Money and Banking - Nadar, E. Narayanan

MONEY
AND
BANKING
E. Narayanan Nadar
MONEY AND BANKING
E. NARAYANAN NADAR
Associate Professor and Head
Postgraduate Department of Economics
V.H.N. Senthikumara Nadar College (Autonomous)
Virudhunagar, Tamil Nadu
Delhi-110092
2013
MONEY AND BANKING
E. Narayanan Nadar
© 2013 by PHI Learning Private Limited, Delhi. All rights reserved. No part of this book may
be reproduced in any form, by mimeograph or any other means, without permission in writing
from the publisher.
ISBN-978-81-203-4795-3
The export rights of this book are vested solely with the publisher.
Published by Asoke K. Ghosh, PHI Learning Private Limited, Rimjhim House, 111, Patparganj
Industrial Estate, Delhi-110092 and Printed by Raj Press, New Delhi-110012.
Contents
Preface xvii
Part I: MONEY

1. An Introduction to Money 3–28
1.1 Meaning of Barter System 3
1.2 Inconveniences of Barter System 3
1.2.1 Lack of Double Coincidence of Wants 4
1.2.2 Lack of Common Measure of Value 4
1.2.3 Lack of Divisibility of Goods 4
1.2.4 Lack of Common Store of Value 4
1.2.5 Lack of Deferred Payments 5
1.2.6 Lack of Specialization 5
1.2.7 Difficulty of Exchanging Services 5
1.2.8 Difficulty of Transporting Goods 5
1.2.9 Inconveniences of Borrowing and Lending 5
1.3 Origin and Evolution of Money 5
1.3.1 Origin of Money 5
1.3.2 Evolution of Money 6
1.4 Meaning and Definitions of Money 7
1.5 Characteristics of Money 9
1.5.1 Acceptability 9
1.5.2 Portability 9
1.5.3 Recognizability 9
1.5.4 Elasticity 10
1.5.5 Manageability 10
1.5.6 Stability 10
1.5.7 Durability 10
1.5.8 Divisibility 10
1.5.9 Accessibility 10
1.5.10 Homogeneity 11
iii
iv Contents
1.6 Kinds of Money 11

1.6.1 Money of Account 11
1.6.2 Money Proper 12
1.7 Functions of Money 13
1.7.1 Primary Functions 13
1.7.2 Secondary Functions 14
1.7.3 Contingent Functions 15
1.8 Significance of Money (Advantages of Money) 17
1.8.1 Money and Consumption 17
1.8.2 Money and Production 17
1.8.3 Money and Exchange 17
1.8.4 Money and Distribution 17
1.8.5 Money and Public Finance 17
1.9 Evils of Money (Disadvantages of Money) 18
1.9.1 Instability of Value 18
1.9.2 Inequality of Income 18
1.9.3 Root of all Vices 18
1.10 Role of Money 19
1.10.1 Role of Money in a Capitalist Economy 19
1.10.2 Role of Money in a Socialist Economy 20
1.11 Concept of Circular Flow of Money 21
1.11.1 Meaning of Circular Flow of Money 21
1.11.2 Simple Model of Circular Flow of Money 21
1.11.3 Significance of Circular Flow of Money 22
1.12 Money-related Concepts 23
1.12.1 Money Illusion 23
1.12.2 Money and Near Money 23
1.12.3 Money and Liquidity 23
1.12.4 Money and Income 24
1.12.5 Money and Wealth 24
1.12.6 Money and Finance 24
Multiple Choice Questions 25
Review Questions 27
Appendix 28
2. Monetary Standards 29–44

2.1 Meaning of Monetary Standard 29
2.2 Forms of Monetary Standard 29
2.2.1 Metallic Standard 29
2.2.2 Gold Standard 31
2.2.3 Paper Currency Standard 35
2.3 Principles of Note Issue 36
2.3.1 Currency Principle 36
2.3.2 Banking Principle 36
2.4 Systems of Note Issue 37
2.4.1 Maximum Fiduciary System 37
Contents v
2.4.2 Fixed Fiduciary System 37
2.4.3 Proportional Reserve System 38
2.4.4 Minimum Reserve System 38
2.5 Qualities of a Good Monetary Standard 39
2.6 Gresham’s Law 39
2.6.1 Assumptions of Gresham’s Law 39
2.6.2 Operation of Gresham’s Law 39
2.6.3 Limitations of Gresham’s Law 40
Review Questions 43
3. Value of Money 45–72

3.1 Meaning of Value of Money 45
3.2 Value of Money versus Value of Commodity 45
3.3 Kinds of Value of Money 46
3.3.1 Absolute Value of Money 46
3.3.2 Relative Value of Money 46
3.4 Measurement of Value of Money 46
3.4.1 Index Numbers 47
3.5 Determination of Value of Money 50
3.5.1 Demand for Money (Flow Concept) 51
3.6 Approaches to Demand for Money 53
3.6.1 Baumol’s Approach 54
3.6.2 Tobin’s Approach 54
3.6.3 Friedman’s Approach 55
3.6.4 Gurley and Shaw’s Approach 55
3.7 Supply of Money (Stock Concept) 56
3.7.1 Constituents or Components of Money Supply 56
3.7.2 Determinants of Money Supply 56
3.7.3 Money Supply Function 58
3.7.4 Measurement of Money Supply 60
3.7.5 High Powered Money or Reserve Money or Monetary Base 61
3.7.6 Money Multiplier 62
3.7.7 Money Supply Function 64
3.7.8 Budgetary Deficit and Money Supply 65
3.7.9 Concept of Velocity of Circulation of Money 65
Review Questions 72
4. Monetary Theories 73–101

4.1 Quantity Theory of Money 73
4.1.1 Approaches to Quantity Theory of Money 74
4.2 Income Theory of Money 82
4.2.1 Explanation of Income Theory of Money 83
4.2.2 Propositions of Income Theory of Money 85
vi Contents
4.2.3 Superiority of Income Theory of Money over Quantity Theory

of Money 85
4.2.4 Shortcomings of Income Theory of Money 86
4.3 Keynesian Theory of Money and Prices 86
4.3.1 Statement of Keynesian Theory of Money and Prices 86
4.3.2 Explanation of Keynesian Theory of Money and Prices 87
4.3.3 Illustration of Keynesian Theory of Money and Prices 87
4.3.4 Superiority of Keynesian Theory of Money and Prices 88
4.3.5 Shortcomings/Criticisms of Keynesian Theory of Money and Prices 89
4.4 Milton Friedman’s Quantity Theory of Money (Chicago Version of Quantity
Theory of Money) 89
4.4.1 Critical Appraisal of Friedman’s Quantity Theory of Money 91
4.5 Don Patinkin’s Real Balance Effect: An Integration of Monetary
and Value Theories 92
4.5.1 Assumptions of Patinkin’s Real Balance Effect 92
4.5.2 Criticisms of Patinkin’s Real Balance Effect 94
4.6 Liquidity Theory of Money 94
4.6.1 Radcliffe–Sayers Thesis 95
4.6.2 Gurley–Shaw Thesis 96
4.6.3 Tobin’s Portfolio–Selection Theory 97
Review Questions 100
5. Analysis of Interest Rates 102–116

5.1 Introduction 102
5.2 Meaning of Interest 102
5.3 Classification of Interest 102
5.4 Theories of Interest 103
5.4.1 Classical Theory of Interest 103
5.4.2 Neo-classical Theory of Interest 104
5.4.3 Liquidity Preference Theory of Interest 106
5.4.4 Neo-Keynesian Theory of Interest 108
5.4.5 Wicksell’s Theory of Interest 110
5.5 Term Structure of Rate of Interest 111
5.5.1 Theories of Term Structure of Rate of Interest 111
5.6 Interest Rates in a Closed Economy 112
5.7 Interest Rates in an Open Economy 113
6. Analysis of Inflation and Deflation 117–137

6.1 Inflation 117
6.1.1 Definitions of Inflation 117
6.1.2 Characteristics of Inflation 118
6.1.3 Types of Inflation 119
Contents vii
6.1.4 Measuring Inflation 122
6.1.5 Causes of Inflation 123
6.1.6 Effects of Inflation 124
6.1.7 Control of Inflation (Antiinflationary Measures) 125
6.1.8 Concept of Inflationary Gap 127
6.1.9 Phillips Curve Analysis 129
6.1.10 Okun’s Law 131
6.1.11 Concept of Stagflation 131
6.2 Deflation 132
6.2.1 Deflation vs Disinflation 132
6.2.2 Causes of Deflation 132
6.2.3 Effects of Deflation 132
6.2.4 Control of Deflation (Antideflationary Measures) 133
6.3 Disinflation 133
6.4 Reflation 133
7. Trade Cycles 138–148

7.1 Meaning of Trade Cycle 138
7.2 Definitions of Trade Cycle 138
7.3 Characteristic Features of Trade Cycle 139
7.4 Phases of Trade Cycle 139
7.4.1 Depression Phase 140
7.4.2 Recovery Phase 140
7.4.3 Prosperity Phase 140
7.4.4 Recession Phase 141
7.5 Theories of Trade Cycle 141
7.5.1 Climatic Theory 142
7.5.2 Psychological Theory 142
7.5.3 Under-consumption Theory 142
7.5.4 Over-investment Theory 142
7.5.5 Monetary Theory 143
7.5.6 Innovation Theory 143
7.5.7 Keynes’ Theory 143
7.5.8 Hicksian Theory 144
7.5.9 Cobweb Theory 144
7.6 Control of Trade Cycle (Anticyclical Measures) 146
8. Money Market 149–164

8.1 Meaning of Money Market 149
8.2 Definitions of Money Market 149
8.3 Functions of Money Market 150
viii Contents
8.4 Institutions of Money Market 150

8.4.1 Central Bank 150
8.4.2 Commercial Bank 150
8.4.3 Non-banking Financial Institutions 151
8.4.4 Discount Houses and Bill Brokers 151
8.4.5 Acceptance Houses 151
8.5 Instruments of Money Market 151
8.5.1 Promissory Note 151
8.5.2 Bill of Exchange 152
8.5.3 Treasury Bills 152
8.5.4 Call Loans 152
8.5.5 Commercial Papers 152
8.5.6 Inter-bank Term Market 152
8.5.7 Certificates of Deposits 152
8.6 Characteristics of a Good Money Market 153
8.7 Importance of Money Market 153
8.8 London Money Market 154
8.8.1 Nature of London Money Market 154
8.8.2 Constituents of London Money Market 154
8.9 New York Money Market 157
8.9.1 Structure and Organization of New York Money Market 157
8.9.2 Constituents of New York Money Market 157
8.10 Indian Money Market 159
8.10.1 Structure of Indian Money Market 159
8.10.2 Defects of Indian Money Market 161
8.10.3 Suggestions for the Improvement of Indian Money Market 161
9. Capital and Stock Markets 165–175

9.1 Capital Market 165
9.2 Constituents of Capital Market 165
9.3 Components of Capital Market 165
9.4 Importance of Capital Market 166
9.5 Functions of Capital Market 166
9.6 Indian Capital Market 166
9.6.1 Nature of Indian Capital Market 166
9.6.2 Components of Indian Capital Market 167
9.6.3 Development of Indian Capital Market 168
9.6.4 Capital Market Regulations 168
9.6.5 Capital Market Reforms 169
9.6.6 Recent Trends in Indian Capital Market 170
9.7 Stock Market 171
9.7.1 Structure of Stock Market 171
9.7.2 Market Participants 171
9.7.3 Importance of Stock Market 172
Contents ix
9.7.4 Indian Stock Market 172
9.7.5 Role of Stock Market in Economic Development 172
9.7.6 Stock Market Indices 173
10. Monetary Policy 176–187

10.1 Meaning of Monetary Policy 176
10.2 Definitions of Monetary Policy 176
10.3 Objectives of Monetary Policy 177
10.3.1 Exchange Rate Stability 177
10.3.2 Price Stability 177
10.3.3 Neutrality of Money 178
10.3.4 Control of Cyclical Fluctuations 178
10.3.5 Full Employment 179
10.3.6 Economic Growth 179
10.4 Instruments of Monetary Policy 180
10.4.1 Quantitative Instruments 180
10.4.2 Qualitative Instruments 181
10.5 Role of Monetary Policy in a Developing Economy 182
10.6 Limitations of Monetary Policy 184
10.7 A Note on ‘Transmission Mechanism’ of Monetary Policy 184
10.7.1 Portfolio Approach 184
10.7.2 Wealth Approach 185
Part II: BANKING
11. An Introduction to Banking 191–203

11.1 Origin of a Bank 191
11.2 Meaning of a Bank 191
11.3 Definitions of a Bank 192
11.4 Characteristic Features of a Bank 192
11.5 Evolution of Banking 193
11.6 Structure of Banking 193
11.7 Systems of Banking 194
11.7.1 Unit Banking System 195
11.7.2 Branch Banking System 196
11.7.3 Mixed Banking System 197
11.8 Types of Banks 198
11.8.1 Commercial Banks 199
11.8.2 Agricultural Banks 199
11.8.3 Industrial or Investment Banks 199
x Contents
11.8.4 Savings Banks 200

11.8.5 Cooperative Banks 200
11.8.6 Exchange Banks 200
11.8.7 Central Banks 200
12. Functions of Commercial Banks 204–209

12.1 Definition of Commercial Bank 204
12.2 Functions of Commercial Banks 204
12.2.1 Primary Functions 204
12.2.2 Secondary Functions 205
12.2.3 Other Functions 206
12.3 Functions of Commercial Banks in India 207
13. Credit Creation Process of Commercial Banks 210–218

13.2 Meaning of Credit Creation 210
13.3 Basis of Credit Creation 210
13.3.1 Primary Deposits (Cash Deposits) 210
13.3.2 Derivative Deposits (Derived Deposits) 211
13.4 Arguments towards Credit Creation 211
13.4.1 Argument against Credit Creation 211
13.4.2 Argument in Favour of Credit Creation 211
13.5 Process of Credit Creation 212
13.6 Calculation of Credit Creation 214
13.7 Limitations of Credit Creation Process 214
13.7.1 Volume of Primary Deposits 214
13.7.2 Cash Reserve Ratio 215
13.7.3 Banking Habits of the Public 215
13.7.4 Monetary Policy of the Central Bank 215
13.7.5 Statutory Liquidity Ratio (SLR) 215
13.7.6 Trade or Business Conditions 215
13.7.7 Existence of Cash Transactions 216
13.7.8 Availability of Sound Securities 216
13.7.9 Willingness to Borrow 216
13.7.10 Liquidity Preference of the People 216
13.7.11 Existence of External Drain 217
Contents xi
14. Balance Sheet of Commercial Banks 219–224
14.1 Meaning of Balance Sheet 219
14.2 Sample Balance Sheet 219
14.3 Sides of a Balance Sheet 220
14.3.1 Liabilities Side 220
14.3.2 Assets Side 221
15. Investment Policy of Commercial Banks 225–228

15.1 Meaning of Investment Policy 225
15.2 Principles underlying Investment Policy 225
15.2.1 Liquidity 225
15.2.2 Profitability 226
15.2.3 Safety or Security of Funds 226
15.2.4 Diversity of Investments 226
15.2.5 Stability in the Value of Investments 226
15.2.6 Saleability of Securities 227
15.2.7 Productivity of Investments 227
15.2.8 Tax-exemption of Investments 227
15.3 Types of Bank Investments 227
15.3.1 Non-profitable Investments 227
15.3.2 Profitable Investments 227
16. Nationalization of Commercial Banks 229–235

16.1 Meaning of Bank Nationalization 229
16.2 Social Control Over Banks 229
16.3 Objectives of Bank Nationalization 229
16.4 Bank Nationalization in India 230
16.4.1 Phases of Bank Nationalization in India 230
16.5 Organization of Nationalized Bank 231
16.6 Arguments in favour of Bank Nationalization 231
16.7 Arguments against Bank Nationalization 232
16.8 Achievements of Bank Nationalization 232
16.8.1 Branch Expansion 233
16.8.2 Deposit Mobilization 233
16.8.3 Rural Credit 233
16.8.4 Advances to Priority Sectors 233
xii Contents
17. State Bank of India 236–244

17.1 Origin of the State Bank of India 236
17.2 Capital Structure of the State Bank of India 236
17.3 Management of the State Bank of India 237
17.4 Functions of the State Bank of India 237
17.5 Role of the State Bank of India 237
17.5.1 Branch Expansion 238
17.5.2 Deposit Mobilization 238
17.5.3 Credit Expansion 238
17.5.4 Agricultural Finance 238
17.5.5 Industrial Finance 239
17.5.6 Personal Finance 239
17.5.7 Personal Banking Services 240
17.6 New Initiatives of the State Bank of India 240
17.7 Deposits, Loans Advances and Branches of the State Bank of India 240
18. Commercial Banks and Economic Development 245–250

18.2 Need for a Sound Banking System 245
18.3 Role of Commercial Banks in the Economic Development of India 246
18.3.1 Mobilization of Savings 246
18.3.2 Capital Formation 246
18.3.3 Monetization 247
18.3.4 Innovations 247
18.3.5 Monetary Policy 247
18.3.6 Priority Sector Finance 247
18.3.7 Agricultural Finance 248
18.3.8 Industrial Finance 248
18.3.9 Export Finance 248
18.3.10 Promotion of Banking Habits 248
18.3.11 Promotion of Regional Development 249
19. India’s Lead Bank Scheme 251–255

19.1 Origin of Lead Bank Scheme 251
19.2 Objectives of Lead Bank Scheme 251
19.3 Functions of Lead Bank Scheme 252
19.4 Benefits Expected from Lead Bank Scheme 252
19.5 Working of Lead Bank Scheme 253
Contents xiii
19.6 Criticisms of Lead Bank Scheme 253
19.7 Suggestions for the Improvement of Lead Bank Scheme 254
20. An Introduction to Central Banking 256–261

20.1 Origin of a Central Bank 256
20.2 Definitions of a Central Bank 256
20.3 Objectives of a Central Bank 257
20.4 Principles of a Central Bank 257
20.5 Evolution of Central Banking 258
20.6 Comparison between Central Banking and Commercial Banking 259
21. Functions of a Central Bank 262–266

21.1 Main Functions 262
21.1.1 Monopoly of Note Issue 262
21.1.2 Bankers’ Bank 263
21.1.3 Banker to the Government 263
21.1.4 Lender of the Last Resort 264
21.1.5 Bank of Clearance 264
21.1.6 Custodian of Foreign Exchange Reserves 264
21.1.7 Custodian of National Reserves 264
21.1.8 Maintenance of Exchange Rates 264
21.1.9 Promotional and Developmental Functions 265
21.1.10 Controller of Credit 265
22. Credit Control Methods 267–272

22.1 Meaning of Credit Control 267
22.2 Need of Credit Control 267
22.3 Methods of Credit Control 267
22.3.1 Quantitative Credit Control Methods 268
22.3.2 Qualitative Credit Control Methods 269
23. Central Banking System in India 273–282

23.1 Banking System 273
23.1.1 Direct Financing 273
xiv Contents
23.1.2 Indirect Financing 273

23.1.3 Creation of Infrastructure 273
23.2 Objectives of Central Banking System 274
23.3 Evolution of the Reserve Bank of India 274
23.4 Objectives of the Reserve Bank of India 275
23.5 Functions of the Reserve Bank of India 275
23.6 Credit Control Methods of the RBI 277
23.6.1 Bank Rate 277
23.6.2 Open Market Operations 277
23.6.3 Variation of Cash Reserve Ratio 278
23.6.4 Moral Suasion 278
23.6.5 Direct Action 278
23.6.6 Prescribing Margins 278
23.7 Radcliffe Committee 279
23.7.1 Incentive Effect 279
23.7.2 General Liquidity Effect 279
24. Reserve Bank of India and Economic Development 283–287

24.2 RBI and Agricultural Finance 283
24.3 RBI and Industrial Finance 284
24.4 RBI and Housing Finance 285
24.5 RBI and Export Finance 285
24.6 RBI and Promotion of Banking Habits 285
25. Central Banking System in the USA 288–293

25.1 Origin 288
25.2 Structure of the Federal Reserve System 288
25.3 Organization of the Federal Reserve System 289
25.4 Functions of the Federal Reserve System 289
25.5 Credit Controls of the Federal Reserve System 290
25.5.1 General Credit Controls 290
25.5.2 Selective Credit Controls 291
26. Central Banking System in the UK 294–299

26.1 Origin 294
26.2 Operations of the Bank of England 294
Contents xv
26.3 Cash Basis of the Banking System 295
26.3.1 Cash of the First Form 295
26.3.2 Cash of the Second Form 295
26.4 Schools of Thought on the Issue of Bank Notes 296
26.4.1 The Currency School 296
26.4.2 The Banking School 296
26.5 Instruments of Banks Monetary Policy 296
26.5.1 Bank Rate 297
26.5.2 Open Market Operations 297
27. International Financial Institutions 300–311

27.1 International Monetary Fund (IMF) 300
27.1.1 Objectives of the IMF 300
27.1.2 Organization and Membership of the IMF 301
27.1.3 Management of the IMF 301
27.1.4 Functions of the IMF 302
27.1.5 India and IMF 303
27.1.6 Advantages of the IMF 304
27.1.7 Criticisms of the IMF 304
27.2 International Bank for Reconstruction and Development (IBRD) 305
27.2.1 Objectives of the IBRD 306
27.2.2 Organization and Membership of the IBRD 306
27.2.3 Management of the IBRD 306
27.2.4 Sources of Funds to the IBRD 306
27.2.5 Functions of the IBRD 307
27.2.6 Advantages of the IBRD 308
27.2.7 Criticisms of the IBRD 308
Bibliography 313–314
Index 315–317
Preface
This book is an outgrowth of author’s long teaching experience. It is written to meet the
requirement of undergraduate students of Economics, Commerce and Business Administration.
Besides, it would also be useful to the postgraduate students of Economics, Commerce and
Business Administration. It covers the syllabi of almost all Indian universities. The objective
of this book is to introduce the subject of money and banking to the student community in
a systematic manner covering the latest facts and figures related to the current monetary and
banking trends in India.
The text is divided into 27 chapters under two parts. Part I on Money consists of
Chapters 1–10 and Part II on Banking consists of Chapters 11–27.
Chapter 1 deals with evolution, nature, functions, role and significance of money. Chapter 2
deals with monetary standards like gold and paper currency standard and principles and
systems of note issue. Chapter 3 discusses the meaning, measurement and determinants of
the value of money. It also discusses demand for and supply of money and the volume and
velocity of circulation of money in the economy. Chapter 4 discusses the various theories of
money: quantity theory of money—cash transaction and cash balance approach, Keynesian
theory of money and prices, Milton Friedman’s quantity theory of money, Don Patinkin’s real
balance effect, Radcliffe–Sayers thesis, Gurley–Shaw thesis, Tobin’s portfolio selection theory.
Chapter 5 analyses the concept of interest rates covering the theories of rate of interest, term
structure of rate of interest, interest rates in a closed and open economy. Chapter 6 presents
the concepts of inflation, deflation, disinflation, reflation of stagflation. Okun’s law and Phillips
curve analysis also discussed in this chapter. Chapter 7 deals with the various phases of a trade
cycle, theories of trade cycle and anti-cyclical measures. Chapter 8 covers the money market,
i.e. London money market, New York money market and Indian money market. A note on
Bill Market Scheme is also given. Chapter 9 deals with capital and stock markets covering
Indian capital market—components, regulations, reforms and recent trends— and also Indian
stock market—its structure and importance. Chapter 10 highlights the monetary policy covering
its objectives and instruments—quantitative and qualitative. It also discusses the concept of
transmission mechanism of monetary policy.
Chapter 11 presents an introduction to banking covering evolution, structure and systems of
banking. Chapters 12–13 discuss the functions and credit creation process of commercial banks
xvii
xviii Preface
in India. Chapters 14–16 discuss the balance sheet, investment policy and nationalization of
commercial banks in India. Chapter 17 deals with State Bank of India—its structure, management,
functions and role in the economic development of India. Chapters 18–19 discuss the role of
commercial banks in the economic development of India and India’s Lead Bank Scheme. Chapters
20–22 present an introduction to central banking covering objectives, principles and functions of
a central bank, and quantitative and qualitative methods of credit control. Chapter 23 discusses
the central banking system in India covering evolution, objectives, functions and credit control
methods of the Reserve Bank of India. Chapter 24 discusses the role of Reserve Bank of India
in the economic development of India. Chapters 25–26 discuss the central banking system in
the USA and in the UK. The last Chapter 27 deals with international financial institutions like
IMF and IBRD in detail.
The text is supported with examples, tables and figures. It also incorporates the chapter-end
multiple choice questions and review questions.
I express my profound and sincere thanks to M/s PHI Learning, New Delhi which has
spontaneously come forward to publish this book. The constant encouragement of its editorial
and marketing team is also gratefully acknowledged.
I take this opportunity to express my sincere and wholehearted thanks to my beloved wife
N. Thangam and my dear daughters N. Amutha Priya ME, MBA, PhD and N. Anuja ME, for
their constant technical assistance and encouragement in the course of preparation of this book.
Above all, I should thank the Almighty without whose Grace nothing could have been
done in this regard.
Any constructive comments and suggestions for the improvement of the book will be
gratefully acknowledged.
E. Narayanan Nadar
Part I
Money
Chapter 1
An Introduction to Money
1.1 Meaning of Barter System

By barter we mean direct exchange of one commodity for another commodity. In other words,
barter means the direct exchange of goods for goods without any mediation of money. Under
the barter system, the exchange process is very simple and direct. For example, rice may be
exchanged for wheat; scooter may be exchanged for bike; cloth may be exchanged for chair
and so on.
In the early stages of civilization, human needs were simple and every individual was able
to produce all that he needed to maintain himself. This was followed by specialization, whereby
people settled down in different occupations, depending on their skills and the availability of
resources. Against this backdrop if we look at the barter system, a person having plenty of one
commodity, say, food, exchanging it with another person having plenty of another commodity,
say, cotton, seems to be an uncomplicated process. However, barter system is not an unmixed
blessing. The barter system has its inconveniences or defects or difficulties or shortcomings
as well.
1.2 Inconveniences of Barter System

The following are the inconveniences of barter system:
• Lack of double coincidence of wants
• Lack of common measure of value
• Lack of divisibility of goods
• Lack of common store of value
• Lack of deferred payments
• Lack of specialization
• Difficulty of exchanging services
• Difficulty of transporting goods
• Inconveniences of borrowing and lending
3
4 Money and Banking
1.2.1 Lack of Double Coincidence of Wants
Under the barter system, no exchange can take place unless the wants of two persons coincide.
In other words, double coincidence of wants is a necessary condition for the exchange of
commodities under barter system.
A man must find another person who has what he wants and wants what he has. This is
not easy. For example, a carpenter has a chair and he wants cloth. He must go in search of
weaver who has cloth and he who wants chair. Suppose the carpenter meets the weaver who has
cloth, but the weaver does not want chair and he wanted again food grains, then the carpenter
cannot exchange his chair with the weaver. Here, wants of the carpenter and the weaver do
not coincide. Lack of coincidence of wants between the carpenter and the weaver will hinder
the exchange of chair for cloth. This involves wastage of time, cost and energy. Thus the lack
of double coincidence of wants is the first and the foremost inconvenience of barter system.
1.2.2 Lack of Common Measure of Value
Another inconvenience of barter system is that there is no common measure of value of

commodities. In the primitive society, there was no common commodity to measure the value
of commodities. Then the people measured the value of commodities in commodities only.
Suppose that a carpenter and a weaver wanted to exchange chair against cloth, they must
first of all decide in what proportion the two goods should be exchanged. This was not easy
as the transactions were isolated. Since there was no common measure of value, the exchange
ratio would be fixed in an arbitrary manner. It was clear that where each exchange was an
isolated transaction, one party should suffer.
1.2.3 Lack of Divisibility of Goods
Some commodities cannot be divided into parts without reduction in their value. Examples are
cows, horses, goats and camels. All commodities are not of equal value. Suppose that a person
has a cow and wants one cotton saree. Let us further assume that one cow is equal in value to
50 sarees. It is not easy to cut the cow to secure one saree. If he gives a cow for one saree,
he will lose heavily. So exchange is not possible. Thus lack of divisibility of goods is another
inconvenience of barter system.
1.2.4 Lack of Common Store of Value
Under the barter system, it is very difficult to store wealth for future use since wealth consists
of perishable commodities. People also have no means to store their wealth. Moreover, the
store of value in terms of real wealth involves cost and, further, the problem of storing the
commodities sometimes also involves a heavy loss. Thus lack of common store of value is
another inconvenience of barter system.
An Introduction to Money 5
1.2.5 Lack of Deferred Payments
Under the barter system, it is very difficult to make payments in the future. Debt contracts
may not be possible due to disagreements between the two parties involved in the exchange
process because of several reasons. Deferred future payments are impossible under barter system
because of the following reasons:
• The quality of goods and services to be repaid.
• The two parties would be unable to agree on the specific commodity to be used for
repayment.
• Both parties would run the risk that the commodity to be repaid would increase or
decrease the value of the commodity over the duration of the contract.
1.2.6 Lack of Specialization
Under the barter system, a high degree of specialization cannot be achieved as the production
system is such that each person is a jack-of-all trades and master of none.
1.2.7 Difficulty of Exchanging Services
Under the barter system, the exchange of services would be far more difficult than the exchange
of goods. For example, how much would be the services of a teacher, a priest, a doctor or a
lawyer paid? How would these persons be paid?
1.2.8 Difficulty of Transporting Goods
Under the barter system, it is inconvenient to carry bulky goods from one place to another for
exchange purposes.
1.2.9 Inconveniences of Borrowing and Lending
The barter system is inconvenient as regards borrowing and lending. For example, if a person
borrows a pair of goats for a year to two, he cannot return the same pair of goats, because
by that time, they would either become old, slim or even die. Therefore, it is not possible to
return the same pair of goats in original form after lapse of time. So borrowing and lending
become extremely difficult under barter system.
1.3 Origin and Evolution of Money

1.3.1 Origin of Money
Money is a human invention to overcome the inconveniences of barter system. In the words
of Geoffrey Crowther in his book An Outline of Money, money is one of the fundamentals of
6 Money and Banking
all man’s inventions. Every branch of knowledge has its fundamental discovery. In mechanics,
it is the wheel; in science, fire; in politics, the vote; and similarly, in economics, money is the
essential invention on which all the rest is based.
The word Money has been derived from the Latin word Moneta which refers to the name
of the Roman Goddess Juno, in whose temple at Rome coins were being minted. Money plays
an important economic role in all societies. It renders invaluable economic services without
which the development of modern industrial societies would hardly be possible. According to
P.F. Drucker, in modern industrial society, money influences, moulds and directs economic life;
changes in the money sphere cause changes in the real economy. In modern societies, nearly
all aspects of economic life involve the use of money. The purchase of goods, services and
claims; the settlement of debts; and payment of taxes are generally effected with the agency
of money. Our individual economic well-being depends upon the amount of money income
we receive for the goods we produce; or the services we render and the goods and services
our money income will buy.
For payment purposes, we always carry with us some money in the form of coins and
notes, or chequebooks with which we can order the transfer of deposit money that we have in
commercial banks. Money is indeed familiar to every one of us.
The complex economies of the modern world would be unable to function without the use
of money. If money is not employed, production or distribution must be completely planned
by the State or all transactions must be carried on by barter, i.e. goods or services must be
exchanged for other goods or services. Money is a commodity the primary function of which
is to facilitate the exchange of goods and services. Money therefore had its origin in the
difficulties associated with barter.
1.3.2 Evolution of Money
The different stages of the evolution of money are discussed below:
Commodity money
Commodity money forms the first and the foremost stage in the evolution of money. Before
money came into existence, people had been using some or the other article as money. In the
hunting stage, skins of wild animals were used as money; in the pastoral society, livestocks
were used as money; in the agricultural society, food grains were used as money. People had
even used stones, shells, fish hooks, tobacco, leather and so on.
Metallic money
Metallic money is the second stage in the evolution of money. Gradually, metals like gold,
silver, copper and iron were used as money in their crude form mainly for the purpose of
international trade relations among countries, both by land and by sea. These metals were
precious, durable and superior to commodities as money. It was inconvenient to weigh, divide
and assess the quality of the metals. This inconvenience of metals paved the way for the usage
of metallic coins as money. The introduction of coins was closely followed by the tampering
of coins both by Kings and by dishonest traders and businessmen.
When the price of gold began to rise, gold coins were melted and converted into their
metal form. This metal was then sold to earn more money. The main inconvenience in the use
of coins was that it was highly risky to carry the coins from one place to another. Tampering
of coins by dishonest traders and businessmen was also another inconvenience in the use of
coins as the medium of exchange. This clearly led to the introduction of paper money.
Paper money
Paper money is the third stage in the evolution of money. Initially, paper money was simply a
substitute for metallic money. Paper money means the legal tender money, i.e. one rupee issued by
the Ministry of Finance and all other notes of higher denomination issued by the Reserve Bank
of India. In India, one thousand rupee note is the highest denomination note issued by the RBI.
In other words, paper money consists of all notes issued by the government and banks.
In developing countries like India, paper money constitutes the largest part of total money in
circulation. It can be conveniently used as medium of exchange, measure of value, store of
value and the standard of deferred payments. Paper money was used as representative money
representing gold and silver coins. It was also easily convertible into gold and silver coins.
Merits of paper money: The merits of paper money are as follows:
• It is cheaper than metal.
• It economizes the use of dearer metals.
• It is convenient to carry from one place to another.
• It is easier to store.
• It is convenient for counting and accounting.
• It is useful to any government.
Demerits of paper money: The following are the demerits of paper money:
• It escalates the costs.
• It increases the prices of all commodities.
• It creates unemployment.
• The durability of paper money is doubtful.
• It cannot be used for foreign exchange payments.
Bank (or credit) money
Bank (or credit) money is the fourth stage in the evolution of money. It refers to bank deposits
kept by people with banks which they can withdraw at any point of time and transfer to someone
else through the cheque. Bank (or credit) money overcomes the difficulty of carrying paper
currency notes from one place to another. Banks are entrusted with the task of issuing the
credit money in different negotiable instruments like cheques, demand drafts, bills of exchange,
insurance policy, treasury bills and also units issued by the Unit Trust of India.
1.4 Meaning and Definitions of Money

Money is anything that is generally acceptable as a means of payment in the settlement of all
transactions including debt.
8 Money and Banking
Economists have defined ‘money’ in different ways. Some of their definitions are given below.
“Money is what money does.” —F.A. Walker
It implies that anything that performs the work of money is called money.
“Money is a commodity which is used to denote anything which is widely accepted in
payment for goods or in discharge of other business obligations.” —D.H. Robertson
“Money is anything that is generally acceptable as a means of exchange (i.e. as a means
of settling debts) and that at the same time acts as a measure and a store of value.”
—Geoffrey Crowther
This definition seems to be comprehensive.
“Money is anything that is commonly used and generally accepted as a medium of
exchange or as a standard of value.” —Raymond P. Kent
“Money is the means established by law (or by custom having the force of law) for the
payment of debts.” —R.G. Hawtrey
“Money is the most convenient way of laying claim which can be used by its owner to
buy anything.” —A.C.L. Day
“Money is any commodity assigned by the State the role of settling debts.”
—Knapp, a German Economist
“Money is purchasing power something which buys things.” —G.D.H. Cole
“Money is the stuff with which we buy and sell things.” —Hartley Withers
“Money has been used to designate the medium of exchange, as well as the standard
of value.” —Halm
“Money includes all those things which are (at any time and place) generally current
without doubt or special enquiry as a means of purchasing commodities and services
and of defraying expenses.” —Alfred Marshall
“Money is one thing that possesses general acceptability.” —E.R.A. Seligman
“Money consists of those things which, within society, are of general acceptability.”
—Ely
“Money itself is that by delivery of which debt contracts and price contracts are discharged
and in the shape of which a store of general purchasing power is held.”
—John Maynard Keynes
“In order for anything to be classified as money, it must be accepted fairly, widely as
an instrument of exchange.” —A.C. Pigou
It is to be noted that the acceptability should be voluntary and not forced by law.
All the economists who have defined money agree that anything which is generally acceptable
in payment of debt and is commonly used as a medium of payments or as a standard of value
can be regarded as money, whatever may be its legal status.
1.5 Characteristics of Money

The important characteristics of money are:
• Acceptability
• Portability
• Recognizability
• Elasticity
• Manageability
• Stability
• Durability
• Divisibility
• Accessibility
• Homogeneity
1.5.1 Acceptability
Money should be generally acceptable by all in exchange of goods and services without
hesitation. Suppose it does not fulfil this primary condition of acceptability, then it cannot be
termed money because it does not act as a common medium of exchange.
Gold and silver coins are generally acceptable anywhere in the world because they have
many alternative values, apart from their exchange value. Under gold standard, gold is generally
acceptable. Under silver standard, silver is generally acceptable. Under paper standard, paper
money or currency (without having any intrinsic value of its own) is generally acceptable.
It should be noted that paper currency notes and subsidiary coins are acceptable only in the
country of issue.
1.5.2 Portability
Money should be easily and conveniently portable. Portability simply means easily takeable,
i.e. a good money material should be easily portable from one place to another without any
delay or difficulty. Though gold and silver possess high value with small bulk, paper money
and bank money are therefore preferred to be used as good money materials. It is because of
the fact that gold and silver coins are of heavy weight, therefore their portability is difficult.
Hence, paper money and bank money are more portable than gold and silver coins.
1.5.3 Recognizability
A good money material should be recognizable, i.e. a good money material should be such
that it is easily identified and distinguished from other materials by shift, sound or weight.
Rupee notes and coins are easily recognized by all. Even a child can recognize these notes
and coins.
10 Money and Banking
1.5.4 Elasticity
A good money material should be highly elastic, i.e. money which can be expanded or contracted
according to commercial needs is said to be elastic. Elasticity is one of the essential qualities of a
good medium of exchange. A sound currency system should provide the characteristic of elasticity.
1.5.5 Manageability
A good money material should be manageable, i.e. the total quality of money in circulation
should be manageable by the issuing authorities so as to maintain the welfare of the economy
through controlling the expansion and contraction of the money supply.
1.5.6 Stability
A good money material should have stable value, i.e. its value must neither fall nor rise. If the
value is unstable, it may not be accepted by all. The stability in the value of money makes the
working of the economy smooth. Such a quality is not possessed by any material. Gold and
silver coins are comparatively more stable in value than other materials. The value of paper
money could be maintained by keeping its issue under control.
Hence, the instability in price level may lead to a defective functioning of money’s other
services, namely, being a standard of deferred payments, measure of value and store of value.
1.5.7 Durability
A good money material should be durable. Money must be durable because it is stored up
for future use. Gold and silver coins are good money material because they have durability.
Paper money does not possess this quality because currency notes are easily destroyable. But
small denomination coins and demand deposits in banks are more durable and indestructible
than the paper money.
1.5.8 Divisibility
A good money material should be capable of being divided into smaller denominations
without any loss of value. For example, the rupee note is printed both in smaller and in bigger
denominations to facilitate all kinds of monetary transactions. Similarly coins are also being
minted in various denominations like fifty paisa coins, one rupee coins, two rupee coins, five
rupee coins and ten rupee coins. The smaller units of money enable the fractional transactions
without any difficulty.
1.5.9 Accessibility
A good money material should be easily accessible, i.e. the money should have easy access
to the foreign market for trade, investment and other purposes. The domestic money should
be easily convertible into any foreign currency at reasonable rates and vice versa. For easy
access to foreign markets, both short term and long term, the rate of exchange should be fixed
at qualities of a good money material of any country.
1.5.10 Homogeneity
A good money material should be uniform in quality and quantity. All prices of the material
used as money should be homogeneous so that equal weight has been exactly the same value.
If the quality is not uniform, it will not contain the same value in the same bulk. Diamonds
and other precious stones are not uniform in quality. So they were not used as good money
material. Gold and silver are homogeneous. Paper money of the same denominations is similar
in shape, size and design. Similarly, subsidiary coins are uniform in appearance, design, weight
and fineness.
1.6 Kinds of Money

The kinds of money are:
1. Money of account
2. Money proper
(i) Commodity money
(ii) Representative money
(a) Full-bodied money
(b) Token money
(c) Fiat money
(iii) Optional money
(iv) Legal tender money
(a) Limited legal tender money
(b) Unlimited legal tender money
1.6.1 Money of Account
Money of account is the money in terms of which accounts are maintained. In our country, rupee
and paise are money of accounts. J.M. Keynes in his book A Treatise on Money defines money
of account as: “money of account is that in which debts and prices and general purchasing
power are expressed.”
Money of account is static in character and being the title of the thing used as money is
not subject to evolutionary change. In India, the money of account has been the ‘rupee’ since
the establishment of a monetary system in the country.
1.6.2 Money Proper
Money proper is also known as common money. Common money is defined as that money
which is consisting of coins of different metals and paper currency notes. It is used for all
rupees of transactions by all persons and is backed by the government of the country. Thus
common money or money proper may either be commodity money or representative money.
Commodity money
Commodity money is composed of actual units of some freely-obtainable, non-monopolized
commodity chosen as money It is also termed full-bodied money because the real value of the
money material is equal to its face value. Since the real and face value of the money material
are equal, it may be called standard money.
Representative money
Representative money refers to that money which is made either of cheap metal or convertible
paper money. It is cared not for its own sake but for the sake of the commodity money whom
it represents. It may either be representative full-bodied money or representative token money
or fiat money.
Full-bodied money: Full-bodied paper money is a warehouse receipt the owner of which
is promised by the receipt issuing authority payment of full-bodied coins or the equivalent
quantity of bullion in exchange of receipt. It is clear that although representative full-bodied
money has no value of its own. The US Gold Certificates circulated in the USA before 1933
is an example of representative full-bodied money because these certificates were fully backed
by the reserves of gold coins and gold bullion.
The principle on which the representative full-bodied money is issued is that there has to be
kept 100 per cent reserve of bullion as backing against the issue of representative full-bodied
money. In this case, the face value and the intrinsic value are almost equal.
Token money: Token money is a circulating warehouse receipt for token coins (or for an equal
weight of gold for which it can be redeemed). In the case of representative token money, there
is not 100 per cent backing of bullion or gold. Hence, the face value of the representative token
money is higher than its intrinsic value. The US Silver Certificates that have been circulated in
the USA since 1878 and against which there is a backing of an equal amount of silver dollars
or silver of equal weight are an example of representative token money.
Fiat money: Fiat money is legal money which is circulated in the country by the formal
command of the government. The features of fiat money are:
• It has a little or no value as a commodity.
• It is non-redeemable in any commodity.
• Its purchasing power is not kept at par with that of gold or silver in which it might
have been formerly convertible.
Fiat money generally consists of paper currency and inconvertible bank notes of different
denominations. Initially, the fiat money was originated in the exigencies of war finance.
Prior to 1914, fiat money was resorted to only as a temporary war expedient. The full-bodied
money was the normal rule. Fiat money standard imparts elasticity to the monetary system of the
country. It allows the supply of money to be adjusted to the needs of growing trade and industry.
Optional money
Optional money refers to that money which may or may not be accepted in the discharge of
debts. Bank cheque is an example of optional money. In this case, the creditor need not accept
cheque from the debtor since this type of money does not possess the characteristic of general
acceptability. No one can be forced to accept cheque against the wishes of the people. It has
no legal sanction behind it.
Legal tender money

Legal tender money refers to that money which is backed by law to accept in the discharge of
debts. It is accepted as a medium of exchange by law. It is of two types: limited legal tender
money and unlimited legal tender money.
Limited legal tender money: Limited legal tender money is one which can be accepted as
legal tender up to a limited amount. The creditor is not bound to accept it if offered beyond
the prescribed limit. In India, fifty paise and one Rupee coins cannot be used as medium of
payment beyond a particular limit.
Unlimited legal tender money: Unlimited legal tender money is one which can be accepted
as legal tender up to any limit. In India, the rupee currency notes of various denominations
such as ` 10, ` 20, ` 50, ` 100, ` 500 and ` 1000 are offered in the discharge of debts up
to any limit. Refused to accept it as a medium of payment is punishable by the government.
1.7 Functions of Money

Traditionally, money performs only four functions which are best summed up as: “money is a
matter of four functions—a medium, a measure, a standard, and a store.” It is clear from the
above discussion that money has been invented only to remove the inconveniences of barter
system. In the modern world, money performs so many functions. The functions of money are
nowadays classified into three main categories, viz.,
1. Primary functions
2. Secondary functions
3. Contingent functions
1.7.1 Primary Functions
Under primary functions, money has been considered as a passive tool. It has been considered
as a common medium through which goods and services are exchanged and also as a general
medium through which the value of goods and services is measured. The primary functions of
money include the following:
Medium of exchange
The most important primary function is that money serves as a common medium of exchange of
goods and services and also as a general medium of payments. In the present day world economy,
money is the only medium through which goods and services are exchanged. Hence money serves
as a common medium of exchange. Payments are also made for the buying and selling of goods
and services through money. Here, money serves as a general medium of payments.
As a medium of exchange, money performs the following functions:
• Money helps in the exchange of goods and services.
• It helps in the smooth operation of all exchange transactions.
• It encourages production indirectly by adopting division of labour which, in turn, increases
work efficiency and output of the economy.
• Itgives us a great deal of economic independence.
• Itperfects market mechanism by encouraging healthy competition in the market.
• Itmakes internal and international trade possible.
• Itovercomes the major defect of barter system, namely, lack of double coincidence of
wants.
Thus, as a medium of exchange, money has rendered all impossible exchange transactions
on a large scale and has paved the way for rapid industrialization in the economy.
Measure of value
Another important primary function is that money serves a common measure of value of
goods and services or as a unit of account. As a measure of value, money serves as a common
denominator representing the value of goods and services in terms of price. Suppose that the price
of a book is ` 250 and the doctor fee is ` 300. By the price of a book or the fee of a doctor,
we mean that the value of the book or the value of the doctor’s service is ` 250 and ` 300
respectively. Thus money determines the value of goods and services in terms of their prices.
As a unit of account, money also helps accounting. Just as the metre is the unit of measuring
length and kilogram is the unit of measuring weight, money is the unit of measuring the value
of goods and services.
As a common measure of value, money also helps in the comparison of relative value of
goods and services by comparing their prices. Suppose that the price of a bike is ` 50,000
and the price of a Maruti Car is ` 5 lakhs. By comparing the money prices one can say that
the value of one car is equivalent to the value of ten bikes. This type of comparison can also
be made for any number of goods.
1.7.2 Secondary Functions
Under secondary functions, money has been considered as a dynamic tool. It has been considered
as a valuable medium through which goods and services are stored for future use; as a suitable
medium through which future payments are easily made and also as a suitable medium through
which the value of goods and services can easily be transferred. The secondary functions of
money include the following:
Store of value
In a monetary economy, money serves as a store of value by virtue of its function as a medium
of exchange. The value of goods can be stored for any length of period in terms of money.
Storing of money means storing of wealth itself. Money is stored mainly because of the reasons
that the value of money does not unduly rise or fall in relation to the expansion or contraction
of money supply in the economy; money is the most liquid asset of all other assets and also
money is generally acceptable and free from deterioration in value.
Standard of deferred payments

By deferred payment we mean that the value is received but the payment is to be made at
a future date, which is based on the assumption that the value of money will remain stable.
Hence, money serves as the link between the present and the future transactions. It makes
borrowing and lending less risky. It has made future transactions possible. Money, thus, serves
as the standard of deferred payments.
Transfer of value
Money also serves as a transfer of value. It facilitates the transfer of value from one person to
another person and also from one place to another place. There is no difficulty in transferring
a few crores of rupees from someone in Delhi to someone else in Tamil Nadu. Such a value
transfer generally takes place either through cheques or through bank drafts but not by means
of money proper.
1.7.3 Contingent Functions
Contingent functions of money include the following:
Measurement and distribution of national income

Money facilitates in the measurement and distribution of national income in any economy. In a
monetary economy, share of each factor of production is being determined in terms of money.
Thus money plays a significant role in the distribution of national income among the factors
of production in the form of rent, wages, interest and profits.
Equalization of marginal utilities

Money facilitates both producers and consumers to maximize their satisfaction. A producer
employs the factors of production in such a way that the price of each factor equals its marginal
utility. A consumer buys products in such a manner that the price of each product equals its
marginal utility. Thus, money plays a significant role in equalizing these marginal utilities as
the prices of all products are expressed in terms of money.
Basis of credit system

In a modern economy, money serves as the basis of credit. More than 75 per cent of the total
transactions are on credit. Money is thus the basis of the credit system. Every commercial
bank in India creates credit only after having sufficient money as reserves. Similarly, the credit
instruments such as cheques, drafts, bills of exchange, promissory notes, etc. are always backed
by cash reserves. Therefore, money serves as the basis of credit system.
Transformation of savings into investments

Money facilitates the transformation of savings from the household sector into investment for
the business sector. Money also brings about equality between savings and investments. This
is an essential condition of the equalization level of income, output and employment. Thus
money serves as a tool for the transformation of savings into investments.
Encouragement of division of labour

In a monetary economy, there is a possibility for everyone to specialize in the production of a
particular product. These products can be bought and sold for the satisfaction of the wants of
both consumers and producers respectively. And also there is no need for everyone to produce
all the products he wants. Thus money encourages division of labour in a modern economy.
Perfectly liquid of all other assets

In a monetary economy, all kinds of assets are bought and sold in terms of money. It is rightly
observed that in a modern economy, money can be converted into wealth and wealth can also
converted into money. Thus money serves as a highly and perfectly liquid asset of all other assets.
The various functions performed by money can be summarized as follows:
1.8 Significance of Money (Advantages of Money)

Money is of great significance in a modern economy. Alfred Marshall rightly says that “money
is the pivot around which economic science clusters.” In every branch of Economics, money
has its own significance.
1.8.1 Money and Consumption
Money enables every consumer to generalize his purchasing power. It gives the consumer to
command over anything he wants to buy. It provides him the freedom of choice of consumption.
Due to the generalized purchasing power of money, money enabled the consumer to derive
maximum satisfaction by equalizing the marginal utilities of expenditure.
1.8.2 Money and Production
Money enables the producer to concentrate his attention on the organization of the production
process. This will add effectively to the general flow of goods and services. Money has made
division of labour in the modern industrial production possible. Without money, production on a
large scale would be impossible. Intensive specialization is essential for large scale production.
This kind of intensive specialization is possible only with the use of money. In fact, money
has changed the basic features of production.
1.8.3 Money and Exchange
Money facilitates exchange of goods and services on easy terms without any difficulty. It has
been the basis of price mechanism in the modern society. Money facilitates trade by serving
as a medium of exchange. It has brought about a spectacular increase in both internal and
international trade. Professor George N. Halm in his book Monetary Economics aptly remarks
that “money is indeed quite indispensable for the functioning of a market economy.”
1.8.4 Money and Distribution
Money enables the organizer to distribute the shares of all factors of production in the form
of rent, wage, interest and profit. It also facilitates to make loans and payments of all kinds
in advance.
1.8.5 Money and Public Finance
Money is of great significance in the field of public finance in a modern economy. In a modern
economy, government plays a significant role. Modern governments are welfare states. As such,
they participate in almost all economic activities. Without the use of money, no policy can
be devised and implemented by the government. Government activities can be expanded only
with the use of money. Money helps in achieving economic stability in the economy. Money,
therefore, plays a significant role in shaping the economic life of a country. Thus, we can
think of a well-organized economic, social and political life of the present day society only
with the use of money.
1.9 Evils of Money (Disadvantages of Money)

“Money is not an unmixed blessing.” “Money is a good servant but a bad master.”
—Henry G. Bohn
Money is one of the fundamental inventions of human beings. As a result of the invention of
money, we find developments in trade and commerce in a modern economy. In the words of
A.C.L. Day, “a considerable degree of economic development lies on the institution of money.”
However, the philosophers and socialists do not agree with the economists. They consider
money as an evil. The major evils of money are:
• Instability of value
• Inequality of income
• Root of all vices
1.9.1 Instability of Value
The main evil of money is its instability. Even though money was invented to measure the
value of all goods and services, sometimes the value of money does not remain stable. Such
instability of its value is mainly due to inflation and deflation. During the period of inflation
and deflation, its inequality increases. This type of inequality of its value creates unfavourable
consequences in the economy. Some economists are of the view that money is responsible for
economic instability found in capitalist economies.
1.9.2 Inequality of Income
There is an inequality in the distribution of income among people. It gives rise to two classes
of people, namely, rich and poor. The rich class saves a large part of their income, whereas
the poor class spends most of their income and saves only less. The rich will become richer
while the poor become poorer due to inequalities in the distribution of income. Hence, the
difference between the rich and the poor is widened.
1.9.3 Root of all Vices
Those people who earn more generally spend their income on vices. It is the root cause for
many vices such as corruption, bribery, prostitution, theft, murder and other social evils. Thus
money is the root of all vices.
To conclude, money is not an evil by itself. But the way we earn and spend our money
makes us to believe that money is an evil.
1.10 Role of Money

1.10.1 Role of Money in a Capitalist Economy
Capitalist economy is an economy in which all the means of production are owned and managed
by private individuals and firms. It is a free market economy where everything is left to market
mechanism. Market mechanism is predominant under capitalist economy, i.e. the various economic
activities are dependent on the free play of market forces—demand and supply. These market
forces determine the prices of goods bought and sold in the market. Price mechanism is, in fact,
the main pillar of the capitalist economy. This price mechanism is expressed in terms of money.
All important decisions are made with the help of price mechanism under capitalist economy.
The capitalist economy is characterized by the existence of private property, absence of
central economic plan, consumer’s sovereignty, system of inheritance, economic freedom of
individual initiative, freedom of choice and freedom of enterprise.
Money plays a significant role in a capitalist economy. Consumers are free to choose within
certain limits what goods to buy and how much to buy. Consumers are also free to spend
money as they like. They may save a part of their income. They may buy any product they
want. Hence, consumers enjoy freedom of choice under capitalist economy.
The capitalist economy is not regulated, planned or controlled by the state or any agency.
There is no Planning Commission in the sense that production and distribution of goods take
place without any planning by the state. They are not controlled by the state.
It also indicates the differences in tastes and preferences. If the price of a product rises, it
indicates that the demand for it has fallen. It is profitable to produce more of this product. On
the other hand, if price falls it indicates that the demand has fallen. It is wise to curtail the
output of his product. Otherwise he incurs loss. Producers try to adjust production according to
price differences. In a capitalist economy, consumer is the king or sovereign as production is
carried on according to his wishes. Thus price mechanism determines what shall be produced
and in what quantities.
In a capitalist economy, the producer employs a number of factors of production and to all
he makes payments in money. The rewards of all these factors of production are determined
by the price mechanism. The various factors of production are rewarded and distributed in
the form of rent, wage, interest and profit which are fixed and expressed in terms of money.
The rewards are fixed according to demand for and supply of the factors of production.
When the demand for the factors increases, the prices of these factors will rise, as a result,
they get higher rewards. Sometimes, on account of competition, a factor of production gets the
same reward in whatever field it is employed. Thus price mechanism determines the distribution
of factors among various industries.
Money has certain disturbing impacts on the capitalist economy. Whenever there is a
continuous rise or fall in prices, certain sections of the society are adversely affected. Continuous
changes in prices are quite often and common under capitalist economy. The value of money
does not remain stable. Changes in the value of money have serious economic and social impacts.
Thus money plays a disturbing role in a capitalist economy owing to free market mechanism.
It is because of the fact that money is a powerful force in shaping the economic welfare of
the people. Therefore, money occupies a pivotal place in a capitalist economy.
1.10.2 Role of Money in a Socialist Economy
Socialist economy is an economy in which all the means of production are owned and managed
by the state. It is economy where everything is left to the state. All economic activities in a
socialist economy are planned, regulated and controlled by the state. There is also a Central
Planning Authority in a socialist economy.
In a socialist economy, even though everything is planned, regulated and controlled by the
Central Planning Authority, this economy has to remain money economy. The only difference is
that money plays a minor role in a socialist economy as compared with its role in a capitalist
economy.
The socialist economy is characterized by the state ownership, centralized planning, lack
of private property and lack of market mechanism. All the means of production are owned
and controlled by the state. There is a Central Planning Authority who plans, regulates and
controls all activities in the economy. There is a little application of market mechanism, i.e.
price which, in turn, depends upon the use of money. Even if everything is controlled by the
Central Planning Authority, a socialist economy cannot function efficiently without the use of
money. Thus socialist economy is also considered to be a money economy.
In a socialist economy, money is essential to serve as a medium of exchange and also as
a measure of value as in a capitalist economy. Money is also essential to guide all economic
activities to allocate economic resources in different lines of production and to distribute goods
among people.
When the Communists came to power in Russia in 1917, the Soviet Government introduced
a system of Cards in selected areas to replace money. It also tried to abolish the use of money
by introducing extensive direct controls and free distribution of goods. But it was soon realized
that it would be very difficult to run a socialist economy without the use of money. It was then
found absolutely essential to the proper functioning of a socialist economy.
Money is the basis for the price mechanism without which socialist economies cannot
function efficiently. Lenin admitted in 1921 that Communism cannot be achieved without the
use of money. It is because of the fact that money is essential for commercial calculation and
control. A.P. Lerner aptly remarked that ‘printing system is essential in a socialist economy to
function with reasonable degree of efficiency.’
Money is essential for the allocation of resources. The sources of such resources are limited
in a socialist economy. The limited resources should be allocated in such a way that maximum
output is secured. For this purpose, the Planning Authority must be able to compare the usefulness
or profitability of resources in different fields. This is not possible unless there will be price
system. Thus money is inevitable and indispensable for proper allocation of limited resources.
Money is also essential to the state for the equitable distribution of income among the
people. The basis of the distribution of income depends on the requirements of the people.
Therefore, it is necessary for a common denominator to decide the requirement of the people.
Money serves as the criterion for the proper distribution of income among the people. Halm
rightly remarks that “a socialist economy will remain a monetary economy.”
1.11 Concept of Circular Flow of Money

1.11.1 Meaning of Circular Flow of Money
By circular flow of money we mean a continual movement of money and commodities in the
economy. It illustrates the flow of money and commodities from households to business firms
and again back to the households.
Modern economy is basically a money economy. It is characterized by the continuous
circular flow of money payments. It involves a continuous flow of money payments in all its
economic activities.
In every economy, there are two major classes of people, namely, producers and consumers,
who are engaged in producing and purchasing goods and services respectively. The circular
flow of money is essential for the smooth functioning and stability of an economic system.
To understand how the circular flow of money helps in achieving the high standard of
living characteristic of a money economy, it is worthwhile to remember that most of us play
a dual role in our economy.
In the first place, all of us are consumers who own and supply productive factor services.
In the second place, all of us are producers who make a continuous flow of goods and services.
Thus we play the dual role of consumers and producers.
Let us now illustrate the circular flow of money assuming a two-sector economy, viz.
Households and business firms sector. On the one side, business firms combine all the factor
services; produce and supply goods and services; and distribute money incomes to all the factor
services in the form of rent, wage, interest and profit.
On the other side, households receive money incomes and spend the same on the goods
and services produced by the business firms.
Supposing that the households sector spends ` 50 crore in purchasing goods and services
produced and supplied by the business firms sector. Then the expenditure of the households
sector (` 50 crores) becomes the income of the business firms sector (` 50 crore). Thus there
is a continuous circular flow of money payments in the economy.
1.11.2 Simple Model of Circular Flow of Money
Figure 1.1 illustrates the simple model of the concept of circular flow of money in an economy:
Figure 1.1 Model of circular flow of money.

