........................................................................................................................................................ 4
INTRODUCTION: RESERVE BANK OF INDIA ........................................................................................................ 5
INTRODUCTION: MONEY SUPPLY ...................................................................................................................... 7
TYPES OF MONEY ............................................................................................................................................... 8
COMPONENTS/MEASURES OF MONEY SUPPLY .............................................................................................. 10
THE SUPPLY OF AND DEMAND FOR MONEY ................................................................................................... 12
HOW RBI CONTROLS MONEY SUPPLY? ............................................................................................................ 14
SYSTEMS OF NOTE ISSUE ................................................................................................................................. 19
EFFECT OF GDP ON MONEY SUPPLY ................................................................................................................ 21
CONCLUSION.................................................................................................................................................... 22
SUGGESTIONS .................................................................................................................................................. 23
BIBLIOGRAPHY ................................................................................................................................................. 24

2| NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 REVIEW OF LITERATURE

 Study Material on Economics by Professor Rajesh Kumar Gautam

This module comprehensively covers all the aspects of modern microeconomic theory and provides
an in-depth analysis of the fundamentals of the subject. The book is written in a simple style that is
easy for most students to follow. The lecture like structure if the book helps students learn theories
and concepts in a step-by-step approach. Moreover, the author’s structural approach in the book has
simplified the process of note-taking for the students.

 Introductory Macroeconomics by Dr. V.K. Ohri and T.R. Jain

Money Supply and its certain important aspects have been explained in a brief and easily
understandable manner, making it convenient and comprehensible to analyse the same.

3| NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 RESEARCH METHODOLOGY

The method used in the research for this paper is doctrinal. The theories have been extracted
from various sources including books, journals and websites. It was then organized in a coherent
manner and analyzed thoroughly following which it was arranged in a logical structure. Hence,
the objectives of the study were reached and the project work was completed.

OBJECTIVES

 To understand the meaning of Money Supply.

 To gain an insight and understanding of types of money and components of money supply.

 To analyse the role of RBI in controlling money supply.

 To understand the influence of additional factor like GDP on money supply.

4| NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 INTRODUCTION: RESERVE BANK OF INDIA

The reserve bank of India is a central bank and was established in April 1, 1935 in accordance with
the provisions of reserve bank of India act 1934. The central office of RBI is located at Mumbai
since inception. Though originally the reserve bank of India was privately owned, since
nationalization in 1949, RBI is fully owned by the Government of India. It was inaugurated with
share capital of Rs. 5 Crores divided into shares of Rs.100 each fully paid up.
RBI is governed by a central board (headed by a governor) appointed by the central government of
India. RBI has 22 regional offices across India. The reserve bank of India was nationalized in the
year 1949. The general superintendence and direction of the bank is entrusted to central board of
directors of 20 members, the Governor and four deputy Governors, one Governmental official from
the ministry of Finance, ten nominated directors by the government to give representation to
important elements in the economic life of the country, and the four nominated director by the
Central Government to represent the four local boards with the headquarters at Mumbai, Kolkata,
Chennai and 29 New Delhi. Local Board consists of five members each central government
appointed for a term of four years to represent territorial and economic interests and the interests of
cooperative and indigenous banks.
The Reserve Bank regulates and supervises the nation’s financial system. Different departments of
the Reserve Bank oversee the various entities that comprise India’s financial infrastructure. They
oversee:

 Commercial banks and all-India development financial institutions: Regulated by the

Department of Banking Operations and Development, supervised by the Department of
Banking Supervision

 Urban co-operative banks: Regulated and supervised by the Urban Banks Department

 Regional Rural Banks (RRB), District Central Cooperative Banks and State Co-
operative Banks: Regulated by the Rural Planning and Credit Department and supervised
by NABARD

5| NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

  Non-Banking Financial Companies (NBFC): Regulated and supervised by the
Department of Non-Banking Supervision

The Bank was constituted for the need of following:

 To regulate the issue of banknotes

 To maintain reserves with a view to securing monetary stability and
 To operate the credit and currency system of the country to its advantage.
 To regulate the financial policy and develop banking facilities through the country.
 To remain free from political influence and be in successful operation for maintaining
financial stability and credit.
 To act as the note issuing authority, bankers’ bank and banker to government and to promote
the growth of the economy within the framework of the general economic policy of the
government, consistent with the need of maintenance of price stability.
 To assist the planned process of development of the Indian economy.

6| NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 INTRODUCTION: MONEY SUPPLY

The supply of money is a stock at their particular point of time, though it conveys the idea of a flow
over time. The term the supply of money: is synonymous with such terms as money stock', 'stock of
money', 'money supply' and 'quantity of money'. The supply of money at any moment is the total
amount of money in the economy.

Professor Friedman defines the money supply at any moment of time as

“Literally the number of dollars people are carrying' around in their pockets, the number of dollars
they have to their credit at banks or dollars they have their credit at banks in the form of demand
deposits, and also commercial bank time deposits.”

The supply of money with the people or the volume of money in circulation- refers to the volume of
money held by the people in the country, i.e, by individuals and business houses. We include only
the amount of money held use by the public for transaction for making payments and for settlement
of dept we exclude money held by the government in its treasuries and the money lying with the
commercial banking system.

The importance of money supply in explaining fluctuations in output, employment and general
price level is now being rightly accepted. It means that the control of money supply is very
important for maintaining a high level of output and employment and for the preservation of price
stability.

Money supply has been generally defined as currency with the public and the demand deposits of
the banks. Ifwe define it a little more technically, we may add ‘the other deposits of the RBI’ also in
the money supply. These other deposits consist of some miscellaneous items such as deposits of
quasi government - institutions, provident funds, pensions and guarantee funds of the RBI
employees' co-operative societies, the balances of foreign central banks and the deposits of the IMF.

7| NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 TYPES OF MONEY

Money can be described as an accepted exchange medium for goods and services. Almost anything
can be considered money, provided that it performs the three main functions of money (i.e. Medium
of exchange, store of value, unit of account). In view of this, it is not surprising that various types of
money have existed throughout history.

 COMMODITY MONEY
Commodity money is the easiest and probably the oldest kind of money. It builds on scarce natural
resources, which act as a means of exchange, value stock and accounting unit. Commodity money is
closely linked to a trading system in which goods and services are exchanged directly for other
goods and services. Commodity money facilitates this process, as it acts as an accepted exchange
medium. It is important to note that the value of commodity money is determined by the intrinsic
value of the commodity itself. In other words, money becomes the commodity itself. Commodity
money includes coins of gold, beads, shells, spices, etc.

 FIAT MONEY
Fiat money gets its value from a government order (i.e. fiat). That means, the government declares
fiat money to be legal tender, which requires all people and firms within the country to accept it as a
means of payment. If they fail to do so, they may be fined or even put in prison. Unlike commodity
money, fiat money is not backed by any physical commodity. By definition, its intrinsic value is
significantly lower than its face value. Hence, the value of fiat money is derived from the
relationship between supply and demand. In fact, most modern economies are based on a fiat
money system. Examples of fiat money include coins and bills.

 FIDUCIARY MONEY
Fiduciary money depends on the confidence that it is generally accepted as a means of exchange for
its value. In contrast to fiat money, the government does not declare a legal offer, which means that
people do not have to accept it as a means of payment by law. The issuer of fiduciary money
promises instead to exchange it for a commodity or fiat money if the bearer so requests. As long as

8| NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

people trust that this promise will not be broken, fiduciary money can be used just like regular fiat
or commodity money. Examples of fiduciary money include cheques, bank notes, or drafts.

 COMMERCIAL MONEY
Commercial bank money can be described as claims against financial institutions that can be used
to purchase goods or services.It is the part of a currency made from debt generated by commercial
banks. In particular, commercial bank money is created by what we call a fractional banking
reserve. Fractional reserve banking describes a process in which commercial banks lend more than
the value of their current currency. At this point, note that commercial bank money is essentially
debt generated by commercial banks that can be exchanged for real money or for the purchase of
goods and services.

 MODERN MONEY
The age of commodity money gave way to the age of paper money. The essence of money is now
laid bare. Money is wanted not for its own sake but for the things it will buy. We do not wish to
consume money directly; rather we use it by getting rid of it. Even when we choose to keep money
it is valuable only because we can spend it later on. The use of paper money has become wide
spread because it is a convenient medium of exchange. Currency is easily carried and stored. The
fact that private individuals cannot legally create money keeps it scarce. Given this limitation on
supply currency has value. It can buy things.