It is obvious that for every flow of factor services from households to business firms, there
is a counterflow of money payments in the form of rent, wages, interest and profit from the
business firms to households. When the households purchase goods and services produced and
sold in the commodity market by the business firms, there is a flow of goods and services from
the business firms to the households. When goods and services are purchased by households,
there is a flow of money payments from households back to the business firms and there is a
corresponding overflow of money payments from households to business firms. Since the factor
services are purchased not directly from the households but in the factor market and final goods
and services are purchased by the households from the business firms not directly but through
the product market, we should introduce in the figure the factor market and the product market
as necessary links between households and business firms. This is clearly shown in Figure1.2.
Figure 1.2 Links of factor market and product market between households and business firms.
1.11.3 Significance of Circular Flow of Money
The concept of circular flow of money has a great policy significance in a modern money
economy:
• It is highly useful to understand the working of an economy.
• It helps us to calculate national income of a country. It expresses the value of all goods
and services produced in terms of money.
• There is a cumulative trend towards lower income, lower demand and lower output.
Similarly, there is also a cumulative trend towards higher income, higher demand and
higher output.
• There is a possibility of cumulative inflationary trend and deflationary trend in the
economy. The inflationary trend can be attempted to be solved through reduction of
money in circulation and the deflationary trend can be attempted to be solved through
expansion of money in circulation. Thus the concept of circular flow of money helps
to maintain price stability in the economy.
J.M. Keynes’ Principle of Multiplier and Aftalian’s Principle of Acceleration are based on
the concept of the circular flow of money.
1.12 Money-related Concepts

1.12.1 Money Illusion
The term ‘money illusion’ was coined by John Maynard Keynes in the early 20th century.
The American Economist, Irving Fisher wrote an important book on the subject, The Money
Illusion, in 1928. In this book, by money illusion Fisher means valuing money for its face
value, without any regard for what it will buy (intrinsic value or purchasing power).
The term ‘money illusion’ is often used to describe the reluctance of workers to accept a
pay cut even when their real wage remains the same, and their enthusiasm for a pay increases
that merely brings real wages in line with rising prices.
In Economics, money illusion refers to the tendency of people to think of currency in
nominal, rather than real terms. In other words, the face value of money is mistaken for its
purchasing power. This is false as modern fiat currencies have no inherent value and their real
value is derived from their ability to be exchanged for goods and used for payment of taxes.
Money illusion influences economic behaviour in the following three main ways:
• Price stickness. Money illusion has been proposed as one reason why nominal prices
are slow to change even where inflation has caused real prices or costs to rise.
• Contracts and laws are not indexed to inflation as frequently as one would rationally
expect.
• Social discourse, in formal media and more generally, reflects some confusion about
real and nominal value.
Money illusion can also influence people’s perceptions of outcomes.
1.12.2 Money and Near Money
Money is the most liquid asset of all the other assets. It commands cent per cent liquidity.
Money consists not only of coins and currency notes but also of bank money. This is a highly
and perfectly liquid asset which is useful in buying anything at anytime.
Near money is that asset which is highly liquid but not perfectly liquid. It is an income
earning asset. It is also a negotiable instrument. It is convertible into money proper whenever
there is a need without any loss within a short period of time and without much difficulty. Bank
deposits, post office deposits, cheques, bills of exchange, treasury bills, shares and securities,
debentures and bonds, savings certificates and deposits in building societies are examples of
near money. Near money assets are not money proper but money substitutes.
1.12.3 Money and Liquidity
Many economists thought that the spending of a person is not limited by the amount of money
that he possesses but determined by the amount of assets which possess liquidity. In simple
terms, liquidity is the ability of an asset to be converted into spendable form without any delay,
inconvenience or any risk of loss to its holder.
The property of liquidity should involve the following conditions:

• The asset must be readily marketable or transferable.
• The asset must be stable in value.
Hence, money in the form of cash and bank deposits is certainly most liquid. But near
moneys are very close to money in liquidity. They are not money proper but money substitutes.
It lacks 100 per cent liquidity characteristics.
1.12.4 Money and Income
Modern economy is a money economy where all transactions take place with the help of
money. A modern community consists of people like shopkeepers, doctors, teachers, lawyers,
businessmen, landlords, industrialists, engineers, etc. The incomes or earnings of all are measured
in terms of money. Therefore, money and income are closely associated concepts.
There is always a distinction between money income and real income. Money income
is the income expressed in terms of money whereas real income is expressed in terms of
the purchasing power of money income. There is also a distinction between the total money
transactions in the economy and the total money income of the community.
1.12.5 Money and Wealth
It is stated that money is wealth, but all wealth is not money. It is the worth of money that
is wealth. There is a close association between money and wealth. Money is the most liquid
asset which is convertible into anything at anytime. Money ensures a command over all other
forms of wealth. Wealth is of two types, namely, real goods and claims over other assets. In
a modern community, people try to hold their wealth in the form of money. Therefore, money
acts as a claim over wealth and sometimes wealth itself. Hence, money and wealth are closely
related but both are distinct.
1.12.6 Money and Finance
It is stated that finance is the lifeblood of an economy. It simply refers to funds needed for
undertaking business and government activities, i.e. finance is indispensable and inevitable for
the people and the government who undertake all of their economic activities in the country.
The amount of finance available determines the nature of economic activities undertaken by
the government and business people in the economy. The availability of finance in an economy
depends, in turn, on the supply of money. Therefore money and finance are closely associated
with each other.
Multiple Choice Questions

1. Barter is a system of
(a) direct exchange of goods for goods
(b) direct exchange of goods for money
(c) indirect exchange of goods for goods
(d) indirect exchange of goods for money
2. Lack of double coincidence of wants is
(a) an advantage of the barter system
(b) a disadvantage of the barter system
(c) an advantage of the monetary system
(d) a disadvantage of the monetary system
3. Barter system can work successfully only when
(a) human wants are limited (b) human wants are unlimited
(c) people are highly educated (d) society is well developed
4. Which of the following is not the inconvenience of barter system?
(a) Lack of divisibility (b) Specialization
(c) Lack of deferred payments (d) Lack of common store of value
5. The highest denomination currency note issued by the RBI is
(a) ` 10,000 (b) ` 1000
(c) ` 500 (d) ` 100
6. Who defines that “money is what money does?”
(a) Crowther (b) Walker
(c) Hawtrey (d) Robertson
7. Who defines that “money is one thing that possesses general acceptability?”
(a) Seligman (b) Robertson
(c) Keynes (d) Hawtrey
8. Which one of the following is not the characteristic feature of money?
(a) Acceptability (b) Stability
(c) Divisibility (d) Transportability
9. Which one of the following is the characteristic feature of money?
(a) Portability (b) Recognizability
(c) Homogeneity (d) All of the above
10. Full-bodied money is a standard money whose
(a) face value is greater than intrinsic value
(b) face value is less than intrinsic value
(c) face value is equal to intrinsic value
(d) none of the above
11. Token money is a money whose
(a) face value is higher than intrinsic value
(b) face value is lower than intrinsic value
(c) face value is equal to intrinsic value
12. Bank cheque is an example of

(a) optional money (b) token money
(c) fiat money (d) full-bodied money
13. Optional money is
(a) bank credit money (b) legal tender money
(c) foreign currency (d) cash in hand
14. Which of the following is the primary function of money?
(a) Store of value (b) Measure of value
(c) Standard of deferred payments (d) Transfer of value
15. Which of the following is the secondary function of money?
(a) Medium of exchange (b) Measure of value
(c) Store of value (d) Basis of credit system
16. Which of the following is the contingent function of money?
(a) Store of value (b) Transfer of value
(c) Measure of value (d) Basis of credit system
17. Who says that “money is the pivot around which economic science clusters?”
(a) Adam Smith (b) Alfred Marshall
(c) Lionel Robbins (d) Keynes
18. Who says that “money is a good servant but a bad master?”
(a) Henry G. Bohn (b) A.C.L. Day
(c) J.N. Keynes (d) Paul A. Samuelson
19. Which of the following is the major evil of money?
(a) Instability of value (b) Inequality of income
(c) Root of all vices (d) All of the above
20. Market mechanism is prominent under
(a) capitalist economy (b) socialist economy
(c) communist economy (d) all of the above
21. Money plays a major role in a
(c) communist economy (d) mixed economy
22. Money plays a minor role in a
(c) communist economy (d) mixed economy
23. Who rightly remarks that “a socialist economy will remain a monetary economy?”
(a) G.N. Halm (b) R.G. Hawtrey
(c) A.P. Lerner (d) A.C.L. Day
24. The concept of circular flow of money is the basis for
(a) multiplier principle only (b) taxation principle only
(c) expenditure principle only (d) both multiplier and acceleration principles
25. The term ‘money illusion’ was coined by
(a) J.M. Keynes (b) J.N. Keynes
(c) Irving Fisher (d) J.R. Hicks
26. The asset which is highly liquid but not perfectly liquid is referred to as
(a) near money (b) money proper
(c) money of account (d) fiat money
27. Post office deposit is an example of
(a) near money (b) money proper
(c) money of account (d) fiat money
28. Which of the following is not near money?
(a) Bank cheque (b) Treasury bills
(c) Liquid cash (d) Savings certificates
29. The purchasing power of money income is called
(a) real income (b) per capita income
(c) national income (d) disposable personal income
30. Who considered money as barren?
(a) Adam Smith (b) Alfred Marshall
(c) Lionel Robbins (d) Paul A. Samuelson
Answers
1. (a) 2. (b) 3. (a) 4. (b) 5. (b)

6. (b) 7. (a) 8. (d) 9. (d) 10. (c)
11. (a) 12. (a) 13. (a) 14. (b) 15. (c)
16. (d) 17. (b) 18. (a) 19. (d) 20. (a)
21. (a) 22. (b) 23. (a) 24. (d) 25. (a)
26. (a) 27. (a) 28. (c) 29. (a) 30. (a)
Review Questions
1. What do you mean by barter system?
2. Bring out and explain the inconveniences of barter system.
3. Describe the evolution of money.
4. Define money and commodity money.
5. What do you mean by paper money? Bring out its merits and demerits.
6. Define bank (or credit) money.
7. Bring out the characteristics of money.
8. Explain the various kinds of money.
9. Define the following:
• Money of account • Representative money
• Money proper • Token money
• Full-bodied money • Optional money
• Fiat money
10. What does legal tender money refer to?

11. Distinguish between limited and unlimited legal tender money.
12. Explain the functions of money.
13. Examine the significance or advantages of money in different branches of economics.
14. Bring out the evils or disadvantages of money.
15. “Money is a good servant but a bad master.” Discuss.
16. Discuss the role of money in a capitalist economy.
17. Discuss the role of money in a socialist economy.
18. Explain the concept of circular flow of money and bring out its significance.
19. Write a brief note on money illusion.
20. Distinguish between money and near money.
21. How do you relate money to liquidity?
22. Distinguish between money income and real income.
23. How do you relate money to income, money to wealth and money to finance.
Appendix
Name of Countries and Currencies
Sl. No. Country Currency

1. India Rupee
2. USA Dollar
3. UK Pound Sterling
4. USSR Rouble
5. Japan Yen
6. France Euro (formerly French Franc)
7. Italy Lira
8. Germany Euro (formerly Deutsche Mark)
9. China Yuan
10. Switzerland Swiss Franc
11. Iran Rial
12. Iraq Dinar
13. Argentina Peso
14. Bangladesh Taka
15. Singapore Dollar
16. South Africa Rand
17. Thailand Baht
18. Pakistan Pakistani Rupee
Chapter 2
Monetary Standards
2.1 Meaning of Monetary Standard

By monetary standard simply we mean the type of standard money used in a country. Raymond
P. Kent in his book Money and Banking defines monetary standard as, “a monetary system
built upon a specific standard of value.” For instance, if the standard money used is gold, it
is called gold standard; if silver is used as standard money, it is called silver standard; and if
paper currency is used as standard money, it is called paper currency standard.
2.2 Forms of Monetary Standard

Monetary standard is broadly of three forms:
1. Metallic standard
2. Gold standard
3. Paper currency standard
2.2.1 Metallic Standard
Metallic coins are used as standard monetary units under metallic standard. Metallic standard
can be classified into monometallism and bimetallism.
Monometallism
Monometallism is a monetary system in which only one metal—either gold or silver—is used
as money. When the standard coins are made up of only one metal, say either gold or silver,
the system is called monometallism.
Features of monometallism: In monometallism, gold coins or silver coins are in circulation.
If gold coins are in circulation in a country, the country is on gold standard, whereas if silver
coins are in circulation, it is on silver standard. Under monometallism, the standard coin
29
is a full-bodied one and also used as an unlimited legal tender. The value of money under
monometallism, therefore, depends upon the value of the metal concerned.
Types of monometallism: Monometallism is of two types: silver standard and gold standard.
Under the silver standard, the value of the standard monetary unit of a country is determined
in terms of silver only. In India, silver standard was in force from 1835 to 1893.
Under the gold standard, the value of the standard monetary unit of the country is determined
in terms of gold only.
Merits of monometallism: The following are the merits of monometallism:
• It is a simple form of monetary system.
• It is easily understandable.
• It is easily adoptable to common people.
• It inspires public confidence.
• It helps in international trade.
Demerits of monometallism: The following are the demerits of monometallism:
• All countries are not able to adopt this system.
• It does not possess the quality of elasticity.
• It hinders economic growth of the country.
• It lacks internal price stability.
Bimetallism
Bimetallism is a monetary system in which two metals—generally gold and silver—are used
as standard money in a country.
Features of bimetallism: The features of bimetallism are as follows:
• Gold coins and silver coins are freely used as standard money.
• There will be free coin age of both gold and silver coins.
• Both coins are unlimited legal tender.
• There will be no restrictions on the melting of coins.
Merits of bimetallism: The following are the merits of bimetallism:
• The prices of goods will be more stable.
• It enjoys stable exchange rates.
• The supply of both metals will be sufficient to meet the demand.
Demerits of bimetallism: The following are the demerits of bimetallism:
• It will work well if the mint ratio and the market ratio of exchange between gold and
silver remain the same.
• There is no guarantee that it is not possible to secure steady prices.
• It encourages speculative dealings in the two metals when the prices of gold and silver
fluctuate in the market.
• It creates confusion and uncertainty in the market.
Monetary Standards 31
2.2.2 Gold Standard
Gold standard is referred to as a monetary system in which gold is used as standard money.
It means that the monetary unit of the country will be declared equal to certain weight of
gold of certain fineness. In the words of Benham, “a country is on the gold standard when
the purchasing power of the unit of its currency is kept equal to the purchasing power of a
given weight of gold.”
In 1817, gold standard was adopted in the United Kingdom (England). The UK was the
pioneering country which adopted gold standard. In 1873, gold standard was adopted in Germany;
in 1878, it was adopted in France; and in 1900, it was adopted in the United States of America
(USA). In the early 20th century, this standard was adopted in Russia, Holland, Austria, etc.
Features of gold standard

The features of gold standard are as follows:
• The value of currency is determined in terms of gold.
• Gold coins are used as standard monetary unit of the country.
• There will be no restrictions on the export and import of gold.
• There will be free coinage in the country.
• Paper currency notes are to be fully backed by gold reserve.
Types of gold standard
Gold standard is of the following five types:
• Gold currency standard
• Gold bullion standard
• Gold exchange standard
• Gold reserve standard
• Gold parity standard
Gold currency standard: Gold currency standard is the oldest type of gold standard. Under
this standard, gold coins are circulated along with other forms of currency in the country. In the
words of Crowther, “a currency system in which gold coins either form the whole circulation
or else circulate equally with notes is known as the full gold standard.” This standard was in
practice in the leading countries like the USA, Germany and France before 1914. This system
has the following features:
• Gold coins of definite weight and fineness will be in circulation.
• Gold coins will be full-bodied, i.e. the face value of the gold coin will be equal to its
intrinsic value.
• There will be free coinage in the country.
• There will be no restrictions on the melting of the gold coins.
• There will be no restrictions on the export and import of gold coins.
Gold bullion standard: Gold bullion standard is another type of gold standard in which gold
coins do not circulate in the country. Under this standard, the currency notes are convertible
into gold bullion at a fixed rate. This standard is adopted to economic on gold but without the
circulation of gold coins. Gold bullion standard has the following features:
• The currency unit of the country will be declared equal to a certain weight of gold of
certain fineness.
• The government undertakes to convert currency notes into gold bullion at fixed rate.
• There will be no restrictions on the export and import of gold.
Gold exchange standard: Gold exchange standard is another type of gold standard. Under
this standard, gold coins will not circulate in the country as under gold currency standard. Gold
exchange standard was adopted by countries like India, Russia, Holland and Phillippines. It
has the following features:
• Paper currency notes and token coins will be in circulation.
• The domestic currency can be converted into a foreign currency which, in turn, can be
converted into gold.
• The monetary authority has to maintain foreign exchange reserves and gold reserves in
the country.
• Itis highly economical.
• Itsecures stable exchange rates.
• Ityields income.
• Itreduces pressure on gold.
• Itsecures stable prices.
Gold reserve standard: Gold reserve standard was developed in 1936 mainly to stabilize
exchange rates. It has the following features:
• Gold is neither used as a medium of exchange nor as a measure of value.
• There will be restrictions on the export and import of gold.
• Exchange rate stability is maintained without disturbing internal economy of the member
country.
Gold parity standard: Gold parity standard is the modern version of the gold standard. Under
the gold parity standard, every member country of the International Monetary Fund (IMF) has
to define the par value of its currency in terms of gold in order to determine the exchange rate.
The aim of this standard is to maintain the stable exchange rate. It has the following features:
• Gold is neither used as a medium of exchange nor as a measure of value.
• The par value of currency is defined in terms of gold.
• Reasonable flexibility is allowed in the exchange rates of member countries.
• Every member country of the IMF enjoys complete freedom in its internal monetary
affairs.
Advantages of gold standard

The advantages of gold standard are as follows:
• It provides a country with a currency which is accepted throughout the world.
• It creates confidence among the people because the domestic currency is linked with
gold.
• It maintains stable exchange rates between countries.
• It secures relatively stable prices.
• It prevents inflation in the country.
• It safeguards the country from irresponsible government.
• It is simple and automatic in working.
Disadvantages of gold standard

The disadvantages of gold standard are as follows:
• It works smoothly so long as conditions are normal and peace prevails in the country.
• It sacrifices internal price stability in order to secure stable exchange rates.
• It does not work automatically in practice.
• There is a great scope for deflation under gold standard.
• It limits national autonomy.
• It is a costly and wasteful monetary system.
Rules of gold standard
Gold standard would work smoothly only when gold standard countries observe the following
three rules:
• There should be free movement of gold between gold standard countries.
• There should be automatic expansion or contraction of money and credit.
• The monetary authorities of gold standard countries should adopt a monetary policy
which helps in the adjustment of balance of payments easily.
The above conditions are called ‘Golden Rule of the Gold Standard.’ The golden rule of
the gold standard is thus: “expand credit when gold is coming in, contract credit when gold
is going out.”
Conditions for gold standard

Gold standard will work smoothly and successfully only when the following six conditions
are satisfied:
• The rules of the gold standard game should be strictly observed.
• The main aim of the monetary policy of any gold standard country should be to maintain
stable exchange rates.
• There should be no restrictions on the movement of goods between gold standard
countries.
• The economic system of the gold standard countries should be flexible and elastic.
• There should be no movement of short-term funds between countries on account of
panic and fear.
• There should be political and financial stability in the gold standard countries.
Working of gold standard
Gold standard was adopted by many countries like the United Kingdom, Germany, France and
USA on account of its various advantages. It creates confidence among the people as currencies
can be converted into gold. It secures stable exchange rates which promote international trade
and international investment.
Let us suppose that Germany and France are on the gold standard. Let us further suppose
that Germany has an adverse balance of payments with France on account of excess of imports
over exports, i.e. Germany has to pay more than what she has to receive from France. So
Germany has to export gold to France in payment of the balance. These gold movements will
have effect both on the French and German economies.
There will be contraction of money in Germany as gold has gone out of the country. There
will be contraction of credit also, i.e. there will be contraction of money supply. As a result,
incomes of the people fall. Demand for goods fall. This leads to a fall in the prices of goods.
German goods now become cheaper. Germany becomes a good market to purchase but a bad
market to sell.
On the other hand, there will be expansion of money in France as gold has come into
the country. There will be expansion of credit also, i.e., there will be expansion of money
supply. As a result, incomes of the people rise. This leads to a rise in the prices of goods.
French goods now become costlier. France becomes a good market to sell but a bad market
to purchase.
On account of the above changes, German exports to France will rise. The reason is German
goods are comparatively cheaper. On the other hand, German imports from France will fall
as French goods are costlier. As a result, Germany enjoys a favourable balance of payments
with France now. Gold will now flow from France to Germany. In other words, Germany will
get back the gold.
It is obvious from the above statements that a gold-losing country will get back gold
on account of changes in prices in its own country and also in the gold-receiving country. The
disequilibrium in the balance of payments is automatically adjusted by gold movements.
The disequilibrium in the balance of payments is corrected by another way. Interest rates will
rise in the gold-losing country as the supply of money falls. Foreign investors will invest their
funds in the gold-losing country as they can earn more income. As a result, the short-term
funds flow into the country and the balance of payments becomes favourable. On the other
hand, interest rates will fall in the gold-receiving country on account of expansion of money
supply. Short-term funds move out of the country as the interest rates are now lower. The
balance of payments becomes unfavourable. Thus gold-losing country will get back the gold
from the gold-receiving country.
Thus changes in prices and interest rates bring about equilibrium in the balance of payments
of both the gold-losing and gold-receiving countries. The disequilibrium in the balance of
payments is automatically adjusted by the movement of goods and short-term funds. This
system ensures automatic working of the gold standard. Gold movements thus secure stable
exchange rates and equilibrium in the balance of payments.
Causes for breakdown of gold standard

The gold standard broke down during the inter-war period as the gold standard countries did
not observe the golden rule—“expand credit when gold is coming in contract credit when gold
is going out.”
The following are the other causes for the breakdown of the gold standard:
• The economic system became rigid during the inter-war period.
• A number of countries imposed high tariffs on imports to protect their industries.
• The USA insisted on the repayment of debts and also on payment of reparations (war
damages) in gold.
• The rates of exchange of parities were not properly fixed by countries like England and
France.
• Sudden and heavy withdrawals of funds by France in 1931 from England led to the
collapse of the gold standard.
• The political instability in the inter-war period and Great Depression during 1929–1933.
2.2.3 Paper Currency Standard
By paper currency standard we mean a system in which the paper money acts as the standard
money. Under this standard, money consists of currency notes and coins which are not convertible
into gold or silver.
Features of paper currency standard

The features of paper currency standard are as follows:
• It is circulated as standard money.
• It is accepted as unlimited legal tender.
• It is inconvertible into gold or a commodity.
• It is national in character.
• There is no link between different paper currency systems.
• The unit of money is not defined in terms of commodity.
• The international exchange value of paper currency depends upon its purchasing power.
Merits of paper currency standard
The merits of paper currency standard are as follows:
• It is very economical.
• It is highly elastic.
• The monetary authority enjoys freedom to adopt monetary policy suitable for the
country.
• The monetary authority can avoid the evils of both inflation and deflation.
• The rate of exchange is determined according to the conditions of demand and
supply.
• It makes quick adjustment of balance of payments.
• It enables the government to secure large funds easily.
• It promotes rapid economic development.
• It enables a country to avoid the effects of violent economic changes in other
countries.
• It enables the government to finance war by printing currency notes.
Demerits of paper currency standard

The following are the demerits of paper currency standard:
• There is a great scope for inflation.
• There will be exchange instability which creates uncertainty in international trade.
• It is not possible to maintain internal price stability as prices sometimes fluctuate violently.
• It has no intrinsic value like gold coins.
• It has limited area of circulation.
2.3 Principles of Note Issue

There are two main principles of note issue, namely, currency principle and banking principle.
2.3.1 Currency Principle
Under the currency principle of note issue, every currency note circulation should be fully backed
by metallic reserves, say gold or silver, by the Central Bank of the country. This principle of
note issue was first adopted by Sir Robert Peel in England in the year 1844.
Under this principle, hundred per cent safety and security for the currency notes in circulation
is ensured. Paper currency notes are merely used as an instrument that helps eliminate the waste
in circulation of the precious metals.
The currency principle of note issue is rigid and inelastic in the sense that it demands for
gold or silver reserves against every currency note issued in the country. There is no need
for hundred per cent backing of gold or silver reserves because people are not interested in
exchanging their currencies into gold or silver. It does not consider the demands of trade and
industry.
2.3.2 Banking Principle
Under the banking principle of note issue, there is no need to provide for hundred per cent
metallic reserves for currency notes in circulation. But a minimum percentage of gold or
silver reserves against every currency note issue is provided, the rest being covered by certain
specific assets such as government securities, trade bills, etc. The following are the advantages
of banking principle of note issue:
• It ensures elasticity in the issue of currency notes.
• It considers the demands of trade and industry.
• It is in practice in most parts of the world.
• It is economical and autonomous. It is economical in the sense that it does not waste
the precious metals like gold or silver by reserving them against every currency note
issued in the country. It is autonomous in the sense that it helps the monetary authorities
to expand or contract money supply in accordance with the inflationary or deflationary
conditions of the country.
Thus the banking principle of note issue is comparatively an ideal principle as it ensures
safety, security, elasticity and autonomous.
2.4 Systems of Note Issue

The four important systems or methods of note issue are:
1. Maximum fiduciary system
2. Fixed fiduciary system
3. Proportional reserve system
4. Minimum reserve system
2.4.1 Maximum Fiduciary System
Under the maximum fiduciary system of note issue, a maximum limit for currency notes in
circulation is fixed without any gold reserve by law. The maximum amount of currency notes
that can be issued by the Central Bank of a country is fixed by the government. The Central
Bank cannot issue currency notes beyond this limit. At the same time, Central Bank is given
complete freedom with regard to the form and amount of reserves that should be kept. The
maximum limit fixed will generally be in excess of normal requirements.
This system of note issue was first adopted on France between 1870 and 1928, followed
by England since 1971 and by Japan since 1941. In England, the Treasury is given power to
fix the maximum limit. In France, the Legislature; in Japan, the Treasury; and in India, the
Central Bank (RBI) is given the power to fix the maximum limit for currency notes circulation
without gold backing.
It is of the advantage that the Central Bank of every country who adopts this system enjoys
complete freedom with regard to the form and amount of reserves to be kept. And also that
it enjoys the elasticity, i.e. the maximum limit for reserves are revisable from time to time.
2.4.2 Fixed Fiduciary System
Under the fixed fiduciary system of note issue, the issuing authority (Central Bank) is empowered
to issue only a fixed amount of currency notes against securities and the currency notes issued
over and above this limit should be backed up by hundred per cent metallic reserves, say gold
or silver.
This system of note issue was first adopted in England by the Act of 1844. The Bank of
England was empowered to issue currency notes up to £ 14 million without the backing of
gold reserves. The Bank was permitted to issue currency notes beyond this limit with hundred
per cent gold reserve.
In India, it was by the Act of 1861. The RBI was empowered to issue currency notes up
to ` 4 crore but in 1920, it was fixed at ` 120 crore. This system is of the advantage that
it enjoys safety, it checks inflation and also it controls government’s over-expenditure. Its
disadvantage is that it is too inelastic to provide for more supply of money unless and until
there is an arrangement for metallic reserves available with the authorities. And that it is not
a suitable system of note issue for a developing country like India where money expansion is
the order of the day. And also this system is wasteful and uneconomical as large amount of
gold is locked up unnecessarily as reserves.
2.4.3 Proportional Reserve System
Under the proportional reserve system of note issue, a certain portion of currency note issue,
say 30 or 40 per cent, should be backed up by metallic reserves, say gold or silver and the
remaining portion of note issue should be backed up by government securities, bills, etc.
This system of note issue was first adopted in Germany in the year 1875. It was adopted
by USA in 1913, and in India, it was adopted between 1935 and 1956. The RBI was required
to keep 40 per cent of the note issue in gold coins, gold bullion and foreign currencies and
the remaining 60 per cent was to be backed up by rupee coins, government securities and bills
of exchange.
The proportional reserve system is of the advantage that it enjoys absolute elasticity, i.e.
every currency note, in excess of notes backed up by metallic reserves, is to be issued against
government securities. And that this system inspires confidence as it assures convertibility of
currency notes into gold. And also that this system is suitable for underdeveloped countries
seeking rapid development.
2.4.4 Minimum Reserve System
Under the minimum reserve system of note issue, a certain amount of gold or foreign
currencies or both is kept as reserve against note issue. There is no limit on the amount of
note issue. This system of note issue has been in practice in India since 1956. Under this
system, the RBI (Central Bank) is required by law, to keep at least a minimum reserve of
` 200 crore against note issue. Out of this, ` 115 crore should be kept in the form of gold
and the remaining ` 85 crore should be kept in the form of foreign currencies, government
securities and eligible bills.
The minimum reserve system of note issue is of the advantage that it is highly elastic,
i.e. the authority can either expand or contract the supply of money in accordance with the
needs of the economy. In other words, the Central Bank of the country can issue any amount
of currency notes without any increase in gold or foreign currencies, provided the minimum
reserve is kept. This system is of the disadvantage that it is highly dangerous, i.e. it is not
safe because the Central Bank may be forced to issue currency notes beyond reasonable limit.
This will lead to inflation.
However, the minimum reserve system of note issue is comparatively very simple, practical,
adjustable and suitable for both developing and developed countries.
2.5 Qualities of a Good Monetary Standard

The following are the main qualities or essentials or requisites of a good monetary standard:
• Itshould secure reasonable price stability in the country.
• Itshould secure stable exchange rate of the currency of the country.
• Itshould be economical.
• Itshould be elastic.
• Itshould be simple and understandable to even ordinary people.
• Itshould inspire the confidence of the people of the country.
• It should be definite and well-defined and also should be subjected to the rules and
regulations.
2.6 Gresham’s Law

Sir Thomas Gresham, an expert on Finance and founder of the Royal Exchange states the
law as: “bad money tends to drive good money out of circulation, when both of them are full
legal tender.”
Gresham’s law, as applied to monometallism states that, “if the coins of the same metal,
but of varying weight and fineness circulate together as legal tender at the same nominal value,
the worse coins will tend to drive the better one from circulation, but the better will never
drive out the worse.”
Gresham’s law, as applied to bimetallism states that, “if the coins of precious metals be
converted at a fixed ratio of exchange with one another, the overvalued metal will tend to drive
the undervalued metal from circulation.”
Gresham’s law, as applied to paper currency standard states that, “if an inconvertible
paper currency be issued in excess, that is to say, to such an extent that the total amount of
the currency becomes greater than the normal amount required by the country, it will tend to
drive the precious metals from circulation.”
2.6.1 Assumptions of Gresham’s Law
The following are the assumptions of Gresham’s law:

• The different currencies in circulation are full legal tender.
• The total supply of money exceeds the total demand for money.
• The supply of overvalued currency is sufficient to meet the currency demand of the
people.
2.6.2 Operation of Gresham’s Law
Gresham’s law operates under monometallism, bimetallism and paper currency standard.
Operation under monometallism

Suppose that a country is on gold standard. A gold coin should have certain weight and fineness
(purity) by currency law. Coins whose weight is less than the standard weight are called worse
coins (bad money). Coins whose weight is equal to the standard weight are called better coins
(good money). If both coins circulate together as legal tender at the same face value, the worse
coins will drive out the better coins from circulation. In other words, bad money tends to drive
out good money from circulation.
Operation under bimetallism

Suppose that a country is on bimetallism where both gold coins and silver coins are in circulation.
When the official value of gold (fixed by the government) is lower than the market value (fixed
by the demand and supply of gold and silver), gold is undervalued which is called good money.
The overvalued silver is called bad money. So the overvalued silver coins will tend to drive
the undervalued gold coins out of circulation.
When the official value of silver is lower than the market value, silver is undervalued and
is called good money. The overvalued gold is called bad money. So the overvalued gold coins
will tend to drive the undervalued silver coins out of circulation. As a result, sometimes gold
coins will be in circulation and sometimes silver coins will be in circulation on account of the
operation of Gresham’s law.
Operation under paper currency standard

Suppose that a country is on paper currency standard where coins and currency notes are in
circulation. When there is an excess issue of paper currency note, the surplus will be converted
into coins or bullion (gold or silver). The value of paper currency note is maintained so long
as its supply exceeds the demand, its value depreciates. It becomes bad money. The metallic
money becomes good money. Thus paper money (bad money) tends to drive the metallic money
(good money) out of circulation.
2.6.3 Limitations of Gresham’s Law
The limitations of Gresham’s law are:

• It will not operate when the supply of money does not exceed the requirements of the
society.
• Bad money will not drive out good money from circulation if people refuse to accept
bad money.

1. When the standard coins are made up of only one metal, the system is called
(a) monometallism (b) bimetallism
(c) multimetallism (d) none of the above
2. In India, silver standard was in force from
(a) 1835 to 1893 (b) 1845 to 1893
(c) 1855 to 1893 (d) 1865 to 1893
3. Gold standard was adopted in 1827 in the
(a) United Kingdom (b) United States of America
(c) USSR (d) Germany
4. In which type of gold standard, gold coins do not circulate in the country?
(a) Gold currency standard (b) Gold bullion standard
(c) Gold parity standard (d) Gold reserve standard
5. Which type of gold standard came into existence with the establishment of the IMF in
1946?
(a) Gold parity standard (b) Gold bullion standard
(c) Gold reserve standard (d) Gold currency standard
6. “Expand credit when gold is coming in, contract credit when gold is going out” is termed
(a) golden rule (b) currency rule
(c) bullion rule (d) parity rule
7. Under which principle of note issue, currency notes in circulation are backed by 100
per cent metallic reserves?
(a) Currency principle (b) Banking principle
(c) Taxation principle (d) All of the above
8. Under which principle of note issue, there is no need for 100 per cent metallic reserves
for currency note in circulation?
(a) Currency principle (b) Banking principle
(c) Taxation principle (d) All of the above
9. Under which system of note issue, a maximum limit of currency notes in circulation is
fixed without any gold reserve by law?
(a) Maximum fiduciary system (b) Fixed fiduciary system
(c) Proportional reserve system (d) Minimum reserve system
10. The fixed fiduciary system of note time was first adopted by the Act of 1944 in
(a) England (b) France
(c) India (d) Germany
11. The proportional reserves system was first adopted in the year 1875 in
(a) England (b) France
(c) India (d) Germany
12. In India, the proportional reserves system of note issue was adopted between
(a) 1925 and 1956 (b) 1935 and 1956
(c) 1945 and 1956 (d) 1955 and 1956
13. In India, which system of note issue has been in practice since 1956?
14. Under the minimum reserve system of note issue, the minimum reserve against note
issue is
(a) ` 85 crore (b) ` 115 crore
(c) ` 120 crore (d) ` 200 crore
15. Under the minimum reserve system of note issue, how much reserve should be kept as
gold?
(c) ` 120 crore (d) ` 200 crore
16. Who states that “bad money tends to drive good money out of circulation, when both
of them are full legal tender”?
(a) Sir Thomas Gresham (b) Sir Thomas Malthus
(c) Sir William Petty (d) Sir Gold Smith
17. When a currency in circulation is defined in terms of a foreign currency-based gold
standard, it is called
(a) gold bullion standard (b) gold exchange standard
(c) gold reserve standard (d) gold parity standard
18. Under which type of gold standard, Exchange Stabilization Fund was created?
(a) Gold bullion standard (b) Gold exchange standard
(c) Gold reserve standard (d) Gold parity standard
19. Bimetallism was in existence up to
(a) 1800 (b) 1900
(c) 1930 (d) 1945
20. Which type of gold standard was recommended by the Hilton Young Commission to
India in the year 1926?
(a) Gold currency standard (b) Gold bullion standard
(c) Gold exchange standard (d) Gold parity standard
21. The member countries of the IMF are on
(a) gold currency standard (b) gold bullion standard
(c) gold exchange standard (d) gold parity standard
22. Which of the following is the most acclaimed advantage of the international gold
standard?
(a) Stability of exchange rates (b) Parity of price levels
(c) Laissez–faire standard (d) All of the above
23. The gold standard was broken down in the year
(a) 1936 (b) 1946
(c) 1956 (d) 1966
24. If the monetary standard is based on gold, it is called
(a) gold standard (b) silver standard
(c) double standard (d) multistandard
25. Under which type of gold standard, gold reserves are maintained at a foreign centre?
(a) Gold exchange standard (b) Gold parity standard
(c) Gold currency standard (d) Gold bullion standard
26. The oldest type of gold standard was
(a) gold currency standard (b) gold bullion standard
(c) gold exchange standard (d) gold parity standard
27. In India, which system of note issue is in practice at present?
Answers
1. (a) 2. (a) 3. (a) 4. (b) 5. (a)

6. (a) 7. (a) 8. (b) 9. (a) 10. (a)
11. (d) 12. (b) 13. (d) 14. (d) 15. (b)
16. (a) 17. (b) 18. (c) 19. (b) 20. (a)
21. (d) 22. (d) 23. (a) 24. (a) 25. (a)
26. (a) 27. (d)
Review Questions
1.
What do you mean by monetary standard?
2.
Mention the different forms of monetary standard.
3.
What is monometallism?
4.
What are the features of monometallism?
5.
What are the two types of monometallism?
6.
Discuss the merits and demerits of monometallism.
7.
What is bimetallism?
8.
Bring out the features of bimetallism.
9.
Discuss the merits and demerits of bimetallism.
10.
What does gold standard refer to?
11.
What are the features of gold standard?
12.
What are the different types of gold standard? Discuss.
13.
What are the advantages and disadvantages of gold standard?
14.
Bring out the rules of gold standard.
15.
What are the conditions to be satisfied for the smooth and successful working of gold
standard?
16. Discuss the working of the gold standard.
17. What are the causes for the breakdown of gold standard?
18. What do you mean by paper currency standard?
19. Bring out the features of paper currency standard.

20. What are the merits and demerits of paper currency standard?
21. What are the two main principles of note issue?
22. Explain the currency principle of note issue.
23. Explain the banking principle of note issue.
24. What are the important systems of note issue?
25. Explain the following:
• Maximum fiduciary system.
• Fixed fiduciary system
• Proportional fiduciary system
• Minimum fiduciary system
26. What are the qualities of a good monetary standard?
27. State Gresham’s law.
28. Explain the operations of Gresham’s law and bring out its limitations.
Chapter 3
Value of Money
3.1 Meaning of Value of Money

Value of money simply refers to the purchasing power of money. Money has value as it
possesses the power or the capacity to command or purchase goods and services. Suppose a
person has ` 500. He has the power or capacity to purchase ` 500 worth of goods and services.
In the words of J.M. Keynes, value of money indicates ‘the capacity of a given unit of money
to command a certain quantity of goods and services.’ Professor Irving Fisher says that ‘the
purchasing power of money is the reciprocal of the level of prices so that the study of the
purchasing power of money is identical with the study of price levels.’
It is obvious that the purchasing power of money depends upon the level of prices of goods
and services to be purchased. When the price rises, the value of money falls. On the other
hand, when the price falls, the value of money rises. Hence, the purchasing power of money
changes inversely with the price level. Lester V. Chandler quotes that “when the price level
is high, the value of money—the ability of each unit to purchase goods and services—is low.
When the price level is low, the value of money is high.”
In symbol,
1
Vm =
where P
Vm = value of money
P = price level
3.2 Value of Money versus Value of Commodity

Value of a commodity simply refers to the price of that commodity. Value of the commodity
is determined by demand for and supply of the commodity. When the price of a commodity
rises, the value of the commodity rises. On the other hand, when the price falls, the value of
the commodity also falls. Hence, the value of a commodity changes directly with the price of
the commodity. The value of commodity is thus expressed in terms of monetary units.
45
The value of money is thus the capacity of a given amount of money to purchase in exchange
certain amount of goods and services. The purchasing power of money depends upon the level
of prices of goods and services. When the price rises, the value of money (purchasing power
of money) also falls. On the other hand, when the price falls, the value of money (purchasing
power of money) rises. Hence, the value of money changes inversely with the price level.
3.3 Kinds of Value of Money

Value of money is of two kinds: absolute value of money and relative value of money.
3.3.1 Absolute Value of Money
Absolute value of money is an old concept introduced by Professor B.M. Anderson. In the
words of Anderson, the value of money depends upon the value of commodity of which money
is made. In good old days, money was of gold and silver coins, this was true because the
government of a country undertakes to redeem its money freely for certain quantity of gold
or silver of certain fineness. Then the value of money is equal to the value of the metallic
contents of money.
3.3.2 Relative Value of Money
Relative value of money is a recent concept introduced by Von Hayek and Fisher. The value
of money cannot be measured in absolute sense. It can only be measured in the relative sense,
i.e. the changes in the value of money over a period of time.
According to Von Hayek and Irving Fisher, value of money depends upon the price level,
which is called the relative value of money, i.e. value of money is expressed in terms of the
prices of goods and services. Hence, the value of money changes inversely with the price level.
Crowther classified the relative value of money into wholesale value of money, retail
value of money and labour value of money. According to him, wholesale value of money is
the value of a money to a person who happens to be concerned only with those commodities
which are traded in wholesale on a public market. The retail value of money is its value to a
family that happens to buy exactly those things which it has been established by inequity that
the average family does buy. The labour value of money is its value to a man or a business
firm that wants to hire every variety of labour.
3.4 Measurement of Value of Money

Value of money depends upon the level of prices of goods and services. When the price level
changes, there will be changes in the value of money. When the price rises, the value of
money falls. On the other hand, when the prices falls, the value of money rises. Hence the
value of money changes inversely with the price level. The changes in the value of money
can be studied by studying the changes in the prices of goods and services. The changes in
Value of Money 47
the general price level of goods and services over a period of time can be measured with the
help of a statistical device or method popularly known as ‘Index Number.’
3.4.1 Index Numbers
Index numbers are statistical devices designed to measure the net change in the level of a
phenomenon or a variable or a group of related variables over a period of time. In other words,
index numbers are the devices for measuring differences in the magnitude of a group of related
variables over two different periods. The related variables may be prices of goods or the quantity
of goods produced, or the quantity of goods consumed. For example, when we say that the
index number of wholesale price is 123 for July 2011 compared to July 2010 it means that
there is a net increase of 23 per cent in the prices of wholesale commodities during the year.
Importance or usefulness of index numbers

Today, index numbers are one of the most widely used statistical devices. Newspapers headline
the fact that prices are going up or down; that industrial (or agricultural) production is rising
or falling; that sales are higher or lower than the previous year, as disclosed by index numbers.
They are used to indicate the pulse of the economy, whether facing inflationary or deflationary
tendencies. The uses of the index numbers are as follows:
• In time series analysis, index numbers are used to adjust the original data for price
changes and to adjust wage changes for the cost of living changes.
• Index numbers are indispensable to economists to study and understand the prevailing
economic trends and in formulating suitable economic policies.
• They are indispensable to businessmen to study and understand the business trends and
in formulating suitable business policies.
• They are useful to the economic planners for allocating resources to different sectors of
the economy.
• They help in studying price movements to discover their causes and effects on the
commodity as a whole.
• They are very useful in deflating a value series, i.e. they are used to adjust the original
data for price changes.
• They are used to measure changes in all sectors—agriculture, industry, service sectors, and
to measure changes in the value of money, i.e. the general price level over a period of time.
Classification of index numbers

Index numbers are generally classified into:
• Price index number
• Quantity index number
• Value index number
Price index number expresses a relative average of the prices of a set of commodities and
measures the price changes of all such commodities collectively. Price index numbers are of
two types—wholesale price index number and retail price index number.
In symbol,
Ê Sp ˆ
P01 = Á 1 ˜ ¥ 100
Ë Sp0 ¯
where
P01 = price index number for the current year based on the base year
Sp1 = sum of current year prices
Sp0 = sum of base year prices
Quantity index number expresses a relative average of the volumes of production in different
sectors of the economy. It measures the volume of goods produced or distributed or consumed.
In symbol,
Ê Sq ˆ
Q01 = Á 1 ˜ ¥ 100
Ë Sq0 ¯
where
Q01 = quantity index number for the current year based on the base year
Sq1 = sum of current year quantities
Sq0 = sum of base year quantities
Value index number is the sum of the values of a current year divided by the sum of the
values of the base year. It is obtained by multiplying price index number and quantity index
number.
In symbol,
Ê Sp q ˆ
V01 = Á 1 1 ˜ ¥ 100
Ë Sp0 q0 ¯
where
V01 = value index number for the current year based on the base year
Sp1q1 = sum of the product of current year price and quantity
Sp0q0 = sum of the product of base year price and quantity
Steps involved in the construction of index numbers

In general, the following seven steps are required in the construction of a price index number:
1. The purpose of the index number has to be defined clearly and exactly.
2. The choice of the index number must be relevant to the purpose of the index.
3. The choice of items based on the purpose and type of index number.
4. The sources of data to be collected must be representative, accurate, adequate and
comparable.
5. The base period should be carefully chosen. It should be a normal year.
6. The relative importance of each item chosen should be determined.
7. Proper weights should be assigned to different items to avoid bias.
Value of Money 49
Problems involved in the construction of index numbers
The following practical problems are involved in the construction of index numbers:
1. Purpose of the index number
2. Selection of the base year
3. Selection of items
4. Obtaining price quotations
5. Selection of an appropriate average
6. Selection of an appropriate weight
7. Selection of an appropriate formula
8. International comparisons
9. Domestic comparisons
Purpose of the index number: There is no all purpose index. Every index has its own uses
and limitations. Therefore, it is necessary to define clearly the purpose or the type of the
index and to determine its scope. For example, if we want to study changes in the prices of
wholesale commodities, we must construct general or wholesale price index numbers, whereas
if we want to study the changes in the cost of living of consumers, we must construct retail
price index numbers.
Selection of the base year: Base year is a period of reference for comparisons to measure
changes in the level of a variable (say, price of a commodity) for the current year. It is very
difficult to find out an ideal base year for the construction of an index number. Great care must
be taken in the selection of the base year. The base year should be a normal year in which
there is no economic and natural disturbances, the base year should not be too short or too
long to the current year.
Selection of items: Selection of items becomes a problem when we have hundreds and thousands
of items. It is impossible to include all the items sold in the market. If all the items are included
in the index number, there will be unnecessary delay in the collection of their prices and also
in the construction of index numbers. The selected items should be representative, cognisable,
fairly large in number and should have economic and social importance.
Obtaining price quotations: The prices of a commodity vary from place to place and from
shop to shop. Obtaining price quotations from a place where a particular commodity is brought
or sold is not possible. Even from the selected place, price quotations cannot be obtained from
all shops. Therefore, the selection of a representative place from where required prices are
obtained has to be made.
Selection of an appropriate average: There are averages like mean, median, mode, geometric
mean and harmonic mean. Theoretically geometric mean is the best average in the construction
of price index numbers. Practically, arithmetic mean is the best average in the construction of
price index numbers. Though geometric mean is comparatively difficult to compute, it is the
most appropriate average in the construction of price index numbers since it measures exactly
the relative changes in the values of the given items.
Selection of an appropriate weight: The term ‘weight’ implies the relative importance of items.
All items are not of equal importance. There are two methods of assigning weights—implicit
and explicit weights. Implicit weights are assigned on the basis of the nature of items selected
and the number of items included in the selection, whereas explicit weights are assigned on
the basis of the importance of items selected.
Selection of an appropriate formula: A large number of formulae have been designed for
the construction of price index numbers. They include Laspyre’s, Paasche’s, Fisher’s Dorbish—
Bowley’s, Marshall Edgeworth’s and Kelly’s index numbers. Theoretically Fisher’s index is
an appropriate or an ideal one because it is based on geometric mean, free from bias, satisfies
both time and factor reversal tests, and takes into account of both current and base year prices
and quantities. Therefore, the selection of an appropriate formula depends upon the availability
of data and accurate desired.
International comparisons: It is impossible to make international comparisons between the
index number of one country and the index number of another country. For example, use of car by
people of an advanced country is common as the use of rice or wheat by people of a poor country.
Domestic comparisons: It is also equally impossible to make domestic comparisons between
the consumption and spending habits of the people of one part of the country and that of the
other parts of the country, e.g. wheat, bread, butter, etc. are used regularly in northern parts of
India, whereas rice, curd, etc. are need regularly in Southern parts of India.
Limitations of index numbers: The following are the various limitations (or difficulties
encountered) in measuring the changes in the value of money:
• The concept of value of money is vague (ambiguous) as it cannot be rigidly defined.
• Index numbers are unrepresentative since they are generally based on a sample.
• Inaccuracy is involved in the construction of index numbers since there can be errors
in every stage.
• Comparison may lead to a false conclusion if the base year is not reasonably selected.
• Index numbers give only a fair idea of changes but not an exact idea of changes in the
general price level.
• Improper usage of methods in a particular situation may lead to misleading results.
• Collecting accurate price quotations becomes a tough task as there may be heterogeneity
in price quotations.
• Non-cooperation of the people who have indifferent attitudes may pose another difficulty
in collecting data.
• An index number constructed for one purpose can not be used for other purposes.
• Index numbers do not recognize dynamic changes occurred in the economy.
• They are not comparable if the base year is reversed.
3.5 Determination of Value of Money