Commodity money, fiat money, fiduciary money and commercial banking money and lately the
introduction of modern money are the five most important types of money. Commodity money
relies on goods that are intrinsically valuable and act as a means of exchange. On the other hand,
fiat money derives its value from a government order. In the meantime, fiduciary money depends
on the confidence that it is generally accepted as a means of exchange for its value. And
commercial bank money can be described as financial institutions ' claims for goods or services.
Modern money is the money of the new age and consists of plastic money and online money.

9| NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 COMPONENTS/MEASURES OF MONEY SUPPLY

There are four measures of money supply in India which are denoted by M1 M2' M3, and M4'. This
classification was introduced by the Reserve Bank of India (RBI) in April 1977.
Prior to this till March 1968, the RBI published only one measure of the money supply, M or MI,
defined a5 currency and demand deposits with the public. This was in keeping with the traditional
and Keynesian views of the narrow measure of the money supply. From April 1968, the RBI 'also
started publishing another measure of the money supply which it called Aggregate Monetary
Resources (AMR). This included M, plus time deposits of banks held by the public. This was a
broad measure of money supply which was in line with Friedman's view. But since April 1977, the
RBI has been publishing data on four measures of the money supply which are discussed as under.

M1
The first measure of money supply, M1 consists of:
(i) Currency with the public which includes notes and coins of all denominations in
circulation excluding cash on hand with banks
(ii) Demand deposits with commercial and cooperative banks, excluding inter-bank deposits
(iii) 'Other deposits' with RBI which include current deposits of foreign central banks,
financial institutions and quasi-financial institutions such as IDBI, IFCI, etc, other than
of banks, IMF, IBRD, etc. The RBI characterizes M1 as narrow money.

M2
The second measure of money supply is M2 which consists of M1 plus post office savings bank
deposits. Since savings bank deposits of commercial and cooperative banks are included in the
money supply, it is essential to include post office savings bank deposits. The majority of people in
rural, and urban India have preference for post office deposits from the safety viewpoint than bank
deposits.

M3
The third measure of money supply in India is M3 which consists of M1 plus time deposits with

10 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

commercial and cooperative banks, excluding inter bank time deposits. The RBI calls M 3 as broad
money.

M4
The fourth measure of money supply is M4 which consists of M3 plus total post office deposits
comprising time deposits and demand deposits as well. This is the broadest measure of money
supply.

Therefore, in a nutshell:

1. Reserve Money (M0) : It is also known as High-Powered Money, monetary base, base
money etc.
M0 = Currency in Circulation + Bankers’ Deposits with RBI + Other deposits with RBI
It is the monetary base of economy.
2. Narrow Money (M1):
M1 = Currency with public + Demand deposits with the Banking system (current account,
saving account) + Other deposits with RBI
3. M2 = M1 + Savings deposits of post office savings banks
4. Broad Money (M3)
M3 = M1 + Time deposits with the banking system
5. M4 = M3 + All deposits with post office savings banks

Of the four inter-related measures of money supply for which the RBI publishes data, it is M3
which is of special significance. It is M3 which is taken into account in formulating macroeconomic
objectives of the economy every year. Since M1 is narrow money and includes only demand
deposits of banks.

Along with currency held by the public, it overlooks the importance of time deposits in policy
making. That is why, the RBI prefers M3 which includes total deposits of banks and currency with
the public in credit budgeting for its credit policy. It is on the estimates of increase in M3 that the
effects of money supply on prices and growth of national income are estimated.
11 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL
 THE SUPPLY OF AND DEMAND FOR MONEY

One major step in the transmission mechanism is the response of interest rates and credit conditions
to changes in the supply of money. The demand for money depends primarily on the need to
undertake transactions. Households, businesses and governments hold money so that they may buy
goods, services and other items. In addition, some part of the demand for money derives from the
need for a safe and highly liquid asset.