Value of money is generally determined by demand for money and supply of money in
circulation in a country. When the demand for money is in excess of the supply of money, the
Value of Money 51
value of money will be high. On the other hand, when the supply of money is in excess of
the demand for money, the value of money will be low. When the demand for money is equal
to the supply of money, the value of money remains constant. In practice, the value of money
does not remain constant but varies since the demand for money and the supply of money do
not remain constant. Hence the determination of value of money is highly essential.
3.5.1 Demand for Money (Flow Concept)
Demand for money simply refers to the desire of the people to hold a part of their income or
asset, or wealth in the form of liquid cash. The desire of the people to hold such cash balances
is called liquidity preference. This arises as money serves as a medium of exchange and as a
store of value. Thus the total demand for money is derived partly from the demand for money
as medium of exchange and partly from the demand for money as store of value.
There are two approaches to the study of demand for money—classical approach and
Keynesian approach.
Under the classical approach to the study of demand for money, money is not demanded
for its own sake but it is demanded because it has purchasing power. Money can satisfy the
wants of the holder indirectly. It can first buy the commodity which, in turn, satisfies his wants.
Thus according to this approach, the demand for money depends upon the supply of goods
and services available in the market. The larger the supply of goods and services, the greater
the demand for money. Keynes thus emphasizes the medium of exchange function of money.
Under the Keynesian approach to the study of demand for money, money is not demanded
for its own sake. According to J.M. Keynes, demand for money is the total requirement of the
cash balances held by the people as a store of value at a particular point of time. The desire
of the people to keep cash or money balance is referred to as liquidity preference.
John Maynard Keynes states that money is demanded for various reasons. Reasons
for which money is demanded in the form of liquid cash are called ‘motives’. According to
J.M. Keynes, there are three motives behind demand for money or liquidity preference.
1. Transaction motive
2. Precautionary motive
3. Speculative motive
Transaction motive
Under the transaction motive, money is demanded for the current transactions of individuals and
business firms. In other words, people (individuals and business firms) should hold a certain
amount of liquid cash all the time to carry out their day-to-day transactions. The amount of
money which individuals desire to hold in the form of liquid cash depends upon the size of their
personal income, spending habits and the intervals of time between the receipt of income and
its expenditure. Further, business people desire to hold liquid cash to meet their current needs
such as payment for raw materials and transport, wages and salaries. Thus both individuals
and business firms hold liquid cash balances under transaction motive. It represents medium
of exchange function of money. It is a flow concept.
The transaction motive may be further classified into: income motive and business motive.
Income motive refers to the transaction motives of individual consumers. As an individual
person’s income rises, he desires to hold more money to satisfy the income motive. Business
motive refers to the transaction motives of businessmen, industrialists and traders. As the
turnover of the business is large, the businessman desires to hold more money to satisfy the
business motive. Thus, the demand for money to satisfy the transaction motive varies in indirect
proportion to changes in the level of money income. The transaction demand for money is thus
income-determined and interest- inelastic. The transaction demand for money is represented by
Mt = f(Y)
where
Mt = transaction demand for money
Y = level of money income
Precautionary motive
Under the precautionary motive, money is demanded for meeting unforeseen contingencies
such as illness, accidents, unemployment, natural calamities, etc. The precautionary demand
for money depends upon the uncertainty of future incomes and expenditures.
The liquid cash held by the people to meet the precautionary motive represents the store
of value function of money. The precautionary demand for money depends upon the level of
income, business profits the cost of keeping liquid cash in banks, etc.
As in the case of transaction demand for money, precautionary demand for money is the
function of the level of income. If the income of an individual is large, he can keep larger
cash balances to meet the unforeseen contingencies. The precautionary demand for money is
represented by
Mp = f(Y)
where
Mp = precautionary demand for money
Y = level of income
Thus the precautionary demand for money is income-determined, relatively stable and also
interest-inelastic.
Speculative motive
Under the speculative motive, money is demanded for speculative activities and thereby making
abnormal profits. John Maynard Keynes defines speculative motive as “the desire of earning
profit by knowing better than the market what the future will bring forth.”
The speculative demand for money depends upon the rate of interest. The amount of cash
balance for speculative motive is determined more by the changes in the future rate of interest.
If people expect the rate of interest is going to fall at some future date (i.e. prices of securities
are going to rise), they will purchase securities (bonds and equities) in order to sell when their
prices rise. They will thus hold less money with them. On the other hand, if people expect the
rate of interest is going to rise at some future date (i.e. prices of securities are going to fall),
Value of Money 53
they will postpone their purchase in order to purchase when their prices fall. They will thus
hold more money with them. Thus people hold their income or wealth in the form of money
or securities based on the rate of interest and their expectation regarding the future.
Hence, there is an inverse relationship between the rate of interest and the speculative
demand for money. That is, other things being equal, when the rate of interest is high, the
speculative demand for money is low whereas when the rate of interest is low, the speculative
demand for money is high. The speculative demand for money is represented as:
Ms = f(r)
where
Ms = speculative demand for money
r = rate of interest
The speculative demand for money is illustrated in Figure 3.1.
Figure 3.1 Speculative demand for money.
In the figure, Ms = f(r) curve is the demand curve or liquidity preference curve. This curve
shows that when the rate of interest rises (from Or1 to Or2), the speculative demand for money
falls (from ON1 to ON2), and when the rate of interest falls (from Or1 to Or3), the speculative
demand for money rises (from ON1 to ON3). At Or3 rate of interest, the demand or liquidity
preference curve becomes perfectly elastic and the speculative demand for money is infinitely
elastic. This is known as liquidity trap.
The speculative demand for money is income-determining and perfectly interest-
elastic.
3.6 Approaches to Demand for Money

After J.M. Keynes, a number of attempts have been made by economists like William J. Baumol,
James Tobin, Milton Friedman, Gurley and Shaw, Harry G. Johnson and Allen H. Meltzer to
study the demand for money.
3.6.1 Baumol’s Approach
William J. Baumol in an article ‘The Transactions Demand for Cash: An Inventory Theoretic
Approach’, published in the Quarterly Journal of Economics in November 1952 emphasized
that the transactions demand for money is also a function of the rate of interest. If the rate of
interest on securities (bonds) rises, the firm will find it profitable to invest on securities and
optimal cash balances will be lower. On the other hand, if the rate of interest on securities
(bonds) falls, the firm will not invest more on securities and optimal cash balances will be
higher. Thus the transactions demand for money varies inversely with the rate of interest.
Baumol’s approach to the study of demand for money is given below.
Let us suppose that r and b are assumed to be constant over the year. At the beginning
of the year, Y is the income of the firm (equal to real value of the transactions), and k is the
size of each cash withdrawal at interval, over the year when securities are sold. Thus Y/k is
the number of cash withdrawals over the year. The cost of brokerage fees during the year will
equal b(Y/k). Since the average cash withdrawals are k/2, the interest costs of holding cash
balances is r(k/2). Then the total cost of transactions is C. This may be written as:
Êkˆ ÊY ˆ
C = r Á ˜ + bÁ ˜
Ë 2¯ Ëk¯
where
C = total cost of transactions (total inventory cost)
k/2 = average cost of withdrawals
b = brokerage fee
Y/k = cost of brokerage fees
Another implication of Baumol’s approach to the study of demand for money is that
economies of scale exist in the transactions demand for money. Economies of scale are said
to exist only when the transactions demand for money varies less than proportionately to the
real value of transactions.
3.6.2 Tobin’s Approach
James Tobin in an article ‘Liquidity Preference as Behaviour towards Risk’ published in review
of Economic Studies in February 1958 formulated the risk aversion theory of liquidity preference
based on ‘portfolios selection.’
Tobin’s approach to the study of demand for money is based on the assumption that
expected value of capital gain or loss from holding interest-bearing assets is always zero. This
approach also explains that an individual’s portfolio holds both money and bonds rather than
only one at a time.
Tobin’s approach suggests that an increase in the quantity of money demanded will occur
only if income rises or rate of interest falls. Tobin defines the demand for money as:
M = f (i, y, k)
Value of Money 55
where
M = demand for money
i = rate of interest
y = income
k = capital stock (earning power)
James Tobin states that the optimal inventory holdings of cash balances is determined by
factors such as rate of returns from alternative liquid assets, cost of exchanging assets, risk
aversion in combination with different assets in the portfolio and transaction costs are to be
balanced against interest costs.
3.6.3 Friedman’s Approach
Milton Friedman formulated the Wealth Theory of Demand for money. According to him money
is demanded as an asset for holding wealth or capital. As such, the wealth theory of demand
for money is a part of the theory of capital. The demand for money is directly influenced by
the price and income levels but inversely related to the cost of holding the cash balances. The
cost of holding cash balances can be measured in terms of (a) the rate of interest and (b) the
expected rate of change in the price level.
Friedman considers that the wealth or the asset of an individual is of the following alternative
forms money (or cash balances), bonds, equities, human capital and physical non-human goods.
Money may yield a real return in the form of convenience security and prefect liquidity,
the magnitude of the real return varies inversely with the price level. Money may also yield a
money return in the form of interest earned on savings deposits with a bank.
Bonds and Equities are calms to perceptual income streams of constant nominal value. Returns
on bonds and equities are determined by changes in the rate of interest and the market prices.
Human capital is the discounted value of the expected income yield.
Physical non-human goods are the real goods which yield income. But the real return will
be affected by the changes in the price level.
3.6.4 Gurley and Shaw’s Approach
Gurley and Shaw’s approach to the study of demand for money emphasized the impact of an
expansion of non-banking financial institutions on the demand for money. The NBFIs convert
primary securities into indirect securities for the portfolio of ultimate lenders. They also
provide such substitutes for money suited to the needs of the ultimate lenders. These
activities lead to decrease in the volume of money. They finally influence the liquidity preference
function.
The implication of this approach is that as the supply of money remains unchanged, the
excess supply of money over its demand for money will be adjusted only at a lower rate of
interest.
3.7 Supply of Money (Stock Concept)

The term ‘supply of money’ is synonymous with the terms ‘money supply,’ ‘quantity of money’
or the ‘stock of money.’
Broadly speaking, money supply means the total stock or the quantity of money held by
the public in a country. The term ‘public’ includes private individuals, business firms, state
and local governments but excludes central government, central bank and commercial banks.
In other words, money supply means the amount of money in circulation in an economy at a
given time.
3.7.1 Constituents or Components of Money Supply
Currency component and deposit component are two main components of money supply.
Under the currency component, money supply consists of coins and paper currency notes. In
all countries of the world, the central bank is entrusted with the task of issuing and regulating
their own currencies. In India, the Reserve bank of India (RBI) has the monopoly of note issue
based on the minimum reserve system of note issue. The total money supply of the country
is fully governed by the actions of the public and is influenced by the banking habits, volume
of demand deposits and the distribution of national income.
Under the deposit component, money supply consists of bank demand deposits withdrawable
by cheques. Demand deposits generally constitute bank money. The demand deposits with
commercial banks can be withdrawn at any time without any prior notice. These deposits are
on current account.
Out of these two components, currency component is applicable in underdeveloped or
developing countries like India, whereas deposit component is more applicable in developed
countries like USA.
The reasons for the differences between the currency component and deposit component of
money supply are the degree of monetization of the economy, the banking habits of the public
and the development of the banking system.
3.7.2 Determinants of Money Supply
The quantity of money in circulation or money supply in an economy is influenced or determined

by many factors. They include:
1. State of the economy
2. Monetary policy
3. Fiscal policy
4. Seasonal factors
5. Size of the monetary base
6. People’s choice
7. Bank Reserves and Deposits
Value of Money 57
State of the economy
If an economy experiences boom or prosperity phase of a business or trade cycle, the quantity
of money in circulation or money supply will tend to rise. On the other hand, if the economy
experiences depression, the quantity of money in circulation or money supply will tend to fall.
Thus money supply in an economy is determined by the business conditions prevailing in the
economy.
Monetary policy
Monetary policy is the policy of monetary authority, say the RBI in India. If the central bank
lowers the bank rate or resorts to open market buying of securities, the money supply tends
to rise. On the other hand, if the central bank raises the bank rate or resorts to open market
selling of securities, the money supply tends to fall. Thus the money supply in the economy
is also determined by the monetary policy (either cheap or dear money policy) of the central
bank of the country.
Fiscal policy
Fiscal policy is the policy of the government regarding the taxation, public expenditure,
borrowing and financial administration. If the public spending through deficit financing rises,
the money supply will tend to rise, on the other hand, if the public spending is on the decline,
the money supply will tend to fall. The fiscal policy of the government is another determinant
of many supplies in the country.
Seasonal factors
During the busy seasons (November to April) crops are harvested and industries tend to buy
their requirements of raw materials. Hence the money supply tends to rise. On the other hand,
during the slack season (May to October), the money supply tends to fall. Thus money supply
in an economy is also determined by seasonal factors.
Size of the monetary base

Monetary base is the supply of funds available for use against demand deposits either as liquid
cash or as reserves. Under the paper currency standard, the monetary base depends largely on
the other types of government money and central bank credit. Thus monetary base is another
determinant of money supply.
People’s choice
If the people desire to hold large portion of their wealth or income in the form of deposits in
banks, the banks (commercial banks) are enabled to create more deposits by expanding loans
and advances to the public. On the other hand, if the people prefer to hold a small portion of
their wealth or income in the form of deposits in banks, the banks are able to create less deposit
by contracting loans and advances to the public. Thus people’s choice is another determinant
of money supply in the economy.
Bank reserves and deposits

The height of the ratio between bank reserves and deposits is another determinant of money
supply for a country. If the ratio of bank reserves to deposits is high, the amount of demand
deposits that can be supported by a given quantity of bank reserves. On the other hand, if the
ratio of bank reserves to deposits is low, the amount of demand deposits is higher.
3.7.3 Money Supply Function
In India, there are four money stock measures used by the Reserve Bank of India for the
formulation of its monetary policy. They are symbolically expressed as M1, M2, M3 and M4.
These are otherwise called concepts of money supply. These money stock measures are defined
thus as follows.
M1 (Narrow money)
M1 (narrow money) consists of currency with the public (currency notes and coins), demand
deposits held by the public with all commercial and cooperative banks excluding interbank
deposits and other deposits (deposits of IFCI, IDBI, ICICI, IMF, IBRD and Foreign Governments)
with the Reserve Bank of India. M1 is thus defined as:
M1 = Cp + Dd + Od
where
M1 = narrow money
Cp = currency with the public
Dd = demand deposits with all banks
Od = other deposits with the RBI
M1 is thus a narrow concept (or measure) of money supply in India.
M2
M2 consists of currency with the public + demand deposits with all banks + other deposits
with the RBI + post office savings bank deposits. In other words,
M2 = M1 (narrow money) + post office savings bank deposits
Thus, M2 is defined as:
M2 = M1 + POSBd
where
M1 = narrow money
POSBd = post office savings bank deposits
M2 is a wider concept (or measure) of money supply. Post office savings bank deposits are
relatively less liquid than demand deposits with banks, but more liquid than time deposits. But
compared to bank deposits, post office savings bank deposits command greater public confidence.
These deposits play a vital role in the mobilization of savings in rural areas in India.
Value of Money 59
M3 (Broad money)
M3 (broad money) consists of currency with the public + demand deposits with all the
banks + other deposits with the RBI + time deposits with all banks (commercial and cooperative
banks) excluding inter-bank time deposits.
M3 = M1 + Td
where
M3 = broad money
M1 = narrow money
Td = time deposits with all banks (commercial and cooperative banks)
M3 is thus a broad concept (or measure) of money supply in India. M3 is otherwise called
‘aggregate monetary resources’ or ‘monetary aggregates.’
M4
M4 consists of the currency with the public + demand deposits with all the banks + other
deposits with the RBI + time deposits with all banks + total post office deposits excluding
deposits on national savings scheme (NSS) and national savings certificates (NSC).
M4 = M3 + TPOd
where
M3 = broad money
TPOd = total post office deposits (including savings and time deposits of the public with the
post offices)
The money stock measures are illustrated in Figure 3.2.
Figure 3.2 Money stock measures.

The various money stock measures are also precisely presented in Figure 3.3.
Figure 3.3 Various money stock measures.
The numerical values of money stock measures are presented in Table 3.1.
Table 3.1 Numerical values of money stock measures
Year M1 M2 M3 M4 High powered money

(reserve money)
(` in crores)
2009–2010 14,892.7 14,943.1 56,027.0 56,286.7 11,556.5
2010–2011 16,383.5 16,433.9 65,041.2 65,300.9 13,768.2
2011–2012 17,342.3 17,392.7 73,592.0 73,851.7 14,271.7
Source: RBI Bulletin, October 2012, p. S1291.
3.7.4 Measurement of Money Supply
There are four important approaches for the measurement of money supply—traditional
approach, monetarist approach, Gurley and Shaw approach and Radcliffe committee
approach.
Traditional approach
Under traditional approach, money supply consists of currency with the public and demand
deposits held by the public with all banks. The money stock is measured by the total issue of
currency notes and demand deposits will all banks at a point of time.
In symbol,
M = Cp + Dd
Value of Money 61
Monetarist approach
Under monetarist approach, money supply consists of currency with the public, demand deposits
with banks and time deposits. Milton Friedman is associated with this approach.
In symbol,
M = Cp + Dd + Td
Gurley and shaw approach

Under Gurley and Shaw approach, money supply consists of currency with the public, demand
deposits held by the public with banks, time deposits and the financial liabilities of monetary and
non-monetary financial institutions. This approach is a modern one which adopts substitutability
criterion to define money as a weighted sum of currency with the public, demand deposits with
all banks and their substitutes (or alternatives)
Radcliffe committee approach

Under Radcliffe Committee approach, money supply is viewed in terms of general liquidity of
the economy which includes currency with the public, deposits of all kinds and deposits with
other institutions and the availability of borrowing facilities. This approach is thus a wider
concept of money supply.
3.7.5 High Powered Money or Reserve Money or Monetary Base
The RBI calls high powered money or reserve money or monetary base. It consists of currency
with the public, cash reserves of the commercial banks and other deposits with the RBI. High
powered money is thus defined as:
HPM = Cp + CRb + Od
where
HPM = high powered money
Cp = currency with the public
CRb = cash reserves of commercial banks
Od = other deposits with the RBI
In India, the RBI is the monetary authority having the power to determine cash reserves
to be kept by the commercial banks. On the basis of the cash reserves, commercial banks can
create demand deposits. Money created out of this is called high powered money. Thus the
complete process of multiple credit creation depends upon high powered money.
The main sources of high powered money are:
1. Net RBI credit to the government +
2. RBI credit to banks +
3. RBI credit to commercial sector +
4. Net foreign exchange assets of the RBI +
5. Government’s currency liabilities to the public –
6. RBI’s net non-monetary liabilities
The high powered money is measured by totalling the values of items (1) to (5) and
subtracting the value of item (6). The determinants of money supply are explained in terms of
high powered money.
The high powered money is the base for the expansion of bank deposits and the creation
of money supply. The money supply and the high powered money are directly related.
Higher the supply of high powered or reserve money available with the monetary authority,
higher will be the money supply. On the other hand, lower the supply of high powered or
reserve money available with the monetary authority, lower will be the money supply.
The money supply and cash reserves of the commercial banks are inversely related. Higher
the amount of cash reserves to be kept by the banks, lower will be the money supply. On the
other hand, lower the amount of cash reserves to be kept by the commercial banks, higher will
be the supply of money.
The cash reserves of commercial banks are a fixed proportion of their total deposits to
be kept with the RBI. The proportion of cash reserves to be kept by the commercial banks
is being decided and fixed by the RBI in India. But the commercial banks may have excess
cash reserves to meet unexpected cash with drawals. There are two reserves ratios—required
cash reserve ratio and excess cash reserve ratio. The required cash reserve ratio is the ratio of
required cash reserves to total deposits. It is thus defined as:
RCR
Td
where
RCR = required cash reserve
Td = total deposits
The excess cash reserve ratio is the ratio of excess cash reserves to the total deposits. It
is thus defined as:
ECR
Td
where
ECR = excess cash reserve
Td = total deposits
Hence the high powered or reserve money consists of the currency with the public, the
required cash reserves and excess cash reserves of commercial banks. Thus high powered or
reserve money is further defined as:
HPM = Cp + RCR + ECR
3.7.6 Money Multiplier
Money multiplier simply refers to the ratio of total money stock or money supply to high
powered money or reserve money or monetary base. Money multiplier is thus defined as:
Value of Money 63
TM
MM =
HPM
or TM = MM  HPM
where
MM = money multiplier coefficient
TM = total money stock or money supply
HPM = high powered or reserve money
Money multiplier is thus the function of high powered money, given the money multiplier
coefficient (MM), a change in the high powered money (HPM) leads to a change in total money
stock (TM) in the economy. That is, if there is an increase in the quantity of high powered
or reserve money, there will be an increase in the total money stock in the economy. On the
other hand, if there is a decrease in the quantity of high powered or reserve money, there will
be a decrease in the total money stock in the economy.
Thus there is a direct or positive relationship between high powered money and the total
money stock (or money supply) in the economy. In other words, the total money stock (or
money supply) changes directly with the changes in high powered money.
Money multiplier is also defined as:
TM
MM =
CR
or TM = MM  CR
where
MM = money multiplier coefficient
TM = total money stock (or money supply)
CR = ratio of cash reserves of commercial banks
Money multiplier is also the function of the ratio of cash reserves of commercial banks. Given
the money multiplier coefficient (MM), a change in the ratio of cash reserves of commercial
banks leads to a change in the total money stock (or money supply) in the economy. That
is, if there is an increase in the ratio of cash reserves of commercial banks, there will be a
decrease in total money stock (or money supply) in the economy. On the other hand, if there
is a decrease in the ratio of cash reserves of commercial banks, there will be an increase in
the total money stock (or money supply) in the economy. Thus there is an inverse relationship
between the ratio of cash reserves of commercial banks and the total money stock (or money
supply) in the economy. In other words, the total money stock (or money supply) changes
inversely with the changes in the ratio of cash reserves of banks.
The concept of money multiplier in terms of high powered money is illustrated in Figure 3.4.
The figure shows the relationship between the high powered money and the total money
supply in the economy. The demand for and supply of high powered or reserve money are
in equilibrium at point A. At this point, the total money supply is OM1. An increase in the
quantity of high powered or reserve money by H1 H2 shifts the HS1 curve upward to HS2. At
point B, the total money supply increases to OM2. The increase in high powered money by
Figure 3.4 Money multiplier in terms of high powered money.
H1 H2 increases the total money supply by M1 M2. This expresses the operation of the money
multiplier in the economy.
3.7.7 Money Supply Function
Money supply function expresses the functional relationship between the quantity of money
supplied and its determinant variables. The determinant variables of money supply include
quantity of total legal tender money possessed by banks, cash reserve ratios for total deposits,
the rate of interest and the national income. Money supply function is thus defined as:
TMs = f(L, C, r, Y)
where
TMs = total money supply
L = total legal tender money
C = cash tender money
Y = national income
The factors L and C are determined by the central bank while factors r and Y are determined
by the market forces—demand and supply. Therefore, the money supply is jointly by the
collective operation of the central bank, the commercial banks and the general public. The
most common determinant factor influencing money supply is the rate of interest. Hence, the
money supply function also states that the total money supply is the function of the rate of
interest, i.e.
TMs = f(r)
where
TMs = total money supply
If the rate of interest rises, the total money supply in the economy will be higher. On the
other hand, if the rate of interest falls, the total money supply will be lower. Thus there is a
direct or positive relationship between the money supply and the rate of interest.
Value of Money 65
3.7.8 Budgetary Deficit and Money Supply
Budgetary deficit occurs only when the government expenditure exceeds the government
revenue. This deficit can be filled up or adjusted through public borrowings. The government
can borrow from the banking and non-banking institutions.
When the government borrows from the non-banking institutions, money is pumped out
from the public. On the other hand, when the government spends the borrowed money, money is
pumped into the economy. But when the government resorts to the banking sector and borrows
from the central bank, the net central bank credit to the government sector is termed deficit
financing. It implies the monetary financing through public borrowing. This leads to a rise in
the money supply in the economy.
The impact of government budgetary policy on the money supply in the economy may be
summarized as:
• Taxation and sale of securities to the public directly reduce the money supply in the
economy.
• When the government spends money by drawing from the central bank, the money
supply with the public and the cash reserves of the commercial banks will rise.
• Deficit budget policy of the government will increase the money supply with the public,
whereas surplus budget policy will reduce the money supply.
• Deficit financing leads to an increase in the money supply which has normally inflationary
impact.
There should be a proper coordination of the monetary and fiscal policies for an effective
monetary management in the country. But how effective a particular policy tool on achieving
a given goal depends upon the factors such as economic and business conditions, political
conditions, development of banking system, nature of money market in the economy, etc.
3.7.9 Concept of Velocity of Circulation of Money
By velocity of circulation of money we mean the average number of times a unit of money
passes on from one hand to another over a period of time. In other words, velocity of circulation
of money is the average number of times money changes or circulates when it is spent for
buying goods and services. For example, if a rupee passes from one person to another towards
payment, it helps in purchasing a commodity or service worth rupee one. If the same rupee
passes on ten times from person to person towards payments, it performs the function of ten
rupees in the economy. This is known as velocity of circulation of money.
When we study the supply of money over a period of time, the concept of velocity of
circulation of money is taken for consideration.
When we multiply the total amount of money of legal tender money in circulation by its
velocity of circulation, we can get the total supply of money in the economy. Thus the total
money supply is being largely affected by its velocity of circulation.
Other things being equal, if the velocity of circulation of legal tender money rises, the
money supply will rise. On the other hand, if the velocity of circulation falls, the money supply
will also fall, other things being equal.
Bank money has also its velocity of circulation. If the velocity of bank money rises, the total
money supply will also rise and vice versa. Thus bank money and its velocity of circulation
are also taken for consideration when we assess the total money supply over a period of time.
In algebraic terms, the total money supply during a given period of time is
MV + M V
where
M = total amount of (legal tender) money in circulation
V = velocity of circulation of legal tender money
M = total amount of bank money in circulation
V = velocity of circulation of bank money
Factors affecting velocity of circulation of money

The velocity of circulation of money depends upon the following factors:
• Quantity of money
• Liquidity preference of the people
• Distribution of income
• Business conditions
• Development of infrastructure
• Anticipation of future changes in prices
• Size of propensity to consume
• Method of payment
• Development of banking system
• Stage of economic development
• Time-lag in receipt of income
• Stability and regularity of income
Quantity of money: The quantity of money in an economy is an important factor which
determined the velocity of circulation of money. A country’s economy requires a fixed quantity
of money to carry out its exchange transactions. If there is less quantity of money, its velocity
will be rapid. On the other hand, if there is more money, its velocity will be slow.
Liquidity preference of the people: The velocity of circulation of money is also determined
by the liquidity preference of the people. Liquidity preference means the motives to hold cash
balances rather than to spend. If people’s desire to keep cash balances is more to meet day-
to-day expenses, the velocity of circulation of money is lower. If people’s desire to keep cash
balances is less, the velocity of circulation of money will be higher.
Distribution of income: The velocity of circulation of money is also influenced by the
distribution of income. In case of rich people, the velocity of circulation of money is lower
because they are inclined to keep cash balances, while in case of poor people, the velocity of
circulation of money will be higher because they spend their money as soon as they receive
on account of their small cash balances. Thus a high degree of inequality causes to lower
velocity of circulation of money.
Value of Money 67
Business conditions: Business conditions prevailing in an economy also influences the velocity
of circulation of money in the economy. In times of business prosperity, the velocity of circulation
of money will be high. In times of slack business slackness, the velocity of circulation of money
will be lower. In short, during the period of inflation, the velocity of circulation of money in
an economy increases, while during the period of deflation (or depression), the velocity of
circulation of money in the economy decreases.
Development of infrastructure: The velocity of circulation of money is also influenced by the
development of infrastructural facilities such as trade transport and communication. Development
of transport facilities and communication services widens the market in the economy. As a
result, the velocity of circulation of money will rise due to increase in transactions.
Anticipation of future changes in prices: Anticipation of people about future changes in prices
exerts considerable influence on velocity of circulation of money in an economy. During the
period of business prosperity, transactions will be more because people anticipate further rise
in the price level. As a result, the velocity of circulation of money will be more. But during
the period of business depression, transactions will be less because people anticipate further
fall in the price level. As a result, the velocity of circulation of money will be less.
Size of propensity to consume: The size of prosperity to consume also influences the velocity
of circulation of money. According to J.M. Keynes, other things being equal higher the prosperity
to consume in an economy higher will be the velocity of circulation of money in the economy
because people spend a major portion of their income on consumption. As a result, the velocity
of circulation of money will be more.
Method of payment: The method of payment also influences the velocity of circulation of
money. Instalment payments require less cash balances which would increase the velocity of
circulation of money in the economy, whereas lump sum payments require more cash balances
which would lower the velocity of circulation of money in the economy.
Development of banking system: The state development of banking system in an economy
largely influences the degree of velocity of circulation of money in the economy. In an
undeveloped or backward society, the velocity of circulation of money will be lower than in a
developed society because in the case of undeveloped or backward society, people are likely
to keep more cash balances to meet their contingency expenses. And also in such a society,
there are no possibilities for investment.
Stage of economic development: The velocity of circulation of money is also influenced
by the stage of economic development of a country. In the developed country, the velocity
of circulation of money is likely to be high because opportunities for savings and investment
are more. In an underdeveloped country, the velocity of circulation of money is low because
opportunities for savings and investment are comparatively low.
Time-lag in receipt of income: Income may be received per day, per week or per month.
Shorter the time interval between successive incomes, higher will be the velocity of circulation
of money in the economy. Longer the time interval between successive incomes, lower will be
the velocity of circulation of money in the economy. Thus time interval of receiving incomes
also influences the velocity of circulation of money in an economy.
Stability and regularity of income: The velocity of circulation of money is also influenced
by the degree of stability and regularity of income. If income received by the people is stable
and regular, they will be inclined to spend money freely at present. As a result, the velocity of
circulation of money will be high. If income received by the people is unstable and irregular,
they will have a tendency to keep more cash balances with them. As a result, the velocity of
circulation of money will be low.
Control of money supply

The Reserve Bank of India (RBI), with its monetary policy and control over money supply,
forms a crucial role in shaping the economic structure of India. A monetary policy that RBI
adopts ensures both the productivity and economic welfare of the citizens. How the central
bank performs this herculean task is explained here in the simplest possible form.
The RBI which was established on April 1, 1935 is the central bank of India. Earlier, it
was a shareholders’ bank, but later on January 1, 1943 it has been nationalized. The RBI, with
its monetary policy, functions as a regulatory body ensuring overall economic stability of India.
The RBI has the sole power of issuing currency notes. The special system by which RBI
issues notes is called minimum reserve system. According to this system, the RBI can issue
any quantity of money if there is a minimum reserve of gold worth ` 115 crore and a foreign
exchange reserve of at least ` 85 crore. This system was adopted in 1956. However, issuing
money depends on several other factors.
Besides issuing money, the RBI, through its monetary policy, regulates the money supply
in the economy. RBI also acts as banker to the government as well as to other commercial
banks. The RBI controls the credit creation and is also responsible for the stability of foreign
exchange reserve of which it acts as a custodian.
The RBI is empowered to control the credit flow which is necessary for accelerating the
economic growth of India. Banks must keep a part of its money as reserve money, a part of
which is kept as vault cash and the rest is deposited with the RBI. When commercial banks
fall short of funds, they can borrow from RBI at a rate called bank rate. In a monetary policy
where the bank rate is high will discourage commercial banks from borrowing from the RBI.
As a result, these banks will naturally charge higher interest rates from their lenders. Thus in
such a monetary policy, which is called dear monetary policy, money supply in the economy
will reduce. On the other hand, a monetary policy, where bank rate is low and money supply is
more, will be called a cheap monetary policy. Thus, the bank rate can be an effective instrument
of The RBI to regulate the money supply in the market.
Another instrument that is frequently used by RBI for this purpose is called cash reserve
ratio (CRR), which represents the fraction of deposit which commercial banks must keep with
the RBI to regulate the money supply. Similar to CRR, statutory liquidity ratio (SLR) is the
portion of deposits that a bank has to keep with RBI in term of gold, bullion or government
securities. Any modification in the levels of CRR or SLR therefore will have significant impact
on the economy. For example, increasing either the SLR or CRR, or both means a decrease
in liquidity of the commercial banks. Thus with appropriate monetary policy RBI can either
siphon off the liquidity or induce more liquidity in the market. Though keeping reserves this
way with the RBI is costly for banks, it is necessary to ensure that they are able to pay their
account holders when asked for it.
Value of Money 69
The RBI can purchase government bonds from or sell the same to the public. When the RBI
buys them, excess money is infused in the economy thereby increase the money supply. The
reverse, i.e. selling the bonds will suck out excess liquidity from the market. This operation is
called the open market operation which is also a part of the monetary policy of the RBI and
may work as complementary of bank rate policy.
The RBI is also responsible to maintain stability of foreign exchange and to hold the foreign
exchange reserve. How can foreign exchange reserve affect a country’s economy? Suppose an
investor from the US wants to invest in Indian market. USD doesn’t work in domestic market
in India. The person who solds goods to the investor will get USD in exchange of his good.
What will he do now? He will go to one of the commercial banks and get Indian rupee in
exchange of the USD. The bank will submit the foreign currency to the RBI which will then
credit the bank equal amount of money in domestic currency. The foreign exchange reserve
of the RBI, at the same time, increases. But money supply in domestic market has already
increased due to this foreign exchange inflow. To adjust this, the RBI will sell out government
securities of an amount equal to the foreign exchange inflow. Thus RBI with its monetary
policy also protects domestic economy from external shocks.
If the money supply suddenly rises in the domestic market without any significant rise in
the supply of goods and services, the price of goods will rise. How well, because a sudden
increase in money supply means an increase in the purchasing power of individuals. So people
will want to buy more goods and services with that money. But supply of goods and services
haven’t increased. This means, more and more people are competing for this limited amount
of resources which, in turn, will increase the price of those resources. This condition is more
popularly known as inflation. On the other hand, lack of money in market is called deflation.
The RBI with its monetary policy prevents such bad things from happening to Indian economy.
As we have already observed, monetary policies of the RBI that are directed to controlling
inflation may, at times, interfere with the economic growth of the country. Since advances made
by commercial banks play a vital role in industrial development, any monetary policy that
hinders the circulation of money will bring the industry to a momentary halt. Moreover, most
of the economic agents that play active roles in forming the market are beyond the jurisdiction
of the RBI. This limitation is often overcome by joint effort of RBI, SEBI and other related
authorities. The RBI also has a vital role in formation and implementation of several policy
initiatives taken by Government of India for the welfare of society and agriculture.

1. The value of money simply refers to
(a) purchasing power of money (b) store of value of money
(c) medium of exchange value of money (d) measure of value of money
2. The value of money changes with the price level
(a) directly (b) inversely
(c) vertically (d) horizontally
3. The value of commodity changes with the price level

4. In the relative value of money, the value of money is expressed in terms of
(a) prices of goods and services (b) prices of gold
(c) liquid cash (d) prices of securities
5. Index numbers are designed to measure
(a) the general price level (b) the prices of consumer goods only
(c) the prices of capital goods only (d) all of the above
6. Index numbers are statistical devices designed to measure the changes in the value of
(a) time (b) money
(c) life (d) distance
7. The base year selected for the construction of an index number should be a
(a) normal year (b) abnormal year
(c) remote year (d) current year
8. Theoretically which is the best average in the construction of price index numbers?
(a) Arithmetic mean (b) Geometric mean
(c) Harmonic mean (d) All of the above
9. Practically which is the best average in the construction of price index numbers?
(a) Arithmetic mean (b) Geometric mean
(c) Harmonic mean (d) All of the above
10. Which index is an appropriate one for the construction of price index number?
(a) Fisher’s index (b) Bowley’s index
(c) Kelly’s index (d) Paasche’s index
11. Value of money is determined by
(a) demand for money (b) supply of money
(c) demand for and supply of money (d) all of the above
12. Demand for money is a
(a) flow concept (b) stock concept
(c) classical concept (d) modern concept
13. Money is demanded for
(a) transaction purposes (b) precautionary purposes
(c) speculative purposes (d) all of the above
14. The transaction demand for money is represented by
(a) Mt = f(y), where y = money income
(b) Mt = f(r), where r = rate of interest
(c) Mt = f(k), where k = proportion of income kept as cash balance
(d) all of the above
15. The speculative demand for money is
(a) perfectly interest-elastic (b) perfectly interest-inelastic
(c) relatively interest-elastic (d) relatively interest-inelastic
Value of Money 71
16. Liquidity preference curve becomes
(a) perfectly elastic (b) perfectly inelastic
(c) relatively elastic (d) relatively inelastic
17. When the speculative demand for money is infinitely elastic and the liquidity preference
curve becomes perfectly elastic, it is known as
(a) inflationary gap (b) deflationary gap
(c) liquidity trap (d) stagflationary gap
18. Whose approach emphasized the impact of non-banking financial institutions on the
demand for money?
(a) Tobin’s approach (b) Baumol’s approach
(c) Friedman’s approach (d) Gurley and Shaw approach
19. Supply of money is a
(a) flow concept (b) stock concept
(c) classical concept (d) modern concept
20. In India, which of the following money stock measures is used by the RBI for the
formulation of its monetary policy?
(a) Narrow money (b) Broad money
(c) Reserve money (d) All of the above
21. Money created out of the demand deposits created by commercial banks is called
(a) high powered money (b) narrow money
(c) broad money (d) near money
22. The money supply and the high powered money are related with each other
23. The ratio of total money supply to high powered money is simply referred to
(a) money multiplier (b) deposit multiplier
(c) investment multiplier (d) employment multiplier
24. The money multiplier is the function of
(a) cash reserve ratio (b) statutory liquidity ratio
(c) bank rate (d) interest rate
25. Velocity of circulation of money means the average number of times money passes from
hand to hand towards payment
(a) over a period of time (b) at a particular period of time
(c) at a point of time (d) all of the above
26. The RBI measures money stock as
(a) monetary aggregates (b) money supply
(c) liquidity (d) none of the above
Answers
1. (a) 2. (b) 3. (a) 4. (a) 5. (a)

6. (b) 7. (a) 8. (b) 9. (a) 10. (a)
11. (c) 12. (a) 13. (d) 14. (a) 15. (a)
16. (a) 17. (c) 18. (d) 19. (b) 20. (d)
21. (a) 22. (a) 23. (a) 24. (a) 25. (a)
26. (a)
Review Questions
1. What do you mean by value of money?
2. Distinguish between the value of money and the value of commodity.
3. Distinguish between the absolute value of money and the relative value of money.
4. How will you measure the value of money?
5. Describe the meaning, usefulness and limitations of index numbers.
• price index number
• quantity index number
• value index number
7. What are the steps involved in the construction of index numbers?
8. Discuss the problems involved in the construction of index numbers.
9. Explain the motives behind the demand for money.
10. Explain the concept of liquidity trap.
11. Explain the different approaches to demand for money.
12. Bring out the various components of money supply.
13. Explain the various determinants of money supply.
14. Bring out the various money stock measures.
15. Define and explain M1, M2, M3 and M4.
16. Explain the important approaches for the measurement of money supply.
17. Explain the concept of high powered money or reserve money.
18. Explain the concept of money multiplier.
19. Define and explain money supply function.
20. Explain the relation between the budgetary deficit and the money supply.
21. What do you mean by velocity of circulation of money?
22. Explain the factors affecting the velocity of circulation of money.
23. Explain how the RBI controls money supply.
Chapter 4
Monetary Theories
4.1 Quantity Theory of Money

The quantity theory of money tries to explain the causes of changes in the value of money. It
states that the value of money depends on its quantity. If the quantity of money rises, other
things remaining the same, the value of money will fall. On the other hand, if the quantity of
money falls, other things remaining the same, the value of money will rise. Thus, there is an
inverse relationship between the quantity of money and the value of money.
The quantity theory of money is stated in another way. A change in the quantity of money,
other things remaining the same, causes a directly proportionate change in the general price
level. For instance, if the quantity of money rises by 40 per cent, the price level will also rise
by 40 per cent. On the other hand, if the quantity of money falls by 10 per cent, the price
level will also fall by 10 per cent. Hence, whenever the quantity of money changes, the price
level also changes in the same direction and in the same proportion.
Irving Fisher states the quantity theory of money thus: “a change in the quantity of money
must normally and ultimately cause a proportionate and direct change in the price level.”
Taussig states the quantity theory of money thus: “double the quantity of money and other
things being equal, prices will be twice as high as before and the value of money one-half.
Halve the quantity of money and other things being equal, prices will be one-half of what they
were before; and the value of money double.”
Modern writers state the quantity theory of money as: “the value of money like the value
of any other commodity is determined by the forces of demand for and supply of money. It is
said that the value of money like the value of anything else is mainly a question of demand
and supply.”
If the supply of money increases, the demand for money remaining the same, the price
level rises and the value of money falls. On the other hand, if the supply of money decreases,
the demand for money remaining the same, the price level falls and the value of money rises.
It is concluded that the quantity of money and the price level are directly related; the price
level and the value of money are also directly related; but the quantity of money and value of
money are inversely related.
73
4.1.1 Approaches to Quantity Theory of Money
There are two important approaches to the quantity of money. They are:
1. Cash transactions approach or Fisher’s quantity theory of money
2. Cash balances approach or Cambridge equations
Cash Transactions Approach or Fisher’s Quantity Theory of Money

Professor Irving Fisher, an American Economist, has developed the transactions approach to
the quantity theory of money in his famous book The Purchasing Power of Money, published
in the year 1911. Fisher explains the quantity theory of money with the help of equation. The
equation is called Fisher’s equation of exchange. Fisher’s quantity theory of money or the
equation of exchange is defined as:
MV = PT
or PT = MV
MV
or P=
T
where
P = general price level
M = legal tender money (coins and notes)
V = velocity of circulation of legal tender money
T = volume of trade transactions
MV = supply of money (total quantity of money in a given period)
PT = demand for money (total value of goods and services transaction during the given
period of time)
The equation of exchange implies that the quantity of money determines the price level
which, in turn, varies directly with the quantity of money if V and T remain constant.
Fisher has extended his equation of exchange as follows:
MV + M V = PT
or PT = MV + M V
MV + M ¢V ¢
or P=
T
where
M = quantity of bank money
V = velocity of circulation of bank money
This extended form of Fisher’s equation of exchange implies that the quantity of money
also determines the price level which, in turn, varies directly with the quantity of money if
V, M , V and T remain constant.
In the words of Irving Fisher, “other things remaining unchanged, as the quantity of money
in circulation increases, the price level also increases in direct proportion and the value of
money decreases and vice versa.”
Monetary Theories 75
Thus, Fisher established a direct and proportionate relationship between the change in the
quantity of money and the resultant price level.
Assumptions of Fisher’s quantity theory of money: Fisher’s quantity theory of money or
equation of exchange is based on the following assumptions:
• The price level (P) is a passive element in the equation of exchange. This means that
P does not change by itself. It is determined by other elements in the equation M, V
and T.
• The volume of trade transactions (T), the velocity of circulation of legal tender of
money (V), the velocity of circulation of bank money (V) are independent elements in
the equation of exchange. This means that the volume of trade transactions (T) and the
velocity of circulation of money depend upon factors outside the equation.
• The ratio of bank money (M) to the legal tender money (M) remains constant.
• This theory is applicable only in the long run.
• It is true only under the conditions of full employment in the economy.
• Commodities are exchanged for money (i.e. no barter transactions).
• Money is used only as a medium of exchange and not as a store of value.
• The entire quantity of money is in circulation (i.e. no hoarding of money).
Explanation of Fisher’s quantity theory of money: Fisher’s quantity theory of money or
equation of exchange can be explained with the help of Figure 4.1.
Figure 4.1 Operation of Fisher’s theory.
This figure clearly explains the operation of Fisher’s quantity theory of money. When
more money is pumped into the economy, the quantity of money in circulation will increase
which, in turn, raises the price level in the economy. As a result, the value of money will fall.
On the other hand, when less money is pumped into the economy, the quantity of money in
circulation will decrease which, in turn, reduces the price level in the economy. As a result,
the value of money will rise.
The figure thus depicts how changes in the quantity of money affect the general price level
in the economy. Every increase in the quantity of money is followed by an increase in the
general price level in the same proportion.
This theory of money can also be explained with the help of Figure 4.2.
Figure 4.2 Relationship between value and quantity of money.
In this figure, the curve VM indicates that the value of money is a function of quantity
of money. The OX axis represents the quantity of money in circulation (M) and the OY axis
represents the value of money (V).
The figure shows the inverse relationship between the quantity of money and the value of
money. When the quantity of money is OM1, the value of money is OV3. When the quantity of
money increases to OM2, the value of money is reduced to OV2. When the quantity of money
further increases to OM3, the value of money gets further reduced to OV1.
Criticisms of Fisher’s quantity theory of money: Fisher’s quantity theory of money is criticized
on the following grounds:
• Fisher’s theory assumes that other things like T and V remain constant. But in practice,
other things like T and V do not remain constant since they are independent elements.
• It explains only the changes in prices during long periods but does not explain changes
in prices that occur during short periods.
• It assumes that it is true only under the conditions of full employment. But in practice,
no country experiences full employment as it is an abnormal condition in any economy.
• It does not explain the causes which govern the rapidity of circulation (Alfred Marshall).
In other words, the theory does not explain why the velocity of circulation of money
rises and falls alternatively.
• It does not explain the process by which a change in the quantity of money brings about
a change in the price level.
• It does not take into account the rate of interest as determinant of the price level even
though changes in the quantity of money have greater influence on it. A theory of money
which does not mention the rate of interest is not a theory of money at all (Mrs Joan
Robinson).
• This theory is merely a truism as it states the fact that money given in exchange for
goods (MV) is equal to the price paid for them (PT). The equation does not tell us
anything new about money or prices; it merely states in a precise and convenient form
what is obviously true (Crowther).
• The value of money changes not due to changes in the quantity of money but due to
changes in the incomes of the people. ‘The value of money in fact is a consequence of
the total incomes rather than the quantity of money’ (Crowther).
• This theory is unrealistic in the sense that it advocates the influence of quantity of money
upon prices even during the trade cycles.
• Professor Halm criticized Fisher’s equation of exchange as being technically inconsistent.
In this equation of exchange, M is a stock concept, whereas V is a flow concept. M
which refers to the stock of money at a particular point of time, and V which refers to
the velocity of circulation of money are, therefore, non-comparable elements and cannot
be multiplied together.
• Don Patinkin criticized Fisher’s quantity theory of money for the undue importance
he has given to the quantity theory and neglected the role of real cash balances in the
economy.
• The theory is one-sided and incomplete because it assumes that the demand for money
is constant, whereas the supply of money is dynamic in bringing about changes in the
economy.
• There is no direct and proportional relationship between the quantity of money and the
price level. Thus critics say that Fisher’s quantity theory of money is more imaginary
rather than real.
• This theory is not comprehensive as it does not include the entire legal tender money
and bank money in the total supply of money. This is because of the fact that the total
money supply is not made use of for purchasing goods and services. A part of it is
hoarded. The hoarded money should be excluded from the total money supply while
analysing the changes in the price level in the country.
• It neglects the human element which has to be accorded due place in the Equation of
exchange.
• It does not discuss the concept of velocity of circulation of money and its determinant
factors. A sound theory of money should deal at length with all those factors which
influence the velocity of circulation of money (Alfred Marshall).
• It entirely ignores the velocity of circulation of commodities while explaining price
changes in the economy.
• This theory is also criticized on the ground that the effect of changes in quantity of
money on the general price level is not immediate but gradual.
• Professor Nicholson says that this theory is not proper to call a ‘theory’ as it expresses
only elementary truth but does not tell us anything new. In fact, an increase in the
quantity of money is followed by an increase in the general price level.
• Critics pointed out that this theory is unnecessary because like any other commodity, the
value of money is also determined by demand for and supply of money. Thus, there is
no need for a separate (quantity) theory to explain the determination of value of money.
Cash balances approach or Cambridge equations

The cash balances approach to the quantity theory of money was developed by British
economists like Alfred Marshall, A.C. Pigou, D.H. Robertson and J.M. Keynes. They belonged
to the Cambridge University. So the equations given by these economists have been called the
Cambridge equations.
Cash balances approach to the quantity theory of money states that the value of money
depends upon the supply of money and the demand for money. The changes in the value of
money are caused by the changes either in its demand or in its supply, or in both.
According to Cambridge economists, the supply of money means the stock of money at
a given time, whereas the demand for money means people’s desire to hold money or cash
balances.
The Cambridge version of money developed by Marshall, Pigou, Robertson and Keynes
considered the demand for money as a store of value, not as a medium of exchange. These
economists studied the relationship between the quantity of money and the price level on the
basis that people desire to hold money or cash balances. People hold money or cash balances
for purposes like transaction motive, precautionary motive and speculative motive.
The equations given by Cambridge economists tell us that when the supply of money
remains the same, the demand for money determines the value of money. Cambridge economists
like Marshall, Pigou, Robertson and Keynes have formulated cash balances equations known
as ‘Cambridge equations’. Let us now discuss the Cambridge equations separately given by
these Cambridge economists.
Marshallian equation: Alfred Marshall, a pioneer among the four Cambridge economists has
given a cash balance equation, which is
M = KPY
This equation can also be written as
KY
P=
M
where
M = total quantity of money
P = price level
Y = real income
K = proportion of Y kept as cash balance
KY
Thus, according to Marshall, the price level P =
M
1 M
or the value of money =
P KY
It is clear that the value of money is the reciprocal of the price level.
According to Marshallian equation, the value of money is determined by changes in M and
K. K has more influence on P than M. A sudden change in K may largely influence P though
the supply of money remains constant. Suppose M = ` 1,00,000, Y = ` 20 lakh units of goods
and services and K = 1/10, then the value of money VM = 2 units of goods. Hence, P = 1/2.
Pigouian equation: Professor A.C. Pigou has developed a new cash balance equation, which is:
KR
P=
M
where
M = total cash held by the public
P = purchasing power of money
R = real income
K = proportion of R kept as cash balance
According to Pigouian equation, the value of money changes directly with K or R and
inversely with M. In other words, the price level changes inversely with K or R and directly
with M. According to Pigou, K is more significant than M to explain changes in the value of
money. This implies that the value of money depends upon the desire of the people to hold
money or cash balance.
Pigou has further enlarged his cash balance equation by including bank deposits in the
total money supply, thus:
KR
P= [C + h(1 - c)]
M
where
C = proportion of money kept in legal tender form
h = proportion of cash reserve to deposits held by the banks
(1 – c) = proportion of total money held by the public in the form of bank deposits
Robertson’s equation: Professor Dennis H. Robertson has given his cash balance equation
as:
M = PKT
This equation can also be written as:
M
P=
KT
where
M = quantity of money
P = price level
T = total amount of goods and services purchased
K = proportion of T kept as cash balance
Suppose that the total quantity of money M = ` 100 crore, total amount of goods and
services purchased T = 200 crore units and the proportion of T kept as cash balance K = 1/10.
Then the value of ` 1 = (20 crore units/` 100 crore), VM = 0.20 unit of goods. The price level
P (reverse of value of money) is calculated as: P = (` 100 crore/20 crore units) = ` 5 per unit.
Keynesian equation: J.M. Keynes has given his cash balance equation, which is
n = PK
n
P=
K
where
n = total quantity of money
P = general price level of consumption of goods
K = proportion of consumption goods which people desire to hold as cash balances
Keynes points out that people are interested in the value of money with regard to consumption
goods only. His equation implies that doubling the quantity of money in circulation will cause
doubling the price level, assuming K to be constant.
Keynes further extended his cash balance equation by including bank deposits in the total
quantity of money, thus:
N = P (K + rK )
n
P=
( K + rK ¢)
where
R = proportion of cash reserves kept by banks against their deposits
K = consumption goods which they desire to hold in the form of bank deposits
According to Keynes, the price level P changes in exact proportion with changes in n,
provided K and K remain constant. However, in the long run, K, K and r may not remain
constant or independent of changes in n. In the long run, a big change in n may influence
K, K and r. If K, K and r are influenced by changes in n, then n may not exert its entire
proportionate effect on P. In this respect, Keynesian cash balance equation differs from that
of Pigou.
Criticisms of cash balances approach: The cash balances approach to the quantity theory of
money suffers from many criticisms. They are:
• This approach does not explain the causes for changes in prices during short periods.
• Cambridge economists gave undue importance to the purchasing power of money in
terms of consumption goods.
• Cambridge equations simply say that changes in the demand for money bring about
changes in the value of money and ignore the influence of factors like savings, investment
and income which often bring about changes in the demand for money.
• Cambridge equations are subject to circular reasoning in the sense that it says, on the
one hand, the value of money is determined by the cash balances kept by the public,
and on the other hand, the value of money determined the cash balances to be kept by
the public.
• This approach is a narrow one in the sense that it considers the value of money in terms
of consumption goods only.
• It gives too much importance to real income as the determinant of K. But it ignores
other factors like price level, cash holding habits of the people, etc.
• It is not realistic in the sense that it assumes K and T remain constant.
• This approach fails to take into account the influence of the rate of interest on the price
level.
• It does not explain fully the various phases of a trade cycle.
• It neglects the speculative demand for money and store of value function of money.
• This approach ignores the role of thrift and productivity.
• It fails to take into account the changes in the liquidity preference of different groups
of people.
• In this approach, it is very difficult to measure the total real income R.
• In this approach, there is no integration between money market and product market.
Comparison between cash transactions approach and cash balances approach to quantity
theory of money: The comparison between cash transactions approach (CTA) and cash
balances approach (CBA) to quantity theory of money can be summarized under similarities
and dissimilarities between the two approaches.
Similarities:
• In both the approaches, the price level depends upon the quantity of money in circulation
in the economy. In other words, the price level varies directly with the supply of money
in both the approaches.
MV
• Both approaches are the same in essence. In CTA, Fisher’s equation is P =
T
M
and in CBA, Robertson’s equation is P = . Fisher’s equation can be written as:
KT
M 1
P= , if V = .
KT K
• Both approaches emphasize the medium of exchange function of money.
• Same symbols are used in all equations except V and K.
Dissimilarities:
• In CTA, money is demanded for transactions (or exchanging goods), whereas in CBA,
money is demanded for storing value.
• In CTA, the demand for money over a period of time is a flow concept (money on the
wing), whereas in CBA, the demand for money at a point of time is a stock concept
(money sitting).
• In CTA, Fisher emphasizes the velocity of circulation of money V, whereas in CBA,
Pigou emphasizes the idle cash balances.
• In CTA, Fisher’s equation of exchange does not integrate the theory of money and
the theory of demand and supply, whereas in CBA, Cambridge equations integrate the
monetary theory and the general theory of demand and supply.
• The CTA fails to explain the effects of quantity of money over the price level, whereas
the CBA explains the effects of quantity of money over the price level using the desire
of the public to hold cash balances.
• Transaction velocity of circulation is explained under CTA, whereas income velocity of
circulation is explained under CBA.
• Cash transactions approach (CTA) is a long period analysis (supply is more important),
whereas CBA is a short period analysis (demand is more important).
• In CTA, velocity of circulation of money V is measured thus: V = 1 , whereas in CBA,
K
1
the proportion of real income K is measured thus: K = .
V
• In CTA, the volume of trade transactions T is the sum of all transactions, whereas in
CBA, Y or R is the only final product that enters the product market.
Superiority of cash transactions approach over cash balances approach to quantity theory of
money: The CBA to quantity theory of money is superior to the CTA on the following grounds:
• CBA is comparatively realistic in the sense that this approach explains how changes in
the liquidity preference of the people may bring about changes in the price level even
without having any change in the quantity of money.
• CBA considers people’s desire to hold money or cash balances (K) as a factor governing
prices rather than quantity of money in circulation (M). Changes in K may widen the
scope of studying other important factors such as expectations, uncertainty, interest rate,
etc. which were not taken into account in CTA.
• CBA is concerned with the level of income as an important factor in the study of price
determination.
M
• According to K.K. Kurihara, Robertson’s equation P = is more useful than Fisher’s
KT
MV
equation P = to explain the value of money. It is because of the fact that it is more
T
convenient to know how people hold large cash balances to total expenditure than how
much they spend on transactions.
• The element of K in Cambridge equations is more significant for analysing the trade
cycle problems than the element of V in Fisher’s equation.
• The CBA has shifted the emphasis from institutional and technological factors to
psychological factors as the important determinants of the demand for money.
• The CBA explains the value of money in terms of demand for money and supply of
money and it integrates monetary theory with value theory, whereas the CTA’s main
emphasis is on supply of money.
4.2 Income Theory of Money

The income theory of money is also known as the income—expenditure theory of money or
the savings–investment theory of money. It was formulated and developed by economists like
Aftalian, Hawtrey, Schumpeter, Tooke, Wicksell, Robertson and J.M. Keynes to explain the
changes in the price level.
The income theory of money simply states that the changes in income and not the quantity
of money in circulation is responsible for the changes in the total demand. This theory explains
that the increase in income of the people will increase the total demand for the goods and
services. Therefore, the expenditure of the people will rise, leading to an increase in the price
level. On the other hand, a reduction in income of the people will reduce the total demand
for goods and services. Therefore, the expenditure of the people will fall, leading to a fall in
the price level. Hence, the changes in the aggregate expenditure of the economy bring about
the changes in the price level which, in turn, is determined by the changes in the level of
income. Thus, changes in the price level are caused by the changes in the level of income and
expenditure or by changes in the level of saving and investment of the economy as a whole.
4.2.1 Explanation of Income Theory of Money
The price of any commodity depends upon its demand and supply. When the demand for a
commodity rises with supply remaining constant, its price will rise. Similarly, when the demand
for a commodity falls with supply remaining constant, its price will fall. The demand for it
arises from the people who have ability and willingness to pay the price. Similarly, the price
level depends upon the total demand for and supply of all goods and services. The reason is
that, price is an average one for all goods.
When the total demand for goods and services rises with supply remaining the same, the
price level rises. Similarly, when the total demand for goods and services falls with supply
remaining the same, the price level falls. Thus it is said that, changes in prices do not depend
upon the changes in demand for and supply of money, but upon the changes in demand for
and supply of goods and services.
Total demand for goods and services depends upon the incomes of people. If the incomes
of the people rise, the total demand for all goods and services in the economy will also rise.
The reason is that the total incomes of the people determine the level of expenditure and, hence,
the total demand for all goods and services. So, the level of income determines the price level.
The level of total income depends upon the relationship between savings and investment.
Savings mean the excess of income over expenditure on consumption goods. Investment means
the creation of new capital assets like construction of new railway lines, buildings, factories,
etc. If both savings and investment are equal, there will be no change in the level of income
and, hence, in the total demand for goods and services. On the other hand, if the savings are
greater than the investment or the investment is greater than the savings, the incomes of people
will change and, hence, the total demand for goods and services will change. As a result, prices
may also change.
The equality between savings and investment brings about price stability and equilibrium
in the economy. On the contrary, any discrepancy between the levels of savings and investment
will disturb the equilibrium in the economy.
Equality of savings and investment (S = I)

Suppose people in a country earn an income of ` 200 crore per year from the production of
goods, i.e. ` 180 crore from the production of consumption goods and ` 20 crore from the
production of capital goods. Further, suppose that they spend ` 180 crore on consumption goods
and save ` 20 crore. Therefore, savings and investment are equal (i.e. ` 20 crore).
Excess of savings over investment (S > I)

Suppose people in the country decide to save more, say ` 40 crore per year instead of
` 20 crore. They will have fewer amounts to spend on consumption goods. That is, they now spend
` 160 crore instead of ` 180 crore in consumption goods. As a result, the demand for consumption
goods falls. The incomes of the producers of consumption goods also fall. Producers of these
goods will curtail production. Unemployment rises and incomes fall further. The demand or
consumption goods fall still further. As a result, investment falls even though savings rise. The
demand for capital goods falls.
Thus, the demand for both consumption goods and capital goods will fall at the same time.
This is on account of fall in the incomes of the people. This leads to a fall in the prices of
goods. This causes depression in the economy. This is due to fall in the incomes of the people
caused by excess of savings over investment.
Excess of investment over savings (S < I)

Suppose that business people decide to increase the investment from ` 20 crore to ` 40 crore
and savings remain the same at ` 20 crore. Further, suppose that banks grant loans to finance
this excess investment. Business people will place more orders for capital goods. As a result,
employment increases and incomes of the producers of capital goods increase. Producers of
consumption goods will also expand their output as the demand for their goods increases. They
will place more orders for machines and establish new units to increase the output. As a result,
employment increases still further. Incomes also increase leading to further increase in all goods.
Thus, an increase in the investment directly increases the demand for capital goods like
machines. This leads to an increase in the demand for consumption goods which, in turn,
increases the demand for investment increases still further.
The income theory of money thus states that the changes in the price level are due to the
changes in the incomes of the people rather than of the changes in the quantity of money.
Crowther aptly remarks that “the value of money, in fact, is a consequence of the total incomes
rather than of the quantity of money.”
Keynes’ contribution to savings and investment theory of money can be illustrated with
the help of Figure 4.3.
In the figure, the OY axis represents both savings and investment and the OX axis represents
income of the people. II1 is the investment function curve and SS1 is the savings function curve.
The SS1 curve cuts the II1 curve from below indicating that there is a stable equilibrium at
point E (i.e. saving equals investment.)
When the income is ON2, the investment exceeds the savings by I2S2. This results in rising
income until it reaches the equilibriumlevel of income, at which savings and investment are equal.
On the other hand, at income ON1 savings exceed investment. This results in decreasing
income until it reaches the equilibrium level of income. Thus according to J.M. Keynes, the
equality of savings and investment is being brought about through the mechanism of equilibrating
income.
Figure 4.3 Illustration of savings–investment theory of money.
4.2.2 Propositions of Income Theory of Money
The following are the major propositions of the income theory of money:
• The term ‘income’ refers to both money income and real income.
• The income theory represents an analysis of total demand and total income.
• There is an equality between the total income and the total expenditure of the community.
• This theory involves on the one side, an analysis of income and expenditure and on the
other side, an analysis of cost and total supply.
In this theory, the value of money depends upon the relationship between the flow of money
income on the one side and the flow of real income on the other.
In this theory, money income generated in a period is equal to the money value of goods
produced during that year.
4.2.3 Superiority of Income Theory of Money over Quantity

Theory of Money
The income theory of money or savings and investment theory of money is regarded as superior
to the quantity theory of money in many respects. Crowther rightly said that the income theory
explains many things about the behaviours of money that the quantity theory of money cannot.
• The income theory of money explains changes in prices, output and employment during
a short period of time, whereas the quantity theory of money explains changes in prices
over a long period of time. But it cannot explain changes during the short period except
the war period.
• The income theory of money integrates general theory of value with monetary theory.
The income theory of money states that the price level depends on the total demand
for and the total supply of goods. According to the quantity theory of money, the price
level depends only on the quantity of money in circulation. But by the general theory
of value, the price of a commodity depends on its demand and supply. Thus, the income
theory of money integrates the general theory of value with the monetary theory.
• The income theory of money explains why shortage of money can stop a boom but plenty
of money cannot start a recovery. But quantity theory of money does not explain this.
• The income theory explains the cause of changes in the velocity of circulation. But
the quantity theory of money does not explain why the velocity of circulation changes
alternatively.
• The income theory explains changes in prices under all levels of employment. But the
quantity theory of money is true under the conditions of full employment.
• The income theory of money explains the value of money which is determined by the
combined effects of the monetary and real factors. But the quantity theory explains the
value of money as determined by monetary factors only.
4.2.4 Shortcomings of Income Theory of Money
The following are the shortcomings of the income theory of money:

• This theory does not consider determination of price as an isolated phenomenon.
• It does not explain the mechanism of adjustment between savings and investment.
• It is relevant for short period only.
• It is too general and is not a perfect guide to the study of actual price changes.
Thus, Crowther rightly remarks that “the quantity theory of money explains, as it were,
the average level of the sea; the savings and investment theory explains the violence of tides.”
4.3 Keynesian Theory of Money and Prices

In Chapter 12 of the book ‘General Theory of Employment, Interest and Money’ (1936), John
Maynard Keynes has presented his theory of money and prices. He integrated the theory of
money with the theory of prices and reformulated the quantity theory of money as the theory
of money and prices.
The old quantity theory of money emphasized the causal relationship between the quantity
of money and the general price level. This relationship was such that an increase in the quantity
of money was associated with a proportionate rise in the level of prices and a decrease in the
quantity of money was associated with a proportionate fall in the level of prices. Thus without
integrating the theory of money with the theory of prices, it was unsound to say that changes
in the quantity of money could influence the general price level in the economy.
4.3.1 Statement of Keynesian Theory of Money and Prices
J.M. Keynes states that the effect of changes in the quantity of money on the general price
level is not direct. He believes that changes in the quantity of money bring about changes in
the general price level (value of money) indirectly by affecting the rate of interest, the level
of investment, employment, output, income and cost of production.
Keynesian theory of money and prices focuses that prices are determined primarily by the
cost of production. The initial impact of changes in the quantity of money is on the rate of
interest rather than on the prices.
4.3.2 Explanation of Keynesian Theory of Money and Prices
The general level of prices is affected not directly but indirectly through a long chain of
causation. This long chain of causation between the changes in the quantity of money and the
changes in the general price levels is shown in the following chart:
Changes in the Quantity of Money (DM)

Changes in the rate of interest (DR)

Changes in investment (DI)

Changes in employment (DE)

Changes in output (DO)

Changes in income (DY)

Changes in cost production (DC)

Changes in prices (DP)
An increase in the quantity of money has its impact upon the rate of interest by lowering
it. When the rate of interest falls, there is an increase in the level of investment, employment,
output and income. As employment, output and income begin to rise as a result of an increase
in the quantity of money (by lowering the rate of interest), prices also begin to rise due to
other factors such as the cost of production, operation of the law of diminishing returns in
production in the short period, bottlenecks in production, etc.
4.3.3 Illustration of Keynesian Theory of Money and Prices
Keynes’ views on money and prices can be illustrated with the help of Figure 4.4.
In the left-hand side figure, when the quantity of money increases from O to QM, the output
rises to OM. At this point, full employment is reached. After the point of full employment, a
further increase in the quantity of money would lead to a proportionate rise in the price level.
The FP price line depicts the rise of the price level in response to the increase of quantity of
money.
Figure 4.4 Illustration of Keynesian theory of money and prices.
Keynesian theory of money and prices integrates the theory of money with the theory of
value. According to the theory of value, the price of any commodity is determined by the
demand for and the supply of it.
Keynes also integrates the theory of money with the theory of output. According to the
theory of output, changes in the quantity of money cause changes in the total output only
through the changes in the rate of interest. As the output changes, the costs of production
change and prices are also affected.
Keynes has reformulated the quantity theory of money by integrating the theory of prices
with the general theory of value and output.
Alvin H. Hansen in his Monetary Theory and Fiscal Policy has said that “the theory
of money and prices is an analysis of the relation of changes in the quantity of money and
changes in prices with a view to determining the elasticity of prices in response to changes in
the quantity of money.”
4.3.4 Superiority of Keynesian Theory of Money and Prices
Keynesian theory of money and prices is superior to the old quantity theory of money on the
following grounds:
• The old quantity theory of money is based on the assumption of full employment.
Under full employment, all increases in the quantity of money tend to be inflationary.
But Keynesian theory of money and prices is based on the assumption of less than full
employment or underemployment.
• Keynesian theory of money and prices is a practical guide to formulate monetary and
other financial policies than the old quantity theory of money.
• Keynesian, theory of money and prices, enables us to distinguish between inflationary
and non-inflationary expansion of money supply in an economy.
• Keynes in his theory of money and prices shows that the quantity of money exerts its
influence on the rate of interest and through it on aggregate demand for investment,
employment and output. The old quantity theory of money missed the above point.
• Keynes integrates the theory of money and prices with the theory of output. Only through
the theory of output, the theories of value and money are brought into juxtaposition with
each other.
• Keynes integrates the theory of money and prices with the theory of value. The theory
of value shows that the price of a commodity is determined by its demand and supply.
Keynes emphasizes the concepts of cost of production, elasticity of demand and elasticity
of supply which are very important in his theory of value.
• Keynes shows that prices are influenced not directly but indirectly through the rate
of interest, whereas the old quantity theory of money stresses that prices are directly
influenced by the quantity of money.
4.3.5 Shortcomings/Criticisms of Keynesian Theory of Money

and Prices
Keynesian theory of money and prices has the following shortcomings:

• It does not explain why prices rise even before full employment is reached.
• It fails to offer a complete explanation of the problem in hand.
• It is too general and difficult to study the actual price changes.
• It is merely a theory of changes in a statistical average of prices.
• If, the two determinants of effective demand, the marginal efficiency of capital and the
propensity of consume remain constant, the whole chain of cauzation may not work at
all.
4.4 Milton Friedman’s Quantity Theory of Money

(Chicago Version of Quantity Theory of Money)
Professor Milton Friedman was associated with the Chicago School of Economics. He formulated
his own version of the quantity theory of money known as the modern quantity theory of money
in the year 1956. He was awarded Nobel Prize for Economics in 1976.
Friedman is of the view that quantity theory is primarily a theory of demand for money.
This is not a theory of output or income, or prices. He emphasizes that money is an asset and
is regarded as one way of holding wealth.
Friedman classified the holders of money into two groups, namely. ‘wealth holders’ and
‘business enterprises.’ Friedman argues that the demand for money by wealth holders is a
function of variables such as money income price level, rate of return on money, bonds and
equities, rate of changes in the prices of goods, ratio of non-human to human wealth and utility
of money (i.e. tastes and preferences of the wealth holders.)
Friedman’s demand for money by wealth holders is symbolically summed up and presented
in the form of a function as:
M = f(Y, P, rm, rb, re, DP/P, H, u)
where
M = total demand for money
Y = money income available to the wealth holders
P = general price level
rm = expected rate of return on money

rb = expected rate of return on bonds, including expected changes in their prices
re = expected rate of return on equities, including expected changes in their prices
DP/P = expected rate of changes in the prices of goods or expected rate of return on real
assets
H = Ratio of non-human to human wealth
u = Variables other than income may affect the utility of money (i.e. tastes and preferences
of the wealth holders)
Friedman considers five different forms in which wealth can be held. They include money,
bonds, equities, physical capital (non-human goods) and human capital. According to Friedman,
the demand for money by wealth holders depends on the volume of total wealth and the rates
of return on different assets in which wealth is held. Let us now explain the variables relating
to Friedman’s modern quantity theory of money.
Income (Y)/Wealth (W)

Friedman begins with the broad concept of wealth comprising all sources of income including
human beings. He relates the demand for money to the total wealth comprising both human
wealth and non-human wealth. Human wealth is nothing but human capital, whereas non-human
wealth is a fraction of income derived from property.
Income may serve as an index of wealth. Friedman elaborated the concept of ‘permanent
income’ in his analysis because it is more stable than the observed income of national accounts.
He argues that as wealth rises, permanent income will rise which, in turn, will increase the
demand for money. Permanent income is thus the weighted average of the past incomes which
are expected to be continued.
Price level (P)

According to Friedman, the demand for money varies directly and proportionately with the changes
in the general price level. As the price level goes up, the demand for money proportionately
goes up and vice versa. He agrees with the earlier quantity theory of money in this regard.
Rate of return on money, bonds and equities (rm, rb, re)

The expected rate of return on money (rm), bonds (rb) and equities (re) influences the demand
for money. The nominal rate of return on money consists of the rate of interest earned by the
wealth holders. The nominal rate of return on bonds consists of the interest earned by the
wealth holders. The nominal rate of return on equities consists of the rate of dividend earned
by the wealth holders.
Rate of changes in prices of goods (DP/P)

The expected rate of return on real assets is otherwise termed the rate of changes in the prices
of goods. The expected rate of changes in the prices of goods also influences significantly the
demand for money. When the rate of change in the prices of goods is expected to be high, the
purchasing power of money rapidly goes down. Therefore, less money is demanded. But if the
rate of changes in the prices of goods is low, the purchasing power of money will increase.
Therefore, more money is demanded. Thus, there is an inverse relationship between the rate
of change in the prices of goods and the demand for money in the economy.
Ratio of non-human to human wealth (H)

Human wealth is nothing but human beings who earn income from all sources. Non-human
wealth is a fraction of income derived from property. The ratio of non-human wealth to human
wealth highly influences the demand for money.
Friedman relates the demand for money to the total wealth comprising both human wealth
and non-human wealth. Human wealth is also referred to as human capital.
4.4.1 Critical Appraisal of Friedman’s Quantity Theory of Money
The following are the points of criticism levelled against Milton Friedman’s quantity theory
of money:
• Friedman has not taken account of the role of ‘non-banking financial intermediaries’
influencing the demand for money.
• Friedman in his theory has neglected the transaction demand for money.
• Friedman’s theory is a timeless static analysis.
• In this theory, the rate of interest does not play any role, but it has only a negligible
effect as a determinant of the demand for money.
• In his theory, Friedman has used income to represent a wealth variable. This has created
some minor confusion of stock and flow concepts in the writings of Chicago monetary
economists.
• In his theory, Friedman says that permanent income has to be calculated from the past
income leading to expected income. Such a calculation is a problem.
• Friedman’s theory is a partial equilibrium analysis depending only on the monetary sector.
• This theory says that the demand for money increases more rapidly than income. He
says that money is treated as a ‘luxury good,’ which is highly misleading.
However, Friedman has given a new dimension to the analysis demand for money and his
theory of money has some basic features which are given below:
• Friedman in his theory introduced the basic principle of capital theory. He said that
income is the yield on capital and capital is the present value of income.
• He gave special emphasis to human wealth which was neglected earlier.
• Friedman’s permanent income concept is a novel feature. He said that the demand for
money is largely a function of permanent income.
• He has used a new concept of money as the temporary abode of purchasing power. He
said that money is equivalent to currency plus demand deposits plus savings and time
deposits.
• He has formulated a ‘monetary rule,’ i.e. money supply should grow at the rate at which
the economy is growing. This will maintain price stability.
• Friedman says that people hold one stock of money, but not two balances, namely idle
and active balances. He considers different types of assets, but not of bond or cash alone.
4.5 Don Patinkin’s Real Balance Effect: An Integration

of Monetary and Value Theories
The term ‘real balance effect’ was coined by Don Patinkin. It is an important discovery in
monetary economics.
Real balance effect means the real purchasing power of the stock of cash balances held
by the public. When the price level changes, it affects the purchasing power of people’s cash
balances which, in turn, affects the supply of and demand for goods. This is ‘real balance
effect.’ It affects both monetary and real sectors. It is a part of dynamic analysis. Real balance
effect is the combination of both ‘Pigou Effect’ and ‘Keynes Effect.’
Pigou effect indicates permanent changes in the consumption–saving ratio. It is the effect
of wage–price reduction on consumption, stock of money (outside money) being constant and
given. It affects only the real sector. It is a part of static analysis.
Keynes’ effect shows that when the real value of cash balance increases owing to wage–
price reduction, smaller transaction balances are required. This creates higher demand for
securities. As a result, security prices rise and the rate of interest falls at each level of income.
Don Patinkin has used the concept of real balance effect to integrate the monetary sector
and real sector and also to rehabilitate the classical quantity theory of money.
The classical quantity theory of money maintains a dichotomy between the monetary sector
and the real sector. It assumes that money is neutral and has no influence on output which
is governed by real factors like labour, capital and technology. An increase in money supply
raises the ‘absolute’ price level without affecting ‘relative’ prices which are determined in the
real sector.
Patinkin rejected the classical dichotomy between the monetary sector and the real sector
in his book Money, Interest and Prices published in 1965. He argues that this dichotomy is
neither necessary nor valid. According to him, an increase in the quantity of money first of all
influences the demand for goods and their relative prices through real balance effect and then
the absolute price level. Thus, Don Patinkin has attempted to integrate the monetary sector
with the real sector through the real balance effect.
4.5.1 Assumptions of Patinkin’s Real Balance Effect
Don Patinkin’s real balance effect is based on the classical assumption that money is neutral.
It means that Patinkin’s real balance effect assumes that
• all prices are flexible
• expectations are unit-elastic
• no existence of distribution effect
• no existence of money illusion
Moreover, Patinkin’s real balance effect also assumes that ‘all money is outside variety
and no government debt exists.’ In Don Patinkin’s theory, introducing ‘real balance’ variable
in the real sector, implies that
• consumption and investment expenditure of the people are influenced not and just by the
current real income alone, but also by the real value of cash balances that they hold.
• the transactions and precautionary demand for money depend not only just on the current
real income, but also on the real value of the stock of liquid assets.
• the liquidity preference affects the total demand for goods not just through investment
via rate of interest but also through consumption.
• the real income is not determined independently of changes in money wages and prices.
Patinkin’s model
In Patinkin’s general equilibrium model, there are three markets, viz. commodity market, labour
market and money market.
The equilibrium values of the variables of the real sector can be determined when we
integrate the real sector with the money sector. In the words of Don Patinkin, “once the real
and monetary data of an economy with outside money are specified, the equilibrium values of
relative prices, the rate of interest, and the absolute price level are simultaneously determined
by all the markets of the economy.”
According to Patinkin, if the price level rises, the real balances (or the purchasing power)
of the people reduce. This will result in low expenditure and a fall in the demand for goods,
and also a fall in wages and prices. As wages and prices fall, the real balance effect tends to
increase demand for goods directly and indirectly through the rate of interest. With this fall
in wages and prices, the full employment level of output and income will be restored. This is
represented in Figure 4.5.
Figure 4.5 Patinkin’s model.
In the figure, the OX axis represents the income, the OY axis represents the rate of interest,
the LM curve represents the money market, and, the IS curve represents the commodity market.
An economy is in equilibrium at OM1 level of income when LM and IS curves intersect
at point P where the rate of interest is Or1. Assuming OMF as the full employment level, the
pressure of unemployment causes a fall in wages and prices. This results in an increase in the
real balances of the people, which shifts the LM curve to the right to LM . It intersects the LS
curve at point Q, resulting into the income level of OM2 and a fall in the rate of interest to
Or2. This encourages investment, discourages savings and increases consumption. There is still
unemployment in the economy. This leads to further fall in wages and prices. As a result, there
is an increase in demand for goods. The IS curve is shifted to the right to IS  which intersects
LM  at point R. This will result in full employment level OMF. This shows that money is neutral
and the rate of interest is independent of the quantity of money through the real balance effect.
Patinkin’s real balance effect has its own validity. He used the real balance effect not only
to integrate the monetary sector and the real sector, but also to validate the quantity theory
of money. The quantity theory of money rests on the condition of neutrality of money which
means that changes in the quantity of money will influence the absolute price level and leave
the relative prices and real variables unaffected. This requires the separation of the monetary
sector from the real sector. Patinkin rehabilitated the quantity theory of money by making the
demand for goods is a function of real balances held by the people. The real balance effect
implies that people do not suffer from money illusion. They are interested only in the real
value of their money balances. They hold money for ‘what it will buy.’ It means that doubling
of the quantity of money will lead to a doubling of the price level, but the relative prices and
the real balances will remain constant and the equilibrium of the economy will not be changed.
Patinkin’s real balance effect highlights three important points which are as follows:
• It eliminates the classical dichotomy between the monetary theory and the value theory
and it integrates both.
• It validates the conclusions of the quantity theory of money.
• The wage–price flexibility leads to full employment in the long run.
4.5.2 Criticisms of Patinkin’s Real Balance Effect
Don Patinkin’s real balance effect has been criticised on the following grounds:
• It is conceptually inadequate in the sense that it works as a short-term phenomenon, but
not works as a long-term one.
• It fails to analyse the manner in which monetary wealth is increased.
• It is required to ensure the stability of the price level and not to determine the real
equilibrium of the system.
4.6 Liquidity Theory of Money

Liquidity theory of money is a new approach to the quantity theory of money. The main
proponents of this theory are Sayers, Schmolder, Gurley and Shaw. According to this theory,
“liquidity is a property of an asset.” It means that the extent to which assets consist of money.
This theory is concerned with the role of liquid assets on money supply and economic activity.
In a broad sense, ‘liquidity’ means “moneyness.” Money is a highly and perfectly liquid
instrument. Money supply includes commercial banks’ demand deposits plus currency in
circulation. All other liquid assets constitute near moneys. Near moneys include time deposits,
shares, securities, bonds, etc. Near moneys are close substitutes for money. They are those
assets which are highly liquid, but not perfectly liquid.
In a narrow sense, liquidity is the degree to which all assets are marketable. An asset is fully
liquid if it can be converted into cash without any loss of value. The banking sector creates
liquidity, but a great deal of liquidity is created outside the banking sector. The non-banking
financial intermediaries provide liquid assets in exchange for short-term and long-term claims.
They provide important near moneys which can compete with money assets.
The monetary policy of the central banks should aim at influencing the total volume of
liquidity in the economy. This policy should include both banking and non-banking financial
intermediaries. This policy has to regulate the general liquidity position of the entire economy.
The two different approaches of the liquidity theory of money are:
1. Radcliffe–Sayers thesis
2. Gurley–Shaw thesis
4.6.1 Radcliffe–Sayers Thesis
The Radcliffe–Sayers Thesis points out that the supply of money is not the main level of
monetary action. The object of monetary action is to influence the level of aggregate demand
by influencing the spending decision of the people. It is of no doubt that the supply of money
is important in the spending decision of the people, but this alone does not influence it. The
spending decisions are also influenced by the degree of liquidity of assets and the liquidity
position of the financial institutions. Thus the decision to spend is influenced by the liquidity
position of the spenders.
According to this thesis, liquidity implies the general liquidity of the entire economy. The
general liquidity is the aggregate liquidity of the private individuals, non-banking financial
intermediaries and the government. The spending decision depends more on the general liquidity
of the whole economy rather than on money supply alone. Money supply is only a part of the
wider liquidity structure of the whole economy. Since the rate of interest affects the liquidity
of various financial institutions, the rate of interest may be regarded as n important influencing
factor. However, the rate of interest plays only a minor role.
According to the Radcliffe Committee, the lending capacity of the financial institutions
could be indirectly controlled through changes in the level and structure of the rate of interest.
An increase in the rate of interest will reduce the lending activities of the financial institutions
by increasing capital losses from the assets held by them. Thus, increase in the rate of interest
reduces the aggregate spending indirectly by reducing the lending capacity of the financial
institutions and the liquidity position of the general public.
Radcliffe–Sayers thesis suggested the following policy instruments for the suitable monetary
action in the economy:
(i) Imposition of ‘liquidity control’ over a wide range of financial institutions.
(ii) ‘Control’ through the exercise of liquidity or changes in the rate of interest.
The imposition of liquidity control policy is difficult to administer because most of the
financial intermediaries other than commercial banks are outside the purview of the central
bank’s regulation and control. Even if such intermediaries are brought under the purview of the
central bank, there is always the possibility of the emergence of new financial bodies outside
the central bank’s control. Professor Sayers observes that as the control weapons are improved
and extended to the existing non-banking financial intermediaries, newer and newer varieties
of such intermediaries will come up and there would be no end to the process of improving
and extending the scope of the monetary policy.
The control through the exercise of liquidity or changes in the rate of interest policy is
also not practicable because it is more likely to result in severe changes in the financial sector.
As a result, Radcliffe–Sayers thesis has no alternative except to regard monetary policy as
subordinate to fiscal policy in normal situations. Monetary policy can be used only during the
period of hyper-inflation. The Radcliffe Committee recommended that a register of non-banking
financial intermediaries may be compiled and the powers of the central bank may be suitably
extended to control such financial intermediaries.
Criticisms of Radcliffe–Sayers Thesis

Radcliffe–Sayers thesis has been criticized on the following grounds:
• The concept of liquidity is a wide one. It has not been defined satisfactorily and its
relation to spending behaviour has not been properly explained.
• Professor Gurley, in his re-examination of the Radcliffe Committee Report, found
‘confusion everywhere in the role of supply of money, the concept of liquidity and in
money to gratify the liquidity earning of the public.’
• The Radcliffe Committee Report denied the significance of money as a means of payment.
• Professor Hawtrey criticized the view of the Radcliffe Committee that interest rates are
not important for investment, demand and economic activity.
• It is possible to explain the demand for money without the use of alternative assets.
• The observation that monetary policy should control not the supply of money but the
liquidity has been severely criticized.
4.6.2 Gurley–Shaw Thesis
Gurley–Shaw Thesis points out that all categories of financial institutions (commercial banks and
non-banking financial intermediaries) can create credit or loanable funds. According to Gurley
and Shaw, monetary policy should recognize the role of financial intermediaries. Monetary
theory becomes more realistic and broad-based when the whole financial structure is taken into
consideration and the role of non-banking financial institutions is recognized.
A narrow-based monetary policy aiming at controlling simply the money supply in terms
of currency with the public and demand deposits cannot be fully effective. A broad-based
monetary policy means the central bank’s control over the non-banking financial institutions.
Gurley and Shaw thesis wanted to make monetary policy wider in scope as against Radcliffe–
Sayers thesis which recognized monetary policy as a subordinate role only in an emergency
or hyper–inflation period.
Gurley–Shaw thesis pinpointed the importance of non-banking financial institutions. They
generate credit varied from commercial banks. But they generate new assets and liabilities
which are likely to overpower the money supply and, thus, hinder the operation of an effectual
fiscal policy.
Gurley and Shaw believe that the present methods of credit control discriminate against
banks in their competition with the non-banking financial institutions. This discrimination
weakens the effectiveness of monetary policy in the long run. The non-banking financial
institutions are growing at a more rapid pace than banks. They produce a destabilizing effect
on the economy, violate monetary and credit policy, engage in multiple credit creation and
compete with the banks.
Gurley and Shaw recognize the potential threat from the growth of non-banking financial
institutions to monetary policy. The introduction of such financial institutions with a financial
asset which is a close substitute for money increases the interest elasticity of demand for money
and thereby impairs the effectiveness of monetary policy.
The whole financial structure must be taken into consideration if the monetary policy is to be
more effective. The non-banking financial institutions create more and more near money assets
and thereby affect the overall liquidity position. Therefore, it is necessary to extend the regulatory
power of the monetary authority to the non-banking financial institutions in the economy.
Gurley and Shaw argue that the central bank’s control over non-banking financial institutions
must be comprehensive for an effective fiscal strategy. This is for the reason that the non-
banking financial institutions generate more near funds assets or quick assets and, thus, afflict
the overall liquidity which, in turn, over power total demand and fiscal performance.
Criticisms of Gurley–Shaw Thesis

Gurley–Shaw thesis has also been criticised on the following grounds:
• Professor Johnson observes that there seems to be no pragmatic case for making the
central bank powerful to lengthen its control over financial intermediaries.
• There is a little ground for assuming that the central bank’s control is destabilized by
the occurrence of financial intermediaries.
• It is not feasible for the rates of interest to settle bank at their old levels even by the
functioning of non-banking financial institutions.
• The manipulation of the supply of money on outlay would be provisional.
• The rapid growth of non-banking financial institutions has helped to strengthen the
efficiency of fiscal strategy than destabilizing it.
• Gurley and Shaw do not detail how the non-banking financial institutions should be
effectively controlled.
4.6.3 Tobin’s Portfolio–Selection Theory
James Tobin, an American economist, propounded a theory called ‘tobin’s portfolio-selection

theory. In this theory, he argued that investors with safer ones so as to achieve a balance in
their portfolios. Tobin’s insights helped to pave the way for further work in finance theory.
Tobin received the 1981 Nobel Prize in Economics for his analysis of “financial markets
and their relations to expenditure decisions, employment, production and prices.” Many people
regard Tobin as America’s most distinguished Keynesian economist. Tobin’s most important
work was on financial markets. He developed theories to explain how financial markets affect
people’s consumption and investment decisions.
Tobin argued that one cannot predict the effect of monetary policy on output and
unemployment simply by knowing the interest rate or the rate of growth of money supply.
He claimed that monetary policy has its effect by affecting capital investment, whether in
plant and equipment or in consumer durables. Although interest rates are an important factor
in capital investment, they are not the only factor. Tobin introduced the concept of “Tobin’s
q” as a measure to predict whether capital investment will increase or decrease. The q is the
ratio between the market value of an asset and its replacement cost. Tobin pointed out that if
an asset’s q is less than one, i.e. the asset’s value is less than its replacement cost, then new
investment in similar assets is not profitable. On the other hand, if q exceeds one, this is a
signal for further investment in similar assets. Tobin’s insight was also relevant to his ongoing
debate with Milton Friedman and other monetarists. Tobin argued that his q, by predicting
future capital investment, would be a good predictor of economy—wide economic conditions.
Tobin’s portfolio-selection theory is another of his contributions.

1. The relationship between the quantity of money and the value of money is
(a) direct (b) inverse
(c) vertical (d) horizontal
2. Who states the quantity theory of money as “a change in the quantity of money must
cause a proportionate and direct change in the price level”?
(a) Irving Fisher (b) King Fisher
(c) Von Fisher (d) Edward Fisher
3. Modern writers state the quantity theory of money as the value of money is determined
by
(a) demand of money (b) supply of money
(c) demand for and supply of money (d) none of the above
4. The cash transactions approach to the quantity theory of money was developed by
(a) Irving Fisher (b) Robertson
(c) Marshall (d) Keynes
5. The cash balances approach to the quantity theory of money was developed by
(a) A.C. Pigou (b) Robertson
(c) Marshall (d) Keynes
(e) All of the above
6. The equation of exchange P = MV/T is given by
(a) Irving Fisher (b) Robertson
(c) Pigou (d) Marshall
7. According to the cash balances approach to the quantity theory of money, the value of
money depends upon
(c) demand for and supply of money (d) none of the above
8. Marshall’s cash balance equation is defined as
(a) P = KY/M (b) P = KM/Y
(c) P = KR/M (d) P = M/KR
9. Pigou’s cash balance equation is defined as
(a) P = KR/M (b) P = M/KR
(c) P = KY/M (d) P = M/KY
10. Robertson’s cash balance equation is defined as
(a) P = M/KT (b) P = KT/M
(c) P = KY/M (d) P = M/KY
11. Keynes’ cash balance equation is defined as
(a) P = n/K (b) P = K/n
(c) P = K/r (d) P = r/K
12. The velocity of circulation of money in the cash transaction approach to the quantity
theory of money is defined as
(a) V = 1/K (b) V = K/n
(c) V = n/K (d) V = 1/n
13. The income theory of money explains the changes in prices
(a) during a very short period of time (b) during a short period of time
(c) over a long period of time (d) over a very long period of time
14. The quantity theory of money explains the changes in prices
(a) during a short period of time (b) during a very short period of time
(c) over a long period of time (d) over a very long period of time
15. Who integrated the theory of money with the theory of prices or value and reformulated
the theory of money and prices?
(a) J.M. Keynes (b) J.R. Hick
(c) J.B. Say (d) T.R. Malthus
16. The modern quantity theory of money was formulated in 1956 by
(a) Irving Fisher (b) Paul A. Samuelson
(c) Milton Friedman (d) Simon Kuznuts
17. Who is of the view that the quantity theory is primarily a theory of demand for money?
(a) Paul A. Samuelson (b) Simon Kuznuts
(c) Milton Friedman (d) J.R. Hicks
18. The term ‘real balance effect’ was coined by
(a) Don Patinkin (b) J.M. Keynes
(c) Milton Friedman (d) Paul S. Samuelson
19. Don Patinkin’s real balance effect is the integration of both
(a) monetary sector and real sector (b) primary sector and secondary sector
(c) monetary sector and fiscal sector (d) Private sector and public sector
20. Real balance effect is the combination of both
(a) Pigou effect and Keynes effect (b) Pigou effect and Fisher effect
(c) Robertson effect and Keynes effect (d) Marshall effect and Pigou effect
21. Patinkin’s general equilibrium model is of the following markets

(a) Commodity market (b) Labour market
(c) Money market (d) All of the above
22. According to which theory of money, ‘liquidity is a property of an asset’?
(a) Quantity theory of money (b) Liquidity theory of money
(c) Income theory of money (d) Theory of money and prices
23. The liquidity theory of money is of the following approaches:
(a) Radcliffe–Sayers thesis (b) Critical minimum effect thesis
(c) Gurley and Shaw thesis (d) Both (a) and (c)
24. The Portfolio-selection theory was propounded by
(a) James Tobin (b) Don Patinkin
(c) Milton Friedman (d) Gurley and Shaw
25. James Tobin was awarded Nobel Prize in Economics in the year 1981 for his analysis
of
(a) financial markets (b) products markets
(c) factor markets (d) all of the above
26. Which of the following is not considered as wealth in Milton Friedman’s modern quantity
theory of money?
(a) Money (b) Bonds
(c) Human wealth (d) Real estate
27. In Fisher’s equation of exchange P = (MV + M V)/T, which element is not assumed to
be constant?
(a) M (b) P
(c) V (d) T
Answers
1. (b) 2. (a) 3. (c) 4. (a) 5. (e)

6. (a) 7. (c) 8. (a) 9. (a) 10. (a)
11. (a) 12. (a) 13. (b) 14. (c) 15. (a)
16. (c) 17. (c) 18. (a) 19. (a) 20. (a)
21. (d) 22. (b) 23. (d) 24. (a) 25. (a)
26. (d) 27. (a)
Review Questions
1. State the quantity theory of money.
2. Critically examine the cash transaction approach to the quantity theory of money.
3. Explain the cash balance approach to the quantity theory of money.
4. State and explain Fisher’s quantity theory of money.
5. Compare cash transaction approach and cash balance approach to the quantity theory of
money.
6. Bring out the superiority of cash balances approach over the cash transaction approach
to the quantity theory of money.
7. State and explain income theory of money or savings and investment theory of money.
8. Bring out the main propositions of the income theory of money.
9. In what way the income theory of money is superior over the quantity theory of money.
10. State and explain Keynesian theory of money and prices.
11. Bring out the superiority of Keynesian theory of money and prices over the old quantity
theories of money.
12. State and explain Milton Friedman’s quantity theory of money.
13. What are the basic features of Friedman’s quantity theory of money?
14. Explain in detail Don Patinkin’s real balance effect.
15. State and explain Radcliffe–Sayers thesis as an approach to liquidity theory of money.
16. State and explain Gurley–Shaw thesis as an approach to liquidity theory of money.
17. State and explain Tobin’s portfolio-selection theory.
Chapter 5
Analysis of Interest Rates
5.1 Introduction
Interest rates are the rates at which banks and other lenders will lend money to people. One
of the influences on interest rate decision is price stability. Inflation is a steady increase in
the prices of goods and services. It is generally accepted that moderate inflation comes with
economic growth.
In an effort to keep inflation at a comfortable level, central banks will most likely increase
interest rates. Setting high interest rates normally forces consumers and businessmen to borrow
less and save more, putting a damper on economic activity. On the other hand, when the interest
rates are decreasing, the consumers and businessmen are more inclined to borrow, boosting
retail and capital spending, thus helping the economy to grow.
When people talk of interest rates, they are either referring to the nominal interest rate or
the real interest rate. The nominal interest rate is the rate of interest before adjustments for
inflation. The real interest rate is calculated as:
Real interest rate = Nominal interest rate – expected inflation
5.2 Meaning of Interest

In an ordinary sense, interest is a payment made by a borrower to the lender for the money
borrowed. But in Economics, interest has been defined as the payment for the use of capital.
As Carver said: “interest is the income which goes to the owner of capital.”
5.3 Classification of Interest

Interest is classified into net interest and gross interest. Net interest is the price paid for the use
of capital without any allowance for risk or any other factor, whereas gross interest includes
net interest plus reward for risk, remuneration for inconvenience, and payment for services.
102
Analysis of Interest Rates 103
Interest rate is bifurcated into short-term rate of interest and long-term rate of interest.
Short-term rate of interest is determined by the volume of transactions and the supply of money,
whereas long-term rate of interest is determined by the anticipations of short-term rates. Bumper
harvest in agriculture and political instability may influence the short-term rates.
Rate of interest is also classified into natural rate of interest and market rate of interest.
natural rate of interest is that rate which equates the saving and investment, whereas market
rate of interest is that rate which equates the supply of money and the demand for money.
Wicksell was the first economist who discusses in detail the natural rate of interest and the
market rate of interest.
Rate of interest is further classified into real rate of interest and money rate of interest.
Real rate of interest refers to the percentage rate paid on borrowed money after making an
adjustment for changes in the price level, whereas money rate of interest refers to the real rate
of interest plus the rate of changes in the price level.
5.4 Theories of Interest

There are many theories of interest. In the analysis of interest rates, let us discuss the classical,
neo-classical, Keynesian and modern theories of interest.
5.4.1 Classical Theory of Interest
The classical theory of interest was propounded by economists like Nassau Senior, Alfred
Marshall. Irving Fisher, J.B. Say and J.M. Clark. This theory is also known as the saving and
investment theory of interest.
According to this theory, the rate of interest is determined by the supply of capital which
depends upon the savings and demand for capital for investment. The supply of capital is
governed by the time preference, whereas the demand for capital is governed by the expected
productivity of capital. The demand for capital consists of the demand for productive and
consumptive purpose. Ignoring the latter, capital is demanded by the investors because it is
productive. The supply of capital depends upon the savings rather upon the will to serve and
the power to save of the commodity.
The classical economists believed that the rate interest is really the equilibrating mechanism
which brings about equality between saving and investment. If there is any disequilibrium
between saving and investment, it is corrected by the rate of interest. For example, if saving is
higher than investment, more people would be prepared to lend out the money. These would be
more of supply of money. Thus the rate of interest will come down to the level of equilibrium
rate of interest. Similarly, if investment is higher than saving, the demand for capital would be
higher than the supply of capital. Thus the rate of interest will rise to the level of equilibrium
rate of interest.
The classical theory of interest can be explained with the help of Figure 5.1.
In the figure, the OX axis represents the demand for and supply of capital. The OY axis
represents the rate of interest. E is the point of equilibrium at which OM quantity of capital
is demanded and supplied at OR rate of interest. If the rate of interest rises from OR to OR,
Figure 5.1 Explanation of classical theory of interest.
the demand for capital will be longer than the supply of capital. Since the supply of capital
is more than the demand for capital (Rs > Rd), the rate of interest will come down to the
equilibrium level OR. On the other hand, if the rate of interest falls from OR to OR, the
demand for capital will be higher than the supply of capital. Since the demand for capital is
more than the supply of capital (Rd > Rs), the rate of interest will rise to the equilibrium
level OR, thus the equality between saving and investment brought about by the equilibrium
or the natural rate of interest.
The classical theory of interest has been criticized on the following grounds:
• Keynes is of the view that income is not a constant but a variable which brings about
the equality between saving and investment.
• It neglects the effect of investment on the level of income and saving.
• It is an indeterminate theory.
• It remains an incomplete theory when it neglects except income other sources of savings.
• It is based on the unrealistic assumption of full employment.
• It is a pure theory of interest which takes into account of real factors, but neglects
monetary factors.
• There is no automatic mechanism for the equality of the market rate of interest and the
natural rate of interest.
• It ignores the store of value function of money.
• It ignores the effect of quantity of money on the rate of interest.
5.4.2 Neo-classical Theory of Interest
The neo-classical theory of interest was propounded by Bertil Ohlin, D.H. Robertson,
A.C. Pigou and K. Wicksell. This theory was also known as the loanable fund theory of interest.
According to this theory, the interest is determined by the demand for loanable funds and
the supply of loanable funds.
Demand for loanable funds
The demand for loanable funds is mainly for three purposes: investment (I), hoarding (H) and
consumption (C) or dissaving (DS).
The demand for loanable funds for the purpose of investment (I) is inversely related to the
rate of interest. Higher the rate of interest, lower will be the demand for loanable funds for
the purpose of investment and vice versa.
The demand for loanable funds for the purpose of hoarding (H) will also be inversely related
to the rate of interest. Higher the rate of interest, lower will be the demand for loanable funds
for the purpose of hoarding and vice versa.
The demand for loanable funds for the purpose of consumption (C) or dissaving (DS) will
also be inversely related to the rate of interest. Higher the rate of interest, lower will be the
demand for loanable funds for the purpose of consumption or dissaving.
Thus, we find that the curves for investment (I), hoarding (H) and consumption (C) or
dissaving (DS) will have negative slopes.
Supply of loanable funds

The supply of loanable funds comes from savings(S), dishoarding (DH), disinvestment (DI)
and bank credit (M).
The supply of loanable funds comes from savings(S) varies directly with the rate of interest.
Higher the rate of interest, higher will be the savings and vice versa.
The supply of loanable funds comes from dishoarding (DH) is also positively related to
the rate of interest. Higher the rate of interest, higher will be the dishoarding and vice versa.
The supply of loanable funds comes from disinvestment (DI) is also positively related to
the rate of interest. Higher the rate of interest, higher will be the disinvestment and vice versa.
The supply of loanable funds comes from bank credit (M) is also directly related to the
market rate of interest. Higher the rate of interest, higher will be the bank credit and vice versa.
Thus, we find that the curves for savings(S), dishoarding (DH), disinvestment (DI) and
bank credit (M) will have positive slopes.
The total demand for loanable funds will be the sum of investment (I), hoarding (H) and
consumption (C) or dissaving (DS). The schedules for these can be laterally summed up to
produce the schedule of LD.
The total supply for loanable funds will be the sum of savings(S), dishoarding(DH),
disinvestment (DI) and bank credit (M). The schedules for these can be laterally summed up
to produce the schedule of LS. These two schedules (LD and LS) will jointly determine the
rate of interest. This can be well explained with the help of Figure 5.2.
In the figure, the OX axis represents the demand for and supply of loanable funds. The
OY axis represents the rate of interest. E is the point of equilibrium at which the demand for
loanable funds schedule and the supply for loanable funds schedule would be equal. The LD
curve represents the aggregate demand curve (SD) for loanable funds. The LS curve represents
the aggregate supply curve (SS) of loanable funds. Both intersect at E and give OR rate of
interest. At this rate of interest, OM amount of funds are borrowed and lent.
The neo-classical theory of interest has been criticized on the following grounds:
1. Professor A.H. Hansen criticized this theory as indeterminate unless the income level
is already known.
Figure 5.2 Supply of loanable funds.
2. It overemphasizes the impact of the rate of interest on savings.

3. It is an unrealistic theory in the sense that it is not correct to combine monetary factors
with the real factors.
5.4.3 Liquidity Preference Theory of Interest
The liquidity preference theory of interest was propounded by John Maynard Keynes.
According to this theory, the interest rate is determined by the demand for money and the
supply of money. The rate of interest is a monetary phenomenon, it is a payment for the use
of money. Keynes has defined, “the rate of interest as the reward for parting with liquidity.”
In other words, “the rate of interest is the reward for not hoarding.”
Demand for money

Demand for money is otherwise termed ‘liquidity preference’, which refers to the desire of the
people to hold their assets in the form of cash.
Keynes has given three motives for liquidity preference or demand for money.
1. Transaction motive
2. Precautionary motive
3. Speculative motive
Under the transaction motive, money is demanded by the people for day-to-day transactions.
The transaction demand for money mainly depends on the level of income of an individual.
It is directly and positively related to income. Higher the level of income, higher will be the
transaction demand for money and vice versa.
Under the precautionary motive, money is demanded by the people for meeting unforeseen
contingencies or uncertain expenditures and also for facing opportunities for unexpected profitable
deals. The precautionary demand for money depends on the level of income as in the case
of transaction motive. It is also directly and positively related to income. Higher the level of
income, higher will be the precautionary demand for money and vice versa.
Under the speculative motive, money is demanded for speculative purposes, i.e. securing
profit. Individuals and businessmen keep money for inverting on bonds. The amount of money
held under this motive depends on the rate of interest. The rate of interest and the speculative
demand for money are inversely related. Higher the rate of interest, lower will be the speculative
demand for money and vice versa.
Supply for money

Supply money refers to the total quantity of money in the country for all purposes at any time.
Though the supply of money is a function of the rate of interest, it is considered to be fixed by
the monetary authorities. The supply of money curve is taken as perfectly inelastic or vertical
line. According to Keynes, supply of money is independent of the level of income and of the
changes in the rate of interest.
The liquidity preference theory of interest can be well explained with the help of Figure 5.3.
Figure 5.3 Explanation of liquidity preference theory of interest.
In the figure, the OX axis represents the demand for and supply of money. The OY axis
represents the rate of interest. MN vertical line represents the supply of money. The LP where
represents the liquidity preference curve. MN and LP curves intersect at point E and equilibrium
rate of interest OR is established. If there is any deviation from this equilibrium position, an
adjustment will take place through the rate of interest. With the upward shifting of LP curve,
the supply of money MN remaining the same, the rate of interest rises to OR at the equilibrium
point E. Thus, according to Keynes’ liquidity preference theory of interest, the rate of interest
is determined at a point where the demand for money equals the supply of money.
Keynes’ liquidity preference theory of rate of interest has been criticized on the following
grounds:
• Robertson criticized this theory as at best “an inadequate and at worst a misleading
account”.
• It is inconsistent with facts. Knight criticized this theory in view of ‘the facts which we
directly contrary to what the theory calls for’.
• Viner criticized Keynes’ that “without saving there can be no liquidity to surrender. The
rate of interest is the return for saving without liquidity”.
• Keynes’ idea of liquidity trap is wrong. In reality, liquidity preference schedule may be
perfectly inelastic rather than elastic at a low rate of interest.
• It ignores the influence of real factors in the determination of rate of interest.
• It is an indeterminate theory like classical and neo-classical theories. Professor Hansen

criticized Keynes’ that “Keynes’ criticism of the classical theory applies equally to his
own theory”.
• Keynes’ fails to provide an integrated theory of rate of interest.
5.4.4 Neo-Keynesian Theory of Interest
J.R. Hicks and A.H. Hansen have synthesized the neo-classical theory of interest and the
Keynesian liquidity preference theory of interest in order to evolve. A new theory of interest
propounded by Hicks and Hansen which is otherwise called the neo-Keynesian or the modern
theory of interest.
According to A.H. Hansen, “an equilibrium condition is reached when the desired volume
of cash balances equals the quantity of money, when the marginal efficiency of capital is equal
to the rate of interest and finally, when the volume of investment is equal to the desired volume
of saving. And these factors are interrelated.”
J.R. Hicks has used the Keynesian tools that include productivity, thrift, liquidity preference
and money supply which are the necessary elements in a determinate theory of rate of interest.
Thus, in the modern theory of rate of interest, quantity of money supply, liquidity preference,
saving and investment are integrated at various levels of income to determine the rate of interest.
These four variables have been combined to construct two new curves, namely IS curve and LM
curve. The IS curve represents the flow variables of the loanable funds formulation, whereas the
LM curve represents the stock variables of the liquidity preference formulation. The equilibrium
between IS curve and LM curve provides a determinate solution.
IS curve
The IS curve gives the various combinations of the rate of interest and income. This curve
explains the relationship between saving and investment at various levels of income and the
rate of interest. This curve is otherwise called Hicksian IS Curve. Figure 5.4 represents the
derivation of the IS curve.
Figure 5.4 Derivation of LS curve.

In the figure, the OX axis represents the rate of interest. The OY axis represents the saving
and investment in part (a) and the level of income in part (b). The II curve represents the
investment curve. MS, M1S1 and M2S2 represent a family of saving schedules. The IS curve
represents the various combinations of the rate of interest and the level of income.
As the saving curves shift to the right and income increases from M to M1 and then to M2,
the rate of interest goes on declining from r2 to r1 and then to r. There is an inverse relationship
between the rate of interest and the level of income. It should also be noted that as the level
of income rises, the level of saving also rises and the rate of interest will come down. This is
shown in Part (b) of the above figure. We thus get the IS curve by joining the various points
of relationship between the rate of interest and the level of income.
LM curve
The LM curve gives the various combinations of the rate of interest and income. This curve
shows the equality of demand for money and supply of money on every point of the curve.
The LM curve has been derived from the Keynesian liquidity preference theory formulation.
The derivation of the LM curve has been presented in Figure 5.5.
Figure 5.5 Derivation of LM curve.
In the figure, the OX axis represents the demand for and supply of money in part (a) and
the level of income in part (b). The OY axis represents the rate of interest. The LM curve shows
the combination of the rate of interest and the level of income where the demand for money
is equal to the supply of money. This is shown in part (b) of the figure. We thus get the LM
curve by joining the various points (A, B and C) of relationship between the rates of interest
(r, r1 and r2) and the levels of income (M, M1 and M2).
Determination of the rate of interest

In the modern theory of interest, the rate of interest is determined by the interaction of IS and
LM curves. The determination of the rate of interest under the modern theory of interest is
illustrated in Figure 5.6.
Figure 5.6 Determination of rate of interest.
In the figure, the OX axis represents the level of income. The OY axis represents the rate of
interest. The IS and LM curves intersect at the point E, where the rate of interest is determined
at the level of income OM.
The neo-Keynesian theory of interest has been criticized on the following grounds:
• It neglects the influence of price level on the demand for goods as the IS and LM curves
are derived on the assumption of constant price level.
• It is unrealistic as both real and monetary sectors are independent sectors.
• It neglects the labour market.
• It is a static one as it does not explain the movement of each point of equilibrium.
5.4.5 Wicksell’s Theory of Interest
Wicksell was the forerunner of modern economists like J. R. Hicks and A. H. Hansen. Wicksell
laid emphasis on the equilibrium between the natural rate of interest and the market rate of
interest and paved the way for a determinate theory of interest as developed by Hicks and
Hansen, which is considered as the integrated and modern theory of interest.
Wicksell was the first economist to discuss in detail the natural rate of interest and the
market rate of interest. Natural rate of interest is that rate of interest at which saving and
investment in the economy become equal. On the other hand, market rate of interest is that rate
of interest at which supply of money and demand for money in the economy become equal.
If the natural rate of interest is greater than the market rate of interest, it would be profitable
to invest. Wicksell is of the opinion that investment is interest-elastic. If the market rate of
interest is greater than the natural rate of interest, it would not be profitable to invest. Wicksell
is of the opinion that investment is interest-inelastic. For example, if the market rate of interest
is below the natural rate of interest, savings will fall and the expenditure will go up on capital
and on consumption. This will increase the prices. On the other hand, if the market rate of
interest is above the natural rate of interest, savings will rise and the expenditure will come
down on capital and on consumption. This will decrease the prices.
When an economy is in equilibrium, the natural rate of interest equals the market rate
of interest. The cumulative process of upward or downward change in prices is traced to a
divergence between the natural rate of interest and the market rate of interest. Expansion in the
economy takes place when the market rate of interest is less than the natural rate of interest
and vice versa. The cumulative process can be controlled by bringing the market rate of interest
to the level of the natural rate of interest.
The cumulative process is also known as the ‘Wicksell Effect’ which emphasizes the
importance of credit creation upon the rate of interest. By ‘Wicksell Effect’, Wicksell
means an increment of capital changes wages and interest and, hence, the purchasing power
of capital.
5.5 Term Structure of Rate of Interest

By ‘term structure of rate of interest’ we mean the interest rate structure in short period and
long period. It also refers to the relationship between interest yield and maturity of securities.
The differences in interest rates in relation to maturities create the ‘term structure’. The short-
period interest rates and long-period interest rates on various securities differ.
5.5.1 Theories of Term Structure of Rate of Interest
There are four main theories of term structure of rate of interest:

1. Liquidity preference theory
2. Segmented market theory
3. Portfolio behaviour theory
4. Expectation theory
Liquidity preference theory

According to the liquidity preference theory, the degree of liquidity of a financial instrument
is the determinant of the structure of the rate of interest. Higher the degree of liquidity, lower
will be the rate of interest; and lower the degree of liquidity, higher will be the rate of interest.
Therefore, it is obvious that there is an inverse relationship between the degree of liquidity
and the rate of interest.
There are two types of securities—short term and long term. The long-term securities involve
greater risk as compared to the short-term securities. Even though the long-term securities are
poor substitutes for money and also they are not readily marketable, a liquidity premium has
to be paid for holding the long-term securities. Recently, the liquidity preference theory and
the expectation theory have been combined together and formulated a new theory called the
‘theory of term structure of interest rate’.
Segmented market theory

According to the segmented market theory, the entire loan market has been segmented into
various submarkets. In each submarkets, there will be a particular rate of interest.
The basic proposition of the segmented market theory is that lenders and borrowers desire
to match the maturity structure of their assets and liabilities. The short-term liabilities and the
long-term liabilities are matched with the short-term assets and the long-term assets respectively.
Different rates of interest are essential for holding the securities of different maturities. For
instance, commercial banks have short-term assets because most of their liabilities are of shorter
maturity whereas the Life Insurance Corporation has long-term assets because most of its liabilities
are of longer maturity. Hence, consumers finance short-term assets like consumption goods
with short-term loans, whereas they finance long-term assets like houses with long-term loans.
Portfolio behaviour theory

According to the portfolio behaviour theory, the term structure of rate of interest is influenced
by the portfolio behaviour of institutional investors. The investors utilize a major part of the
savings of the community into the productive channel. The investors are also interested to have
an optimum portfolio which combines maximum return and minimum risk.
Expectation theory
The expectation theory was developed by J. R. Hicks, Meiselman, Lutz and others. The basic
proposition of the expectation theory is that the structure of rate of interest is determined by
the expectation of the lenders and borrowers concerning future rate of interest.
The expectation theory states that long-term expectation is less-volatile than short-term
expectation. The long-term rates are more stable than the short-term rates.
According to this theory, the short-term securities and the long-term securities are comparable
in all respects, excepting for maturity. It is pointed that the institutional investors can have
accurate expectation about the future pattern of rates of interest. There is also certainty of
expectations of investors. They will have regressive interest rate expectations. They have an
idea of normal interest rate. When the short-term rate of interest is away from this ‘normal
interest rate’, the investors expect it to regress back towards the normal level.
5.6 Interest Rates in a Closed Economy

A closed economy is a situation where the economy does not have the exports and imports,
interest rates and money supply are the monetary policy tools used by the government to ensure
that there is proper economic growth and employment in the economy.
According to John Maynard Keynes, a closed economy has the following model:
Y=C+I+G
where
Y = national income
C = consumption
I = investment
G = government
When the nominal quantity of money (price level multiplied by real money where real
money is the quantity of money and is usually a constant) doubles the level of prices to rise
in the economy, the output level will also increase because of the increased price incentive for
producers and, finally, the interest rates will rise.
When the willingness to work increases, the price of goods is expected to decrease, the
output level is also expected to rise as a result of increased labour productivity, the interest
rates will decrease in order to encourage more investment in the economy.
When the propensity to save decreases, this will be as a result of a reduction in the level
of savings in the economy, because savings and investment are directly related. Therefore, the
level of investment is low. Then the output level will decline, prices will rise and the interest
rates will be reduced in order to encourage investment.
Therefore, the government will not only increase interest rates to get rid of inflation, but
also reduce interest rates in order to increase the level of output. When the interest rates are
decreased, the prices will rise and this will lead to inflation in the economy. When the interest
rates are increased, the level of investment will be low and, therefore, low levels of output,
but the economy will experience low inflation. Therefore, any policy measure to increase or
decrease interest rates will take into consideration the negative and positive effects on the
economy such as higher output and inflation.
5.7 Interest Rates in an Open Economy

An open economy is one that interacts freely with other economies around the world. In other
words, in an open economy, there are economic activities between domestic community and
outside. In an open economy, people can trade in goods and services with other people in the
international community and flow of funds as investment across the border. Trade can be in
the form of managerial exchange, technology transfers, all kinds of goods and services.
The act of selling goods or services to a foreign country is called exporting. The act of
buying goods or services from a foreign country is called importing. Together exporting and
importing are collectively called international trade.
There are a number of advantages for citizens of a country with an open economy. In an
open economy, the domestic markets are merged with international markets and so the consumers
are not limited to consume domestically produced goods and services. They can choose the
best from the world market.
In case of a small open economy, we assume ‘perfect capital mobility’. By ‘small’ we
mean that an economy has very little share in the world markets. It has a negligible effect on
interest rate. By ‘perfect capital mobility’ we mean that residents of a country have full access
to goods and services and especially financial markets of the world. Because of this assumption
of perfect capital mobility, the interest rate in open economy (r) must equal the world interest
rate (rw ), the real interest rate prevailing in world financial markets: r = rw. This means that
people in this open economy will never borrow at more than the interest rate in home country.
This will shift to international markets to borrow or invest in case r > rw. Thus, we can say that
the interest rates in an open economy are determined by the world markets. World interest rate
(rw), on the other hand, is determined by the equilibrium of world saving and world investment.
Hence, the equilibrium interest rate is the rate at which the amount that people want to save
exactly balances the desired quantities of investment and net capital outflows.
1. Which rate of interest equates saving and investment?