The supply of money is jointly determined by the private banking system and the nation’s central
bank. The central bank, through open market operations and other instruments, provides reserves to
the banking system. Commercial banks then create deposits out of the central bank reserves. By
manipulating reserves, the central bank can determine the money supply within a narrow margin of
error.

The supply and demand for money jointly determine the market interest rates. The following figure
shows the total quantity of money M on the horizontal axis and the nominal interest rate i on the
vertical axis. The supply curve is drawn as a vertical line on the assumption that the Central Bank
keeps the money supply constant at M*. In addition we show the money demand schedule as a
downward sloping curve because the holdings of money decline as interest rates rise during
inflation. At higher interest rates, people and businesses shift more of their funds to higher yield
assets.

12 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

The intersection of the supply and demand schedules in the figure determines the market interest
rate. Interest rates are the prices paid for the use of money. In the figure, the equilibrium interest
rate at the point of intersection of supply and demand. Only at this point is the level of the money
supply that the Central Bank has targeted consistent with the desired money holdings of the public.
During inflation, at a higher interest rate, there would be excessive money balances. People would
get rid of their excessive money holdings by buying bonds and other financial instruments, thereby
lowering market interest rates towards the equilibrium rate.

13 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 HOW RBI CONTROLS MONEY SUPPLY?

The money supply means the total amount of liquid assets circulating in the economy. At
any given time, this whole amount of money in circulation determines the price levels prevailing in
an economy. Whenever this supply of money goes up, there is an all round increase in prices. This
is because more money is being used for the same goods and services.

The RBI adopts various measures to control the supply of money in the economy. Largely, these
measures relate to credit supply by commercial banks which is why monetary policy of central bank
is often known as credit control policy. Instruments of monetary policy of the RBI are broadly
classified as:

Quantitative Instruments: These instruments are those which focus on the overall supply of money
in the economy. These instruments relate to two policy rates and two policy ratios. The two policy
rates are: (i) Bank rate and (ii) Repo Rate. The two policy ratios are: (i) CRR and (ii) SLR. It is by
varying these rates and ratios, that RBI increases or decreases the supply of money in the economy.
Quantitative instruments also include the policy of open market operations. It relates to the sale and
purchase of securities in the open market. These Quantitative instruments are used in a manner such
that the overall supply of money in the economy is reduced during inflation and increased during
deflation.1

Qualitative Instruments: These instruments which focus on select sectors of the economy. These
instruments control the flow of credit to select sectors not by varying policy rates and ratios, but by
issuing advisories to the commercial banks. The banks are advised to be selective in offering loans,
particularly, when the economy is gripped by the inflationary spiral. This policy of credit control is
also called ‘policy of selective credit control’. 2

1
Dr. V.K. Ohri and T.R. Jain, Introductory Macroeconomics, 2016-17 Edition, VK Global Publications Pvt. Ltd., page.
141.
2
Ibid.

14 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 A. QUANTITATIVE INSTRUMENTS

TWO POLICY RATES

Both bank rate and Repo rate are rates at which commercial banks can borrow money from the RBI
to tackle the shortage of liquidity. By varying these rates the RBI can increase and decrease the
supply of money.

 BANK RATE
RBI lends to the commercial banks through its discount window to help the banks meet depositors'
demands and reserve requirements for long term. The interest rate the RBI charges the banks for
this purpose is called bank rate or repo rate. If the RBI wants to increase the liquidity and money
supply in the market, it will decrease the bank rate and if RBI wants to reduce the liquidity and
money supply in the system, it will increase the bank rate. The bank rate has lost its significance as
a monetary policy tool as the central bank signals stance through changes in repo, the rate at which
banks borrow short-term funds from RBI. The bank rate, which is the standard rate at which the
RBI buys or re-discounts bills of exchange or other commercial paper, is presently used in the
country. 3
 REPO RATE
The interest rate at which RBI provides liquidity to banks is known as Repo Rate. The interest rate
at which RBI absorbs excess liquidity of banks is known as Reverse Repo Rate. An increase in repo
rate increases the cost of credit for commercial banks and leads to a reduction in amount of credit
created in the economy. The increase in reverse repo rate has the opposite effect on credit creation.
Repo rate relates to the loans offered by the RBI to the commercial banks not without collateral.
The securities are pledged as a security for the loan. Repo rate allows purchase of securities. The
holder of securities can purchase them at a later date. Therefore Repo rate in also called Repurchase
rate.