(a) Natural rate of interest (b) Market rate of interest
(c) Short-term rate of interest (d) Long-term rate of interest
2. Which rate of interest equates the demand for money and supply of money?
(a) Natural rate of interest (b) Market rate of interest
(c) Short-term rate of interest (d) Long-term rate of interest
3. The classical theory of interest was propounded by
(a) Nassau Senior (b) J.B. Say
(c) Irving Fisher (d) J.M. Clark
4. According to which theory of interest, the rate of interest is determined by demand for
and supply of capital?
(a) Classical theory of interest (b) Neo-classical theory of interest
(c) Modern theory of interest (d) All of the above
5. The Neo-classical theory of interest is also known as
(a) Liquidity preference theory of interest
(b) Loanable fund theory of interest
(c) Subsistence theory of interest
(d) Dynamic theory of interest
6. Loanable fund theory of interest was propounded by
(a) Bertil Otilin (b) Robertson
(c) Pigou (d) Wicksell
7. The demand for loanable funds is of the following purpose
(a) Investment (b) Hoarding
(c) Consumption (d) All of the above
8. The supply of loanable funds comes from
(a) savings (b) dishoarding
(c) disinvestment (d) bank credit
9. The liquidity preference theory of interest was propounded by
(a) J.M. Keynes (b) J.R. Hicks
(c) D.H. Robertson (d) Paul A. Samuelson
10. According to which theory of interest, the rate of interest is determined by the demand
for money and the supply of money?
(a) Classical theory of interest
(b) Neo-classical theory of interest
(c) Liquidity preference theory of interest
(d) Modern theory of interest
11. Who defines that “the rate of interest is the reward for parting with liquidity”?
(a) J.M. Keynes (b) J.R. Hicks
(c) D.H. Robertson (d) Paul A. Samuelson
12. Liquidity preference indicates
(c) demand for and supply of money (d) all of the above
13. According to J.M. Keynes, money is demanded for
(a) transaction purposes (b) precautionary purposes
(c) speculative purposes (d) all of the above
14. The relationship between the rate of interest and the speculative demand for money is
15. Modern theory of interest was propounded by
(a) J.R. Hicks (b) A.H. Hansen
(c) J.R. Hicks and A.H. Hansen (d) J.B. Say
16. The relationship between saving and investment at various levels of income and the rate
of interest is explained by
(a) IS curve (b) LM curve
(c) indifference curve (d) production possibility curve
17. The equality of demand for money and the supply of money on every point of the
(a) IS curve (b) LM curve
(c) indifference curve (d) production possibility curve
18. In which theory of interest, the rate of interest is determined by the interaction of IS
and LM curves?
(a) Classical theory of interest
(b) Neo-classical theory of interest
(c) Liquidity preference theory of interest
(d) Modern theory of interest
19. Who laid emphasis on the equilibrium between the natural rate of interest and the market
rate of interest?
(a) J.R. Hicks (b) A.H. Hansen
(c) Wicksell (d) J.B. Say
20. Term structure of rate of interest means interest rate structure in
(a) short period (b) long period
(c) short and long periods (d) secular period
21. The relationship between the degree of liquidity and the rate of interest is
22. The theory of term structure of interest rate is the outcome of
(a) liquidity preference theory (b) expectation theory
(c) both (a) and (b) (d) segmented market theory
23. The expectation theory of term structure of rate of interest was developed by
(a) J.R Hicks (b) Meiselman
(c) Lutz (d) All of the above
Answers
1. (a) 2. (b) 3. (e) 4. (a) 5. (b)

6. (e) 7. (d) 8. (e) 9. (a) 10. (c)
11. (a) 12. (a) 13. (d) 14. (b) 15. (c)
16. (a) 17. (b) 18. (d) 19. (c) 20. (c)
21. (b) 22. (c) 23. (d)
Review Questions
1. What do you mean by interest?
2. What is the real interest rate?
3. Distinguish between the net interest and the gross interest.
4. Distinguish between the natural rate of interest and the market rate of interest.
5. Distinguish between the real rate of interest and the money rate of interest.
6. State and explain the classical theory of rate of interest.
7. Explain the loanable fund theory of rate of interest.
8. “Rate of interest is the reward for parting with liquidity.” Discuss.
9. Discuss in detail the liquidity preference theory of rate of interest.
10. Explain the modern theory of rate of interest.
11. Illustrate how IS and LM curves can be derived.
12. State and explain Wicksell’s theory of rate of interest.
13. What is the meaning of ‘term structure of rate of interest’?
14. Explain briefly the various theories of term structure of rate of interest.
15. Explain briefly the segmented market theory of term structure of rate of interest.
16. Briefly explain expectation theory of term structure of rate of interest.
17. Discuss the role of interest rates in a closed economy.
18. Discuss the role of interest rates in an open economy.
Chapter 6
Analysis of Inflation and

Deflation
6.1 Inflation
Inflation is a sustained rise in the general level of prices of goods and services over a period
of time, say, one year. It generally refers to the percentage change in the prices of a set of
goods and services over a period of time and represents a change in overall price level in the
economy. In short, inflation is a period of rising prices.
6.1.1 Definitions of Inflation
The term ‘inflation’ has been defined by different economists, dictionaries and systems. A few
definitions are given below:
“A continuing increase in the general price level.” —Brooman
“Too much money chasing too few goods.” —Professor Coulbourn
“A state in which the value of money is falling, i.e. prices are rising.”
—Geoffrey Crowther
“The rise in prices due to the increase in the volume of money without an increase in
the supply of goods.” —R.G. Hawtrey
“The rise in the price level after the stage of full employment is reached in the economy.”
—John Maynard Keynes
“Inflation occurs when the volume of money actively bidding for goods and services
increases faster than the available supply of goods.” —Professor Golden Weiser
“A self-perpetuating and irreversible upward movement of prices caused by an excess
of demand over capacity to supply.” —Professor Emile James
117
“A condition when money income is expanding relatively to the output of work done
by the productive agents for which it is the payment.” —A.C. Pigou
“A state of abnormal increase in the quantity of purchasing power.” —T.E. Gregory
“That state of disequilibrium in which an expansion of purchasing power tends to cause
or is the effect of an increase of the price level.” —Professor Paul Einzig
“A persistent and appreciable rise in the general level or average of prices.”
—Professor Ackley
“A sustained rise in prices.” —Harry Johnson
“A process of steady and sustained rise in prices.” —Milton Friedman
“Too much currency in relation to the physical volume of business being done.”
—Professor Kemmerer
“A persistent and appreciable rise in the general level of prices.” —Edward Shapiro
“A continuing rise in prices as measured by an index such as the consumer price index
(CPI).” —Dernberg and McDougall
“The process of price increase.” —Professor Rowan
“Inflation occurs when the general level of prices and cost is rising.”
—Professor Paul A. Samuelson
“A process of rising prices.” —A.C.L. Day
“A process of making additions to credits not based upon a commensurate increase in
the production of goods.” —The Federal Reserve System (USA)
“A continuous and sustained upward movement of general price level” (or) “a more than
proportionate increase in the volume of money in circulation than the physical volume
of goods and services in the country.” —Hansen
“An undue increase in quantity of money in proportion to buying power, as on an
excessive issue of fiduciary money.” —Chamber’s Twentieth Century Dictionary
6.1.2 Characteristics of Inflation
The following are the characteristics of inflation:

• Inflation is a dynamic process which can be observed only over a long period of time.
• It is related to a rise in prices which is persistent and continuous.
• It is fundamentally an economic phenomenon as it originates within the economic system.
• It is a monetary phenomenon which is characterized by an excessive supply of money.
• It is always cumulative in character.
• It is a condition of economic disequilibrium.
Analysis of Inflation and Deflation 119
6.1.3 Types of Inflation
On the basis of the rate of rise in prices

On the basis of the rate of rise in prices, inflation is of the following four types:
1. Creeping inflation
2. Walking inflation
3. Running inflation
4. Hyperinflation or galloping inflation
Creeping inflation: When the annual rate of rise in prices is less than 3 per cent, it is called
Creeping Inflation. This type of inflation is very slow and is in mild form. Such type of inflation
is considered essential for economic growth of a country.
Walking inflation: When the annual rate of rise in prices is less than 10 per cent, it is called
walking inflation. This type of inflation is in moderate form. Such type of inflation is a warning
signal for the government to control it before it turns into running inflation.
Running inflation: When the annual rate of rise in prices is more than 10 per cent, say, at
the rate of 10–20 per cent, it is called running inflation. This type of inflation adversely affects
the poor and the middle class people. An immediate step is to be taken by the government to
control such type of rise in prices. Otherwise, it will lead to hyperinflation.
Hyperinflation or galloping inflation: When the annual rate of rise in prices is more than 20
per cent, (i.e. from 20 per cent to 100 per cent) it is called hyperinflation or galloping inflation.
This type of inflation is the most severe and rapid one. It is a situation when the rate of inflation
becomes immeasurable and completely uncontrollable. This situation brings a total collapse of
the monetary system because the purchasing power of money is continuously falling. During
the post-war period, this type of inflation was experienced by Germany and France. It is said
that during the periods of hyperinflation or galloping inflation, ‘a cart load of currency notes
had to be carried to buy a cup of coffee in Germany’. Similarly, it is said that ‘a basket load
of currency had to be carried to buy a loaf of bread in France’.
On the basis of the time period

On the basis of the time period, inflation is of the following three types:
1. War time inflation
2. Post-war inflation
3. Peace time inflation
War time inflation: On account of the increasing government expenditure on defence during
the war time, the government allocates a substantial part of goods and services produced for
war. This will lead to low availability of such goods and services. This results in rise in prices
and leads to inflation. Such type of inflation is called war time inflation.
Post-war inflation: During the post-war period, the disposable income of the people increases
as a result of the withdrawal of war-time taxation. This will lead to continuous rise in the
demand for goods and services. This results in rise in prices and leads to inflation. Such type
of inflation is called post-war inflation.
Peace time inflation: During the peace time or normal period, the government expenditure on
the long period capital projects increases. As a result, prices may rise. This leads to inflation.
Such type of inflation is called peace time inflation.
On the basis of the coverage or scope

On the basis of the coverage or scope, inflation is of the following two types:
1. Comprehensive inflation
2. Sporadic inflation
Comprehensive inflation: When the prices of goods and services rise throughout the economy,
it is called comprehensive inflation. This type of inflation is a normal inflationary phenomenon
as it indicates a rise in the general price level.
Sporadic inflation: When the prices of goods and services rise in certain sectors of the economy,
it is called sporadic inflation. Rise in the prices of food grains in the agricultural sector on
account of the crop failure and rise in the prices of manufactured goods in the industrial sector
on account of the dominance of monopolist are examples of sporadic inflation. Such type of
inflation is a situation in which direct price control is the most beneficial to the people at large.
On the basis of government reaction

On the basis of government reaction, inflation is of the following two types:
1. Open inflation
2. Suppressed inflation
Open inflation: Open inflation is a situation where the government does not make any attempt
to control the rising prices. In short, inflation is said to be open when prices rise without
government interruption. In such type of inflation, free market mechanism is allowed to operate
in the distribution of goods and services. The post-war hyperinflation experienced by Germany
is an example of open inflation.
Suppressed inflation: Suppressed inflation occurs when the government imposes monetary and
fiscal controls like price control, rationing, licensing, etc. to control inflation. In short, inflation is
said to be suppressed when prices rise on account of government interruption. Private holdings
of cash and bank balances rise during the period of suppressed inflation.
On the basis of origin

On the basis of origin, inflation is of the following two types:
1. Demand-pull inflation
2. Cost-push inflation
Demand-pull inflation: Demand-pull inflation occurs when the general price level rises due
to the demand for goods and services exceed the supply of goods and services at the prevailing
prices. Such type of inflation originates from the demand side.
Cost-push inflation: Cost-push inflation occurs when there is an increase in the cost of
production such as a rise in the cost of raw materials or a rise in wages or a rise in interest
payment or a rise in profits. Such type of inflation originates from the supply side.
Other types
The other types of inflation are:
1. Deficit-induced inflation
2. War-induced inflation
3. True inflation
4. Semi-inflation
5. Ratchet inflation
6. Currency inflation
7. Credit inflation
Deficit-induced inflation: Deficit-induced inflation occurs when the government resorts to
printing currency notes in order to cover the budgetary deficit. This tendency will lead to increase
the total money supply and results in rising prices in the economy. Such type of inflation is
found in developing countries like India.
War-induced inflation: War-induced inflation occurs when the government expenditure on
defence during the war period increases substantially as modern welfare is very costly. To meet
this increased war expenditure, the supply of money is increased. This will result in a rise in
prices of goods and services in the economy.
True inflation: True inflation occurs when there is a rise in the general price level after the
stage of full employment is reached in an economy. This type of inflation is associated with
J.M. Keynes.
Semiinflation: Semiinflation occurs when there is a rise in the general price level before
reaching the stage of full employment in the economy. This rise in prices is mainly owing to
bottlenecks in the economy. This type of inflation is also associated with J.M. Keynes.
Ratchet inflation: Ratchet inflation occurs when prices in certain sectors of the economy are
not permitted to fall by strong trade unions and monopolists even after a decline in the total
demand. In this type of inflation, prices are more in one direction, i.e. prices have an upward
ratchet effect.
Currency inflation: Currency inflation occurs when there is an excess supply of money in
relation to the available output.
Credit inflation: Credit inflation occurs when there is an excess supply of credit. Sometimes
government encourages expansion of credit for the purpose of financing the process of
development or expanding production.
6.1.4 Measuring Inflation
There are two kinds of indices for measuring inflation in India. They are wholesale price index
(WPI) and consumer price index (CPI).
Wholesale price index (WPI)

The wholesale price index (WPI) measures the changes in wholesale prices which may be more
meaningful from the producer’s point of view. In India, the inflation rate is calculated on the
basis of the WPI. For example, when the annual inflation rate for particular week has reached
7.3 per cent, it means that the average level of prices of the commodities for that week was
7.3 per cent, which is higher than for the corresponding week a year earlier. It is important to
note that the inflation rate going down does not mean prices are declining. It means the rate
at which prices are going up has slowed down.
Inflation based on WPI is considered as representative figure for the whole economy. The
following formula has been used for calculating the WPI inflation rate:
È Pt - Pt -1 ˘
WPI inflation rate = Í ˙ ¥ 100
Î Pt -1 ˚
where
Pt = Price indices of current year
Pt–1 = price indices of previous year
The WPI is the weighted price index of a basket of goods consisting of 435 commodities
which are characterized under three major groups, namely primary articles (98 commodities),
fuel, power, light and lubricants (19 commodities) and manufactured goods (318 commodities).
WPI is compiled on a weekly basis. The Government of India has taken WPI as a better
indicator of the inflation rate in the economy.
Consumer price index (CPI)

The consumer price index (CPI) measures the changes in retail prices which may be more
meaningful from the consumer’s point of view. CPI is constructed on the basis of the change in
retail prices of a specified set of goods and services on which a particular group of consumers
spend their money. It reflects the cost of living condition for a homogeneous group based on
retail price. India is the only major country that uses WPI to measure inflation. Most countries
use the CPI as a measure of inflation.
Within CPI, there are three subindices that cover three groups, namely CPI for agricultural
labour, CPI for industrial workers and CPI for urban non-manual employees. But there is no
consolidated CPI for the whole economy. The following formula has been used for calculating
the CPI inflation rate:
È CPt - CPt -1 ˘
CPI inflation rate = Í ˙ ¥ 100
Î CPt -1 ˚
where
CPt = consumer price index of current year
CPt–1 = consumer price index of previous year
6.1.5 Causes of Inflation
The causes of inflation in an economy are as follows:

• An increase in the supply of money gives rise to an increase in the total demand for
goods and services. This leads to heavy rise in the price level.
• An increase in government expenditure due to increasing state activities will result in
an increase in the total demand for goods and services. This leads to a rapid increase
in the price level.
• An increase in private sector expenditure on consumption and investment leads to an
increase in the total demand for goods and services. This will result in an increase in
the price level.
• The government resorts to deficit financing to meet the deficit in the budget. This deficit
is financed by printing currency notes by the government through the central bank of
the country. As a result, there will be an increase in the total demand for goods and
services and prices rise rapidly.
• The existence of black money due to corruption, tax evasion, hoarding and black marketing
leads to an increase in the total demand for goods and services and prices rise rapidly.
• Rapid growth of population of the country also leads to an increase in the total demand
for goods and services and so prices rise.
• The repayment of old debts by the government to the public leads to an increase in the
money supply. This will result in an increase in the total demand for goods and services.
This leads to a rapid rise in the price level.
• A reduction in taxes by the government increases the disposable income of the people
and also their purchasing power. As a result, the total demand for goods and services
increases. This leads to rise in the price level.
• Rapid expansion of credit by commercial banks leads to an increase in the total demand
for goods and services. As a result, the prices rise.
• A continuous increase in the defence expenditure leads to a heavy demand for goods
and services. This will result in a rapid rise in the price level.
• Monopoly profits and unfair trade practices by big industrial houses lead to a rise in
the price level.
• The shortage of factors of production including raw materials would lead to a heavy
reduction in the production of goods. This will result in a heavy fall in the supply of
goods. This leads to rise in prices.
• The demand for higher wages by strong trade unions would lead to a reduction in the
level of production and there by a fall in the supply of goods. This will result in a rise
in prices.
• The natural calamities like droughts, floods, fire and damages caused by pests and insects
to crops would lead to a fall in the production of agricultural goods. This will result in
a heavy fall in the supply of goods. This leads to rise in prices.
• An artificial scarcity of essential goods created by hoarders and speculators raises the
prices of those goods which they hoard.
• An increase in the export of goods for the purpose of earning foreign exchange would
lead to shortage of goods in the domestic market. This leads to rise in prices.
• A prolonged industrial unrest would lead to a reduction in the production of goods. This
will result in a heavy fall in the supply of goods. This leads to rise in prices.
• Planning for rapid economic development is another important cause of inflation. Planning
requires large funds. These funds can be mobilized by way of taxation, borrowings and
foreign aid. This will lead to inflationary situation in the economy.
6.1.6 Effects of Inflation
Whenever there is inflation in an economy, some groups will benefit while others will lose. At
the initial stage, mild inflation proves beneficial as it creates an all round expansion of business
activity. Inflation is welcome, according to J.M. Keynes, up to the stage of full employment.
The effects of inflation are as follows:
• Inflation encourages production and new investment. It increases employment and also
income of the people. It increases the demand for all goods still further.
• Inflation affects different classes of people unequally. Some classes gain while many
others lose.
• Inflation is a boon to businessmen. They make huge profits on account of low cost.
During inflation, cost of production do not rise as rapidly as prices.
• Workers and salaried people suffer a lot during inflation. The rise in the wages of workers
and the rise in the salaries of salaried people are not proportionate to the rise in prices.
• Investors in shares, debentures and bonds lose during inflation. It is because of the fact
that the prices of these securities fall as the rate of interest or dividend rises during
inflation.
• Debtors (borrowers) gain while creditors (lenders) lose during inflation. Debtors repay
the same amount. But they pay less in terms of goods. Creditors receive the amount
which has less value at the time of repayment.
• Farmers gain during inflation. They are benefited by rising prices because the increase
in the prices of agricultural goods is higher than the increase in the prices of goods they
purchase.
• Government gains during inflation since it is the largest borrower. The burden of debt
also falls.
• During inflation, the rich people become still richer while the poor become still poorer.
• People lose confidence in currency if there is hyperinflation or galloping inflation.
• Inflation sometimes leads to revolution.
• The political party in power will lose election during inflation.
• During inflation, speculation, hoarding, profiteering, black marketing and corruption
prevail.
Professor C.N. Vakil aptly compares inflation with robbery. Both deprive the viction of
some possession with the difference that the robber is visible. Inflation is invisible; the robber’s
victim may be one or a few at a time, the victims of inflation are the whole nation; the robber
may be dragged to the court of law, inflation is legal.
It is rightly remarked that inflation is economically unsound, politically dangerous, socially
disastrous and morally indefensible. So inflation is an evil its lust should be avoided at all costs.
6.1.7 Control of Inflation (Antiinflationary Measures)
Inflation is a serious evil. It should be controlled in the early stage itself. Otherwise, it brings
miserly and suffering to most of the people. Measures to control inflation are called antiinflationary
measures. These measures are broadly divided into three heads, namely
1. Monetary measures
2. Fiscal measures
3. Non-monetary measures
Monetary measures
Inflation occurs when there is an increase in the supply of money in the economy. The central
bank of the country (RBI in India) should reduce the supply of money and also credit created
by commercial banks, in order to reduce the inflationary pressure in the economy. The policy
adopted by the central bank for controlling the supply of money is called monetary policy.
The following monetary measures are adopted by the central bank (RBI) of the country
to control inflation:
1. Bank rate policy
2. Open market operations
3. Variation of cash reserve ratio
4. Selective credit controls
Bank rate policy: Bank rate is the minimum rate of interest at which the central bank of the
country grants loans to commercial banks against approved securities. When the bank rate is
raised, the market rate of interest will also rise. When commercial banks raise the interest rates
on loans, credit is discouraged as it becomes costly. So the borrowers are reluctant to borrow
more and, hence, they reduce their borrowings. As a result, investment falls, employment falls,
income falls, demand for goods fall and, finally, prices fall. Hence inflation is controlled.
Open market operations: During inflation, the central bank sells securities in the open market.
Commercial banks are forced to reduce loans because the cash reserves of the commercial banks
fall. As a result, investment falls, employment falls, income falls, demand for goods fall and,
finally, prices fall. Hence inflation is controlled.
Variation of cash reserve ratio: Cash reserve ratio (CRR) is a certain percentage of the total
deposits to be kept as reserve by each commercial bank with the central bank of the country.
During inflation, the central bank raises the cash reserve ratio. If the cash reserve ratio is raised,
commercial banks have to keep more cash with the central bank. They will be compelled to
reduce loans on account of fall in cash balances. This reduction in credit by commercial banks
leads to a fall in the demand for goods. As a result, prices of goods fall. Hence inflation is
controlled.
Selective credit controls: Selective credit controls are otherwise called qualitative credit control
measures. These measures aim at encouraging credit to essential industries and at the same
time discouraging credit to non-essential industries. Similarly, these qualitative measures to
control inflation encourage productive activities and at the same time discourage unproductive
or speculative activities during inflation.
The following selective credit control measures have been adopted to control inflation to
some extent:
(i) Raising the margin against the stock exchange securities and also against the stock of
food grains.
(ii) Controlling the consumer credit by reducing the number of instalments, raising the
down payment at the time of purchase.
(iii) Moral suasion is used as an effective selective credit control measure to control
inflation. Under this, the central bank persuades or requests commercial banks not to
finance non-essential or speculative activities.
(iv) Direct action by central bank is another effective method adopted to control inflation.
A penal rate of interest will be charged against the banks who do not follow the
guidelines of the central bank. Sometimes central bank refuses to grant further loans
to commercial banks.
Fiscal measures
Fiscal policy is the policy of the government relating to public revenue (taxation), public
expenditure and public borrowing. Fiscal measures to control inflation involve:
1. Raising the prevailing rate of taxation and imposing the new taxes to check inflationary
pressures in the economy.
2. Reducing the unnecessary, wasteful and unproductive government expenditure.
3. Maintaining the surplus budget to fight inflation.
4. Increasing the voluntary savings by the people.
5. Stoppage of borrowings by the government.
6. Government must encourage people to save and invest in government securities.
Non-money measures
The government should undertake the following non-monetary measures to control inflation:
1. The government should control private investment by licensing. Licenses should be
issued for starting essential industries.
2. Speculation on stock exchanges and goods should be controlled by prohibiting forward
contracts. Otherwise, it will lead to excessive rise in prices.
3. The government should fix the prices of various commodities, especially those of
essential commodities by adopting price control and rationing.
4. The government should import the essential commodities which are in short supply. This
will lead to increase in the domestic supply of goods and, hence, inflation is controlled.
5. The government should adopt a new wage-income policy and thereby check the
inflationary pressure in the economy.
6. The government should encourage the production of goods by offering various incentives
to the producers. This will increase the production of goods. Hence inflation is effectively
controlled.
It should be noted that no single measure will be able to control inflation. A large number
of measures should be undertaken to control inflation. It is aptly remarked that ‘inflation is a
hydra-headed monster and should be fought with many weapons’.
6.1.8 Concept of Inflationary Gap
John Maynard Keynes originated the concept of inflationary gap not only to emphasize the
strategic significance of the flow of money incomes in influencing the general price level but
also to show the primary importance of fiscal measures (taxation and borrowing) for wiping
out the inflationary gap.
In the words of Kenneth K. Kurihara, the inflationary gap is defined as, “an excess of
anticipated expenditures over available output at base prices”. The ‘anticipated expenditures’
are given by conditions of employment plus technological structure.
The aggregate expenditure of the community is determined by the aggregate consumption
expenditure, the aggregate investment expenditure and the aggregate government expenditure
on goods and services. In symbol,
Aggregate anticipated expenditure = C + I + G
where
C = consumption expenditure
I = investment expenditure
G = government expenditure
Illustration
The concept of inflationary gap can be well explained with the help of the Tables 6.1 and 6.2.
Table 6.1 Items on Demand Side
Demand Side of the Economy

National income ` 50,000 crore
Minus —
Government taxes ` 20,000 crore
Gross disposable income ` 30,000 crore
Minus —
Community savings (10% of GDI) ` 3000 crore
Net disposable income ` 27,000 crore
Table 6.2 Items on Supply Side
Supply Side of the Economy

Gross national product (at preinflation prices) ` 50,000 crore
Minus —
Government war expenditures ` 27,000 crore
Available output for civilian consumption (at preinflation prices) ` 23,000 crore
Here, anticipated expenditure ` 27,000 crore
Minus —
Available output at base prices ` 23,000 crore
Inflationary gap ` 4000 crore
Let us take the case of war time full employment economy. To illustrate the concept of
inflationary gap, let us suppose that the level of war time national income is determined by the
government war expenditure. Let us assume that the value of Gross National Product (GNP) at
preinflation prices is ` 50,000 crore. Of this GNP, the government war expenditure is ` 27,000
crore and the balance of ` 23,000 crore represents the available output for civilian consumption.
This represents actually the total output of the economy at preinflation prices. In this way,
` 23,000 crore represents the supply side of the economy.
Now let us suppose that the national income being paid to the factors of production is
` 50,000 crore. Of this, the government taxes away ` 20,000 crore leaving a gross disposable
income of ` 30,000 crore. This is the amount of money income which may be spent for
available output. Let us also assume that ` 3000 crore (10 per cent of ` 30,000 crore) may
be saved by the community. Then the net disposable income would be ` 27,000 crore. This
is the actual amount of money income available for spending purposes. In this way, ` 27,000
crore represents the demand side of the economy.
Therefore, when the net disposable income of ` 27,000 crore is left to compete with the
available output of ` 23,000 crore for civilian consumption at preinflation prices, there arises
an inflationary gap equivalent to ` 4000 crore. The process involved in the development of the
inflationary gap has been illustrated in the following model (Figure 6.1).
Figure 6.1 Development of inflationary gap.

In the figure, the OX axis represents the GNP at preinflation prices or the available output
at base prices. The OY axis represents the aggregate anticipated expenditure (C + I + G). The
45° line (C = Y line) measures the quantitative relation of consumption expenditure to various
levels of income. This line is regarded as a zero-saving function.
The C + I + G represents the amount people would want to spend for both consumption
and investment at all levels of income. The intersection of the C + I + G curve with C = Y
line at the equilibrium point E0 gives us the equilibrium income Y0. Suppose if there is an
increase in the government war expenditure, the total demand would shift to C + I + G which
is parallel to C + I + G.
It is noted that the new C + I + G curve intersects the 45° line at the new equilibrium
point E1, which gives us the new equilibrium income Y1. The gap between C + I + G and
C + I + G is shown by K0E0, which represents the inflationary gap.
6.1.9 Phillips Curve Analysis
A.W. Phillips, a British economist, was the first to identify the inverse relation between the rate
of unemployment and the rate of increase in money wages. An empirical study was conducted
by Phillips during 1862–1956 in the United Kingdom and found that
• when unemployment was high, the rate of increase in money wage rates was low.
• when unemployment was low, the rate of increase in money wage rates was high.
This is known as the ‘trade-off’ between unemployment and money wages. This idea has
been illustrated in the Figure 6.2.
Figure 6.2 Phillips curve.
In the figure, the OX axis represents the unemployment rate. The OY axis represents the
rate of money wages. The PC curve represents the Phillips curve which is sloping downwards.
It is convex to the origin and cuts through the horizontal axis. The convexity of the Phillips
curve shows that there is an inverse relationship between the unemployment rate and the rate
of money wages. This relationship is based on the nature of business activity.
During a period of rising business activity, there is

rise in the price level

rise in profit margins

increase in the demand for labour

decline in the rate of unemployment

employers will bid up wages
During a period of falling business activity, there is
fall in the price level

fall in profit margins

decrease in the demand for labour

increase in the rate of unemployment

employers will reduce wages
Thus according to Phillips, there is trade-off between unemployment and money wages.
In Economics, the Phillips curve is a historical inverse relationship between the rate of
unemployment and the rate of inflation in the economy. It simply stated that the lower the
unemployment in an economy, the higher the rate of inflation. It has been observed that there
is a stable short run trade-off between unemployment and inflation and this has not been
observed in the long run.
Paul A. Samuelson and Robert Solow extended the Phillips curve analysis to the relationship
between the rate of inflation and the rate of unemployment. This has been well illustrated in
Figure 6.3.
Figure 6.3 Phillips curve: An extension.

In the figure, the OX axis represents the unemployment rate. The OY axis represents the
annual rate of inflation. The PC curve represents the Phillips curve. It is obvious that higher
the rate of inflation, lower will be the unemployment rate, whereas lower the rate of inflation,
higher will be the unemployment rate. Thus, there is an inverse relationship between the rate
of inflation and the rate of unemployment in the economy.
The major implication of the Phillips curve analysis is the guidance to the government
and the monetary authorities on the rate of inflation could be tolerated with a given level
of unemployment. The real problem is to find out where the rate of inflation and the rate of
unemployment should strike the balance.
6.1.10 Okun’s Law
Arthur M. Okun, a twentieth century economist, has developed an idea of the relationship
between an economy’s unemployment rate and its gross national product (GNP). Okun has
developed this idea in the year 1962. Okun’s law states that when unemployment falls by
1 per cent, the gross national product (GNP) rises by 3 per cent. It also states that a 1 per cent
in the unemployment rate is associated with a 2 per cent in the real GDP. The relationship
varies depending on the country and time period under consideration.
There are two versions of Okun’s law. They include:
1. Gap version
2. Difference version
The gap version of Okun’s law states that for every 1 per cent increase in the unemployment
rate, a country’s GDP will be at an additional 2 per cent lower than its potential GDP.
The difference version of Okun’s law describes the relationship between quarterly changes
in employment and quarterly changes in real GDP.
In Okun’s original statement of his law, a 3 per cent increase in the output corresponds to
a 1 per cent decline in the rate of unemployment; a 0.5 per cent increase in the labour force
participation; a 0.5 per cent increase in the hours worked per employee; and a 1 per cent increase
in the output per hours worked (labour productivity.) Okun’s law is more accurately called
“Okun’s rule of thumb”, because it is primarily an empirical observation rather than a result
derived from theory. It is approximate because factors other than employment (productivity)
affect output. The major implication of Okun’s law is that an increase in labour productivity
or an increase in the size of the labour force can mean that the real net output grows without
the net unemployment rates falling.
6.1.11 Concept of Stagflation
The term ‘stagflation’ was coined by Paul A. Samuelson. In the words of Samuelson, “stagflation
involves inflationary rise in prices and wages, at the same time, people are unable to find jobs
and the firms are unable to find customers for their products.”
Stagflation means the coexistence of unemployment and inflation in an economy, i.e.
Stagflation = Stagnation + Inflation
It means that an economy experiences on the one side rapid rise in prices (high inflation)
and, at the same time, it experiences on the other side decline in output (high unemployment).
Thus, it is said that stagflation is the coexistence of stagnation and inflation in the economy.
In the industrialized countries, the rates of inflation are higher and these higher rates of
inflation are accompanied by various degrees of depression. In India, this situation was witnessed
in recent years. During 1974–1975, the rise in prices (high inflation) was accompanied by a
shortage of agricultural raw materials and other basic goods.
During the period of stagflation, the price level was rising, the rate of growth of output
was declining, and the rate of unemployment was increasing. To get out of this problem, we
should have an appropriate mix of monetary and fiscal policies.
6.2 Deflation
Deflation is a sustained fall in the general price level in an economy over a period of time.
Crowther defines deflation as, “a state in which the value of money is rising, i.e. prices are
falling”. When the price falls, the value of money rises. A rupee will have greater purchasing
power than before. It purchases larger quantity of goods than before. Paul Einzig defines
deflation as, “a state of disequilibrium in which a contraction of purchasing power tends to
cause a decline in the price level”. In short, deflation is a period of falling prices.
6.2.1 Deflation vs Disinflation
In case of deflation, prices fall and unemployment rises. The fall in the prices on account of
antiinflationary measures adopted by the government is called ‘disinflation’. The government
adopt antiinflationary policies in such a way to bring down prices in an orderly way without
causing unemployment.
6.2.2 Causes of Deflation
Deflation occurs when there is a contraction of money supply in the economy. Deflation may
also occur when there is an excessive rise in the production of goods on account of technical
improvements and improvement in the efficiency of the workers and the organizers. In this
case, deflation occurs on account of scarcity of money.
Deflation occurs when the central bank of the country raises the bank rate, sells securities in
the open market, raising the cash reserve ratios of commercial banks. Deflation occurs when a
country faces adverse balance of payments. The supply of money contracts on account of heavy
payment for imports. The payment is made in the form of gold. This leads to fall in prices.
6.2.3 Effects of Deflation
During the period of deflation, businessmen incur losses due to fixed cost of production. As
a result, profit margin declines. Producers will not be willing to invest and produce further.
They sometimes stop production.
Debtors (borrowers) lose as they have to pay more in terms of goods, while creditors
(lenders) gain as they receive more.
People with fixed income (salaried people) gain during the period of deflation as they can
secure more goods and services with their money income which has more purchasing power. As
workers lose their jobs during the period of deflation, they are suffering from widespread misery.
The government also suffers during deflation as its income from taxes fall and its expenditure
remains almost fixed. As the government is the largest borrower (debtor), the burden of debt
increases during deflation.
6.2.4 Control of Deflation (Antideflationary Measures)

Deflation causes unemployment, widespread misery and suffering among the people in the
economy. So, deflation should be controlled.
The following three methods have been adopted to control deflation in the economy:
1. The Central Government should adopt cheap money policy to encourage commercial
banks to lend more to business people at low rate of interest. In order to achieve this,
the central bank should reduce the bank rate purchase securities in the open market and
reduce the cash reserve ratios kept by the commercial banks with the central bank. It
is said that granting of liberal loans may encourage investment, increase employment
and raise the incomes of the people. But during the period of deflation (falling prices),
business people or investors are not interested to borrow more even though the interest
rates are very low. Hence, monetary policy alone is insufficient to control deflation.
2. During the period of deflation, the government should increase its expenditure on
productive activities such as construction of public works like roads, railways, irrigation
and power projects. The government should grant various incentives and concessions to
encourage new investment. Thus, government should aim at deficit budgets by spending
more and reducing taxes.
3. The government should fix minimum prices for commodities and procure them at
reasonable prices. This reduces further fall in prices and provides reasonable income
to the producers. In this way, the government should encourage producers to adopt
scientific management to reduce the cost of production.
6.3 Disinflation
Disinflation refers to bringing about an orderly lowering of prices and costs without causing
unemployment. In other words, disinflation is the process of reversing inflation without creating
unemployment. It is mainly due to the antiinflationary measures taken by the monetary authorities
and the government of the country.
6.4 Reflation
Reflation refers to a policy designed to check a steady fall in prices without causing inflation.
When prices fall to a very large extent in the economy, it is desirable that there should be a
gradual rise in the price level. The government has to take stages to control deflation. Such
government action is termed reflation. Professor Cole rightly remarks that “reflation is an
inflation deliberately undertaken to relieve depression.” Thus reflation is a cure for deflation.

1. The wholesale price index is complied on a
(a) daily basis (b) weekly basis
(c) monthly basis (d) yearly basis
2. Inflation is a period of
(a) rising prices (b) falling prices
(c) stable prices (d) all of the above
3. Who defines that “inflation is too much money chasing too few goods”?
(a) Walker (b) Brooman
(c) Coulbourn (d) Crowther
4. Who defines that “inflation is the rise in the price level after the stage of full employment
is reacted in the economy”?
(a) Crowther (b) Hewtrey
(c) Emile James (d) J.M. Keynes
5. Who defines that “inflation is a continuing increase in the general price level”?
(a) Brooman (b) Coulbourn
(c) Crowther (d) Howtrey
6. Who defines that “inflation is a process of steady and sustained rise in prices”?
(a) Milton Friedman (b) Edward Shapiro
(c) A.C.L. Day (d) Harry Johnson
7. Which of the following is not a feature of inflation?
(a) Dynamic process (b) Monetary phenomenon
(c) Economic phenomenon (d) Static process
8. During the post-war period, galloping inflation was experienced by
(a) Germany and France (b) Germany and England
(c) England and France (d) Italy and France
9. When prices of goods and services in certain sectors of the economy, it is called
(a) comprehensive inflation (b) sporadic inflation
(c) open inflation (d) suppressed inflation
10. Which type of inflation is associated with J.M. Keynes?
(a) True inflation (b) Semiinflation
(c) Credit inflation (d) Currency inflation
11. According to which type of inflation, there is an increase in the price level due to an
increase in the cost of factors of production?
(a) Demand-pull inflation (b) Cost-push inflation
(c) True inflation (d) Semiinflation
12. Which of the following is not a cause of inflation?
(a) Artificial scarcity (b) Natural calamities
(c) Expansion of bank credit (d) Increase in taxes
13. Inflation is due to
(a) increase in money supply and increase in food supply
(b) increase in money supply and decrease in food supply
(c) decrease in money supply and increase in food supply
(d) decrease in money supply and decrease in food supply
14. Inflation is
(a) economically unsound (b) socially disastrous
(c) politically dangerous (d) morally indefensible
(e) all of the above
15. During the period of inflation, central bank of the country
(a) raises the bank rate (b) reduces the bank rate
(c) keeps the bank rate constant (d) all of the above
(a) sells securities in the open market (b) buys securities in the open market
(c) neither sell nor buy securities (d) all of the above
(a) raises the cash reserve ratio (b) reduces the cash reserve ratio
(c) keeps the CRR constant (d) all of the above
18. Under which method of credit control, the central bank requests the commercial banks
not to finance for speculative activities?
(a) Rationing of credit (b) Regulation of consumer credit
(c) Moral suasion (d) Direct action
19. The concept of inflationary gap was originated by
(a) Kenneth K. Kurihara (b) J.M. Keynes
(c) Milton Friedman (d) Brooman
20. The inverse relationship between the rate of unemployment and the rate of increase in
money wages was initiated by
(a) Kenneth K. Kurihara (b) A.W. Phillips
(c) J.M. Keynes (d) Milton Friedman
21. Who extended the Phillips curve analysis to the relationship between the rate of inflation
and the rate of unemployment?
(a) Paul A Samuelson (b) Robert Solow
(c) Paul A Samuelson and Robert Solow (d) Keynes and Friedman
22. The relationship between the rate of unemployment and the gross national product of
the economy was developed by
(a) Robert Solow (b) Arthur M. Okun
(c) Paul A. Samuelson (d) J.M. Keynes
23. Okun’s law states that when the rate of unemployment falls by 1 per cent, the GNP
rises by
(a) 2 per cent (b) 3 per cent
(c) 4 per cent (d) 5 per cent
24. The term ‘stagflation’ was coined by
(a) Paul A Samuelson (b) A.W. Phillips
(c) Kenneth K. Kurihara (d) J.M. Keynes
25. The coexistence of unemployment and inflation in an economy is termed
(a) inflation (b) deflation
(c) stagflation (d) stagnation
26. A state in which the value of money is rising, i.e. the prices are falling is termed
(a) Deflation (b) Disinflation
(c) Stagflation (d) Inflation
27. Lowering of prices and costs without causing unemployment is termed
(a) deflation (b) reflation
(c) disinflation (d) disdeflation
28. Disinflation is mainly due to
(a) antiinflationary measures (b) antideflationary measure
(c) antimonetary measures (d) antifiscal measures
29. Reflation is a cure for
(a) inflation (b) deflation
(c) disinflation (d) disdeflation
Answers
1. (b) 2. (a) 3. (c) 4. (d) 5. (a)

6. (a) 7. (d) 8. (a) 9. (b) 10. (a)
11. (b) 12. (d) 13. (b) 14. (e) 15. (a)
16. (a) 17. (a) 18. (c) 19. (b) 20. (b)
21. (c) 22. (b) 23. (b) 24. (a) 25. (c)
26. (a) 27. (c) 28. (a) 29. (b)
Review Questions
1. How do you measure inflation rate?
2. What is the meaning of inflation?
3. Define inflation.
4. Bring out the characteristics of inflation.
5. Discuss in detail the various types of inflation.
6. Distinguish between true inflation and semiinflation.
7. Explain demand-pull inflation theory with a suitable diagram.
8. Explain cost-push inflation theory with a suitable diagram.
9. What are the causes of inflation?
10. Discuss the effects of inflation.
11. Explain the various measures adopted to control inflation.
12. Briefly explain the monetary measures to control inflation.
13. Illustrate in detail the concept of inflationary gap.
14. Explain the Phillips curve analysis with a suitable diagram.
15. Write a detailed note on Okun’s law.
16. Explain the concept of stagflation.
17. What do you mean by deflation?
18. Distinguish between deflation and disflation.
19. Bring out the causes of deflation.
20. What are the effects of deflation?
21. Explain the methods adopted to control deflation in the economy.
22. Define deflation and reflation.
Chapter 7
Trade Cycles
7.1 Meaning of Trade Cycle

Thew existence of the alternating periods of prosperity and depression is generally referred to
as a trade cycle. In other words, any fluctuations in economic activity which occur in more or
less regular time sequence are known as a trade cycle.
Cyclical fluctuation is usually called ‘trade cycle’ by the British economists; ‘business cycle’
by the American economists; and ‘economic cycle’ by Professor M.W. Lee.
A trade cycle consists of a period of good trade and a period of bad trade. Period of good
trade is called prosperity and period of bad trade is called depression. Both periods together
constitute a trade cycle.
7.2 Definitions of Trade Cycle

A trade cycle has been defined by several economists. A few definitions are given below.
“A type of fluctuation found in the aggregate economic activity of nations that organise
their work mainly in business enterprises.” —W.C. Mitchell
A cycle consists of expansion in economic activities followed by contractions which occur
with a fair degree of regularity.
“A wave-like movement caused by those outside forces which operate upon the economy
in such a manner that the latter starts moving in a wave-like manner.”
—Ragnar Frisch
“The interplay between erratic shocks and an economic system able to perform cyclical
adjustment movements in such shocks.” —Tinbergen
“A manifestation of the industrial segment of the economy from which prosperity or

depression is redistributed to other groups in the highly interrelated modern society.”
—Hansen
138
Trade Cycles 139
“A cycle composed of periods of good trade characterised by rising prices and low
unemployment percentages alternating with periods of bad trade characterised by falling
prices and high unemployment percentages. —J.M. Keynes
“A period of prosperity followed by a period of depression. It is not surprising that
economic process should be irregular, trade being good at some time and bad at
others.” —Frederic Benham
In short, a trade cycle is an alternate expansion or contraction in overall trade or business
activities as evidenced by fluctuations in measures of aggregate economic activities such as
investment, employment, production, income and prices.
7.3 Characteristic Features of Trade Cycle

The characteric features of a trade cycle are as follows:
• It is a wave-like movement, characterized by expansion and contraction in economic
activity.
• It operates periodically at regular time sequence.
• It is recurrent in nature in the sense that prosperity is followed by depression which, in
turn, is followed by prosperity.
• It is all-pervading and synchronizing in its impact on the economy.
• It is of all embracing nature in the sense that it prevails in all economic activities in a
country.
• Its process of expansion and contraction is cumulative in nature.
• It contains self-generating forces which tend to terminate the phase of prosperity or
depression and start the reverse process.
• It has a common pattern of phases which are sequential in nature.
• It is not a periodic phenomenon in the sense that the time span between peaks and
troughs is not invariant.
• It is thus characterized by upward and downward movements in all economic activities
in a country.
7.4 Phases of Trade Cycle

There are four important phases of a trade cycle:
1. Depression phase
2. Recovery phase
3. Prosperity phase
4. Recession phase
7.4.1 Depression Phase
Depression is one of the four distinct phases of a trade cycle. It is characterized by low
investment, low employment, low production, low income, and low demand for goods and
low prices. During the depression phase of a trade cycle, prices fall heavily. There will be
wide-spread unemployment in the economy. Production will be at a low level because of poor
demand for goods. All industries incur losses. People suffer greatly because of unemployment
and lack of income. The whole economic system becomes motionless. During the depression
phase, money incomes are generally low in all sectors of the economy. In the agricultural
sector, the low money income of the agriculturists is mainly due to low prices of agricultural
goods because production level remains high. The low money income of the industrialists is
due to low production in the industrial sector. The construction goods industries suffer a lot
all construction activities come to a standstill. Both consumers and producers are unsafe and
in an unfavourable conditions. Thus depression is a period of pessimism.
7.4.2 Recovery Phase
Depression phase of a trade cycle is followed by recovery phase. During this phase, employment
and production slowly and steadily begin to rise. As a result, income of the people rises. The
demand for goods slowly increases. These conditions encourage producers to produce more
goods. Employment and incomes of the people further increase. This will further increase the
demand for consumer goods. This will lead to a further rise in prices of goods. There will be
growing confidence among producers and business people as profits appear. Producers will be
willing to replace old equipment. They will place orders for new equipment. An increase in
the demand for consumer goods leads to an increase in the demand for labour, machine and
materials, as a result, employment and income rise which lead to further increase in the demand
for consumer goods. This cumulative process goes on during the recovery phase.
7.4.3 Prosperity Phase
Prosperity phase is the most desirable phase of a trade cycle. During this phase, the optimum
level of economic activity is achieved and all the means of production are fully employed.
The all round economic stability in production, income and prices is the most pronounced
feature of the economy. During this phase, voluntary and frictional unemployment may exist.
There is heavy investment in durable capital goods. Business confidence is at the highest.
Borrowing from banks is heavy to expand business activities. During the prosperity phase
of a trade cycle, prices of goods begin to rise because of increased demand for goods. Producers
make huge profits. They feel optimistic. Banks are liberal in granting loans to business
people. Thus there will be expansion of bank credit. This leads to larger investments. Increased
investment, in turn, leads to an increase in employment, income and prices. This is a period
of optimism.
Trade Cycles 141
7.4.4 Recession Phase
Recession phase of a trade cycle is characterized by fall in investment, fall in employment,

fall in production, fall in demand for goods and falls in prices. During this phase, credit is
contracted by banks. Business expansion stops. Orders are cancelled and workers are laid off.
Business failures increase. Investment stops. Unemployment expands. There is landslide in
prices. Confidence is shaken. People prefer cash assets to securities. Unemployment causes
fall in income, fall in profits and fall in business activity. There is panic in the stock market.
The prices of shares and commodities finally fall. These conditions are described as recession.
Recession may be mild or severe. If recession is severe, it is called a crisis. Crisis is a
period of difficulty. It may be commercial crisis or financial crisis. If business people find it
difficult to pay their old debts only, it is called commercial crisis. If banks fail, it is called
financial crisis. Thus there is a violent disturbance in the business world during the recession
phase of a trade cycle.
Illustration
The phases of a trade cycle are illustrated in Figure 7.1.
Figure 7.1 Phases of a trade cycle.
In the figure, points A to B indicate the depression phase of the trade or business cycle;
points B to C indicate the recovery phase; points C to D indicate the prosperity phase and
points D to E indicate the recession phase of the trade cycle.
7.5 Theories of Trade Cycle

The following theories have been evolved to explain the causes of a trade cycle:
1. Climatic theory
2. Psychological theory
3. Under-consumption theory
4. Over-investment theory
5. Monetary theory
6. Innovation theory
7. Keynes’ theory
8. Hicksian theory
9. Cobweb theory
7.5.1 Climatic Theory
The climatic theory of trade cycle was propounded by an English economist, William Stanley
Jevons (1835–1882). According to Jevons, ‘sunspots are the cause of trade cycles’. It means
that when the dark and irregular patches appear on the surface of the sun (i.e. sunspots), the
sun emits less heat. The climate is influenced via the changes in rainfall. It has a very large
influence upon harvests. As a result, agricultural production falls. Due to poor harvest, demand
for various goods fall. Industries suffer heavily. Thus it is said that depressions are caused by
sunspots or changes in climatic conditions.
The advocates of the climatic theory of trade cycle emphasize that the explanation of
great depression of the ‘thirties’ can be found in the climatic theory of trade cycle because
the climatic changes by causing depression in the agricultural countries caused it to spread to
industrial countries and also the world as a whole.
7.5.2 Psychological Theory
The psychological theory of trade cycle was associated with a classical economist, A.C. Pigou.
According to Pigou, ‘changes in the psychology of business people are responsible for trade
cycles’. When business is good, business people expect good profit and they feel very optimistic
about future. So producers expand their business activities beyond their capacity. This leads to
over-production. Producers find it very difficult to sell their goods produced. As a result, prices
fall and producers incur losses. They become pessimistic about future. So producers curtail their
business activities. Therefore, trade cycles in the economy are due to the psychological feelings of
optimism and pessimism in business. Thus according to A.C. Pigou, the sole cause of trade cycles
rests on the waves of ‘over-optimism’ and ‘over-pessimism’ that overtake the business community.
7.5.3 Under-consumption Theory
The under-consumption theory of trade cycle was associated with J.A. Hobson (1858–1940).
According to Hobson, ‘under-consumption or over-saving is the cause of trade cycle’. When
trade is good, incomes of the rich people increase greatly. They save a large part of their
income and invest for the expansion of business activities. But most of the people do not
have sufficient purchasing power because of low income. So producers find it very difficult
to sell their goods produced. As a result, prices fall heavily and thus depression begins. Thus
according to Hobson, under consumption causes the trade cycle.
7.5.4 Over-investment Theory
The over-investment theory of trade cycle was associated with an F.A. Von Hayek (1899–1992).
According to Hayek, ‘over-investment is the cause of trade cycle’. It means that the failure
Trade Cycles 143
of banking system to keep the money supply constant leads to over-lending on the part of the
banking institutions and over-borrowing for over-investment in the existing business activities.
This will lead to over-production. This over-production results in fall in prices that leads to
depression in the economy.
According to Hayek, alternating phases of prosperity and depression are the result of the
shortening and lengthening of the process of production brought about as a result of the increase
in money supply that causes the market rate of interest to fall below the natural rate of interest.
Thus according to Hayek, over-investment causes trade cycle in the economy.
7.5.5 Monetary Theory
The monetary theory of trade cycle was associated with an English economist, R.G. Hawtrey
(1879–1974). According to Hawtrey, ‘expansion and contraction of circular flow of money
income is the cause of trade cycle’. He emphasizes that changes in the circular flow of money
income and spending give rise to cyclical fluctuations in the level of economic activity.
According to Hawtrey, changes in income and spending are caused by changes in the supply
of bank credit. When the bank expands credit, the producers increase production by employing
more labour and purchasing more raw materials. As a result, employment and income of the
people increase. The prices of goods begin to rise because of an increase in the demand for
goods. The opposite will happen when the bank contracts credit. Thus, according to Hawtrey,
the expansion and contraction of bank credit are responsible for trade cycle in the economy.
7.5.6 Innovation Theory
The innovation theory of trade cycle was associated with an American economist, Joseph A.
Schumpeter (1883–1950). According to Schumpeter, ‘innovations are responsible for trade
cycles’. In other words, innovations are the originating cause of trade cycles in the capitalist
economy. According to Schumpeter, an innovation is the commercial application of new
techniques of production, new materials or new methods of doing business. In Schumpeter’s
explanation, prosperity is the first phase, the last phase being the recovery. Every innovation
increases the demand for capital and other resources. Banks expand credit and prices rise. If
innovation becomes successful, many new concerns will be started. The demand for capital
increases and prices rise still further. Thus boom conditions prevail. Once the goods of an
innovator reach the market, the demand for old goods falls. This leads to unemployment and,
thus, income falls, and depression begins. Thus according to Schumpeter, innovations cause
trade cycles in the economy.
7.5.7 Keynes’ Theory
John Maynard Keynes (1883–1946) did not formulate any theory of trade cycle. As such, his
ideas do not explain the phases of trade cycle. His explanation of trade cycle is a by-product
of his General Theory of Employment and Income (1936). According to Keynes, the primary
cause of cyclical fluctuations exists inseparably in the changes in the volume of investment
caused by the cyclical fluctuations in the marginal efficiency of capital (expected rate of return
on current investment).
According to Keynes, changes in the marginal efficiency of capital are responsible for trade
cycles. When marginal efficiency of capital is high, the rate of investment increases. Through
multiplier effect, each increment of initial investment stimulates consumption to cause a multiple
increase in final income. This process will continue till the peak or boom level is reached.
Thus according to Keynes, marginal efficiency of capital causes trade cycle in the economy.
7.5.8 Hicksian Theory
J.R. Hicks has developed a theory of trade cycle of his own based on the interaction of the
multiplier and the accelerator. According to Hicks, ‘multiplier and accelerator are the two sides
of the theory of fluctuations just as demand and supply are the two sides of the theory of value’.
In the words of Hicks, autonomous investment through multiplier and induced investment
through accelerator cause cyclical fluctuations in business activity in the economy. The initial
increase in autonomous investment results in greater income through the multiplier and the
increased national income induces further investment through the accelerator.
In his explanation of the trade cycle, the multiplier, the accelerator and the warranted rate
of growth plan a significant role. The warranted rate of growth is that rate of growth which
will maintain itself incongruity with the equilibrium of saving and investment, the economy is
said to be growing at a warranted rate of growth when the real investment is in line with the
real saving in an economy.
According to Hicks, the upper turning point is the result of natural growth rate as developed
by Harrod. It is one which is allowed by the increase in population, accumulation of capital,
development of technology, etc. The economy cannot afford to expand beyond this as it forms
the production limit. The lower turning point is the result of the working of the autonomous
investment simply because of the fact that the induced investment is negative.
Hence, the turning point for strong cycle occurs after the production limit is reached,
whereas the turning point for weak cycle occurs before the production limit is reached. Thus
according to Hicks, the interaction of multiplier and accelerator causes trade or business cycle
in the economy.
7.5.9 Cobweb Theory
The cobweb theory of trade cycle was first suggested by Professor Nicholas Kaldor in 1934.
This theory has been based on the concept of ‘lag’. The concept of lag implies the time taken
by the supply to adjust itself to changing conditions of demand. Thus the quantity supplied
during a given period of time (t) is the function of the price prevailing at an early period of
time (t–1), while the demand depends upon the price prevailing in a particular period of time
(t) itself. This theory suggested by Kaldor relates only to the agricultural sector of the economy.
Since the supply in agriculture is slow to adjust itself to changes in demand, radial fluctuations
in prices and output are likely to occur.
Trade Cycles 145
Cobwebs, according to Kaldor, are divided into converging cobweb, diverging cobweb and
continuous cobweb.
Converging cobweb is a type of cobweb in which a disturbed economy has a tendency
to regain the original equilibrium position through a series of oscillations. In this type, the
movement of prices and output turns inside towards equilibrium. The elasticity of supply is
less than the elasticity of demand. The slope of the supply curve is greater than of demand
curve. The converging cobweb is illustrated in Figure 7.2.
Figure 7.2 Converging cobweb.
Diverging cobweb is a type of cobweb in which a disturbed economy has a tendency to

move away from the original equilibrium position. In this type, the movement of prices and
output turns outward from the original equilibrium position through every subsequent oscillation.
The elasticity of supply is more than the elasticity of demand. The slope of the supply curve
is less than that of the demand curve. The diverging cobweb is illustrated in Figure 7.3.
Figure 7.3 Diverging cobweb.
Continuous cobweb is a type of cobweb in which the price and output are fluctuating
continuously and regularly around the original equilibrium position. In this type, the elasticity
of supply is equal to the elasticity of demand. The slope of the supply curve is equal to the
slope of demand curve. The continuous cobweb is illustrated in Figure 7.4.
Figure 7.4 Continuous cobweb.
7.6 Control of Trade Cycle (Anticyclical Measures)

Trade cycle generally disturbs the level of economic activity which is not beneficial to the
community. It adversely affects the economic system. Therefore, cyclical fluctuations in business
and economic activity should be controlled.
Economists advocate various policy measures to control the trade cycle in the economy.
They include:
• The central bank of the country (RBI) should control the supply of money and credit
by adopting various monetary methods such as bank rate, open market operations and
variations in cash reserve ratios. During the depression phase, the central bank should
reduce the bank rate, buying securities in the open market and reducing the cash reserve
ratio, whereas during the period of prosperity, the central bank should raise the bank
rate, selling securities and raising the cash reserve ratio.
• The government should adopt fiscal measures such as taxation and expenditure. The
government should spend more and tax less during the period of depression, whereas
the government should spend less and tax more during the period of prosperity.
• The inequalities in the distribution of income and wealth among the people should be
considerably reduced.
• There should be complete reorganization of the economic system, i.e. socialism should
be established to control trade or business cycle in the economy.