3
A study of impact of rbi policy rates on inflation by Pallavi Ingale* Volume 2, Issue 2 (February, 2012)
International Journal of Research in IT & Management

15 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 TWO RATIOS

 CASH RESERVE RATIO (CRR)

Every commercial bank has to keep certain minimum cash reserves with Reserve Bank of India.
Consequent upon amendment to sub-Section 42(1), the Reserve Bank, having regard to the needs of
securing the monetary stability in the country, RBI can prescribe Cash Reserve Ratio (CRR) for
scheduled banks without any floor rate or ceiling rate. Before the enactment of this amendment, in
terms of Section 42(1) of the RBI Act, the Reserve Bank could prescribe CRR for scheduled banks
between 3% and 20[48]% of total of their demand and time liabilities.4 RBI uses this tool to
increase or decrease the reserve requirement depending on whether it wants to effect a decrease or
an increase in the money supply. An increase in Cash Reserve Ratio (CRR) will make it mandatory
on the part of the banks to hold a large proportion of their deposits in the form of deposits with the
RBI. This will reduce the size of their deposits and they will lend less. This will in turn decrease the
money supply.
 STATUTORY LIQUIDITY RATIO (SLR)
Apart from the CRR, banks are required to maintain liquid assets in the form of gold, cash and
approved securities. Higher liquidity ratio forces commercial banks to maintain a larger proportion
of their resources in liquid form and thus reduces their capacity to grant loans and advances, thus it
is an anti-inflationary impact. A higher liquidity ratio diverts the bank funds from loans and
advances to investment in government and approved securities. In well-developed economies,
central banks use open market operations—buying and selling of eligible securities by central bank
in the money market—to influence the volume of cash reserves with commercial banks and thus
influence the volume of loans and advances they can make to the commercial and industrial sectors.
In the open money market, government securities are traded at market-related rates of interest. The
RBI is resorting more to open market operations in the more recent years. Generally RBI uses:
 Minimum margins for lending against specific securities.
 Ceiling on the amounts of credit for certain purposes.
 Discriminatory rate of interest charged on certain types of advances.
 Direct credit controls in India are of three types:

4
www.//rbi.org.in, last visited on 3/12/18 at 11:22 p.m.

16 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

  Part of the interest rate structure, i.e., on small savings and provident funds, is
administratively set. Banks are mandatory required to keep 21.50% of their deposits in the
form of government securities. Banks are required to lend to the priority sectors to the extent
of 40% of their advances.

OPEN MARKET OPERATIONS

The open market operation refers to the purchase and/or sale in the open market of short- and long
- term securities by the RBI. This is a very effective and popular monetary policy instrument. The
OMO is used to eliminate the money shortage in the monetary market, to influence the term and
structure of the interest rate and to stabilize the government securities market, etc. It is important to
understand the OMO 's activities. When the RBI sells open market securities, commercial banks
and private individuals buy them. This reduces the current supply of money when money is
transferred to the RBI from commercial banks. Contrary to this, when the RBI buys securities from
open market commercial banks, commercial banks sell them and get the money they had invested in
them back. The money supply in the economy obviously increases. This means that when the RBI
enters into the OMO transactions, the actual money stock is changed. Normally during the inflation
period to reduce the purchasing power, the RBI sells securities and purchases securities during the
recession or depression phase and makes more money available through the banking system in the
economy. As a result, the OMO continues to purchase and sell securities which lead to changes in
the availability of credit in an economy.

B. QUALITATIVE MEASURES

 MARGIN REQUIREMENTS
Changes in margin requirements are designed to influence the flow of credit against specific
commodities. The commercial banks generally advance loans to their customers against some
security or securities offered by the borrower and acceptable to banks.
More generally, the commercial banks do not lend up to the full amount of the security but lend an
amount less than its value. The margin requirements against specific securities are determined by
the RBI. A change in margin requirements will influence the flow of credit.

17 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

A rise in the margin requirement results in a contraction in the borrowing value of the security and
similarly, a fall in the margin requirement results in expansion in the borrowing value of the
security.

 CREDIT RATIONING
Rationing of credit is a method by which the RBI seeks to limit the maximum amount of loans and
advances and, also in certain cases, fix ceiling for specific categories of loans and advances.

 REGULATION OF CONSUMER CREDIT

Regulation of consumer credit is designed to check the flow of credit for consumer durable goods.
This can be done by regulating the total volume of credit that may be extended for purchasing
specific durable goods and regulating the number of installments through which such loan can be
spread. RBI uses this method to restrict or liberalise loan conditions accordingly to stabilise the
economy.

 MORAL SUASION
Moral suasion and credit monitoring arrangement are other methods of credit control. The policy of
moral suasion will succeed only if the Central Bank is strong enough to influence the commercial
banks.
In India, from 1949 onwards, the Reserve Bank has been successful in using the method of moral
suasion to bring the commercial banks to fall in line with its policies regarding credit. Publicity is
another method, whereby the Reserve Bank marks direct appeal to the public and publishes data
which will have sobering effect on other banks and the commercial circles.

18 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 SYSTEMS OF NOTE ISSUE

SIMPLE DEPOSIT SYSTEM

Under this system, the monetary authority is required to keep 100% of the bullion (gold or silver)
for every note issued. That is why it is also known as the Full Reserve System. This system has
certain merits. It is safe and enjoys public confidence because there is full backing of the bullion for
every note issued.
The monetary authority cannot take any arbitrary decision in issuing notes. So there is no possibility
of over issue of notes. There is also the saving of precious metals through debasement because
metal coins are not circulated.
However, this system lacks in elasticity firstly, because the money supply cannot be increased
without the full backing of bullion reserves. This may be harmful during war or emergency or for
development. It may also adversely affect trade and currency.
Second, this system is especially unsuited for poor countries lacking insufficient quantities of gold
or silver. Third, it is uneconomical for it does not make a profitable use of bullion reserves lying
idle with the monetary authority. Thus this system is highly impracticable in modern times. Perhaps
this is the reason for its being not put into practice in any country of the world.

PROPORTIONAL RESERVE SYSTEM

In this system, a certain percentage of the total notes issued by the central bank has to be in gold
reserves and the remaining in the form of government securities. This percentage varied between 25
to 40 per cent in countries like Switzerland, Holland, Belgium, USA and India.5
This system is simple and elastic. The money supply can be changed with changes in the percentage
of gold reserves. It provides sufficient security because a certain percentage of note issue is
supported by gold.

5
http://www.microeconomicsnotes.com/monetary-standards/top-5-methods-used-for-issuing-notes-india/1224, last
visited on 3/12/18 at 10:30 p.m.

19 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

Still, this system has certain drawbacks. Firstly, It is uneconomical because large quantities of gold
reserves have to be kept which cannot be issued for productive purposes. Second, if the gold
reserves fall, the reduction in currency in circulation may be more than in proportion to the fall in
reserves. This may lead to deflationary tendencies. The opposite may happen when gold reserves
increase.’ This system was in vogue in India between 1927 to 1956.

MINIMUM RESERVE SYSTEM

Under the minimum reserve system, the central bank is authorised to issue notes up to any extent
but it must keep a statutory minimum reserve of gold and foreign securities. India adopted this
system of note issue in 1956 after discarding the proportional reserve system. Accordingly, the
Reserve Bank of India is required to keep a minimum reserve of Rs. 200 crores. Of this, Rs. 115
crores must be in gold and Rs 85 crores in foreign securities.
This system is highly useful for developing countries because they can meet their financial
requirements by printing more notes. They can also reduce the money supply to check inflation. It
is, therefore, an elastic system. Further, it is very economical because only a small and fixed amount
of gold is required to be kept in reserve.
Despite these merits, the minimum reserve system is a dangerous tool in the hands of the monetary
authority. It can print any number of notes, thereby creating inflationary pressure within the
economy. A corrupt and inefficient government can bring disaster to the economy by excessive
printing of notes and thus lose confidence of the people. On the other hand, an efficient and honest
administration can transform the economy by a judicious use of this system.