1. A trade cycle is composed of the periods of
(a) good trade (b) bad trade
(c) good and bad trade (d) all of the above
2. A trade cycle is
(a) cumulative in nature (b) recurrent in nature
(c) sequential in nature (d) all of the above
Trade Cycles 147
3. Depression is a period of
(a) pessimism (b) optimism
(c) protectionism (d) all of the above
4. Prosperity is a period of
(a) pessimism (b) optimism
(c) protectionism (d) all of the above
5. Which of the following phase of a trade cycle is the most desirable one?
(a) Depression (b) Recovery
(c) Prosperity (d) Recession
6. In which of the following phase of a trade cycle there is violent disturbances in the
business world?
7. The climatic theory of trade cycle was propounded by
(a) J.A. Hobson (b) W.S. Jevons
(c) A.C. Pigou (d) R.G. Hawtrey
8. The psychological theory of trade cycle was associated with
(a) A.C. Pigou (b) J.A. Hobson
(c) J.A. Schumpeter (d) Von Hayek
9. The under-consumption theory of trade cycle was associated with
(a) A.C. Pigou (b) J.A. Hobson
(c) W.S. Jevons (d) R.G. Hawtrey
10. The over-investment theory of trade cycle was propounded by
(a) F.A. Von Hayek (b) J.A. Hobson
(c) A.C. Pigou (d) R.G. Hawtrey
11. The monetary theory of trade cycle was associated with
(a) J.A. Schumpeter (b) J. M. Keynes
(c) R.G. Hawtrey (d) Von Hayek
12. In which theory of trade cycle, the expansion and contraction of bank credit are responsible
for trade cycle in the economy?
(a) Innovation theory (b) Monetary theory
(c) Keynesian theory (d) Over-investment theory
13. The innovation theory of trade cycle was associated with
(a) Joseph A. Schumpeter (b) Paul A. Samuelson
(c) John Maynard Keynes (d) Milton Friedman
14. Which is the first phase in Schumpeter’s innovation theory of trade cycle?
15. According to J.M. Keynes, which of the following is the cause of a trade cycle?
(a) Aggregate demand (b) Aggregate supply
(c) Marginal efficiency of capital (d) Rate of interest
16. In which theory of trade cycle, autonomous investment through multiplier and induced
investment through accelerator cause trade cycle?
(a) Keynesian theory of trade cycle (b) Hicksian theory of trade cycle
(c) Schumpeter’s theory of trade cycle (d) Aftalian’s theory of trade cycle
17. The cobweb theory of trade cycle was suggested by
(a) J.A. Hobson (b) J.R. Hicks
(c) Nicholas Kaldor (d) R.F. Kahn
Answers
1. (c) 2. (d) 3. (a) 4. (b) 5. (c)

6. (d) 7. (b) 8. (a) 9. (b) 10. (a)
11. (c) 12. (b) 13. (a) 14. (c) 15. (c)
16. (b) 17. (c)
Review Questions
1. What is a trade cycle?
2. Bring out the characteristics of a trade cycle.
3. What are the four different phases of a trade cycle? Explain.
4. Diagrammatically illustrate the four phases of a trade cycle.
5. State and explain the various theories of a trade cycle.
6. Suggest measures to control a trade cycle in an economy.
7. What are the monetary measures suggested by economists to control business fluctuations
in an economy?
8. What are the fiscal measures adopted by the government to control a trade cycle?
Chapter 8
Money Market
8.1 Meaning of Money Market

Money market is the market for short-term loanable funds. In other words, money market is the
market in which short-term funds are borrowed and lent. Money market consists of borrowers
of short-term funds and lenders of short-term funds. The borrowers of short-term funds include
traders, manufacturers, speculators, bill brokers, share brokers and the government. The lenders
of short-term funds include commercial banks, financial companies and central bank. The short-
term funds are borrowed and lent through the use of instruments like short-term government
securities and commercial bills of exchange.
8.2 Definitions of Money Market

A few definitions of money market are as follows:
The Reserve Bank of India (RBI) defines money market as, “a centre for dealings, mainly
of a short-term character, in monetary assets; it meets the short-term requirements of the
borrowers and provides liquidity or cash to lenders. It is the place where short-term surplus
investible funds at the disposal of the financial and other institutions and individuals are bid
by borrowers, again comprising institutions and individuals and also by the government”.
According to Dr. S.N. Sen, “the organization for the lending and borrowing of short-term
funds through the use of such instruments as commercial bills of exchange short-term government
securities, bankers’ acceptances, etc.”
Madden Naddler’s definition says, “a mechanism through which short-term funds are loaned
and borrowed and through which a large part of financial transactions of a particular country
or of the world are cleared”.
R.P. Kent in his definition says, “a market comprises all the facilities by means of which
people arrange to borrow and lend money periods not exceeding one year”.
149
8.3 Functions of Money Market

Money market performs the following ten important functions:
1. Money market enhances the amount of liquidity available to the entire country.
2. It helps to enhance the profit of financial institutions and individuals.
3. It helps to avoid regional gluts and stringencies of funds.
4. It helps in making funds available at cheaper rates.
5. It helps to avoid seasonal fluctuations in the interest rates.
6. It augments the supply of loanable funds.
7. It helps to minimize gluts and stringencies which are caused by seasonal variations in
the flow of and demand for funds.
8. It helps in rational allocation of resources.
9. It promotes liquidity and safety of financial assets.
10. It helps the government to borrow short-term funds at low rate of interest on the basis
of treasury bills.
8.4 Institutions of Money Market

The institutions of a money market are:
1. Central bank
2. Commercial banks
3. Non-banking financial institutions
4. Discount houses and bill brokers
5. Acceptance houses
8.4.1 Central Bank
The central bank of a country is the supreme authority of the money market. It acts as the
guardian of the money market by increasing or decreasing the supply of money and credit in
the interest of stability of the economy. It channelizes the credit facilities effectively through
methods like open market operations, rediscounting of securities and also controls credit through
changes in the bank rate. It does not enter into direct transactions with the public.
8.4.2 Commercial Bank
Commercial banks constitute an important component of money market. They provide short-
term funds for business and industrial concerns. They provide short-term funds by discounting
bills of exchange and treasury bills. They lend loans against promissory notes. They make
advances and facilitate overdrafts to the business community.
Money Market 151
8.4.3 Non-banking Financial Institutions
The non-banking financial institutions like insurance companies, savings banks, investment
banks, provident funds and other business corporations play an active part in the transactions
of the money market with their surplus short-term loanable funds.
8.4.4 Discount Houses and Bill Brokers
Discount houses are established for discounting bills of exchange on behalf of others. In developed
money markets, private companies operate discount houses. There are also bill brokers in the
money market. They act as intermediaries between borrowers and lenders. They buy and sell
all kinds of bills on commercial basis. They charge a nominal commission. In underdeveloped
money market, bill brokers only operate.
8.4.5 Acceptance Houses
Acceptance houses are established for the purpose of facilitating international trade. They
are the commission agents of trading partners. They act as agents between the exporters and
importers and also between the borrowers and lenders. They accept the trade bills and guarantee
the payment of bills at maturity. They operate from the international money market, i.e. from
London money market.
8.5 Instruments of Money Market

Money market operates through the following important instruments:
1. Promissory note
2. Bill of exchange
3. Treasury bills
4. Call loans
5. Commercial papers
6. Inter-bank term market
7. Certificates of deposits
8.5.1 Promissory Note
Promissory note is the earliest instrument used in the money market. It is a written promise
made by one person to another to pay the latter a certain sum of money at a mutually agreed
future date. It will mature for payment generally after 90 days with 3 days more being grace
period. It is drawn by the debtor and has to be accepted by the bank in which the debtor has
his account, to be valid. Promissory notes are widely used in the USA.
8.5.2 Bill of Exchange
Bill of exchange is another instrument used in the money market. It is an unconditional written
order made by one person to another, signed by the person giving it, to pay on demand a certain
sum of money at a fixed future date. It is drawn by the creditor and is accepted by the bank
of the debtor. The creditor can discount the bill of exchange either with a bank or a broker.
Bill of exchange is also known as trade bill.
8.5.3 Treasury Bills
Treasury bills are the short-term securities issued by the government for 91 days. In India,
the treasury bills are issued by the Government of India at a discount generally between 91
days and 364 days. These treasury bills are floated through auctions conducted by the RBI.
Treasury bills are issued by the Secretary to the Treasury in England and payable at the Bank
of England. Treasury bills are also the short-term government securities in the USA which are
traded by commercial banks and dealers in securities.
8.5.4 Call Loans
Call loans are short-term loans provided for a period of one day. They are renewable on a
day-to-day basis. Funds are borrowed and lent up to 14 days without any collateral security.
In India, commercial and cooperative banks borrow and lend in this call loan market. Apart
from banks, the LIC of India and the Unit Trust of India are also permitted to participate in
the call loan market.
8.5.5 Commercial Papers
Commercial papers are issued by high-rated companies to raise short-term working capital
requirements directly from the market. It is a promise made by the borrowing company to repay
the loan at a specified period, usually for a period of 90 days to 180 days. This instrument is
famous in the USA, UK, Japan and Australia. In 1990, it was introduced in India.
8.5.6 Inter-bank Term Market
Inter-bank term market is exclusively for commercial banks and cooperative banks. They borrow
and lend short-term funds for a period of 14 days to 90 days without any collateral security.
8.5.7 Certificates of Deposits
Certificates of deposits are short-term deposits issued by commercial banks at a discount

rate. The discount rate is freely determined by issuing banks and the market. In India, the
minimum size of the issue of certificates of deposits is ` 25 lakh with a minimum subscription
of ` 5 lakh. The maturity period is between 90 days and 364 days.
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The certificates of deposits can be issued to individuals, companies, corporations, trusts,
non-resident Indians (NRIs) on a non-repatriable basis. Commercial banks are not allowed to
buy back their certificates of deposits before their maturity and to grant loans against their own
certificates of deposits. They are freely transferable by endorsement. This can be done only
after 45 days from the date of issue.
8.6 Characteristics of a Good Money Market

A good money market should possess certain characteristics. The following are the characteristics
of a well-developed money market:
• There must be a ‘highly organized commercial banking system’ mainly dealing with
short-term funds.
• There must be a ‘central bank’ in the country for providing ultimate liquidity which is
essential for the efficient functioning of the money market.
• There must be a ‘number of submarkets’ like call loan market, commercial bill market
and treasury bill market.
• There must be a ‘reasonably workable competition’ among the submarkets to bring out
changes in interest rates according to the requirements of funds in each submarket.
• There must be an ‘adequate of funds’ for short-term loan facilities which can meet the
financial needs of its customers.
• There must be an adequate flow of funds from other countries in the sense that it must
be capable of attracting funds from the countries.
• There must be a very favourable balance of payments position in the economy.
• There must be stable political conditions in the country.
• There must be price stabilization in the country.
• There must be well-organized stock exchange market.
• The whole structure of the money market should be a highly integrated one in which
each submarket is dependent upon and influenced by other parts.
A money market which does not satisfy the above may be described as an underdeveloped
money market.
8.7 Importance of Money Market

Money market is of great importance on the following grounds:
• It finances the short-term working capital requirements of the public and private sector
organizations.
• It helps the financial institutions functioning in the money market to earn profits in the
short period.
• It helps the financial institutions for the mobilization or the flow funds from one sector
to another which is essential for balanced growth of an economy.
• It helps the financial institutions to convert the savings of the community into investment
leading to proper allocation of resources in the economy.
• It is useful to the government because the rate of interest is at the low level and the
government may resort to deficit financing leading to rise in prices.
• It safeguards the liquidity and safety of financial assets of the financial institutions
functioning in the money market.
• It can effectively handle credit control measures adopted by the central bank of the
country.
8.8 London Money Market

8.8.1 Nature of London Money Market
The London money market is a highly organized and well-developed money market at the
global level. It satisfies all the conditions of a good money market. It has a well-developed
banking system. The Bank of England is the central bank of the country which performs its
functions efficiently and effectively. There are a number of submarkets. Each submarket is an
attractive market consisting of a number of dealers with large funds. It has a number of well-
known banks which handle foreign funds. It is a highly integrated structure. London money
market is an international financial centre for a very long period.
8.8.2 Constituents of London Money Market
Principal traditional constituents of London money market

The following are the principal traditional constituents of the London money market:
1. Bank of England 2. Joint stock banks
3. Acceptance houses 4. Discount houses
5. Bill brokers
Bank of England: The Bank of England was established in 1691. It is the central bank of
the United Kingdom (UK). It was given the sole authority of note issue in 1884. Originally,
it was a shareholders bank. It was nationalized in 1946.
The Bank of England is the leader and occupies the top position of the London money
market. It is the lender of the last resort and the ultimate reservoir of cash. It also borrows
large sum money in the money market by its weekly issues of treasury bills by tender.
The Bank of England acts as the banker to the government. It acts as a banker’s bank.
It controls credit created by commercial banks. It uses bank rate and open market operations
to control credit created by commercial banks. It depends heavily on moral suasion. It also
exercises effective control over other financial institutions functioning in the money markets.
Its credit policy is more effective as London money market is a well-developed one.
Joint stock banks: Joint stock banks are the most important constituent of the London money
market, next to Bank of England. Most of the banking business in England is concentrated in
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a few banks, popularly known as the ‘BIG FIVE’. The ‘big five’ banks are: Midland, Barclays,
Lloyds, the Westministor and the National Provincial. About 80 per cent of the total bank
deposits in the country are controlled by the ‘big five’ banks.
Joint stock banks receive deposits from the public and lend money to merchants and
manufacturers for short periods. They also lend to brokers and discount houses and these loans
are repayable on demand or a short notice. These are called ‘call loans’. They purchase bills
of exchange from the discount houses. They also perform customer services.
Acceptance houses: The acceptance houses are the peculiar constituent of the London money
market because such houses are not found in anywhere else in the world. The acceptance houses
specialize in accepting bills of exchange on behalf of their customers. Businessmen will be
willing to sell goods on credit to foreigners provided the bill of exchange usually in export and
import business. The seller of goods (exporter) normally draws a bill on the buyer of goods
(importer) and the buyer accepts to pay the amount after a certain period, say, 3 months. After
the acceptance, the bill will be discounted in the discount market. But if the buyer (importer)
is not known to the seller (exporter), the bill accepted by the buyer may not be taken by the
seller. In this case, the buyer can approach the acceptance house which accepts the bill on
his behalf. The bill, accepted by the international reputed acceptance houses can be readily
discounted in the London money market at a low rate of interest. A small commission for this
service is charged by the acceptance house.
Discount houses: The discount houses specialize in discounting bills of exchange. They deal
in commercial bills and treasury bills. They borrow from the commercial banks for short periods
at a low rate of interest and invest them in bills of exchange. The purpose is to discount bills
at a high rate and enjoy profit.
When the cash balances of the commercial banks fall, they will recall the loans already
granted to discount houses. The discount houses go to the Bank of England for financial
accommodation. The Bank of England, in turn, rediscounts the bills of the discount houses. Thus
in England, commercial banks get financial accommodation from the Bank of England indirectly
but the discount houses can directly approach the Bank of England for financial assistance
by way of rediscounting their bills. The Bank of England can impose certain conditions for
rediscounting of bills surrendered by discount houses. In such a case, the bank rate is higher
than the market rate of discount. Hence discount houses approach the Banks of England only
during financial emergencies.
Bill brokers: Bill brokers act as intermediaries between those who want to discount bills and
those who want to invest in bills. They get brokerage for their services.
Current constituents of London money market

At present, London money market consists of the following three markets, in addition to the
earlier and traditional constituents:
1. Eurodollar market
2. Local authorities market
3. Inter-bank market
Eurodollar market: The term ‘Eurodollar’ simply refers to the US dollar deposits with a
bank outside the United States. The depositor lends these dollar balances with the US banks
through London although the place to lend these dollars is New York.
The Eurodollar market has developed with London as its centre because of the following:
• The owners of dollar balances get better interest rate by lending in London than from
New York banks.
• In London, Eurodollars are more easily available than in New York.
• The system of control of the Bank of England is more flexible.
• A well-established banking system in London with its long history of financing international
trade.
• The London merchant banks were the pioneer in originating the Eurodollar market.
The important dealers of the Eurodollar market are:
• London clearing banks
• British overseas banks
• European and other foreign banks with or without their offices in London.
A large number of American banks have been established in London mainly to deal in
Eurodollar market. Though the Eurodollar market was the first one to develop, markets in
other currencies have also subsequently developed in Swiss Francs and Deutsche Marks.
This market has been referred to as the Euro Currency Market. Thus, the banks which accept
deposits denominated in foreign currencies and repayable in the same currencies are designated
as Euro Bank.
In the Eurodollar market, an European bank is the leader of all other banks. The European
bank gets dollar deposits from a British exported who exports goods to America. The exporter
decides to deposit the dollar draft received as a dollar time deposits with the London Bank.
The London Bank would in turn send the dollar draft received from the British exporter to
its American correspondent bank for credit in its demand deposit. In lending Eurodollars, the
British Bank simply draws a draft on its American correspondent bank payable to the borrower.
Local authorities market: Local authorities market simply refers to the market dealing with
short-term loans and advances local government authorities. These loans are dealt with only
in British currency—pound sterling. In this market, there are borrowers and lenders. The
borrowers in the local authorities market are the local government authorities. The lenders in the
local authorities market are banks, financial institutions, industrial and commercial companies,
charitable trusts and other miscellaneous organizations. The borrowers or the local authorities
have tended to use the money market mostly in times of high rates of interest.
In the local authorities market, several firms act as brokers, a few as stock exchange firms,
a few as foreign exchange firms and two or three as specialist firms. The specialist firms have a
large share in the total business transactions which are, in turn, fixed by these brokers normally
over telephone. They also maintain a constant contact with local authorities.
Inter-bank market: Inter-bank market is a market dealing with borrowing and lending between
banks. The following are the participants of the inter-bank market:
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(i) Scottish banks
(ii) Merchant banks
(iii) British overseas banks
(iv) Foreign banks
There are a large number of outside banks in London. It is believed that all of these banks
deal in the inter-bank market. All transactions in the inter-bank market are measure. In this
market, money is borrowed an lent for a period of ever might up to 5 years. The transactions
are mostly for short periods. The inter-bank market is operated by brokers who arrange for all
transactions between banks and discount houses.
8.9 New York Money Market

8.9.1 Structure and Organization of New York Money Market
The New York money market is a well-developed money market in the world. Although
Washington is the capital of the United States of America, New York has become the most
important financial centre of the world as a whole.
In the New York money market, the main dealers are of two groups—lenders and borrowers.
The principal lenders in the New York money market are:
1. Federal reserve banks
2. Commercial banks
3. Money brokers
4. Insurance companies, savings banks, trusts, etc.
The borrowers in the New York money market are:
(i) Business concerns
(ii) Exporters and importers
(iii) Dealers in commodities
(iv) Investment banking houses
(v) Dealers in government securities
(vi) Government of the United States
(vii) Traders in securities
8.9.2 Constituents of New York Money Market
The following five important constituents or submarkets of New York money market are:
1. Commercial paper market
2. Collateral loan market
3. Acceptance market
4. Treasury bill market
5. Federal funds market
Commercial paper market

Commercial paper market is the oldest of the money markets. This type of market is not found
in other countries. ‘Commercial paper’ is a promissory note of well-known business concerns.
This promissory note is one which matures within a short period of 3 to 6 months.
When a business concern requires funds for a short period for running its business, it will
issue commercial paper (i.e. promissory note). This paper is secured by a lien on the assets of
the business concern. This paper is issued in denominations of $5000 or multiple of it. The
commercial paper is sold to dealers who are in commercial paper houses. These commercial
paper houses resell them to banks. This is a convenient method of securing funds for working
capital. The interest rate on the commercial paper is lower than the interest rate on loans
granted by banks.
Collateral loan market

Banks grant loans to dealers and brokers who deal in securities. These loans are granted on the
security of shares, debentures or government securities. So these loans are called collateral loans.
These loans are mostly made on the condition that the borrowers will have to repay whenever
a call is made by the bank. These loans are also called ‘call loans’. Call loans are made on a
day-to-day basis and are repayable on demand on the day followed the day contracted. If these
loans are not called for repayment, they are automatically renewed for another day.
The Federal Reserve Banks have powers to fix margins against stock exchange securities.
This is found necessary to check speculation on the stock exchange. A large amount of loans in
the New York Money Market are call loans to the dealers and brokers who deal in securities.
Acceptance market
The acceptance business is usually done by commercial banks. They accept bills of exchange
on behalf of their customers. A bank which has accepted a bill on behalf of its customer must
pay money to the holder of the bill on the due date. The maturity of bank acceptances is
usually up to 6 months. The bank will collect money from the customer on whose behalf it
has accepted the bill of exchange. Banks get commission for this service. The bills accepted
by a bank are called bankers bill or bankers acceptance. These bills can be easily sold in the
money market. These bills can also be rediscounted with the Federal Reserve Banks. These
bills are used for financing international trade.
Treasury bill market

Treasury bill market is a market for the US treasury bills. Treasury bills are non-interest bearing
obligations of the US treasury. These bills are generally repayable after 90 days and are traded
in on a discount basis. These bills are the best form of short-term investment. These bills are
purchased by banks because of their high degree of liquidity, safety, easy marketability and
short maturity.
Federal funds market

In the USA, every commercial bank has to keep a certain percentage of its total deposits
with the federal funds banks by law. These reserves are called ‘legal reserves’. Banks having
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excess cash reserves (more than legal minimum) with the federal funds banks are in a position
to lend to those banks which are deficient in reserves. These excess cash reserves are called
‘federal funds’.
Banks having deficit cash reserves (less than legal minimum) should deposit additional
cash with the federal funds banks. So banks having deficit reserves borrow from banks having
surplus reserves. These loans are granted on day-to-day basis. In this case, the amount will be
transferred from the account of the bank granting the loan to the account of the bank getting
the loan. This will avoid borrowing from the federal reserve bank. Besides, the interest rate
charged by banks is lower than the interest rate charged by the federal reserve banks.
8.10 Indian Money Market

8.10.1 Structure of Indian Money Market
Indian money market is an underdeveloped money market. It does not satisfy all the conditions
of a good money market. The banking system is not well developed in the country. A bill
market does not exist in the country. The various constituents are not closely connected with
each other. Hence, the structure of Indian money market is poorly organized. Indian money
market is divided into two parts:
1. Organized part of Indian money market
2. Unorganized part of Indian money market
Organized part of indian money market

The organized part of the Indian money market consists of the following:
1. Reserve Bank of India (RBI)
2. State Bank of India (SBI)
3. Nationalized commercial banks
4. Private sector banks
5. Foreign exchange banks
6. Cooperative banks
Reserve Bank of India (RBI): The RBI was established in 1935. It was nationalized in 1949.
It occupies an important position in the Indian money market. It enjoys monopoly of note
issue. It acts as a banker to the government, bankers’ bank and the lender of the last resort.
State Bank of India (SBI): The SBI was established in 1955. It occupies an important position
in the Indian money market. It is the biggest commercial bank in the country. It performs all
the functions of a commercial bank. It has 7 subsidiary or associate banks.
Nationalized commercial banks: The Government of India has nationalized so far 14 major
commercial banks in 1969 and 6 in 1980. At present, we have 20 nationalized commercial
banks. They perform commercial banking functions. They are granting loans on an increasing
scale to farmers and small industries. They are opening branches in rural and semiurban areas
in order to promote banking habit among the people.
Private sector banks: The banks in the private sector perform commercial banking functions.
They control only about 15 per cent of the total deposits in the country, whereas public sector
banks control about 85 per cent of the total deposits.
Foreign exchange banks: Foreign exchange banks have their head offices in foreign countries.
They finance international trade of India. They provide finance to importers and exporters.
They discount foreign bills of exchange. They compete with the commercial banks to attract
deposits. They encourage foreigners to invest their funds in Indian industries.
Cooperative banks: Cooperative banks also occupy an important position in the organized
part of the Indian money market. They grant short-term loans to farmers. They specialize in
financing agriculture. There are primary credit societies at the village level, cooperative banks
at the district level and state cooperative banks at the state level. The state cooperative banks
maintain current accounts with State Bank of India (SBI) and obtain cash credits and over-
draft facilities from it.
Unorganized part of Indian money market

The unorganized part of the Indian money market consists of the following:
1. Indigenous bankers
2. Money lenders
Indigenous bankers: The Central Banking Enquiry Committee defines an indigenous bankers
as, “any individual or private firm receiving deposits and dealing in hundies or lending money”.
The indigenous bankers accept deposits and make credit arrangements with the Indian Joint Stock
Banks. They finance trade and industry. They deal in short-term credit instruments (hundies)
for financing the production and distribution of goods. They charge lower interest rates on the
loans. They insist on security. The indigenous bankers occupy an important position in the
credit structure of the country. They receive deposits from the public and pay interest on these
deposits. No cheque system is permitted. In times of need, they borrow from the State Bank
of India and Joint Stock Banks either on demand promissory notes or by discounting. They
discharge a large number of banking functions such as remittances, discounting hundies and
giving loans against stock-in-trade.
Money lenders: The Central Banking Enquiry Committee defines a money lender as, “a person
whose primary business is not banking but money lending”.
Money lenders do not accept deposits but they do business with their own money. They
finance consumption more than trade. They deal in cash. They charge an exorbitant rates of
interest. They are generally unsecured.
In India, money lenders are of two types: professional money lenders and non-professional
money lenders. The professional money lenders include rural money lenders, urban money
lenders and itinerant money lenders. The non-professional money lenders include agriculturalists,
landlords, merchants, traders, pensioners, priests and widows.
Professional money lenders grant loans on personal security for agricultural purposes on the
condition that the crops will be sold only to them. When large loans are given by professional
money lenders, they insist on mortgage of land, house or ornaments. They also charge compound
Money Market 161
rates of interest. Further, money lenders lend money for all types of purposes. They never
bother about the purpose for which the loan is needed.
8.10.2 Defects of Indian Money Market
The main seven defects of the Indian money market are:

1. There is no proper coordination and cooperation among the various members of the
Indian money market. Hence Indian money market is regarded as a financial market
of loose structure or organization.
2. The absence of control over the indigenous bankers and money lenders who occupy an
important position in the Indian economy. They remain outside the effective control of
the Reserve Bank of India.
3. The existence of disparities in interest rates in different parts of the country.
4. The absence of a well-organized bill market scheme in India, i.e. there are no separate
institutions like discount houses for discounting bills.
5. There is no proper call loan market in the country. In India, call loans are not granted
to traders or brokers but granted only by one bank to another bank.
6. There will be scarcity of funds (or monetary stringency during busy season).
7. The absence of a well-developed banking system in the country.
8.10.3 Suggestions for the Improvement of Indian Money Market
The following are the important suggestions for the improvement of the Indian money market:
1. The Reserve Bank of India should bring the indigenous bankers under its effective
control.
2. The RBI and the government should encourage commercial banks to open branches in
rural and semi-urban areas.
3. The RBI should encourage the establishment of discount houses and acceptance houses
to develop the bill market scheme in the country.
4. The RBI should grant liberal loans and advances to commercial banks during busy
season in order to remove seasonal financial stringencies.
5. The RBI should bring about proper coordination and cooperation among the various
members of the money market.
6. Disparities in the rates of interest can be reduced by the RBI by bringing the indigenous
bankers under its control. This can be achieved by way of encouraging the movement
of funds from surplus areas to deficit areas.
A note on ‘Bill Market Scheme’

The Bill Market Scheme was introduced by the Reserve Bank of India on January 16, 1952.
Under this scheme, the RBI granted advances to scheduled commercial banks in the form of
demand loans against promissory notes of their members. Scheduled banks were permitted to
convert a part of their advances into nuisance promissory notes for 90 days. The RBI offered
to make such advances at 0.5 per cent below the bank rate. This market scheme has been
described as ‘pseudo’ bill market scheme as it was limited to commercial banks mainly to
obtain refinance facilities from the RBI by converting a part of their cash credits. Hence the
Bill Market Scheme was withdrawn with effect from July 1, 1971.
On the recommendations of the study group constituted in February 1970 under the
chairmanship of M. Narasimhan, the RBI announced a New Bill Market Scheme. This new
scheme came into force from November 1, 1970. Under the new Bill Market Scheme, the
Reserve Bank of India rediscounts genuine trade bills. This scheme is a very big step towards
the development of a bill market in India. This scheme would tend to bring about an integration
of the credit structure and monetary policy of the country.
1. Money market is a market for

(a) short-term loanable funds (b) medium-term loanable funds
(c) long-term loanable funds (d) all of the above
2. A money market
(a) enhances liquidity (b) enhances profit
(c) enhances availability of funds (d) all of the above
3. Who is the supreme authority of the money market?
(a) Central Bank (b) Commercial Banks
(c) State Bank of India (d) all of the above
4. Which of the following is the earliest instrument used in the money market?
(a) Treasury bills (b) Bill of exchange
(c) Promissory note (d) Commercial papers
5. Treasury bills are
(a) short-term securities (b) medium-term securities
(c) long-term securities (d) none of the above
6. Which of the following instrument used in the money market is an unconditional written
order made by one person to another?
(a) Promissory note (b) Bill of exchange
(c) Treasury bills (d) Commercial paper
7. Certificates of deposits issued by commercial banks at a discount rates are
(a) short-term deposits (b) medium-term deposits
(c) long-term deposits (d) all of the above
8. A well-developed money market should have
(a) adequate funds (b) organized commercial banking system
(c) competition among submarkets (d) all of the above
9. The Central Bank of the United Kingdom is
(a) Bank of England (b) Bank of Baroda
(c) Bank of London (d) Bank of France
Money Market 163
10. Midland, Barclays, Lloyds, Westminster and National Provincial in England are popularly
known as
(a) ‘Big Five’ Banks (b) ‘Big Authorities’
(c) ‘Big States’ (d) ‘Big Provincials’
11. At present, which of the following are the constituents of the London Money Market?
(a) Eurodollar market (b) Local authorities market
(c) Inter-bank market (d) All of the above
12. Eurodollar simply refers to
(a) US dollar deposits with a bank outside the US
(b) US dollar deposits with a bank inside the US
(c) US dollar deposits with a bank outside the UK
(d) US dollar deposits with a bank inside the UK
13. Who are the important dealers of the Eurodollar Market?
(a) London clearing banks (b) British overseas banks
(c) European and other banks (d) All of the above
14. Who is the inter-bank market dealing with borrowing and lending between banks?
(a) Scottish banks (b) Merchant banks
(c) British overseas banks (d) Foreign banks
15. The principal lenders in the New York money market are
(a) Federal Reserve Banks (b) Commercial Banks
(c) Money Brokers (d) All of the above
16. The principal borrowers in the New York money market are
(a) exporters and importers (b) traders in securities
(c) business concerns (d) all of the above
17. Which is the constituent of the New York money market?
(a) Commercial paper market (b) Collateral loan market
(c) Acceptance market (d) Treasury bill market
18. Indian money market is
(a) a developed one (b) an underdeveloped one
(c) a developing one (d) none of the above
19. The organized part of the Indian money market consists of
(a) RBI (b) SBI
(c) nationalized commercial banks (d) all of the above
20. The unorganized part of the Indian money market does not consist of
(a) money lenders (b) indigenous bankers
(c) scheduled banks (d) private sector banks
21. The Bill Market Scheme was announced by the RBI on
(a) January 16, 1948 (b) January 16, 1950
(c) January 16, 1952 (d) January 16, 1962
22. A new Bill Market Scheme was announced by the RBI on November 1, 1970 on the
recommendations of the Study Group constituted under the chairmanship of
(a) M. Narasimhan (b) M. Narasima Rao
(c) M. Subbarao (d) M. Renga Reddi
Answers
1. (a) 2. (d) 3. (a) 4. (c) 5. (a)

6. (b) 7. (a) 8. (d) 9. (a) 10. (a)
11. (d) 12. (a) 13. (d) 14. (e) 15. (d)
16. (d) 17. (e) 18. (b) 19. (d) 20. (d)
21. (c) 22. (a)
Review Questions
1. What is the meaning of money market?
2. Bring out the functions of money market.
3. Explain the various institutions of money market.
4. Describe the important instruments of money market.
5. Bring out the characteristics of a good money market.
6. Bring out the importance of money market.
7. Discuss the structure, constituents and working of the London money market.
8. Write short notes on:
• Eurodollar market
• Local authorities market
• Inter-bank market
9. Explain the structure, constituents and working of the New York money market.
10. Explain the structure or organization of the Indian money market.
11. Describe the organized part of the Indian money market.
12. Describe the unorganized part of the Indian money market.
13. Discuss the role of indigenous bankers and money lenders in the Indian money market.
14. What are the main defects of the Indian money market?
15. Suggest measures or steps to improve the Indian money market.
16. Write a note on ‘Bill Market Scheme’.
Chapter 9
Capital and Stock Markets
9.1 Capital Market

A capital market is a market in which the long-term funds are borrowed and lent. Hence it is
the market for long-term funds. A capital market may be defined as an organized mechanism
for the smooth and effective transfer of financial resources from the potential investors to the
entrepreneurs.
The capital market consists of a number of individuals and institutions (including the
government) that canalize the demand for and supply of long-term capital and claims on capital.
9.2 Constituents of Capital Market

The seven important constituents of the capital market include:
1. Stock exchanges 2. Commercial banks
3. Cooperative banks 4. Savings banks
5. Development banks 6. Insurance companies
7. Investment trusts
9.3 Components of Capital Market

The following three important components of the capital market are:
1. Suppliers of loanable funds
2. Borrowers of loanable funds
3. Intermediaries
In the capital market, the supply of funds/capital comes from the individual savings, corporate
savings, institutional investors and the surplus of governments. The demand for funds/capital
comes from agriculture, industry, trade and the government.
165
9.4 Importance of Capital Market

The pace of economic development of any country depends on a well-developed capital market.
It also conditioned by the rate of long-term investment and capital formation.
Capital formation is conditioned by the mobilization, augmentation and channelization
of investible funds. The capital market serves effectively by pooling the capital resources of
the country and making them available to the potential investors. Eurocurrency market and
Eurobond market are international financial markets in terms of both the supply of and demand
for funds. ‘Eurodollar’ market is the market for short-term funds and ‘Eurobond market’ is the
market for long-term funds.
The increase in the size of industrial units and business corporation due to technological
developments has created a situation where in the capital availability in the hands of one or
few individuations is insufficient to meet the invisible demands. A developed capital market
can solve this problem of paucity of funds.
In the process of economic development, the saving capacity of certain class of people
and institutions increases. The capital market satisfies the tastes of savers and the requirements
of investors through its financial instruments and institutions. In brief, the importance of
capital market in the process of economic development of a country can be summarized as
follows:
The capital market plays a vital role in mobilizing savings and, hence, it serves as a bridge
between the savers and the investors. Capital market also plays a significant role in diverting
the unproductive use of resources to their productive use. Thus it is clear that capital market
is the lifeblood of the economic development of the country.
9.5 Functions of Capital Market

The capital market performs the following four major functions:
1. Mobilization of financial resources at the national level.
2. Securing the required foreign capital and know-how in order to attain rapid economic
growth.
3. Allocation of the mobilized financial resources effectively to those projects yielding
higher returns.
4. Effective allocation of financial resources is ensured to the priority areas where there
is an urgent need to promote rapid industrialization.
9.6 Indian Capital Market

9.6.1 Nature of Indian Capital Market
Indian capital market consists of an organized sector and an unorganised sector. In the organized
sector of the Indian capital market, the demand for long-term capital comes from corporate
enterprises, public sector enterprises, government and semigovernment institutions. The supply
Capital and Stock Markets 167
of long-term funds comes from household savings (individual investors), institutional investors
like commercial banks, investment trusts, insurance companies, government and international
financing agencies.
Like the Indian money market, the unorganized sector of the capital market also consists
of indigenous bankers and private money lenders. The unorganized sector of the Indian money
market is characterized by the existence of multiplicity of interest rates, exorbitant rates of
interest and lack of uniformity in their business dealings. The demand for long-term capital
comes mainly from agriculturists, private individuals for consumption purposes and from small
traders. The supply of long-term funds comes from own financial resources of money lenders.
The indigenous bankers function in urban areas and the money lenders function in rural areas.
9.6.2 Components of Indian Capital Market
The following three main components of the Indian capital market are:
1. New issues market (primary market)
2. Stock (exchange) market (secondary market)
3. Financial institutions
New issues market (primary market)

The new issues market represents the ‘primary market’ where new shares, debentures and
bonds are issued. Its main function is to transfer the funds from the potential investors to
the willing entrepreneurs not only for the establishment of new corporate enterprises but also
for the expansion, diversification and modernization of the existing enterprises. This market
also helps the corporate enterprises to secure their own funds and channelizes the savings of
individuals into productive investments.
Stock (exchange) market

The stock (exchange) market represents the secondary market where already existing (old)
securities (shares, debentures and bonds) are bought and sold. In other words, stock exchange
market offers an organized mechanism of buying and selling of existing or old securities. Hence
this market is also called old issues market.
Financial institutions
The developing financial institutions constitute the active and main component of the Indian
capital market. Such financial institutions include: IFCI (Industrial Finance Corporation of India),
ICICI (Industrial Credit and Investment Corporation of India), IDBI (Industrial Development
Bank of India), SIDBI (Small Industries Development Bank of India), SFC (State Financial
Corporation), UTI (Unit Trust of India), LIC (Life Insurance Corporation of India) and
Nationalized Commercial Banks.
9.6.3 Development of Indian Capital Market
The economic development of any country depends upon a well-developed capital market in
the country. In India, capital market was not properly developed. Since independence, Indian
capital market has grown in size. There has been steady improvement in the volume of savings
and investment in the country. New Economic Policy (1991) was announced by the Government
of India. Liberalization has been accepted and private sector has entered all avenues of trade,
commerce and industry all over the country.
The following factors have contributed to the development of Indian capital market:
1. Legislative measures
2. Establishment of development banks
3. Expansion of the public sector
4. Growth of underwriting business
5. Public confidence
6. Increasing awareness of investment opportunities
The legislations like the Capital Issues (Control) Act, 1947, the Indian Companies Act,
1956, the Securities Contract (Regulation) Act,1956, the MRTP Act, 1970 and the Foreign
Exchange Regulations Act, 1973 empowered the government to regulate the activities of the
Indian capital market with a view to assuring healthy trends in the market, protecting the
interest of the investors and efficient administration of the financial resources. A large number
of development banks have been established at all levels to offer financial assistance to the
enterprises and the entrepreneurs.
The expansion of the public sector has been rapidly accelerated by nationalizing Life
Insurance in 1956 and Group Insurance in1972. The RBI was nationalized in 1949. The Imperial
Bank was nationalized and established the State Bank of India (SBI) in 1955. The 14 major
commercial banks were nationalized in 1969 and 6 leading private banks in 1980.
There has been a considerable progress in the underwriting business on account of the
emergence and expansion of public financial institutions and commercial banks. The overall
performance of certain large companies encouraged public confidence in securities. The public
awareness about the investment opportunities in the business sector has been created through
the improvement in education and communication among the public.
In addition to the above developments, the growth of ‘mutual funds’ is another remarkable
recent development in the Indian capital market. Mutual funds are also allowed in the private sector.
9.6.4 Capital Market Regulations
The Government of India has taken a number of legislative measures including the establishment
of the Securities and Exchange Board of India (SEBI) in the year 1988 to regulate the working
of the financial system (capital market) in the country.
Securities and Exchange Board of India (SEBI)

Origin of SEBI: The SEBI was established by the Government of India on April 12, 1988.
The SEBI has been given statutory powers only by the Securities and Exchange Board of
India Act, 1992.
Objectives of SEBI: The main objectives of the SEBI are:
(i) It provides protection to investors by safeguarding their rights and welfare.
(ii) It promotes fair dealings by issuing securities at a low cost.
(iii) It also promotes efficient services by the intermediaries like brokers and merchant
bankers (acceptance houses).
Organization of SEBI: The SEBI has the following five departments:
(i) Primary market department: It deals with the policy issues of the primary market
and the market intermediaries and redressal of the grievances of the investors.
(ii) Issue management and intermediaries department: It deals with the issue of documents,
registration, regulation and monitoring of issues related to intermediaries.
(iii) Secondary market development: It deals with the policy issues of the secondary
market such as price monitoring, insider and kerb trading.
(iv) Institutional investment department: It formulates the policy for foreign institutional
investors and mutual funds.
(v) Advisory committee department: It offers advisory inputs in formulating policies for
primary and secondary markets.
Functions of SEBI: The SEBI performs the following two important functions under Section 11
of the SEBI Act, 1992:
(i) Regulatory functions
(ii) Developmental functions
The ‘regulatory functions’ performed by the SEBI include:
(a) Registration of brokers, share transfer agents, merchant bankers, underwriters, portfolio
managers and investment advisors.
(b) Registration and regulation of investment and mutual funds schemes.
(c) Regulation of stock exchanges and other self-regulatory organizations.
(d) Takeover bids and impose penalties for insider trading.
The ‘development functions’ performed by the SEBI include:
(a) Promotion of investors’ education and trading of market intermediaries.
(b) Promotion of a code of conduct for self-regulatory organizations.
(c) Promotion of fair trade practices.
(d) Conduct of research and publishing information to all the market participants who
include individual retail investors, institutional investors such as mutual funds, banks,
insurance companies and hedge funds.
9.6.5 Capital Market Reforms
In India, the number of stock exchanges has gradually increased and the capital market has
substantially expanded. But the functioning style of the stock exchanges shows many deficiencies.
The deficiencies include long delays, lack of transparency in procedures and vulnerability
to price rigging and insider trading. To counter these deficiencies, the Government of India
established the SEBI in 1988.
In recent years, a number of steps have been taken by the Government of India and the
SEBI to introduce improved practices in the capital market in the interest of the healthy capital
market development in India. The following are the important steps:
1. The SEBI has been authorized to conduct inspections of various mutual funds.
2. The SEBI has drawn up a programme of inspecting stock exchanges.
3. The process registration of market intermediaries has been provided under the provisions
of the SEBI Act, 1992.
4. Merchant banking has been statutorily brought under the regulatory framework of the
SEBI.
5. The National Stock Exchange of India (NSEI) has been established and is expected to
serve as a nodal agency.
6. The RBI has liberaliszd the investment norms evolved for NRIs by allowing companies
to accept capital contributions and issue shares or debentures to NRIs.
7. The Government has allowed foreign institutional investors (FIIs) such as pension funds,
mutual funds, investment trusts asset or portfolio management companies, etc. to invest
in the Indian capital market, provided they register with SEBI.
8. The ‘Banker to the Issue’ has been brought under the purview of SEBI for investor
protection.
9. The SEBI has introduced a code of advertisement for public issues for ensuring fair
and truthful disclosures.
10. The SEBI has introduced regulations governing acquisition of shares and takeovers and
lays down the conditions under which disclosures and mandatory public offers are to
be made to the shareholders.
11. Renewal of transactions in ‘B’ group securities is prohibited so that transactions could
be settled within 7 days.
12. Private mutual funds are permitted.
13. The Unit Trust of India (UTI) has been brought under the regulatory jurisdiction of
SEBI.
14. The practice of making preferential allotment of shares at prices unrelated to the
prevailing market prices was stopped and fresh guidelines were issued by SEBI.
Thus the process of reforms in the Indian capital market needs to be deepened to bring
about speedier conclusion of transactions, greater transparency in operations, improved services
to investors and greater investors’ protection.
9.6.6 Recent Trends in Indian Capital Market
Bombay Stock Exchange is the pioneer in executing a programme of computerization in settlement

processes. The computerization programme is of four phases. The first phase offers display of
information through the display information driven system. The second phase transfers the input
and output interfaces from the present manual mode to an electronic mode. The third phase
provides automation in trading system. The fourth phase extends the facility of screen-based
trading to specified shares.
The National Stock Exchange was launched in 1994 as an automated stock exchange in
India. In this exchange, members are provided with computers connected through very small
aperture terminals.
Abolition of the Controller of Capital Issues (CCIs), enactment of SEBI Act, 1992,
emergence of merchant banking system, setting up of mutual funds, venture capital financing
and permitting six private sector companies to set up mutual funds by SEBI are some of the
recent developments in the Indian capital market.
9.7 Stock Market

A stock market is a public entity for the trading of company stock (shares) and derivatives at
an agreed price; these are securities listed on a stock exchange as well as those only traded
privately. Stock market is otherwise called equity market.
The term ‘equity financing’ is used for issuing stock to raise money. The term ‘equity
capital’ represents the money received from investors who buy stocks.
9.7.1 Structure of Stock Market
A stock or equity market is made up of primary market and secondary market. The primary
market is the market in which the investors have the first chance to buy a newly issued security.
Investors may sell their shares through brokers to other investors. The secondary market is
the market in which the stock prices can be found in newspapers, on television and on the
internet (computer network). In other words, stock exchange (place where stocks are bought
and sold) market and over-the-counter (OTC) market (place where securities are transacted
over telephone and computer network) form the secondary market. The primary market and
the secondary market together make up the stock market.
9.7.2 Market Participants
Participants in the Indian stock market include individual retail investors, institutional
investors such as mutual funds, banks, insurance companies and hedge funds traders and
corporations trading in their own shares. It has been suggested that institutional investors and
corporations trading in their own shares generally receive higher risk-adjusted returns than the
retail investors.
Participants in the stock market range from individual stock investors to large hedge fund
traders. Their orders usually end up with a professional at a stock exchange, who executes
the order of buying or selling. Actual trades are based on an auction market model where a
potential buyer bids a specific price for a stock and a potential seller asks a specific price for
the stock. A sale takes place when the bid and ask prices match.
9.7.3 Importance of Stock Market
The stock market is one of the important sources for companies to raise money. This market
permits businesses to raise additional financial capital for expansion by selling shares of the
company in the public market. Stock market is often considered as the primary indicator of the
economic strength and development of a country. Stock exchanges act as the clearing houses
for each transaction, i.e. they collect and deliver the shares and guarantee payment to the seller
of a security. This eliminates the default on the transactions.
The smooth functioning of the stock market facilitates economic growth in that lower costs
and enterprise risks promote the production of goods and services as well as employment. In
this way, the financial system is assumed to contribute to increased prosperity.
9.7.4 Indian Stock Market
Indian Stock market is one of the oldest in Asia. Its history dates back to nearly 200 years
ago. The earliest records of security dealings are meagre and obscure. The East India Company
was the dominant institution in those days.
In 1887, the brokers established, “the Native Share and Stock Brokers’ Association” in
Bombay. In 1894, the brokers formed “The Ahmedabad Share and Stock Brokers’ Association.”
On June 1908, the Calcutta Stock Exchange association was formed. In 1920, The Madras Stock
Exchange was formed with 100 members. However, the number of members reduced from
100 to 3, by 1923 and it went out of existence. Again in 1957, the Madras Stock Exchange
was formed.
At present, there are totally 21 recognized stock exchanges in India excluding the NSEIL
(National Stock Exchange of India Limited) and the OTCEI (Over-the-counter Exchange of
India Limited).
National Stock Exchange of India Limited (NSEIL)

The NSEIL was incorporated with the Indian Stock Market in 1992 on the basis of the
recommendations of the Pherwani Committee. The purpose was to lift the Indian stock market
trading system on par with the international standards.
Over-the-counter Exchange of India Limited (OTCEI)

The OTCEI was created in 1992 as the country’s first electronic stock exchange to provide
improved services to investors. Trading at OTCEI is done over centres spread across the country.
Securities traded on the OTCEI are classified into: listed securities, permitted securities, and
initiated debentures.
9.7.5 Role of Stock Market in Economic Development
The recent evidence suggests that stock markets can give a big boost to economic development.
Stock markets may affect economic activity through the creation of liquidity. Many profitable
investments require a long-term commitment of capital, but investors are often reluctant to
relinquish control of their savings for long periods.
Liquid equity markets make investment less risky and more profitable because they allow
savers to acquire an asset-equity and to sell it quickly and cheaply if they need an access to
their savings or want to alter their portfolios. At the same time, companies enjoy permanent
access to capital raised through equity issues. By making less risky and more profitable, stock
market liquidity can also lead to more investment.
There are three measures of market liquidity, namely:
1. The total value of shares traded on a country’s stock exchanges as a share of Gross
Domestic Product (GDP).
2. The value of traded shares as a percentage of total market capitalization (the value of
stocks listed on the exchange).
3. The value-traded-ratio divided by stock price volatility.
Stock market liquidity helps forecast economic growth even after accounting for a variety
of non-financial factors that influence economic growth. After controlling for inflation, fiscal
policy, political stability, education, exchange rate policy and openness to international trade,
stock market liquidity is still a reliable indicator of future long-term growth.
Countries with both liquid stock markets and well-developed banks grew much faster
than countries with illiquid stock markets and underdeveloped banks. Further, greater stock
market liquidity is associated with faster future growth no matter what the level of banking
development. Similarly, greater banking development implies faster growth no matter what the
level of stock market liquidity. Thus, it is not the banking development—each on its own is a
strong predictor of future economic growth.
Stock markets provide services to the non-financial economy that are crucial for long-term
economic development. The ability to trade securities may easily facilitate investment, promote
the efficient allocation of capital and stimulate long-term economic growth.
9.7.6 Stock Market Indices
Stock market indices are one of the important methods of measuring the movements of the prices
in a market or section of the market. Stock market indices are usually market capitalization
weighted with the weights reflecting the contribution of the stock to the index. The constituents
of the index are reviewed frequently to include or exclude stocks in order to reflect the changing
business environment.
The stock market indices reflect the overall price movements of a set of securities. There
are two types of stock market indices used in practice. They are:
1. An index representing simple arithmetic mean of the price relatives of the shares.
2. An index representing aggregate market capitalization of a sample share.
Both indices are constructed for a certain year with reference to base year. National index
and the sensex are two main stock market indices covering equity shares.