20 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 EFFECT OF GDP ON MONEY SUPPLY

Money supply and GDP do not automatically affect each other, but Money Supply can affect GDP
depending on monetary policy; the expressed intention in economic management is to monitor the
money supply to allow transactions to take place. Therefore, if money supply is severely restricted
it is likely to affect the GDP: i.e., reduce the volume of transactions. The GDP can only increase the
demand of money and transactions will stall if that demand is not met. GDP is also inadequate as a
measure of real production, because it does not truly represent production, but it is a statistic of
dollar value of all transactions that have taken place. A comparison of the two statistics maybe
valuable after the fact to examine the difference in growth ratio, to maybe predict near term
inflation, if money growth was too much larger than GDP.

Money is not increased as a result of greater ability to produce, but it is increased

intentionally to attempt to allow the greater ability potential to materialize. Money supply affects
GDP by making transactions more efficient. You don't need to find someone to trade with to get
what you want, everyone takes money. The more of it there is, the larger this effect becomes.
GDP affects money supply through the banking system. When growth is high, banks make
additional loans and expand the money supply. The Federal Reserve also has something to do with
it, but the dynamic aspects of money supply rest with the banking sector.

21 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 CONCLUSION

India’s financial system has undergone development as part of the economic reform process that
began in 1990. This has resulted in the expansion of both the banking sector and the stock market.
However, India’s banking sector remains relatively small compared with those of most East Asian
economies, and there appears to be scope for further expansion. Individual banks are also small by
international standards. Furthermore, the corporate bond market is still immature and has not yet
started to develop on a significant scale.

The main role of RBI is related to the Indian economy, and the banks are an instrument to help RBI
make changes according to different macroeconomic facets of the Indian economy.

The money supply is ultimately determined by the policies of the Central Bank. By setting reserve
requirements and the discount rate, and especially by undertaking open market operations, the
Central Bank determines the level of reserves, the money supply and short term interest rates based
on the Inflation rate and the GDP figures. Inflation rates and GDP figures have a direct impact on
the money supply since their increase and decrease determines the level of circulating money in the
system as and when required by the Central Bank. Banks and the public are cooperating partners in
this process. Banks create money by multiple expansions of reserves; the public agrees to hold
money in depository institutions.

22 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 SUGGESTIONS

These suggestions discuss improving the financial performance of banks, and also improving their
performance in terms of improved customer service, contribution to the growth of our economy and
enhancing the trust and confidence of the public in the banking institutions of our country.

 Use of technology must be increased to make banking easier and improve efficiency of the
banks
 The RBI conducts an annual financial review of all banks, but their reports are kept
confidential and their findings are never published. Those banks who continue to be rated
poor must be pulled up and made answerable for their poor performance. The banks’
performance under all parameters must be made known to the customers of banks to keep
the managements of banks on their toes.
 It is a well-known fact that window dressing of balance sheet of banks is most common in
our country. Now that the appointment of auditors is proposed to be delegated to individual
banks, the chances of such financial jugglery taking place will be much higher, unless
drastic steps are taken to ensure that the auditors are made accountable for large variations
in key parameters every quarter and shown the door if found to be hand in glove with the
management.
 Improving corporate governance: In order to improve the performance of public sector
banks, it is necessary to bring all public sector banks under the Companies Act, 2013 and
make them accountable to public shareholders.

23 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL

 BIBLIOGRAPHY

BOOKS

 Study Material on Economics by Professor Rajesh Kumar Gautam

 Introductory Macroeconomics by Dr. V.K. Ohri and T.R. Jain

ARTICLES

 A study of impact of rbi policy rates on inflation by Pallavi Ingale* Volume 2, Issue 2
(February, 2012) International Journal of Research in IT & Management
http://www.mairec.org

WEBSITES

 http://www.microeconomicsnotes.com/monetary-standards/top-5-methods-used-for-issuing-
notes-india/1224
 http://www.economicsdiscussion.net/banks/currency/alternative-systems-of-currency-note-
issue-5-systems/12760
 http://www.yourarticlelibrary.com/banking/important-methods-adapted-by-rbi-to-control-
credit-creation/23490

 www.shodhganga.inflibnet.ac.in
 www.//rbi.org.in

24 | NATIONAL LAW INSTITUTE UNIVERSITY, BHOPAL