1. Capital market is a market for
(a) short-term loanable funds (b) medium-term loanable funds
(c) long-term loanable funds (d) all of the above
2. The components of capital market are
(a) suppliers of loanable funds (b) borrowers of loanable funds
(c) intermediaries (d) all of the above
3. The components of Indian capital market are
(a) new issues market (b) stock exchange market
(c) financial institutions (d) all of the above
4. The new issues market in the Indian capital market represents
(a) primary market (b) secondary market
(c) internal market (d) external market
5. The stock exchange market in the Indian capital market represents
(a) primary market (b) secondary market
(c) internal market (d) external market
6. The SEBI (Securities and Exchange Board of India) was established by the Government
of India on
(a) April 12,1968 (b) April 12,1978
(c) April 12,1988 (d) April 12,1998
7. The SEBI performs its functions under Section 11 of the
(a) SEBI Act, 1962 (b) SEBI Act, 1972
(c) SEBI Act, 1982 (d) SEBI Act, 1992
8. The National Stock Exchange was launched in
(a) 1964 (b) 1974
(c) 1984 (d) 1994
9. The recent developments in the Indian capital market are
(a) enactment of SEBI Act, 1992 (b) emergence of merchant banking system
(c) setting up of mutual funds (d) venture capital financing
10. Stock market is otherwise called
(a) bill market (b) securities market
(c) equity market (d) share market
11. The place where stocks are bought and sold is called
(a) primary market (b) stock exchange market
(c) over-the-counter market (d) none of the above
12. The place where securities are transacted over telephone and computer network is called
(a) stock exchange market (b) primary market
(c) over-the-counter market (d) none of the above
13. Who are the participants in the Indian Stock Market?
(a) Individual retail investors (b) Institutional investors
(c) Hedge funds traders (d) Corporations trading in their own shares
14. The National Stock Exchange of India Limited was incorporated with the Indian Stock
Market in 1992 on the recommendations of the
(a) Bhagawati Committee (b) Narasimhan Committee
(c) Pherwani Committee (d) Dantwala Committee
15. Which was the first electronic stock exchange providing improved services to investors
in India?
(a) National Stock Exchange of India Limited
(b) Securities and Exchange Board of India
(c) Over-the-Counter Exchange of India Limited
(d) None of the above
16. The main stock market indices covering equity shares are
(a) national index (b) sensex index
(c) national and sensex indices (d) capital indices
Answers
1. (c) 2. (d) 3. (d) 4. (a) 5. (b)

6. (c) 7. (d) 8. (d) 9. (e) 10. (c)
11. (b) 12. (c) 13. (e) 14. (c) 15. (c)
16. (c)
Review Questions
1. What is the meaning of capital market?
2. What are the important constituents of capital market?
3. What are the components of capital market?
4. Bring out the importance of capital market.
5. What are the main functions of capital market?
6. Briefly explain the main components of the Indian capital market.
7. Discuss briefly the role of capital market in the economic development of a country.
8. Explain the objectives and functions of SEBI.
9. What are the important steps taken by the Government and the SEBI for a healthy
capital market development in India?
10. Give the recent trends in Indian capital market.
11. What is stock market?
12. Distinguish between primary and secondary markets.
13. Bring out the importance of stock market.
14. Discuss the role of stock market in the economic development of a country.
15. Write a note on ‘Stock Market Indices’.
Chapter 10
Monetary Policy
10.1 Meaning of Monetary Policy

By monetary policy, we mean the policy adopted by the monetary authorities with regard
to money. Monetary policy is a policy by which the monetary authorities try to increase the
advantages of money to the maximum as well as to reduce the disadvantages of money to the
minimum. The monetary authorities may include the central bank as well as the government
of the country.
10.2 Definitions of Monetary Policy

Monetary policy has been defined differently by different authors:
Crowther in his book An outline of Money defines monetary policy as, “the policy by
which monetary authorities should try to reduce the disadvantages of money to the minimum”.
G.K. Shaw in his book An Introduction to the Theory of Macro Economic Policy defines
monetary policy as, “any conscious action undertaken by the monetary authorities to change
the quantity, availability or cost (interest rate) of money”.
Professor H.G. Johnson in his Recent Developments in Monetary Theory defines monetary
policy as, “a policy employing central bank’s control of the supply of money as an instrument
for achieving the objectives of general economic policy”.
Professor Wrightsman defines monetary policy as, “the deliberate effort by the central bank
to control the money supply and credit condition for the purpose of achieving certain broad
economic objectives”.
According R.P. Kent, “the management of the expansion and contraction of the volume
of money in circulation for the explicit purpose of attaining a specific objective such as full
employment”.
In the words of Professor Paul Einzig, “monetary policy is the attitude of the political
authority towards monetary system of the country”.
176
Monetary Policy 177
In the words of C.K. Johri, a monetary policy will consist of the decisions of the government
and the central bank which affect the volume and composition of the money supply, the size and
distribution of credit, the level and structure of interest rates and the effects of these variables
on the factors determining price and output in the economy.
Milton Friedman defines monetary policy as, “the effect of the actions of the monetary
authorities on the stock of money—on the number of prices of paper in people’s pockets, or
the quantity of deposits on the books of banks”.
10.3 Objectives of Monetary Policy

The six main objectives of monetary policy are:
1. Exchange rate stability
2. Price stability
3. Neutrality of money
4. Control of cyclical fluctuations
5. Full employment
6. Economic growth
10.3.1 Exchange Rate Stability
Prior to the First World War, the main objective of the monetary policy was to maintain the
exchange rates stability. The stable exchange rates encourage foreign trade and investment. They
also remove risk and uncertainty in foreign trade. The exchange rate stability was secured by
adopting the gold standard. Under the gold standard, the exchange rate was determined on the
basis of gold contained in the coins of both the countries. This exchange rate is called mint
par of exchange.
Under the gold standard, the exchange rate could ensure automatic balance of payment
equilibrium. A favourable balance of payment could lead to an inflow of gold which would result
in the expansion of currency and, consequently, an increasing price level. This will promote
import and reduce exports. On the other hand, an unfavourable balance of payment could lead
to an outflow of gold which would result in the contraction of currency and, consequently, a
decreasing price level. This will promote export and reduce imports. Therefore, the balance of
payments will be ultimately in equilibrium.
Thus a stable exchange rate is considered as an essential condition for internal stability. In
other words, internal stability is sacrificed in order to secure exchange rate stability. Besides,
exchange rate stability as an objective of monetary policy to countries depends mostly on
foreign trade. Thus monetary policy for exchange rate stability has its relevance.
10.3.2 Price Stability
Many economists suggest that the objective of monetary policy should be to maintain stable
price level in the economy. They agree that both inflation (rising prices) and deflation (falling
prices) are evils. Both rising prices and falling prices have serious economic and social
consequences in the economy. Money acts as a measure of value and so it should be stable
in value. If its value changes, some people gain at the expense of others. This is against the
principle of social justice.
Price stability would ensure justice between employees and employers, and also between
debtors and creditors. Internal price stability will also reduce the changes in business activity on
account of trade cycles. Therefore, maintenance of internal prices at a stable level is considered
as an important objective of monetary policy. Thus monetary policy for internal price stability
has its relevance.
10.3.3 Neutrality of Money
Neutrality of money is considered to be another objective of monetary policy. Neutrality of

money implies a situation in which changes in the quantity of money cause a proportionate
change in the prices of goods. In other words, money has influence on the price level. It is
responsible for inflation and deflation in the economy. So, economists like Hayek suggest that
money should be neutral in its effect on prices. When money remains neutral, an increase
or decrease in the quantity of money will not produce any disturbing effect in the economy.
Therefore, monetary policy should bring about neutrality of money. Neutrality of money does
not mean that money supply remains constant, but it means that supply remains constant, and
that the effect of changes in the money supply in terms of non-monetary factors in the economy
would be neutral. Thus neutrality of money should be the goal of monetary policy.
The effective supply of money must be kept constant in order to achieve this goal. The
effective supply of money is calculated by multiplying both quantity of money and velocity
of circulation of money i.e.
Effective supply of money = Quantity of money  Velocity of circulation of money
For example, the quantity of money should be increased when the velocity of circulation
of money falls. Similarly, the quantity of money should be decreased when the velocity of
money rises.
The main defect of this neutrality of money policy is that it is not easy to measure the
changes in the velocity of circulation of money and also not easy to keep the effective supply
of money at a stable level. It is because of the fact that prices of goods may rise or fall on
account of non-monetary factors. Thus monetary policy for neutrality of money has its relevance.
10.3.4 Control of Cyclical Fluctuations
Monetary policy serves as an anticyclical policy to achieve economic stabilization. During

inflationary situation, a restrictive (or dear) monetary policy is adopted, whereas during
deflationary situation, an expansionary (or cheap) monetary policy is adopted.
Some economists of the view that cyclical fluctuations occur on account of changes in
the supply of money and credit. They suggest that the goal of monetary policy should be to
control cyclical fluctuations in investment, employment, output, income, demand and prices in
Monetary Policy 179
the economy. Monetary authorities should control the supply of money and credit in order to
achieve this objective. For example, the central bank of the country should contract money
supply and credit by raising the bank rate and reducing the cash balances of the commercial
banks. Similarly, the central bank should expand money supply and credit by lowering the
bank rate and increasing the cash balances of the commercial banks. Thus monetary policy is
regarded as an effective weapon to control the cyclical fluctuations in the economy. But J.M.
Keynes says that monetary policy alone is not adequate and effective in controlling cyclical
fluctuations. However, monetary policy for controlling cyclical fluctuations has its relevance.
10.3.5 Full Employment
The main objective of monetary policy is to achieve and maintain full employment in the
economy. Full employment simply means that everyone who is able and willing to work
at the existing rate of wages gets job. According to A.C Pigou, there is full employment in
the country when “everybody who at the ruling rate of wages wishes to be employed is in
fact employed”. The term ‘full employment’ does not mean that everyone is fully employed.
Some rich people may like to remain idle and enjoy life. This level of employment cannot be
achieved at any given time.
The monetary authorities should adopt cheap money policy by keeping the bank rate at
a low level. This encourages investment. Once full employment is achieved, the monetary
authorities should maintain it by bringing about equality between saving and investment. Thus
monetary policy for full employment has its relevance.
10.3.6 Economic Growth
In India, the main objective of monetary policy is to promote rapid economic growth. Economic
growth implies the creation of new employment opportunities and continuous rise in the level
of employment quantitatively and qualitatively. Such a creation of job opportunities in made
possible by increasing the volume of real resources used in production process.
Rapid economic growth can be achieved by investing the large quantity of money on the
basic industries and on the construction of irrigation and power projects. These projects yield
returns only after some years. But income of the people increase at once and the demand for
all goods rise greatly. As a result, inflation occurs in the economy. It has serious economic and
social consequences. So inflation should be controlled. The main objective of monetary policy
is to secure economic growth with stability. In order to achieve this, the monetary authorities
should control the supply of money and credit in the economy. They should encourage credit
to priority and essential industries and discourage credit to non-priority and non-essential
industries. They should encourage credit to productive activities and discourage credit to
unproductive or speculative activities. Further, they should encourage the saving and thrift habit
among the people. They should play an important role in the established financial institutions
like agricultural banks and industrial banks. They should help in solving balance of payments
problem. They should provide an efficient monetary system in keeping with the rapid expansion
of internal market and growing specialization. Thus monetary policy for economic growth has
its relevance in the economy.
10.4 Instruments of Monetary Policy

Monetary policy is of the following two kinds of instruments:
1. Quantitative instruments
2. Qualitative instruments
10.4.1 Quantitative Instruments
The quantitative instruments of monetary policy include bank rate policy, open market operations
and changes in cash reserve ratios. They are otherwise called general or indirect instruments
of monetary policy. They aim at regulating the overall level of credit in the economy through
the commercial banks.
Bank rate policy

Bank rate is the rate at which the central bank rediscounts eligible bills of exchange and
government securities and against which the central bank grants loans and advances to the
commercial banks.
When there is inflation in an economy, the central bank raises the bank rate to control it.
Borrowing from the central bank becomes costly. Commercial banks also raise their rates of
interest on credit. The borrowers are reluctant to borrow more from the commercial banks. They
borrow less. There is contraction of credit. This will lead to low investment, low employment,
low output, low income, low demand and low price level. Hence inflation is controlled. On
the contrary, when there is deflation in the economy, the central bank reduces the bank rate.
Borrowing from the central bank becomes cheaper. Commercial banks also reduce their rates
of interest. Borrowers borrow more. There is an expansion of credit. This will lead to more
investment, more employment, more output, more income, more demand and high price level.
Hence deflation is controlled. Thus bank rate policy is adopted by the central bank to check
the upward movement of prices (inflation) and downward movement of prices (deflation) in
the economy.
Open market operations

Open market operations refer to the buying and selling of securities in the open market. It
is assumed than when the central bank sells securities, the commercial banks are expected to
buy them in the open market and when the central bank buys securities, the commercial banks
expected to sell them in the open market.
When there is inflation in the economy, the central bank sells securities in the open market
to control it. The commercial banks are expected to buy these securities. The cash reserves
at the disposal of the commercial banks for lending loans and advances to the public are
reduced, i.e. the lending capacity of the banks is reduced. Borrowing for further investment is
discouraged. As a result, there will be fall in investment, employment, output, income, demand
and finally fall in the price level. On the contrary, when there is deflation in the economy,
the central bank buys securities in the open market to control it. The commercial banks are
Monetary Policy 181
expected to sell the securities at their disposal. The cash reserves of the banks are raised. They
also lend more to the borrowers. Borrowing for further investment is encouraged. As a result,
there is rise in investment, employment, output, income, demand and, finally, rise in the price
level. Thus open market operations are adopted by the central bank to check both inflation
and deflation in the economy.
Changes in cash reserve ratios

Cash reserve ratios means that every commercial bank is required to keep a certain percentage
of its total deposits as reserve fund with the central bank of the country. Where there is inflation
in the economy, the central bank raises the cash reserve ratio. Commercial banks are now
required to keep more with the central bank. As a result, the cash reserves meant for lending
of the commercial banks are reduced. Therefore, commercial banks reduce their lending. This
will lead to fall in investment, employment, output, income, demand and, finally, rise in the
price level. On the contrary, when there is deflation in the economy, the central bank reduces
the cash reserve ratio. Commercial banks are now required to keep less with the central bank.
As a result, the cash reserves meant for lending of the commercial banks are raised. Therefore,
commercial banks raise their lending. This will lead to rise in investment, employment, output,
income, demand and, finally, rise in the price level. Thus changes in cash reserve ratios are
adopted by the central bank to check inflation and deflation in the economy.
10.4.2 Qualitative Instruments
The qualitative instruments of monetary policy include prescribing margin requirements,

regulation of consumer credit, rationing of credit, moral suasion and direct action. They are
otherwise called selective or direct instruments of monetary policy. They aim at controlling
specific types of credit for particular purposes.
Prescribing margin requirements

Under this method, the central bank prescribing the margin to be kept for loans against
securities either in the form shares or commodities. The term ‘margin’ means the difference
between the value of the security and the amount of loan granted, expressed in percentage.
When there is speculative activity in the economy or in a particular sector, the central bank
raises the margin requirements. As a result, the borrowers are granted less amount of loan
against specified securities. For Example, raising the margin requirements to 65 per cent means
that the pledger of securities of the value ` 100,000 will be given only 35 per cent of their
value, i.e. ` 35,000 as loan. On the contrary, when there is recession in a particular sector of
the economy, the central bank encourages borrowing by reducing the margin requirements of
securities.
Regulation of consumer credit

Under this method, credit granted to consumers for the purchase of durable commodities is
regulated. When there is rise in prices, the central bank raises the percentage of the price to be
paid at the time of delivery (or down payment), reduces the number of instalments and raises
the amount of each instalment. This will reduce the demand. Thus inflationary pressure in the
economy is reduced. On the contrary, when there is fall in prices, the central bank reduces the
percentage of the price to be paid at the time of delivery (or down payment), raises the number
of instalments and reduces the amount of each instalment. This will increase the demand. Thus
deflationary pressure is in the economy is reduced.
Rationing of credit
Under this method, the central bank controls credit by rationing of credit among its various
uses. The central bank may fix a ceiling on the total amount of loans that can be granted by
each commercial bank. This method can be adopted only in planned economies.
Moral suasion
Under this method, the central bank persuades or requests commercial banks not to apply for
further accommodation and not to extend more credit to the public.
Direct action
Under this method, the central bank takes action against those commercial banks who adopt
unsound credit policies or work against the credit policy of the central bank. The central bank
may charge a penal rate of interest on loans granted in excess of the prescribed amount. The
central bank may also refuse to grant further loans to the abovesaid banks. The direct action
method of credit control is more effective.
10.5 Role of Monetary Policy in a Developing Economy

In a developing country like India, monetary policy plays an important role in developing the
economy from the stage of backwardness to the stage of self-sustained growth. In other words,
monetary policy in developing countries is the policy of promoting rapid economic growth.
In promoting economic growth, the primary role of a monetary authority is to provide an
efficient payment mechanism. The monetary authority must see to it that the quantity of money
supply is suitable for growth process. As economic growth progresses, the demand for money
becomes higher on account of increased transaction demand, increased monetized sector and
diversification of demand for money during the growth process.
A growth-oriented monetary policy must be expected to include monetary management by
the central bank of the country. When a country aims at promoting rapid economic growth, it
should adopt economic planning. In this process, a suitable monetary management is essential
for financial or credit planning.
In a developing country like India, inflation occurs when there is an abnormal increase in
the effective demand mainly due to huge government expenditures under planning process. The
maintenance of internal price stability and exchange rate stability are the necessary conditions to
achieve sustained economic growth. It is commonly agreed that development through inflation in
developing countries is successful only when inflation is effectively controlled. Thus monetary
Monetary Policy 183
policy needs special attention to bring about rapid economic growth with controlled inflation
in a developing country.
Monetary policy also plays an important role in improving the efficiency of the banking
system as a whole. The central banking authority should extend sound credit where required.
The monetary authorities take efforts to improve the conditions of unorganized money
market and unorganized capital market in a developing country in the interest of rapid economic
growth and the smooth functioning of the monetary management.
The monetary policy also plays a vital role in making use of an appropriate interest rate
structure in a developing economy like India. Central bank’s effort in the matter of interest rate
commands a Meagle effect in an unorganized money market. The assertion that a high rate of
interest leads is a higher savings is not true always. Saving depends upon the level of income
and propensity to save. A high rate of interest will not direct financial resources for productive
uses. This is on account of undeveloped banking habits, unorganized money markets and the
existence of black money. Thus, a cheap (expansionary) money policy is generally suitable for
a developing country like India.
Monetary policy also plays an important role is increasing the growth rate of the economy
of controlling inflation. To control inflationary pressures in a developing country like India,
monetary policy needs the adoption of both quantitative and qualitative instruments of credit
control. The bank rate policy is not effective in developing countries because of the existence
of large non-monetized sector, indigenous bankers, keeping more cash reserves by commercial
banks and the existence of unorganized money market.
The open market operations are also not successful in controlling inflation in developing
countries because of the existence of underdeveloped bill market. The use of variable cash
reserve ratio is more effective in the developing countries. The qualitative or selective credit
control measures are more effective in influencing the allocation of credit and the pattern of
investment. These measures are more suitable for limiting or controlling credit facilities for
unproductive or speculative activities.
Monetary policy also plays an important role in achieving internal price stability. An imbalance
between the demand for money and the supply of money is reflected in the price level. A
shortage of money supply will retard economic growth while an excess of money supply will
lead to inflation. As an economy develops, the demand for money expands due to monetization
of non-monetized sector and expansion in agricultural and in industrial production. Hence the
monetary authority has to raise money supply more than proportionate to the demand for money.
Monetary policy plays an active role in a developing economy in bridging the deficits in
the balance of payments. An imbalance between imports and exports leads to disequilibrium in
the balance of payments. Monetary policy helps in reducing the disequilibrium in the balance
of payments only through charging of high rates of interest. A high interest rate attracts the
inflow of foreign investments and helps in bridging the gap in the balance of payment of the
developing countries.
In a developing country like India, monetary policy is of the objective to develop banking
institutions in order to encourage, mobilize and channelize savings for capital formation. This is
essential for the success of a growth-oriented monetary policy, including monetary management.
However, a suitable monetary policy is essential for controlling inflationary pressures, bridging
the balance of payment gaps, encouraging capital formation through savings and promoting
rapid economic growth. Thus monetary policy and monetary management are of vital role to
play in the process of planning for rapid economic growth in developing economies.
10.6 Limitations of Monetary Policy

The limitations of monetary policy are as follows:
• The scope of monetary policy is limited when there is an existence of unorganized
money market which consists of money lenders and indigenous bankers who are outside
the purview of the central bank.
• The existence of large non-monetized sector limits the scope and effectiveness of monetary
policy in developing countries.
• The banking habits on the part of the people in developing countries are underdeveloped
and, hence, the credit control policy is less effective.
• Monetary policy is not much effective in the short run.
• It is ineffective for controlling inflationary pressures in developing countries.
• The role of monetary policy in a developing economy is not compulsive but permissive
and this limits the effectiveness of monetary policy.
• The bill market and call loan market schemes are narrow and not developed in developing
countries and, hence, the monetary policy is made ineffective.
• Most of the commercial banks have high liquidity so that they are not influenced by
the credit policy of the central bank. This makes monetary policy less effective.
• Monetary expansion in developing countries generally leads to increased imports,
unfavourable balance of payments and loss of gold reserves.
• The government resorts to public borrowing and keep the interest rates at a low level.
This will keep the security market narrow and makes monetary policy ineffective.
10.7 A Note on ‘Transmission Mechanism’ of Monetary

Policy
By ‘transmission mechanism’, we mean the mechanism by which the effects of monetary policy
are transmitted to the other sectors of the economy or how the money affects the real sector.
Transmission mechanism can be well explained with the help of two important approaches—
portfolio approach and wealth approach.
10.7.1 Portfolio Approach
Under the portfolio approach to the transmission mechanism of monetary policy, when the money
supply in an economy increases, the interest rate will fall. This will affect the investment which,
in turn, affects income, comsumption, saving and so on. Monetary policy affects all types of
expenditures. People start purchasing assets (financial assets). In this case, prices of assets will
rise. As a result, the interest rate will fall. In this situation, more assets will be issued in the
Monetary Policy 185
open market. By selling these assets, people receive money which can be used for purchasing
real investment. This will expand income via multiplier.
There are two types of assets—financial assets and real assets. The financial assets are held
by households and real assets are held by firm. Both households and firms adjust their stock
of assets which will affect the level of demand. The portfolio decision to hold various types
of assets is influenced by the structure of interest rate. The interest rates are the real and best
indicators of monetary policy of any country in the world.
10.7.2 Wealth Approach
Under the wealth approach to the transmission mechanism of the monetary policy, we include
non-human wealth (NHW) which will affect the aggregate demand in the economy, i.e.
NHW = High powered money (reserve money) + Present value of stock in the market
When the price level falls, the real value of high powered or reserve money will rise through
the operation of the principle of real balance effect. The real balance effect is the mechanism
of monetary policy which will affect the aggregate demand by changing the value of wealth.
When the government buys securities, the prices of these securities will rise, other things
remaining the same. As a result, the interest rate will tend to fall. People buy securities when
their prices rise.

1. Which one of the following is the objective of monetary policy?
(a) Exchange rate stability (b) Price stability
(c) Neutrality of money (d) Full employment
2. Bank rate is the interest rate of the
(a) central bank (b) commercial bank
(c) cooperative bank (d) state bank
3. The quantitative credit control measures include
(a) bank rate policy (b) open market operations
(c) variation in cash reserve ratio (d) all of the above
4. Which of the following is not included in the qualitative credit control measures?
(a) moral suasion (b) direct action
(c) regulation of consumer credit (d) variation in CRR
5. When the central bank feels that inflation in the country is on account of the excessive
credit created by commercial banks,
(a) it raises the bank rate (b) it reduces the bank rate
(c) it makes no change in the bank rate (d) none of the above
(a) it sells securities in the open market
(b) it buys securities in the open market
(c) it neither sells nor buys securities
(a) it raises the cash reserve ratio
(b) it reduces the cash reserve ratio
(c) it neither raises nor reduces the CRR
8. Moral suasion is a
(a) quantitative method of credit control (b) qualitative method of credit control
(c) both quantitative and qualitative (d) neither quantitative nor qualitative
9. Which of the following method of credit is more effective in India?
(a) Bank rate policy (b) Open market operations
(c) Moral suasion (d) Direct action
10. The role of monetary policy in a developing economy is
(a) compulsive (b) permissive
(c) both compulsive and permissive (d) neither compulsive nor permissive
11. Monetary policy is ineffective in India because of
(a) underdeveloped bill and call loan market schemes
(b) underdeveloped banking habit
(c) existence of non-monetized sector
12. The mechanism by which the effects of monetary policy are transmitted to other sectors
of the economy is
(a) price mechanism (b) market mechanism
(c) transmission mechanism (d) transit mechanism
13. Transmission mechanism of the monetary policy explained with the help of
(a) portfolio approach (b) wealth approach
(c) both Portfolio and wealth approaches (d) cardinal approach
14. Under the wealth approach to the transmission mechanism of the monetary policy, we
include
(a) human wealth (b) non-human wealth
(c) both human and non-human wealth (d) national wealth
15. Non-human wealth is equal to
(a) high powered money
(b) present value of stock in the market
(c) high powered money plus present value of stock in the market
(d) total volume of money
Monetary Policy 187
Answers
1. (e) 2. (a) 3. (d) 4. (d) 5. (a)

6. (a) 7. (a) 8. (b) 9. (d) 10. (b)
11. (d) 12. (c) 13. (c) 14. (b) 15. (c)
Review Questions
1. What is the meaning of monetary policy?
2. Define monetary policy.
3. Bring out the objectives of monetary policy.
• Exchange rate stability
• Price stability
• Neutrality of money
• Full employment
• Economic growth
5. Explain the important objectives or goals of monetary policy.
6. What are the quantitative instruments of monetary policy?
7. What are the qualitative instruments of monetary policy?
• Bank rate
• Open market operations
• Cash reserve ratio (CRR)
• Moral suasion
9. Discuss the role of monetary policy in a developing economy.
10. What are the limitations of monetary policy?
11. Write a note on ‘transmission mechanism’ of monetary policy.
Part II
Banking
Chapter 11
An Introduction to Banking
11.1 Origin of a Bank

The Bank of Venice was the first public banking institution founded in 1157. The Bank of
Genoa was established in 1407. Both the Bank of Venice and the Bank of Genoa continued to
operate until the end of the 18th century.
The General Bank of India was established in 1786. The East India Company established
Bank of Bengal in 1809; Bank of Bombay in 1840; and Bank of Madras in 1843. These banks
were considered independent units and called them Presidency Banks. These three banks were
amalgamated in 1920 and named the Imperial Bank of India.
The Reserve Bank of India (RBI) was established in 1935. The RBI was established as an
apex bank under the Reserve Bank of India Act of 1934. The Government of India nationalized
the RBI in 1949 and vested with extensive powers to streamline the functioning and activities
of commercial banks in India.
In 1955, the Government of India nationalized the Imperial Bank of India and formed
the State Bank of India to act as the principal agent of the RBI and to undertake banking
transactions of both the Central and State Governments of the country.
11.2 Meaning of a Bank

In an ordinary sense, the term ‘bank’ refers to an establishment which trades in money. It borrows
money from the public at lower rates of interest. It lends the same to the public at higher rates
of interest. In this way, it makes profits. Thus a bank is a dealer in money and credit.
In other words, a bank is a financial institution which deals with deposits and advances, and
other related services. It receives money from those who want to save in the form of deposits
and it lends money to those who need it. In short, a bank is an institution in which people
keep their cash balances in the form of deposits.
191
11.3 Definitions of a Bank

The term ‘bank’ has been defined differently by different economists. The definition of a bank
varies from country to country. A few definitions are given below.
R.S. Sayers in his book Modern Banking (7th edition) defines, “banks are the institutions
whose debts—usually referred to as bank deposits—are commonly accepted in final settlement
of other people’s debts”.
Raymond P. Kent in his book Money and Banking (4th edition) defines, “bank is an
organization whose principal operations are concerned with the accumulation of the temporarily
idle money of the general public for the purpose of advancing it to others for expenditure”.
Oxford Dictionary defines, “a bank is an establishment for custody of money, which it
pays out on customer’s order”.
Geoffrey Crowther in his book An Outline of Money defines, “a banker as a dealer on
debts—his own and other peoples. He writes further that the banker’s business is to take the
debts of other people, to offer his own in exchange, and thereby to ‘create’ money. He may
be a dealer in debts, but indebtedness is only the obverse of wealth and it would be equally
permissible to describe the banker as a liquefier of wealth”.
Professor Hart in his book Law of Banking defines that a banker is one who, in the ordinary
course of his business, honours cheques drawn upon him by persons from and for whom he
receives money on current account.
Under the English Common Law, banker is defined as, “a person who carries on the business
banking which is specified as: conducting current accounts for his customers; paying cheques
drawn on him, and collecting cheques for his customers”.
Under the Bills of Exchange Act, a banker is legally defined as, “a body of persons, whether
incorporated or not, who carries on the business of banking (Section 2, Interpretation)”.
Section 5 (1) (6) of the Banking Companies (Regulation) Act, 1949 defines banking as,
“accepting, for the purpose of lending or investment, of deposits of money from the public;
repayable on demand or otherwise, and withdrawable by cheque, draft, order, or otherwise”.
11.4 Characteristic Features of a Bank

The characteristic features of a bank are as follows:
• It accepts money from the people in the form of deposits.
• It is a financial institution which deals with other people’s money.
• It gives safety to the deposits of its customers.
• It acts as a custodian of funds of its customers.
• It lends out money in the form of loans.
• It provides easy payment and withdrawal facility to its customers.
• It provides utility services and agency services to its customers.
• It is a profit-seeking institution having service-oriented approach.
• It has a continuous expansion and diversification of functions.
• It acts as a connecting link between the borrowers and the lenders.
An Introduction to Banking 193
11.5 Evolution of Banking

In a developing country like India, the banking sector has played a multi-dimensional and
multi-directional role in overall development of the country. The nature of this role has changed
significantly over the period since independence.
During the period between 1947 and 1969, the RBI was nationalized in 1949 and the SBI
was established in 1955. The focus of the banking sector till June 1969 was restricted only in
the industrial sector.
During the period between 1969 and 1991, fourteen major commercial banks were nationalized
on July 19, 1969 and six more banks were nationalized on April 15, 1980; the NABARD was
established in 1982 to channelize credit for rural sector, the NEP policy with the theme of P,
L and G was announced by the Government of India in July 1, 1991.
Thus the evolution of banking sector in India and its role towards the growth and development
of the country has been distinct and definitive.
The fourteen nationalized commercial banks which were nationalized on July 19, 1969 are:
1. Allahabad Bank
2. Bank of Baroda
3. Bank of India
4. Bank of Maharashtra
5. Canara Bank
6. Central Bank of India
7. Dena Bank
8. Indian Bank
9. Indian Overseas Bank
10. Punjab National Bank
11. Syndicate Bank
12. Union Bank of India
13. United Bank of India
14. United Commercial Bank
On April 15, 1980, six more Indian scheduled banks (with deposits of over ` 200 crore)
were nationalized by the Government of India. The six nationalized commercial banks are:
1. Andhra Bank
2. Corporation Bank
3. New Bank of India
4. Oriental Bank of Commerce
5. Punjab and Sind Bank
6. Vijaya Bank
11.6 Structure of Banking

The banking structure in India is presented in Figure 11.1
Figure 11.1 Structure of banking.
11.7 Systems of Banking

An efficient and diversified banking system is a must for promoting savings and channelizing
them into investment and help to achieve a faster rate of economic growth. Thus, the good
health of an economy is reflected in the good health of its banking system.
In a modern economy, banks are considered not only as the dealers in money but also as
the leaders of development. The banking sector is dominant in India as it accounts for more
than half the assets of the financial sector.
The systems of banking are:
1. Unit banking system
2. Branch banking system
3. Mixed banking system
11.7.1 Unit Banking System
When a bank carries on banking operations in a single locality with a single office, the system
is called unit banking. In this system of banking, there is no branches; each bank has its own
shareholders and management; and each bank is a separate and independent unit. If a bank has
a few offices strictly within a limited area, it is also sometimes called unit bank. The USA is
the only centre of unit banking system. In the USA, the unit banks generally operate in small
towns and cities. They are named as country banks and city banks respectively. The country
banks have their deposits in other banks in the same city and the city banks have their deposits
in the banks operating in metropolitan cities.
Merits of unit banking system

The merits or advantages of the unit banking system are as follows:
• The unit banking operations are more economical and flexible.
• This system fosters economic growth and development of the country.
• It is more convenient is the efficient management, supervision and control.
• There is no delay in decision-making under the unit banking system.
• It is comparatively easy for the management to accumulate resources and also to grant
loans and advances immediately without delay.
• There will be sympathy towards local needs since the mobilized resources are used
generally for traders, needy persons and weaker sections residing in the same locality.
• As the unit banks are small organizations, the monopolistic advances are avoided.
• There will be more chances of creating personal contact and friendly relationship between
the banker and the people of the locality concerned.
• There are less chances for frauds and irregularities in the unit banking operations.
• The unit banking system has almost all the merits of small scale business in the USA.
Demerits of unit banking system

The demerits or disadvantages of the unit banking system are as follows:
• The unit banking system has limited financial resources.
• There is absence of division of labour.
• There will be limited possibility of granting credit facilities.
• There is a delicate position on the part of the banker when he has a very close and
personal contact with the people of the locality concerned.
• There arises inconvenient remittances and inefficient operations under the unit banking
system.
• The economies of operation are not possible under the unit banking system.
• There is no guarantee on the part of the unit banker to grant loans to the needy sections
of the society.
• It is prone to failures at the slightest provocation, i.e. during financial crisis, there is
mass withdrawal of deposits from the bank, and then the bank may have to close the
unit for want of operational funds.
11.7.2 Branch Banking System
When a bank carries on banking operations in different towns or cities with a number of
branches, the system is called branch banking. In this system of banking, the bank will have
a head office in one town or city and branches in different parts of the state or the country.
The head office of the bank and all its branches will be under single ownership and
management. The UK (United Kingdom / England) is the origin of branch banking system.
In the UK, the banking system was dominated by ‘Big Five’—the Midland, Barclays, Lloyds,
Westminster and National Provincial.
The branch banking system was also in existence in Canada and Australia. Traditionally,
the branch was the only channel of access to a financial institution’s services. Today, with such
features as ATM (automated teller machine), telephone and online banking, customers can bank
anywhere at any time which brings banks to reduce their business hours.
Merits of branch banking system

The merits or advantages of the branch banking system are as follows:
• The branch banking system enjoys economies of large scale operation. That is, a bank
with a number of branches can secure large funds by way of deposits; can employ
experts to manage the bank; and can introduce division of labour in the management.
• Loans and advances are granted mainly on the basis of merit, i.e. lending policy of the
branch banking system is purely on merit.
• A branch bank can transfer funds from places where there is less demand for loans to
places where there is more demand for loans. This enables the bank to use the funds
for the most productive uses.
• This system ensures efficient and superior management by the well-qualified, trained
and experienced personnel.
• This system itself is capable of doing better services to their customers and also can
arrange for the needed services even through their head office.
• There is a wide scope for the choice of securities and investments on better terms which
helps in attaining higher degree of safety and liquidity for the bank.
• The workload is shared among the branches and the head office.
• The formulation of duplicate departments in branches and in the head office is avoided.
Duplicate department refers to two different sections formed to do the same type of
work.
• Banking business operations can be carried on with lower cash reservers, in times of
need, one branch can secure funds from another branch or from the head office.
• A bank with a number of branches can provide cheap remittance facilities to the public.
That is, it can issue drafts on its branches at a very low charge.
• A central bank can effectively control a few banks having branches. That is, branch
banking system ensures more effective control by the central bank of a country.
Demerits of branch banking system
The demerits or disadvantages of the branch banking system are as follows:
• The management, supervision and control of a large number of branches become difficult.
• There is a large scope for fraud in the form of misuse of power and misappropriation
of funds.
• Managers do not have personal knowledge of the customers since their customers are
not local people and they are frequently transferred.
• A branch bank does not enjoy local sympathy and support. It means that it is unsympathetic
towards the local needs of the people.
• There will be widespread ruin in case of failure. When a branch bank fails, more of
depositors will suffer losses. There will be suffering and misery in different parts of the
country.
• Some bank branches may be making losses which will lead to the collapse of the banks
ultimately.
• It encourages unhealthy competition among different branches. This will lead to increased
operational and maintenance expenses of the bank branches.
• Under this system of banking, there will be red-tapism and delay in making decisions.
• It encourages monopolistic tendencies in the banking system. It means that there is a
possibility of the emergence of monopoly in banking operations.
• There will be drainage of savings from rural areas. This is due to the unwillingness of
granting loans to small farmers and traders and also the willingness of investing funds
on multi-crore companies in big towns and cities.
11.7.3 Mixed Banking System
When the banks undertake both commercial banking (or deposit banking) and industrial banking
(or investment banking) activities in a country, the system is called mixed banking.
The essence of commercial banking is that a commercial bank receives deposits for short
periods and lends to traders and manufacturers for short periods. The essence of industrial
banking is that an industrial bank receives deposits for long periods and lends to industries for
long periods. Thus mixed banking is a system of banking in which commercial banks grant
both short-term and long-term loans to trade(rs) and industries (manufacturers). Trade needs
only short-term loans, whereas industries need both short-term and long-term loans.
Mixed banking was well developed in countries like Germany, Netherlands, Belgium, and
Hungary. The system of banking in operation in India is also mixed banking which should be
undertaken with a great care.
Merits of mixed banking system

The merits or advantages of the mixed banking system are as follows:
• It meets all the financial needs of industrial concerns fully. It grants short-term loans for
the purchase of raw materials and for payments of wages to workers. It grants long-term
loans for the purchase of plant and machinery and for construction of buildings.
• It promotes short-period industrial development of a country mainly on account of

vigorous and bold efforts of banks.
• Under mixed banking system, a commercial bank can secure large funds from the
public by way of deposits. An industrial bank cannot secure large funds from the sale of
debentures and long-term deposits. If a commercial bank undertakes industrial banking,
it will have large funds to provide financial assistance to industries.
• Mixed banks can secure cash quickly by selling industrial securities in times of need.
• A mixed bank gives valuable advice to its customers on investments in shares and
debentures since it has a personal knowledge on the working of industrial concerns.
• A mixed bank appoints experts to access the soundness of industrial unit and to evaluate
its securities.
• The mixed banks follow the practice of joining together of banks into groups to share
the risk of industrial finance.
• Mixed banking stimulates capital formation in the country.
• Mixed banks in developing countries facilitate industrialization by providing both short-
term and long-term financial assistance.
• All sections of the society, whether they are businessmen or traders or manufacturers
or small farmers or stockbrokers, will be benefited by the mixed banking system.
Demerits of mixed banking system

The demerits or disadvantages of the mixed banking system are as follows:
• A mixed bank may be sound but not liquid. When a bank grants long-term loans, its
funds are locked up. It cannot recover the amount in times of need. The banks may
not be able to repay depositors when they demand money. As a result, people will lose
confidence in banks and, finally, banks may fail.
• Mixed banks incur heavy losses during the period of depression when the industrial
securities lose their value because of fall in demand. Banks with poor reserves may fail.
• They make capital profit when they sell shares during the period of prosperity. They
may indulge in speculation by purchasing more and more shares expecting further rise
in prices of shares. Banks will make heavy losses. As a result, a number of banks will
go out of existence.
11.8 Types of Banks

Banks are of the following seven types:
1. Commercial banks
2. Agricultural banks
3. Industrial or investment banks
4. Savings banks
5. Cooperative banks
6. Exchange banks
7. Central banks
11.8.1 Commercial Banks
Commercial banks are those banks which are engaged in accepting deposits, granting loans and
advances, and discounting bills of exchange. The existence and operation of the commercial
banking system is a common form of banking institution all over the world. Commercial banks
in India are classified into two broad groups:
(i) Scheduled commercial banks
(ii) Non-scheduled commercial banks
Scheduled commercial banks are those banks which have been included in the Second
Schedule of the Reserve Bank of India Act, 1934. The scheduled commercial banks in India
include State Bank of India and its associates, nationalized banks, private sector Indian and
foreign banks, regional rural banks, and cooperative banks.
Non-scheduled commercial banks are those banks which are not included in the Second
Schedule of the RBI Act,1934. They operate in all banking sectors. They have a paid-up capital
and reserves of less than ` 5 lakh. The number of these banks has been declining steadily over
the years. Since 1997, there is no such bank exists in India.
11.8.2 Agricultural Banks
Agricultural banks are those banks which are engaged in financing agriculturists. Farmers
require credit for short, medium and long periods. They require loans for short periods for
the purchase of seeds and manures. These loans can be repaid after the crop is sold. They
require loans for medium periods for the purchase of bullocks and agricultural implements.
These loans can be repaid over a period of 2 to 3 years. Besides, farmers require loans for
long periods for the purchase of land and costly agricultural equipment like tractors. These
loans can be repaid easily in instalments over a period of 10 to 15 years. In India, agricultural
banks help the development of agriculture through cooperative banks or credit societies and
also through land mortgage or development banks. In recent years, nationalised commercial
banks and regional rural banks are also granting financial assistance for the development of
agriculture in India.
11.8.3 Industrial or Investment Banks
Industrial or investment banks are those banks which are engaged in granting loans to industries
or investors only for long periods. They purchase the stocks and shares of the newly established
joint-stock companies. They underwrite the issue of shares and debentures by joint-stock
companies. They invest in the shares of industrial concerns on a long-term basis. Thus they
help industrial concerns to secure necessary funds for their business by selling shares and
debentures to the public. They receive deposits from the public for long periods. So they are
in a position to lend money for long periods. Thus industrial or investment banks help the
establishment and development of industries in any country.
11.8.4 Savings Banks
Savings banks are those banks which are engaged in mobilizing the savings of the public.
These banks encourage the habit of thrift and saving among the people having small incomes.
One can deposit small amounts and withdraw small amounts. But the savings bank imposes
certain conditions on its depositors for withdrawal of cash from their deposits. The depositors
concerned are required to come in person with passbooks for withdrawing cash from
their accounts. They are also restricted to withdraw the maximum cash in a given period of
time. In India, postal department and recently commercial banks undertake such savings bank
operations.
11.8.5 Cooperative Banks
Cooperative banks are those banks which are engaged in pooling the resources of people
of the same profession and jointly help each other in times of financial crisis. When a
cooperative society is engaged in banking business operation, it is called a cooperative bank.
Cooperative banks are functioning in rural and semi-urban areas. Cooperative banks grant
loans to their members on the basis of personal security. In India, cooperative banks are at
the state level.
11.8.6 Exchange Banks
Exchange banks are those banks which are engaged in dealing with foreign exchange business in
a big way. They purchase and sell foreign currencies. They discount foreign bills of exchange.
They grant financial assistance to exporters and importers. Thus they encourage foreign trade.
Initially, the foreign exchange business was the monopoly of foreign banks in the country.
Recently, nationalized commercial banks in India are doing the foreign exchange business.
Exchange banks are so called because they have their head offices abroad.
11.8.7 Central Banks
Every country has a central bank. It is the top of all banking institutions in any country. Reserve
Bank of India (RBI) is the central bank of our country. It enjoys the monopoly power of printing
and issuing currency notes in the country. It acts as a banker to the government; bankers’ bank;
lender of the last resort; custodian of cash reserves of commercial banks; custodian of national
reserves; and controller of credit created by commercial banks.
The central bank of any country does not have any direct dealings with the public. It is
not a profit-motivated but service-motivated bank. It means that central bank of any country
never operates on the criterion of earning profits.

1. The Bank of Venice was the first public banking institution founded in the year
(a) 1057 (b) 1157
(c) 1257 (d) 1357
2. Which was the first bank established in the year 1786?
(a) Bank of Venice (b) General Bank of India
(c) National Bank of India (d) Oriental Bank of India
3. The Bank of Bengal (1809), the Bank of Bombay (1840) and the Bank of Madras (1843)
were established by the
(a) East India Company (b) General Bank of India
(c) Reserve Bank of India (d) State Bank of India
4. The period of evolution of banking sector in India is divided into
(a) 1947–1969 (1st phase) (b) 1969–1991 (2nd phase)
(c) 1991 till date (3rd phase) (d) all of the above 3 phases
5. On July 19, 1969, the number of major commercial banks nationalized was
(a) 14 (b) 11
(c) 16 (d) 19
6. On April 15, 1980, the number of major commercial banks nationalized was
(a) 14 (b) 20
(c) 6 (d) 18
7. NABARD was established to channelize credit in rural sector in the year
(a) 1962 (b) 1972
(c) 1982 (d) 1992
8. The New Economic Policy was announced by the Government of India on
(a) July 1, 1961 (b) July 1, 1971
(c) July 1, 1981 (d) July 1, 1991
9. The main theme of the NEP was
(a) privatization (b) liberalization
(c) globalization (d) all of the above
10. When a bank carries on banking operations in a single locality with a single office, the
system is called
(a) unit banking (b) branch banking
(c) mixed banking (d) merchant banking
11. Which country is the origin of unit banking system?
(a) USA (b) UK
12. When a bank carries on banking operations in different towns or cities with a number
of branches, the system is called
13. Which country is the origin of the branch banking system?

(a) USA (b) UK
14. When the commercial banking and industrial banking activities are undertaken together
in a country, the system is called
15. A system of banking in which two or more banks are controlled by an individual or a
group of individuals is called
(c) mixed banking (d) chain banking
16. Which country is the centre of chain banking system?
(a) USA (b) UK
17. A system of banking in which banking services are accessed via Internet’s World Wide
Web is called
(a) chain banking (b) mixed banking
(c) virtual banking (d) narrow banking
Answers
1. (b) 2. (b) 3. (a) 4. (d) 5. (a)

6. (c) 7. (c) 8. (d) 9. (d) 10. (a)
11. (a) 12. (b) 13. (b) 14. (c) 15. (d)
16. (a) 17. (c)
Review Questions
1. What is a ‘bank’?
2. Define a ‘banker’.
3. Define ‘banking’.
4. Bring out the characteristics of a bank.
5. Explain the evolution of banking since independence.
6. Briefly explain the Indian banking structure.
7. Explain the various systems of banking.
8. Define unit banking system and bring out its merits and demerits.
9. Define branch banking system and bring out its merits and demerits.
10. Define mixed banking system and bring out its merits and demerits.
• Group banking system
• Chain banking system
• Correspondent banking system
• Rural banking system
• Virtual banking system
• Narrow banking system
12. Distinguish between retail and wholesale banking systems.
13. Explain the various types of banks in India.
14. What are commercial banks?
15. Define scheduled and non-scheduled commercial banks.
16. What are agricultural banks?
17. What are industrial or investment banks?
18. What are saving banks?
19. Define cooperative bank. How the cooperative credit societies are functioning in India.
20. What are exchange banks? Bring out their functions.
21. Define a central bank and bring out its main functions.
Chapter 12
Functions of Commercial Banks
12.1 Definition of Commercial Bank

Commercial bank is an institution that collects savings from the public as deposits and lends
the same as loans, and advances to the public on interest and thereby earns profits. It is thus
a profit-motivated bank.
12.2 Functions of Commercial Banks

A modern commercial bank performs the following important functions:
12.2.1 Primary Functions
They are discussed below.
Receiving deposits from the public

The most important function of a modern commercial bank is to receive deposits from the
public. It accepts three types of deposits. They include current account deposits, savings account
deposits and fixed account deposits.
Under the current account deposit, a person who deposits money can withdraw the amount
whenever he wants by means of a cheque. In other words, current account deposits are repayable
on demand. That is why these deposits are called demand liabilities. Commercial banks do not pay
interest on these deposits. These deposits are generally kept by industrialists and business people.
Under the savings account deposit, a person can open an account with a small account
as deposits. Small amount can be deposited and withdrawn. There will be no restrictions on
the number of withdrawals and the amount that can be withdrawn. But the maximum amount
of money to be withdrawn at a time cannot go beyond a limit. If the account holder wants
to withdraw more than the specified limit, he has to give prior notice to the bank. Interest is
given only on the balance of this account.
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Functions of Commercial Banks 205
Under the fixed account deposit, a person can deposit money for a fixed period. These
deposits will be repaid after the expiry of the fixed period. These deposits are generally for a
period of 3 months to 10 years in India. These are known as time deposits. Commercial banks
pay interest on these deposits as they can freely use these funds. The interest rate depends
on the period of deposits. It implies that the higher the period of deposits, the higher will be
the rate of interest given to the depositors and vice versa. These deposits are also called time
liabilities as the debts are repayable after a fixed period of time. Fixed account deposits are
mostly liked by the account holders for their safety and interest.
Lending loans and advances to the public

Lending loans and advances to the public is another primary function of a modern commercial
bank. It makes loans and advances to merchants (businessmen) and manufacturers (entrepreneurs).
Nowadays, it lends money to agriculturists and consumers. It makes loans and advances only
against personal security, gold and silver, assets like stock of goods and other government
securities.
Commercial banks generally make advances to the public in various ways—cash credit,
overdraft, discounting bills of exchange, packing credit to exporters, call loans to bill brokers
(loans for a very short period), term loan (loans to industrialists, agriculturists and traders
against common security), consumer credit and ordinary loans.
Commercial banks initially lend for short period only. They cannot afford to lend for long
periods. If they do so, they may not be in a position to pay the account holders when money
is demanded. In such cases, the commercial banks fail and the public lose confidence in them.
Now modern commercial banks lend loans and advances for long period also. Such loans
are provided against security. Personal loans may also be given against personal security.
Transfer of funds
Transfer of funds is another important function performed by a modern commercial bank.
The commercial bank provides facilities for transfer of funds from one place to another
within a country or from one country to another. Commercial banks provide such a facility
to their customers in the form of cheque, demand draft, mail transfer and telegraphic transfer
on nominal commission charges. These are considered as cheap means of remitting funds to
business community at large.
12.2.2 Secondary Functions
They are discussed below.
Discounting bills
A modern commercial bank also performs another important function of discounting bills of
exchange of a creditor. By discounting bills of exchange, the commercial bank helps the creditor
to convert his bills into money instantly. The bank, in turn, gets its payment on the maturity
of the bills. Bills of exchange may mature sometimes in future. But the holders of the bill
may need money urgently. They may take these bills to the commercial bank and have them
discounted. The commercial bank will deduct a certain sum (commission) at the ruling rate of
interest for the period during which they have to wait for the bills to mature. This function
is beneficial to those holders of the bills who require money urgently. In times of need, the
commercial bank can rediscount the discounted bills with the central bank and gets money.
Dealings in foreign exchange

A modern commercial bank at present performs an important function of dealings in foreign
exchange. It undertakes the business of buying and selling foreign exchanges. Generally,
the foreign exchange banks undertake this business. In India, commercial banks undertake
the dealings in foreign exchange in addition to their other functions. This function helps in
international payments.
Creation of credit
Creation of credit is another important function of a modern commercial bank. Commercial
banks supply money to traders and manufacturers. They also create credit. When a commercial
bank grants loans to a customer, it does not pay cash. It simply credits the amount of loan
in the account of the borrower. Whenever the borrower wants, he can withdraw the amount
from his account by means of a cheque. In this way, a commercial bank has created credit.
Professor R.S. Sayers rightly remarks that “banks are not merely purveyors, but also in an
important sense manufacturers of money”. In this definition, purveyors mean suppliers and
manufacturers mean creators.
When an account either current or even savings is opened, the bank issues a cheque book
to its customers. The customer can make payments to his suppliers and lenders by cheque.
This is a convenient method of payment.
Nowadays if an account is opened in any commercial bank, the account-holder or customer
is issued an ATM (Automatic Teller Machine) card on request. The customer can use his ATM
card to withdraw amount from his account at any time. There is no limit for the number of
withdrawals by using ATM card. But there is a limit for the amount that can be taken every day.
Financing trade
Financing internal and international trade is another important function of a modern commercial
bank. The commercial bank finances trade through discounting of bills of exchange. It lends
short-term loans to traders and merchants on the security of commercial papers. This function
of a commercial bank helps the promotion of internal and international trade.
12.2.3 Other Functions
The other functions of the commercial banks are as follows:
Agency functions
A modern commercial bank also performs some agency functions to its customers. They are:
1. The commercial bank collects cheques, promissory notes, bills of exchange.
2. It purchases and sells shares, debentures and government securities.
3. It also collects interest and dividend applicable to the above securities for their customers
and credits them in their accounts.
4. It serves as an executor and trustee by preserving and executing the ‘wills’ of its
customers.
5. It buys and sells foreign currencies and thereby encourages foreign trade.
6. It helps the public to remit money from one place to another by issuing demand drafts.
7. It acts as a referee with regard to the financial standing and integrity of its customers.
8. It provides trade information by publishing magazines.
9. It acts as an agent, correspondent or representative to its customers.
10. It acts as an income tax consultant by preparing IT returns for their customers and
helping them to get the refund without any difficulty.
11. It also acts as a well-wisher, friend and messenger to its customers.
Utility functions
A modern commercial bank performs the following important general utility functions to the
community at large:
1. It provides safety locker facility to its customers for keeping their valuables like gold
jewellery and documents.
2. It issues a letter of credit to its customers in foreign trade. The letter of credit is a
document issued by an importer’s bank to an exporter.
3. It issues a traveller’s cheque to its customers who are saved from the risk of carrying
cash during the travel time.
4. It collects statistical information relating to trade, industry, commerce, money and
banking and made available to its customers in the form of journals, bulletins, booklets,
periodicals, pamphlets and handouts. This will help its customers to be well aware of
the present economic and business situation and thereby making future economic and
business policies.
5. It renders advices to its customers on financial matters.
6. It underwrites the shares and debentures issued by the government.
7. It helps its customers by getting travel tickets (train or air), passports, insurance, etc.
12.3 Functions of Commercial Banks in India

In India, the functions of commercial banks are obviously defined by the Banking Regulation
Act, 1949 [Clause (a) of Subsection (1) of Section 6 of Act] thus:
1. The borrowing and lending of money with or without security.
2. The discounting bills of exchange, promissory notes, drafts, debentures and other
securities transferable or not.
3. The issuing of letter of credit and traveller’s cheques.
4. The buying and selling of foreign currencies.
5. The underwriting and dealing in stocks, bonds and securities of all kinds.
6. The acceptance of all kinds of valuables on deposits for safe custody.

7. The purchasing and selling of bonds or other forms of securities and negotiating of
loans and advances.
8. The buying and selling, and dealing in bullion and species.
In clauses (b) to (i) of Subsection (1) of Section(b) under the Banking Regulation Act,
1949, the commercial bank performs the following important ancillary functions:
(i) The carrying on the agency business of any description.
(ii) The contracting for private and public loans.
(iii) The carrying out of any issue and the lending of money.
(iv) The carrying on of guarantee and indemnity business.
(v) The managing any property.
(vi) The dealing with any property.
(vii) The undertaking and executing trusts.
(viii) The undertaking the administration of estates as executor and trustee.
Today, the nationalized commercial banks in India are directed to frame special and innovative
programmes of credit to help small farmers, village and cottage industries, retailers, artisans,
self-employed persons through granting loans and advances at concessional rates of interest.
Thus commercial banks aim at achieving the national level objectives of eradication of poverty,
solving unemployment problem and reducing inequalities of income and wealth distribution.

1. Commercial bank is a
(a) profit-motivated bank (b) service-motivated bank
(c) goal-oriented bank (d) approach-oriented bank
2. Accepting deposits from the public is a
(a) primary function of a bank (b) secondary function of a bank
(c) contingent function of a bank (d) static function of a bank
3. Credit creation is a
(a) primary function of a bank (b) secondary function of a bank
(c) contingent function of a bank (d) static function of a bank
4. Current account deposits of a bank are
(a) repayable on demand (b) not repayable on demand
(c) repayable on some future date (d) none of the above
5. Safety locker facility provided by commercial banks is its
(a) utility function (b) agency function
(c) primary function (d) secondary function
6. In India, the functions of commercial banks are obviously defined by the
(a) Banking Regulation Act, 1949 (b) Reserve Bank of India Act, 1935
(c) State Bank of India Act, 1955 (d) All of the above
7. Commercial banks lend to merchants and manufacturers against their securities generally
for
(a) short period only (b) medium period only
(c) long period only (d) all of the above
Answers
1. (a) 2. (a) 3. (b) 4. (a) 5. (a)

6. (a) 7. (a)
Review Questions
1. Define commercial bank.
2. Explain the primary functions of a commercial bank.
3. Explain the secondary functions of a commercial bank.
4. List out the agency functions of a commercial bank.
5. Bring out the utility functions of a commercial bank.
6. What are the functions of commercial banks defined by the Banking Regulation Act,
1949?
7. Explain in detail the various functions performed by a modern commercial bank.
Chapter 13
Credit Creation Process of

Commercial Banks
13.1 Introduction
Commercial banks borrow money from the public by receiving deposits in various forms. They
lend the same (borrowed money) to merchants and manufacturers. Besides, they also create
credit money. When a bank grants a loan or purchases a bill, it does not pay cash. It simply
credits the account of the customer. In other words, deposits are written in the books of the
bank without receiving cash. It is said that ‘every loan creates a deposit’.
13.2 Meaning of Credit Creation

By credit creation, we mean the creation of credit or bank money by commercial banks. Credit
creation is one of the important functions of a modern commercial bank. In the words of Professor
R.S. Sayers, “banks are not merely purveyors, but also in an important sense manufacturers of
money”. Thus credit creation implies multiplication of bank deposits. It can be defined as, “the
expansion of bank deposits through the process of more loans, advances and investments”.
13.3 Basis of Credit Creation

Credit creation by commercial banks is based on bank deposits. Bank deposits are of two
types—primary deposits (cash deposits) and derivative deposits (derived deposits).
13.3.1 Primary Deposits (Cash Deposits)
When a person deposits cash or cheque, the bank will credit his account with the amount.
The customer is free to withdraw the amount whenever he wants by cheque. These deposits
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Credit Creation Process of Commercial Banks 211
are called ‘primary deposits’. They are passive deposits. It is because of the fact that these
deposits are automatically created against cash or cheque received by commercial banks from
their customers.
Primary deposits do not increase the money supply in the economy. There is only a chance
in the form of money. If cash is deposited in a bank, the legal tender money (cash) is turned
into bank (credit) money. That is all. So primary deposits arise when cash or cheque is deposited
by a customer in a bank.
13.3.2 Derivative Deposits (Derived Deposits)
Deposits which arise on account of granting a loan or purchase of asset by a commercial bank
are called ‘derivative deposits’. When a bank credits the account of a person without receiving
cash, it means that the bank has created credit.
When a bank grants loans to a person, it does not pay him cash but simply credits his
account with the amount of the loan. The customer is free to withdraw the amount whenever
he wants by cheque. Thus loans create deposits. Professor Hartley Whithers aptly remarks that
‘every loan creates a deposit’ or ‘loans create deposits’.
Derivative deposits are active deposits. It is because of the fact that these deposits are
actively created by commercial banks based on primary or cash deposits while investing in
securities. These deposits do increase the money supply in the economy. Thus the deliberate
creation of deposits by banks through loans and advances are called derivative or active deposits.
13.4 Arguments towards Credit Creation

There are two arguments towards the creation of credit by commercial banks—argument against
credit creation and argument in favour of credit creation.
13.4.1 Argument against Credit Creation
One group argue that commercial banks cannot create credit. A bank is just like a cloakroom
attendant. It is said that a bank cannot lend more than what it has received. Suppose a bank
receives deposits of ` 5 crore, it can lend up to ` 5 crore only. It cannot lend more than this
amount. It has to keep some cash reserve. Suppose if it keeps 5 per cent cash reserve, it can
lend only 75 lakh. Hence it is said that banks can lend not more than what they can borrow
from the public.
13.4.2 Argument in Favour of Credit Creation
Another group argue that commercial banks can lend more than what they have borrowed from
the public. It is because of the fact that the amount lent by banks may come back again to the
same bank or some other bank as new deposit. The bank whose deposits have increased will
lend again. This process will continue till the deposits have increased by a number of times
of the original deposit of cash.
13.5 Process of Credit Creation

The process of credit creation by commercial banks can be illustrated with the help of following
simple tabular explanation.
Assumptions
The process of credit creation by commercial banks is mainly based on the following
assumptions:
• There are many banks in the country.
• Every bank has to keep cash reserves.
• Money received by the borrower will be deposited in the bank.
Let us illustrate the process of credit creation by assuming that
• There are banks like A, B, C, D, ....
• Ten per cent cash reserve to be kept by cash bank.
• A fresh deposit of ` 5000 with Bank A.
Illustration
Suppose ` 5000 is deposited with Bank A and cash reserve ratio is 10 per cent. Then the
balance sheet of Bank A will be as follows:
Balance Sheet of Bank A
Liabilities Assets
Fresh deposits ` 5000 Cash ` 5000
Total ` 5000 Total ` 5000
After keeping 10 per cent cash reserve by Bank A, the balance of ` 4500 is lent to
Mr. X. Then the balance sheet of Bank A will be as follows:
Balance Sheet of Bank A
Liabilities Assets
Fresh deposits ` 5000 Cash ` 5000
Loan to Mr. X ` 4500
Suppose Mr. X purchases goods of worth ` 4500 from Mr. Y and pays cash. Mr. Y deposits
the amount with Bank B. Then the balance sheet of Bank B will be as follows:
Balance Sheet of Bank B
Liabilities Assets
Deposits ` 4500 Cash ` 4500
After keeping 10% cash reserve by Bank B, the balance amount of ` 4050 is lent to Mr.
Z. Then the balance sheet of Bank B will be as follows:
Balance Sheet of Bank B
Liabilities Assets
Deposits ` 4500 Cash reserve ` 450
Loan to Mr. Z ` 4050
Suppose Mr. Z purchases goods of worth ` 4050 from Mr. P and pays the cash. Mr. P
deposits the amount with Bank C. Then the balance sheet of Bank C will be as follows:
Balance Sheet of Bank C
Liabilities Assets
Deposits ` 4500 Cash ` 4050
After keeping 10 per cent cash reserve by Bank C, the balance amount of ` 36,450 is lent
to a merchant. Then the balance sheet of Bank C will be as follows:
Balance Sheet of Bank C
Liabilities Assets
Deposits ` 4500 Cash reserve ` 405
Loan to a merchant ` 3645
It is clear from the tabular illustration that the original deposit of ` 5000 in bank has
increased the total deposits of banks A, B and C by ` 13,550 (5000 + 4500 + 4050). This
process will continue till the total deposits of all the banks increase ` 50,000, i.e. the total
deposits increase by 10 times the original deposit of money. This is called ‘multiple expansions
of deposits’. The illustration also shows that banks can create credit. Even if there is a single
bank, it can also create credit as the amount will be deposited again in the same bank. It is to
be noted that when there are withdrawals of cash from banks, there will be multiple contraction
of deposits.
13.6 Calculation of Credit Creation

The multiple expansion of deposits or multiple credit creation can be calculated with the help
of the following formula:
e
DN =
r
where
DN = Increase in new deposits
e = Excess cash reserves
r = Cash reserve ratio
Suppose e = ` 4500 and r = 10 per cent, then
e 4500 4500 ¥ 100

DN = = = = ` 45, 000
r 10 10
100
13.7 Limitations of Credit Creation Process

The following are the limitations to the power of commercial banks to create credit:
• The volume of money received as primary deposits from the public.
• The cash reserve ratio to be kept by each commercial bank with the central bank of the
country.
• The banking habits of the public.
• The monetary policy of the central bank.
• The statutory liquidity ratio (SLR) to be kept by cash commercial bank with itself.
• The trade or business conditions.
• The existence of cash transactions in the economy.
• The availability of sound securities.
• The willingness of the customers to borrow from banks.
• The liquidity preference of the people.
• The existence of external drain.
13.7.1 Volume of Primary Deposits
The commercial banks can create credit only when the volume of money received as primary
deposits from the public is large. There is also a close relationship between the volume of
primary deposits and the volume of money in circulation. If the volume of money in circulation
increases, the volume of primary deposits will also increase. This will help the commercial
banks to create credit in the form of derivative deposits. Thus the power to create credit depends
upon the volume of money received as primary deposits from the public. If banks receive more
volume of money, they can create more credit and vice versa.
13.7.2 Cash Reserve Ratio
Cash reserve ratio implies that every commercial bank is required to keep a certain percentage
of its total deposits as cash reserve with the central bank of the country. The credit creation
power of the commercial banks depends upon the amount of cash reserve ratio kept by them.
There is an inverse relationship between the cash reserve ratio and the volume of credit created
by the banks. If the cash reserve ratio is large, the smaller will be the volume of credit created
by the banks and if the cash reserve ratio is small, the larger will be the volume of credit
created by the banks. Thus, if the commercial banks lend more, the cash reserve ratio will fall.
They may fail to pay the depositors on demand. As a result, they may go out of existence.
13.7.3 Banking Habits of the Public
The power of the commercial banks to create credit also depends upon the banking habits of
the public. If people prefer to have business transactions in cash rather than by cheques, credit
creation by commercial banks will suffer because only limited cash is left with the banks for
the purpose of credit creation. Further, frequent withdrawals and cash payments for importing
goods by customers will also reduce the power of commercial banks to create credit.
13.7.4 Monetary Policy of the Central Bank
The monetary policy adopted by the central bank will determine the degree of credit creation
by commercial banks. If the Central bank adopts cheap money and prescribes low cash reserve
requirements, credit creation is encouraged and vice versa. The central bank of the country uses
its bank rate and open market operations as powerful weapons to influence on the expansion
and contraction of credit by commercial banks. If the monetary policy of the central bank is
to discourage credit, the commercial banks cannot go on creating credit. Thus the power of
the commercial banks to create credit will also be checked by the central bank of the country.
13.7.5 Statutory Liquidity Ratio (SLR)
The power of the commercial banks to create credit is also limited by the statutory liquidity
ratio maintained by every commercial bank. The statutory liquidity ratio implies that every
commercial bank is required by law to keep a certain percentage of its total deposits as cash
reserve with itself. These reserves can be kept in the form of near-money which can easily be
converted into cash without any loss during emergency. Keeping more statutory liquidity ratio
will reduce the leading capacity of the banks and thereby limiting their power to create credit.
13.7.6 Trade or Business Conditions
A trade cycle is composed of the periods of bad trade (depression) and the periods of good
trade (inflation). If there is depression in the economy, business people will be making losses.
They will not come forward to borrow and invest. As a result, the demand for goods will be
very low. Banks can create credit only when people borrow from them. When the business
people do not approach for loans, the power to create credit by banks is largely reduced. If
there is inflation in the economy, businessmen will be earning profits. They come forward to
borrow more and to make fresh investment. As a result, employment income and demand for
goods will be very high. Now banks can create credit as business people frequently approach
for loans. Hence the power to create credit by banks is largely increased.
13.7.7 Existence of Cash Transactions
The power to create credit by commercial banks is also limited by the existence of cash
transactions in the country. In an underdeveloped economy, most of the transactions are in
cash as banking habits of the people are not well developed. In a developed economy, most
of the transactions are in bank or credit money. As such, the power of the commercial banks
to create credit will be increased as the ratio of credit money to the total supply of money in
the country increases.
13.7.8 Availability of Sound Securities
The power to create credit by commercial banks is further limited by the availability of sound
securities. Every bank loan is secured by valuable assets such as shares, stocks, bills, bonds,
etc. If the availability of such securities is not enough, the commercial banks cannot expand
credit in the country. Crowther aptly remarks that “a bank cannot create money out of thin air,
it transmutes other forms of wealth into money”.
13.7.9 Willingness to Borrow
The power to create credit by commercial banks is also limited by the willingness of the
customers to borrow from banks. Banks cannot create credit at their own will. There must be
customers’ willingness and asking for money. During the lean season, people are not willing to
borrow more. Hence less credit is created by banks. During the busy season, people are willing
to borrow more. Hence more credit is created by banks. Thus willingness to borrow on the part
of the public is another limiting factor of the degree of credit creation by commercial banks.
13.7.10 Liquidity Preference of the People
The power to create credit by commercial banks is also determined by the liquidity preference
of the people. The liquidity preference means the desire of the people to hold liquid cash. If
the people desire to hold more liquid cash, the power of commercial banks to create credit
largely be reduced and vice versa.
13.7.11 Existence of External Drain
The power of commercial banks to create credit is limited by the existence of external drain.
By external drain, we mean the cash withdrawals by the public from the banks. With frequent
withdrawals of cash by the public, the possible excess reserves of the commercial banks are
reduced to a large extent. As a result, the power of banks to create credit will be heavily reduced.

1. Credit creation implies
(a) addition of bank deposits (b) multiplication of bank deposits
(c) contraction of bank deposits (d) division of bank deposits
2. Bank deposits are
(a) primary deposits (b) derivative deposits
(c) both (a) and (b) (d) none of the above
3. Primary deposits are
(a) passive deposits (b) active deposits
4. Deposits which arise on account of granting loans or purchasing of assets by commercial
banks are called
(c) both (a) and (b) (d) all of the above
5. Deposits which are automatically created against cash or cheque received by commercial
banks are called
6. Who aptly remarks that ‘loans create deposits’?
(a) R.S. Sayers (b) Hartley Whithers
(c) Hawtrey (d) Crowther
7. Who says that “banks are not merely purveyors, but also in an important sense
manufacturers of money”?
(a) R.S. Sayers (b) Hartley Whithers
(c) Hawtrey (d) Crowther
8. Derivate deposits are
(a) active deposits (b) passive deposits
9. The process of credit creation by commercial banks is mainly based on the assumption
that
(a) many banks operate in the country
(b) every bank has to keep cash reserves
(c) money received to be deposited in the bank
10. The relationship between the cash reserve ratio and the volume of credit created by
banks is
11. External drain means
(a) cash withdrawals by the public (b) cash deposits by the public
(c) transfer of deposits by the public (d) all of the above
Answers
1. (b) 2. (c) 3. (a) 4. (b) 5. (a)

6. (b) 7. (a) 8. (a) 9. (d) 10. (b)
11. (a)
Review Questions
1. What do you mean by credit creation?
2. What are primary deposits?
3. What are derivative deposits?
4. Distinguish between primary and derivative deposits.
5. Bring out the arguments in favour of credit creation by commercial banks.
6. Bring out the arguments against credit creation by commercial banks.
7. Discuss the process of credit creation by commercial banks.
8. How do you calculate credit creation?
9. What are the limitations of credit creation by commercial banks?
Chapter 14
Balance Sheet of
Commercial Banks
14.1 Meaning of Balance Sheet

Balance sheet is a financial statement showing the liabilities and the assets of a bank on a
particular date. It shows whether the bank is sound or not and also whether the bank has
maintained liquidity or not. Balance sheet of a bank also shows the main business of borrowing
and lending of the bank.
14.2 Sample Balance Sheet

A sample balance sheet of a commercial bank is given below:
Balance Sheet of Bank A as on .........................
Liabilities Assets
1. Capital 1. Cash in hand and with central bank
2. Reserve fund 2. Balances with other banks
3. Deposits—Fixed, current, savings account 3. Money at call and short notice
4. Borrowings from other banks 4. Bills discounted and purchased
5. Bills for collection being bills receivable 5. Investments
6. Acceptances, endorsements and other 6. Loans and advances
obligations 7. Bills for collection being bills receivable
7. Profit and loss 8. Acceptances, endorsements and other
obligations
9. Fixed assets
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14.3 Sides of a Balance Sheet

A balance sheet of a bank has two sides—liabilities side and assets side.
14.3.1 Liabilities Side
The left-hand side of the balance sheet of a bank shows the liabilities of the bank. The liabilities
are those items on account of which the bank is liable to pay others.
Items on the liabilities side

The various items on the liabilities side of the balance sheet of the bank include:
1. Capital
2. Reserve fund
3. Deposits— fixed, current, savings account
4. Borrowings from other banks
5. Bills for collection being bills receivable
6. Acceptances, endorsements and other obligations
7. Profit and loss
Capital: Capital is the first item on the liabilities side of the balance sheet which covers
authorized capital, issued capital, subscribed capital, called-up capital and paid-up capital. Out
of these, paid-up capital represents the actual amount of money paid by the shareholders. This
is the actual amount received by the bank from its shareholders for its business. In other words,
capital represents the bank’s liabilities to its shareholders. This amount is shown only on the
outer column of the balance sheet.
Reserve fund: Reserve fund is a fund created by transferring the accumulated (undistributed)
profits of the bank. In India, every commercial bank is required by the Banking Regulation Act
of 1949 to transfer 20 per cent of the net profits to this fund every year. This fund is built up
to meet unforeseen and unexpected losses. It improves the financial strength of the bank. Since
the reserve fund belongs to the shareholders, it is the liability of the bank. These reserves may
be invested in government securities.
Deposits: Deposits are the largest source of funds to a bank contributed by its customers—
individuals, business people, government bodies and other institutions. Deposits are of various
types in commercial banks. They are current/demand deposits, fixed deposits and savings deposits.
Deposits constitute an important item on the liabilities side of a bank’s balance sheet. Out of
the above three types of deposits, the demand deposits of the bank forms the total supply of
money which can be used directly as money.
Borrowings: Borrowing from the public is the most important function of a modern commercial
bank. It borrows money by accepting deposits of various types. The bank also secures funds by
borrowing from other banks like other commercial banks, the State Bank of India and financial
institutions. It may borrow from the central bank of the country in times of need. It may also
borrow from other banks which have surplus funds. The commercial banks generally borrow
Balance Sheet of Commercial Banks 221
from other banks to meet contingencies and temporary shortage of funds. Thus borrowings
from other banks appear on the liability side of the balance sheet of the bank.
Bills for collection: Bills for collection is another item on the liability side of the balance
sheet of a commercial bank. Bills are usually accepted for the purpose collection. They will be
held by the bank till the date of maturity. This item appears on the assets side of the balance
sheet also. When a commercial bank holds a cheque or a bill on behalf of its customers for
collection, it has to receive money on the cheque or bill from the acceptor. So it is an asset.
It has to pay the amount to the customer. So it is a liability. Hence this item appears on both
the sides of the balance sheet of the commercial bank.
Acceptances and endorsements: Acceptances and endorsements are another important items
that appear on the liabilities side of the balance sheet of a commercial bank.
When the commercial bank accepts and endorses the bills on behalf of its customers, they
are called acceptances and endorsements. It has to pay money on the due date. It has also to
receive money from its customers. For rendering this service, a commission is charged by the
bank. And also its customers are liable to the bank for full payment of the bills. So the same
item appears on the both sides of the balance sheet of the bank.
Profit and loss: Profit and loss is another item that appears on the liabilities side of the
balance sheet of a commercial bank. The profit earned by the bank in a year is shown on the
liabilities side of the balance sheet. Since profit is payable to its shareholders, it represents
liability on the bank.
14.3.2 Assets Side
The right-hand side of the balance sheet of a bank shows the assets of the bank. The assets
are the claims of the bank on others. The assets side represents the manner in which the funds
resources of the bank are distributed.
There are three important guiding principles by which the funds can be invested. They are
liquidity, profitability and security. The assets on the assets side of the balance sheet of the
bank are arranged in the order of liquidity.
Items on the assets side

The various items on the assets side of the balance sheet of the bank include:
1. Cash in hand and with central bank
2. Balances with other banks
3. Money at call and short notice
4. Bills discounted and purchased
5. Investments
6. Loans and advances
7. Bills for collection bills receivable
8. Acceptances, endorsements and other obligations
9. Fixed assets
Cash in hand and with central bank: Cash in hand is the first item on the assets side of the
balance sheet of a commercial bank. It refers to the amount of legal tender money held with
the bank itself to meet the requirements of its customers. Cash with other banks refers to the
amount of money kept by the commercial banks with the central bank of the country in the
form of deposits. Cash in hand is considered to be the most liquid asset. Every commercial
bank knows by experience that all the depositors will not withdraw money at a time. Some
will be depositing and some others will be withdrawing money. So the bank is in a position
to lend most of the deposits. However, it keeps a certain percentage of its deposits in cash.
Cash is an idle asset as it earns no income. However, every commercial bank is required by
law to maintain a certain minimum reserves with the central bank as cash reserves to meet
their day-to-day obligations.
Balances with other banks: Commercial banks generally maintain their excess cash balances
with other banks. This excess cash balances can be withdrawn in times of financial difficulty.
These balances with other banks form an important item on the assets side of the balance
sheet of a commercial bank. These balances with other banks are also considered as good as
liquid cash.
Money-at-call and short notice: Money-at-call and short notice refers to short-term loans
given to stock brokers for a week or for 15 days. These loans can be withdrawn without any
prior notice by the banker. These loans earn low rate of interest. In England, it represents loans
given to discount houses. In India, it represents loans given to other banks. Thus money-at-
call and short notice is another item that appears on the assets side of the balance sheet of
the commercial bank.
Bills discounted and purchased: By bills discounted and purchased, we mean the loans
granted by the commercial banks to the owners of the bills of exchange. Banks discount bills
of exchange. They receive money within a short period. They can be rediscounted with the
central bank in times of need. A major portion of the funds of a bank will be invested on the
bills of exchange because the date of maturity of a bill is definite, investment on such a bill
is a self-liquidating, most liquid and shiftable asset and earns income by discounting bills of
exchange. Thus bills discounted and purchased is another important item that appears on the
assets side of the balance sheet of the commercial bank.
Investments: Commercial banks invest mostly in government securities, stocks, shares, bands
and debentures of companies. These securities are readily shiftable to other banks as they are
highly liquid. These securities can also be easily converted into cash as there is a ready stock
exchange market. These securities can be sold in the market in times of need. Money can be
borrowed from the central bank of the country on the security of these near-money assets. Thus
investments are the important items on the assets side of the balance sheet of the commercial
bank.
Loans and advances: Loans and advances are generally granted by a commercial bank to its
customers against approved government securities. The customers of the bank may be traders,
entrepreneurs and businessmen. These loans and advances are granted for a fixed period, normally
for short periods. Loans and advances are the largest item appeared on the assets side of the
Balance Sheet of Commercial Banks 223
balance sheet of the bank. The reason is that this item (loans and advances) yields the largest
income to the bank. But these loans and advances are comparatively least liquid assets of all
other assets of the bank. These assets cannot be converted into liquid cash as and when needed.
Bills for collection: Bills for collection is another item that appears on the assets side of the
balance sheet of the bank. When a commercial bank holds a bill on behalf of its customers
for collection, it has to receive money on the bill from the acceptor. So it is an asset. The
same item has already been appeared on the liabilities side of the balance sheet of the bank.
Acceptances and endorsements: Acceptances and endorsements are another items that appear
on the assets side of the balance sheet of a bank. When the commercial bank accepts and
endorses the bill of exchange on behalf of its customers, it has to pay money on the due date.
The banker will receive money before the due date of the bills from its customers. Its customers
are liable to the bank for full payment of the bill.
Fixed assets: Fixed assets are the last items that appear on the assets side of the balance sheet
of a bank. Fixed assets include landed property, buildings, furniture, fixtures, etc. owned by
the bank. A certain amount of bank funds is invested on these fixed assets. These fixed assets
cannot be realized to meet emergencies of the bank.

1. The business of borrowing and lending of the bank is shown by the
(a) balance sheet of the bank (b) journal of the bank
(c) ledger of the bank (d) profit and loss account of the bank
2. A balance sheet of a bank has the following sides:
(a) Liabilities side (b) Assets side
(c) Both (a) and (b) (d) None of the above
3. Those items which are the claims of the bank on others are reflected in
(a) liabilities of the bank (b) assets of the bank
4. Those items on account of which the bank is liable to pay others are reflected in
(a) liabilities of the bank (b) assets of the bank
5. The liabilities side of the balance sheet of a bank include
(a) borrowings from other banks (b) reserve fund
(c) profit and loss (d) all the above
6. The actual amount of money paid by the shareholders of the bank is called
(a) authorized capital (b) paid-up capital
(c) issued capital (d) subscribed capital
7. The guiding principles by which funds can be invested by the banks include
(a) liquidity (b) profitability
(c) security (d) all of the above
8. The assets side of the balance sheet of the bank include

(a) loans and advances (b) balances with other banks
(c) investments (d) all of the above
9. Cash in hand with a bank is an idle asset as it earns
(a) interest (b) no interest
(c) income (d) no income
10. Money-at-call and short notice represents loans given to
(a) other banks (b) the public
(c) foreign investors (d) exporters
11. Loans and advances appeared in the assets side of the balance sheet are the
(a) largest item (b) smallest item
(c) minor item (d) insignificant item
12. Which assets cannot be realized to meet emergencies of the bank?
(a) Fixed assets (b) Investments
(c) Cash in hand (d) Recurring assets
Answers
1. (a) 2. (c) 3. (b) 4. (a) 5. (d)

6. (b) 7. (d) 8. (d) 9. (d) 10. (a)
11. (a) 12. (a)
Review Questions
1. What is a balance sheet?
2. Give a sample balance sheet of a bank.
3. What are the items included in the liabilities side of the balance sheet?
4. What are the items included in the assets side of the balance sheet?
5. Briefly explain the various items included in the liabilities side of the balance sheet of
a bank.
6. Briefly explain the various items included in the assets side of the balance sheet of a
bank.
7. Explain in detail the balance sheet of a modern commercial bank.
Chapter 15
Investment Policy of
Commercial Banks
15.1 Meaning of Investment Policy

The balance sheet is a financial statement of the assets and liabilities of a bank. The assets of
the bank are distributed on the basis of certain banking principles. These principles reflect the
investment policy of a commercial bank.
Geoffrey Crowther (1974) in his book An Outline of Money aptly remarks that “the secret
of successful banking is to distribute resources between the various forms of assets in such a
way as to get a sound balance between liquidity and profitability, so that there is cash to meet
every claim and at the same time enough income for the bank to pay its way and earn profits
for its shareholders.”
15.2 Principles underlying Investment Policy

The eight guiding principles underlying the investment policy of a commercial bank are:
1. Liquidity 2. Profitability
3. Security of funds 4. Diversity of investment
5. Stability in the value of investments 6. Saleability of securities
7. Productivity of investment 8. Tax-exemption of investments
15.2.1 Liquidity
The term ‘liquidity’ simply refers to the ability of the bank to convert its assets into liquid cash
on demand. An asset is said to be liquid if it can be converted into cash quickly and without
loss. Liquidity is the first and the foremost guiding principle underlying the investment policy
of a commercial bank.
225
The position of the bank is liquid only when it is able to pay cash to its depositors whenever
they demand, i.e. the bank must satisfy demand for cash in exchange of deposits. The very
existence of a bank depends upon people’s confidence in the bank. When the customers make
their demands by issuing cheques, these cheques should be honoured without postponing the
payment. To honour these cheques on demand, the bank should maintain sufficient cash reserves.
Hence the bank should keep its investment in a liquid form.
15.2.2 Profitability
The term ‘profitability’ refers to the capacity of a bank to earn profit through investment on
long period assets. But the bank cannot lock up funds for long period investments without
affecting liquidity. The bank should strike a balance between liquidity and profitability. This
balance can be achieved by the bank in investing a part of its funds in liquid assets and a
part in long period assets. Profitability is thus the second important principle underlying the
investment policy of a commercial bank. The main aim of the book is to make as much profit
as possible. It should earn enough income to pay for interest on deposits, meet expenses like
payment of salaries to managerial staff, build up reserve fund, pay dividend to shareholders
and to earn profits for its shareholders.
15.2.3 Safety or Security of Funds
Security of funds is another guiding principle underlying the investment policy of a commercial
bank. A bank by experience never lends money without enough security. If loans and advances
are granted by a bank on the basis of security, the bank can realize the amount by disposing
of the security of the borrower. In this case, the bank should also ensure safety of investment.
Thus the motives behind the investment policy of the commercial bank are liquidity, profitability
and security of funds.
15.2.4 Diversity of Investments
Diversity of investments is another guiding principle underlying the investment policy of a

commercial bank. It is essential to avoid the adverse results of investing funds in one or a
group of channels. The bank should see that all funds are invested in one industry or a group
of industries. If the bank invests its funds in various types of securities or makes loans and
advances to various business enterprises, the bank should ensure a regular flow of funds with
the help of which it can meet the demand of its customers.
15.2.5 Stability in the Value of Investments
Stability in the value of investments is another guiding principle underlying the investment policy
of a commercial bank. The bank should invest its funds in those securities whose prices are
more or less stable. In other words, the bank should invest its funds in those securities whose
Investment Policy of Commercial Banks 227
values are more or less stable. The bank cannot afford to invest its funds in those securities
whose values are changing widely.
15.2.6 Saleability of Securities
Saleability of securities is another guiding principle underlying the investment policy of a

commercial bank. The bank should invest its funds in easily saleable types of securities like
government securities or debentures of well-established firms. The bank also makes loans and
advances against easily saleable stocks and immovable property. During emergencies, the bank
can sell these approved securities, stocks and property without incurring any loss. The bank
cannot afford to invest its funds in long period unsaleable securities.
15.2.7 Productivity of Investments
Productivity of investments is another guiding principle underlying the investment policy of a

commercial bank. The bank should invest its funds on productive assets. There is a positive or
direct relationship between the productivity of the investments and the profitability of the bank.
The higher the productivity of investments, the higher will be the profits of the bank and vice
versa. The bank should not make loans and advances for speculative purposes.
15.2.8 Tax-exemption of Investments
Tax-exemption of investments is another guiding principle underlying the investment policy

of a commercial bank. The bank should invest its funds in those approved securities which
are exempted from income tax and other taxes. In this way, the bank can increase its profits.
15.3 Types of Bank Investments

Bank investments are of two types: non-profitable investments and profitable investments.
15.3.1 Non-profitable Investments
Non-profitable investments of a commercial bank are essential to meet the cash needs of its
depositors. The non-profitable investments of the bank depend mainly on cash reserves kept
by it either with itself or with the central bank of the country. Dead locks refer to those non-
profitable investments which yield no profits to the bank.
15.3.2 Profitable Investments
Profitable investments of a bank consist of the following items: call money, discounting bills
of exchange and treasury bills, investing in government securities, granting loans and advances
to its customers in the form of ordinary loans, overdraft facility and cash credit.

1. The principle on which the assets of the banks are distributed reflects the
(a) balance sheet of a bank (b) credit creation of a bank
(c) investment policy of a bank (d) all of the above
2. The guiding principles underlying the investment policy of a commercial bank include
(a) liquidity, profitability and security (b) diversity of investment
(c) saleability of securities (d) all of the above
3. The bank makes loans and advances against easily saleable
(a) stocks (b) immovable property
(c) approved securities (d) all of the above
4. The relationship between the productivity of investments and the profitability of the
bank is
(a) positive (b) negative
5. Bank investments include
(a) non-profitable investment (b) profitable investment
6. Dead locks are the
(a) non-profitable investments (b) profitable investments
7. Overdraft facility is a
(a) non-profitable investment (b) profitable investment
Answers
1. (c) 2. (d) 3. (d) 4. (a) 5. (c)

6. (a) 7. (b)
Review Questions
1. What is investment policy?
2. What are the guiding principles underlying the investment policy of a commercial bank?
3. Write a note on liquidity of a bank.
4. Write a note on profitability of a bank.
5. What are the two types of bank investments?
6. Distinguish between non-profitable and profitable investments.
7. Write a short note on non-profitable investments.
8. Write a short note on profitable investments.
Chapter 16
Nationalization of
Commercial Banks
16.1 Meaning of Bank Nationalization

By bank nationalization, we mean transfer of ownership and management of banks from private
hands to the government. Prior to nationalization of banks, a policy of ‘social control over
banks’ was adopted in the banking sector.
16.2 Social Control Over Banks

The social control over banks refers to the control, guidance and direction of the commercial
banks by the government to achieve certain socio-economic objectives. Under the social
control policy, the ownership of the banks will be in the hands of their shareholders and the
management of the banks will be in the hands of the elected Board of Directors. The Board of
Directors consisted mainly of industrialists and businessmen. A major part of the total advances
was given to directors and the concerns in which they were interested. Banking facilities were
neglected to small farmers, small entrepreneurs and other sectors of the economy in rural,
semiurban and undeveloped areas. A majority of the people in these areas remained outside
the purview of banks.
16.3 Objectives of Bank Nationalization

The seven main objectives of bank nationalization in India were:
1. To remove control over banks by a few or concentration of economic power in a few
hands.
2. To provide adequate credit to the priority sectors like agriculture, small scale industries
and exports.
229
3. To encourage new entrepreneurs to start new businesses and provided with incentives.
4. To extend banking facilities to unbanked rural and semiurban areas.
5. To impart training facilities to bank employees so as to improve their services conditions.
6. To eliminate the use of bank credit for speculative purposes.
7. To introduce professional management in commercial banking system.
16.4 Bank Nationalization in India

The then Prime Minister of India, Mrs. Indira Gandhi issued an Ordinance on July 19, 1969,
and nationalized fourteen major commercial banks with a deposit of not less than ` 50 crore
each at the end of June 1969. Thus July 19, 1969 has become a memorable day in the long
history of commercial banking system in India.
16.4.1 Phases of Bank Nationalization in India
There were two phases of bank nationalization in India—the first phase and the second phase.
The first phase

In the first phase of bank nationalization, on July 19, 1969, fourteen major commercial banks
were nationalized. They were:
1. Allahabad Bank 2. Bank of Baroda
3. Bank of India 4. Bank of Maharashtra
5. Canara Bank 6. Central Bank of India
7. Dena Bank 8. Indian Bank
9. Indian Overseas Bank 10. Punjab National Bank
11. Syndicate Bank 12. Union Bank of India
13. United Bank of India 14. United Commercial Bank
At the time of nationalization, the fourteen banks had an aggregate deposits of ` 2741.76
crore with 4130 branches.
The second phase

In the first phase of bank nationalization, on April 15, 1980, six more commercial banks were
nationalized. They were:
1. Andhra Bank 2. Corporation Bank
3. New Bank of India 4. Punjab and Sind Bank
5. Oriental Bank of Commerce 6. Vijaya Bank
On September 4, 1993, the New Bank of India was merged with the Punjab National Bank.
Now the number of nationalized commercial banks has been reduced from twenty to nineteen.
A drastic change was occurred in the entire commercial banking system in India after bank
nationalization. The emphasis was shifted from security orientation to purpose orientation and
also from creditworthiness of persons to creditworthiness of purpose.
Nationalization of Commercial Banks 231
16.5 Organization of Nationalized Bank

The Banking Companies Act, 1970 authorized the Central Government, after having consulted
with the Reserve Bank of India, to carry out the following three provisions of the Act:
1. Constitution of Board of Directors
2. Capital structure
3. Reconstruction and amalgamation
According to Section 3(2) of the Banking Companies Act, the paid-up capital of a new bank
shall be equal to the corresponding banking company. As per Section 9 of the Bank (Second)
Nationalization Act, as amended in 1994, the management of a corresponding new bank shall
be in hands of Board of Directors.
The Government of India has to pay compensation to a person from whom they acquire
property by law. Section 11 of the Banking Companies Act provides for the payment of
compensation to the shareholders of every nationalized bank in any one of the following ways:
• Three equal instalments in cash with the interest of 4 per cent per annum.
• Issue of promissory notes or stock certificates of the Central Government with the interest
rates of 4.5 per cent and 5.5 per cent respectively.
• Compensation payment partly in cash and partly in promissory notes or stock certificates.
The Banking Companies Act was amended again on July 15, 1994 so as to enable the
nationalized banks to access the capital market to strengthen their capital base. The amended
Act allowed the public to contribute the paid-up capital up to 49 per cent.
The Banking Companies Act was again amended in 2005. This amend Act came into
existence with effect from October 16, 2006. The three important provisions of the 2005
(Amended) Companies Act are:
1. Elect one to three directors on the basis of issued capital of the bank instead of one to
six directors under the existing provisions.
2. Modify the provisions relating to nomination of directors by the RBI.
3. Confer powers upon the RBI to appoint directors.
16.6 Arguments in Favour of Bank Nationalization

The following are the arguments in favour of bank nationalization in India:
• It increases the efficiency of banks.
• It has effective control over the supply of money including bank deposits in the interests
of the public.
• It brings about greater cooperation and coordination between the central bank and the
commercial banks for the effective implementation of credit policies in the country.
• It established socialism (socialist pattern of society) through the achievement of rapid
progress in the economy.
• It makes more effective mobilization of financial resources and capital formation in the
country in order to accelerate its economic development.
• It helps in the effective implementation of various Five Year Plans in the country.
• It promotes industrialization in such a way that balanced growth would be assured.
• It bring about a more desirable distribution of credit on agriculture and small scale
industries. In other words, it lends more to priority sectors.
• It provides better security for the depositors.
• It prevents concentration of power in the hands of a few people.
• It may have more of service-motive rather than of profit-motive.
• It avoids wastes of competition and duplication of establishment.
• It bring in large revenue to the government.
• It inspires greater confidence and promotes banking habits of the people at large.
• It lends stability to the commercial banking system in the economy.
• It brings about regional balance through branch expansion in rural, semiurban and
neglected areas.
16.7 Arguments against Bank Nationalization

The following arguments are levelled against bank nationalization by critics in India:
• The net benefit of the government is insignificant as the payment of compensation to
its shareholders is beyond the means of the government.
• The intervention of the political party in power reduces the efficiency of banks.
• Nationalization for securing effective control over the supply of money is unnecessary as
the central bank of the country has full control over the credit created by the commercial
banks.
• The economic development of the country will be retarded due to bank nationalization as
procedural delays and rigidities in the advancement of credit to deserving businessmen.
• The existing banks are not able to enlarge its area of operations and render more efficient
services on account of bank nationalization.
• The evil of corruption persists in every department of the government on account of
bank nationalization.
• The depositors may suffer many inconveniences as their savings and investment are
adversely affected on account of bank nationalization.
16.8 Achievements of Bank Nationalization

The nationalized commercial banks in India have contributed much for the rural and
agricultural developments in the country. They have also become powerful financial
institutions contributing for the upliftment of the weaker and downtrodden sections of the rural
community. The flow of credit to the priority sectors has got a considerable boost with the
bank nationalization.
The following developments and progress have taken place in the country after bank
nationalization:
• Branch expansion
• Deposit mobilization
• Rural credit
• Advances to the priority sectors.
16.8.1 Branch Expansion
After bank nationalization in 1969, the commercial banks initiated a programme of branch
expansion in unbanked rural and semiurban areas. The growth of branch expansion between
July 1969 and June 1979 was more than that of branch expansion since banking started in India.
The total number of branches opened between 1969 and 1979 was 21,881. Out of this, the
number of branches opened at hitherto unbanked areas was 11,476 (52.00 per cent). The total
number of branches increased from 8321 in 1969 to 60,220 in 1991 and further increased to
63,092 in 1996 to 69,412 in 2006. The total number of rural branches opened was 1500 as
against 16,000 in 1996 and against 29,738 in 2006.
16.8.2 Deposit Mobilization
The branch expansion has created a potential market for deposit mobilization. Deposit mobilization
had also shown positive results after bank nationalization. The total deposits of all the nationalized
commercial banks increased from ` 3873 crore in 1969 to ` 7570 crore in 1973 (95.46 per
cent). The bank deposits further registered 100 per cent increase during 1973–1976 by banks.
The total deposits increased from ` 28,980 crore in 1980 to ` 55,183 crore in 1984, and further
increased to ` 199,530 crore in 1990 and also to ` 2,164,477 crore in 2006.
16.8.3 Rural Credit
There has been a rapid expansion of bank credit in rural areas after bank nationalization.
The bank credit expanded remarkably from ` 4700 crore in 1970–1971 to ` 120,000 crore in
1991–1992. The bank credit had been further expanded to ` 305,125 crore in 1996 and also
to ` 1,516,557 crore in 2006.
16.8.4 Advances to Priority Sectors
The priority sector includes agriculture, small scale industries, exports, transport (road and
water) operators and other weaker sections of the rural community. The adoption of modern
techniques of production in agriculture requires more credit. Prior to bank nationalization,
cooperative credit institutions shouldered the responsibility of financing agriculture. But after
bank nationalization, the commercial banks rendered the service of providing huge financial
assistance to farmers in various ways.
The total agricultural credit extended by commercial banks in 1969 was 188 crore (5.2 per
cent). It increased to ` 2459 crore (12.9 per cent). It also increased to ` 26,000 crore in 1996
and further to ` 154,980 in 2006.
The total amount of credit extended to small scale industries by commercial banks in 1969
was ` 294 crore (8.17 per cent). This had been increased to ` 2820 crore (14.7 per cent) in
1996. The total bank credit extended again to ` 82,492 crore in 2006.
The total bank credit granted to the transport (both road and water) operators by the
nationalized banks was ` 8 crore (0.22 per cent) in 1969 and this increased to ` 286 crore
(1.5 per cent) in 2006.
The weaker sections of the rural community get loans at the concessional rate of interest
of 4 per cent under the Differential Rate of Interest (DRI) Scheme. The DRI Scheme was
introduced by the Government of India in 1972 to improve the economic conditions of the
weaker sections (low income group) of the rural community. There is a notable improvement
in the lending of the nationalized commercial banks under the DRI Scheme.

1. Bank nationalization means transfer of ownership and management of banks from
(a) government to private hands (b) private hands to government
(c) shareholders to private hands (d) government to shareholders
2. Prior to bank nationalization, the following policy was adopted in the banking sector:
(a) Monetary policy (b) Fiscal policy
(c) Social control policy (d) All of the above
3. Which of the following day has become a memorable day in the long history of
commercial banking system in India?
(a) July 19, 1969 (b) July 19, 1959
(c) July 19, 1979 (d) July 19, 1989
4. The first phase of bank nationalization was on July 19, 1969 with
(a) 16 commercial banks (b) 15 commercial banks
(c) 14 commercial banks (d) 20 commercial banks
5. The second phase of bank nationalization was on April 15, 1980 with
(a) 4 commercial banks (b) 5 commercial banks
(c) 6 commercial banks (d) 7 commercial banks
6. On September 4, 1993 which of the following banks were merged?
(a) Andhra Bank and Vijaya Bank
(b) New Bank of India and Punjab National Bank
(c) Syndicate Bank and Dena Bank
(d) Bank of Baroda and Central Bank of India
7. The payment of compensation to the shareholders of every nationalized bank was made
(a) fully in cash
(b) fully in promissory notes
(c) partly in cash and partly in cheque
(d) partly in cash and partly in promissory notes
8. Bank nationalization
(a) provides better security for the depositors
(b) promotes banking habits of the people
(c) promotes industrialization
9. Which of the following is the argument against bank nationalization?
(a) security (b) stability
(c) corruption (d) efficiency
10. The total number of bank branches at the time of bank nationalization in 1969 was
(a) 8321 (b) 3821
(c) 3281 (d) 8123
11. The total agricultural credit extended by commercial banks in 1969 was
(a) ` 168 crore (b) ` 178 crore
(c) ` 188 crore (d) ` 198 crore
12. The total amount of bank credit extended to small scale industries in 1969 was
(a) ` 294 crore (b) ` 492 crore
(c) ` 924 crore (d) ` 429 crore
13. The Differential Rate of Interest (DRI) Scheme was introduced by the Government of
India in 1972 to improve the economic conditions of
(a) small scale industrialists
(b) small agriculturists
(c) weaker sections of the rural community
(d) small entrepreneurs
Answers
1. (b) 2. (c) 3. (a) 4. (c) 5. (c)

6. (b) 7. (d) 8. (d) 9. (c) 10. (a)
11. (c) 12. (a) 13. (c)
Review Questions
1. What do you mean by bank nationalization?
2. What does social control over banks refer to?
3. What are the main objectives of bank nationalization?
4. Name the fourteen commercial banks nationalized on July 19, 1969.
5. Name the six commercial banks nationalized on April 15, 1980.
6. What is the organization of nationalized banks?
7. Bring out the arguments in favour of bank nationalization.
8. Bring out the arguments against bank nationalization.
Chapter 17
State Bank of India
17.1 Origin of the State Bank of India

The State Bank of India (SBI) was established on July 1, 1955. Its origin goes back to the
nineteenth century with the establishment of Bank of Calcutta in 1806 (renamed as Bank of
Bengal in 1809, Bank of Bombay in 1840 and Bank of Madras in 1843). These three banks
were called ‘Presidency Banks’ which came into force in 1876. In the year 1921, the Presidency
Banks (Bank of Bengal, Bank of Bombay and Bank of Madras) were merged and renamed as
the Imperial Bank of India. It was established as a shareholders bank. It acted as a commercial
bank, bankers’ bank and banker to the government. After the establishment of the Reserve
Bank of India (RBI) in 1935, all the government accounts were transferred to the RBI. The
Imperial Bank of India served only as an agent to the RBI. The Imperial Bank of India was
nationalized on December 20, 1954 and renamed as the State Bank of India (SBI) in 1955.
The SBI came into force on July 1, 1955.
17.2 Capital Structure of the State Bank of India

The SBI was established with an authorized capital of ` 20 crore divided into shares of ` 100
each. The shareholders of the Imperial Bank of India were given the option to transfer their
shares to the RBI or take up the shares in the SBI. The shareholders were given a compensation
of ` 1765–10–0 annas of each fully paid share and ` 431–12–4 annas for every partly paid share
of ` 125. The compensation was paid partly in cash and partly in government securities. The
shares of the SBI were allotted at the rate of ` 350 per share of ` 100. There is a provision
for the shareholders to hold the share capital up to 45 per cent. The share capital of the RBI
should not fall below 55 per cent.
236
State Bank of India 237
17.3 Management of the State Bank of India

The SBI has a head office in Mumbai (formerly Bombay). It has local offices in Mumbai,
Kolkata (formerly Calcutta), Chennai (formerly Madras), Hyderabad, Ahmedabad, Kanpur and
Delhi. It is managed by a Central Board of Directors consisting of 20 members. A chairman,
a vice chairman, 2 managing directors and 16 directors. The chairman and the vice chairman
are appointed by the Central Government in consultation with the RBI, 6 directors are selected
by the shareholders other than the RBI, 8 directors are nominated by the Central Government
in consultation with the RBI, 1 director is nominated by the Central Government and another
director is nominated by the RBI. There will not be more than 2 managing directors with the
permission of the Central Government.
The chairman, vice chairman and the managing directors shall hold office for a period of
not exceeding 5 years. The directors elected by the shareholders and directors nominated by
the Central Government will hold office for a period of 4 years. A member of the Central or
State Legislature should not be a director of the SBI so as to prevent politicians interfering
with the management of the Bank.
17.4 Functions of the State Bank of India

The SBI performs the following ten important functions:
1. It performs all the functions of commercial banks like receiving deposits from the public,
lending loans and advances to the public, financing small industries and direct finance
to agriculture, undertaking foreign exchange businesses, and providing free remittance
facilities to the public as well as cooperative banks.
2. It acts as the agent of the Central Bank in places where the bank has no branches.
3. It acts as an agent of the registered cooperative banks.
4. It indulges in purchasing and selling of gold and silver.
5. It underwrites the issue of shares, stocks, debentures and other securities.
6. It grants financial assistance to the firms/companies dealing in the granting of loans
and advances on hire-purchase basis against securities.
7. It collects cheques, drafts, bills of exchange, on behalf of its customers.
8. It receives valuables and documents for safe custody and maintains safe deposit values.
9. It acts as an executor or trustee of attorney on behalf of its customers.
10. It issues letters of credit to the exporters of the country. The letter of credit is a document
issued by the importer’s bank in favour of the exporters giving him authority to draw
bills up to a particular amount.
17.5 Role of the State Bank of India

The SBI and its 7 associate banks [State Bank of Hyderabad, State Bank of Indore, State
Bank of Mysore, State Bank of Patiala, State Bank of Sourastra, State Bank of Travancore and
State Bank of Bikaner and Jaipur] form the second largest segment of the public sector banks.
The SBI and its associates play a vital role in the economic development of the country in
terms of branch expansion, deposit mobilization, credit expansion, agricultural finance, industrial
finance, personal finance, personal banking services, etc.
17.5.1 Branch Expansion

Rapid expansion of bank branches in rural and unbanked areas is essential for the economic
development of the country. The SBI had 477 branches at the end of June 1955. This number
has increased to 7979 by March 1989 and to 8627 branches at the end of March 1992. The
SBI and its associate banks have 12,845 branches at the end of 1992. This represents the
largest network of commercial bank branches in the world. The total number of branches of
the SBI was 13,844, of which 5331 branches were in the rural areas, 4345 branches were in
the semiurban areas and the remaining 3168 branches were in the urban areas. The number
of branches in the rural and semiurban areas accounts for 67.7 per cent of the bank’s total
branches. The SBI accounts for 20 per cent of the total branches of the commercial banks. Thus
the SBI has achieved this branch expansion in a remarkable way by playing its role actively
in the economic development of the country.
17.5.2 Deposit Mobilization

Since 1955, the SBI and its associate banks have been making efforts towards deposit mobilization.
The total deposits of the SBI were ` 188 crore in 1955. It increased to ` 34,328 crore in 1989
recorded a growth of 182 times over a period of 34 years. The total deposits of the bank again
increased to ` 58,258 crore in 1992 and to ` 154,133 crore in 1999. During the same period,
the share of the SBI in the total bank deposits was 21.2 per cent. The total deposits of the SBI
and in associates was ` 542,409.12 crore at the end of March 2006 and its share in the total
deposits was 78.4 per cent during the same period. Hence the growth of the SBI in terms of
deposits has been quite phenomenal.
17.5.3 Credit Expansion

The total credit advances of the SBI and its associates increased from ` 110 crore in June 1955
to ` 34,328 crore in 1989. The total advances of the bank again increased to ` 75,209 crore in
1999. The share of the SBI in the advances of all schedules commercial banks increased from
18 per cent to 20.4 per cent during 1955 and 1999 respectively. The total advances of the SBI
and its associates again increased to ` 371,509.93 crore by the end of March 2006. The share
of the SBI in the advances of all commercial banks increased to 53.70 per cent during period
between 1955 and 2006. Over the years, there has been a substantial shift in the deposits of
the SBI from current deposits to fixed deposits.
17.5.4 Agricultural Finance

The SBI and its associate banks provide direct finance to agriculture. At the time of its inception
in 1955, the SBI has involved in indirect financing of agriculture only through cooperatives.
After sometime, the SBI has been providing direct and indirect finance to agriculture. In 1969,
the Small Farmers and the Farm Graduate Schemes were introduced by the SBI. The Village
Adoption Scheme was also introduced by the SBI. Under this scheme, the branches of the
bank are required to adopt a number of villages and formulate a new strategy for the overall
development of these villages. The SBI also provides financial assistance to irrigation schemes. The
Bank has also made advances to corporations and agencies engaged in financing of agriculture.
The SBI also provides financial assistance to small farmers and landless agricultural labourers
through a large network of rural and semiurban branches. The Bank also extends credit to those
agriculturists who are engaged in dry, drip irrigation, and modernizing agricultural methods. The
bank has also introduced an agricultural credit card (SBI Green Card) to give greater liquidity
and flexibility to farmers in procuring agricultural inputs.
The Agricultural Development Branches (ADBs) have been opened since 1970 in the
backward areas for financing agriculture.
17.5.5 Industrial Finance
The SBI and its associates provide financial assistance to industries. The various forms of
industrial finance extended by the SBI are working capital finance, project finance, deferred
payment guarantees, corporate term loans, structural finance, dealer finance, equipment leasing
and loan syndication. The SBI and its associates usually extend their financial facilities to the
industries like basic (iron and steel) coal, power, engineering, chemical, electronics, cotton
textile and cement industries.
The working capital finance is provided by the SBI to meet the day-to-day short-term
financial needs of a firm. This may help the firm in financing inventories and funding of
production and marketing activities.
The project finance is provided by the SBI to large industrial projects for its diversification,
expansion and replacement of capital equipment and machinery. The deferred payment guarantees
are provided by the SBI to obtain imported equipment from other countries.
The corporate term loans are provided by the SBI to support the firm in funding ongoing
business expansion and technology upgradation. The structured finance is a scheme of the SBI
to meet the financial requirements of large industrial projects. The structured finance is the
combination of funded and non-funded assistances.
The dealer financing is being extended by the SBI to provide both working capital and
term loans to the selected dealers of the firm.
The equipment leasing is a type of financial assistance extended by the SBI to the members
of the business firms in arranging for buying costly credit products for firm customers.
The loan syndication is nothing but the syndicated credit products arranged for firm customers
and industrial projects by the SBI.
17.5.6 Personal Finance
The SBI also provides personal finance in various forms such as housing loan, car loan, travel
loan, educational loan, surety (personal loan) loan, property loan, loans to pensioners, festival
loan, and so on. These loan schemes are offered by the SBI with attractive interest rates.
17.5.7 Personal Banking Services
The various personal banking schemes offered by the SBI include ATM (Automatic Teller
Machine) services, Internet banking, locker facility, foreign inward remittance facility, gift
cheque facility, SBI vishwa yatra foreign travel card facility, etc. for the benefit of its customers.
17.6 New Initiatives of the State Bank of India

They are:
• To promote trade finance, the SBI has launched in March 2011, a web-based online
portal ‘e-trade SBI’ to provide the means to customers access trade finance services
with speed and efficiency by enabling them to lodge letters of credit, bank guarantees
and bill collection/negotiation requirements online from any corner of the world. The
SBI has been awarded the ‘Best Trade Finance Bank of India’ Award for 2012 by the
Asian Banker.
• The new product ‘unfixed deposits’ introduced by the SBI for deposits of 7–180 days,
with option to break the deposits any time without penalty, has been a great success.
• In order to facilitate non-home cash deposits, the SBI has introduced ‘Green Remit Cards’
(GRCs) on January 3, 2012 to the remitters who need not be the account holder of the
bank. This facility does not require filling up pay-in-slips by the remitter. All branches
with Green Channel Counters are enabled to offer this facility.
• ‘Third Party E-Tax’, a new product, enables all our branches to pay taxes online, on
behalf of all customers/non-customers who either do not have access to Internet banking
or are not comfortable in using it.
• E-Auction project of Indian Railways for payment/registration fee/EMD/auction money
was successfully implemented on March 16, 2012.
• ‘Electronic Data Integration (EDI) Model’ was launched for collecting fee for recruitment
boards, examination fee for colleges, schools union and state public service commissions,
etc.
• The Bank has opened 133 new branches in under-banked/unbanked areas in minority
community districts taking the total number of such branches to 3266 as on March 31,
2012.
• The number of foreign offices increased from 156 as on 31–03–2011 to 173 as on
31–03–2012 spread across 34 countries. The offices comprised 50 branches, 8 representative
offices, 103 offices of the six foreign banking subsidiaries and 12 other offices.
17.7 Deposits, Loans Advances and Branches of

the State Bank of India
Table 17.1 presents the total deposits mobilized, the total loans and advances granted, and the
total number of branches opened during the period from 2007–2008 to 2011–2012.
Table 17.1 Total deposits, loans, advances and branches of the SBI
Year Total deposits Total advances granted Total number of

mobilized (` crore) branches opened
(` crore) Domestic Foreign
2007–2008 537,404 416,768 10,186 84
2008–2009 742,073 542,503 11,448 92
2009–2010 804,116 631,914 12,496 142
2010–2011 933,933 756,719 13,542 156
2011–2012 1,043,647 867,579 14,097 173
Source: State Bank of India Annual Report 2011–2012.
Table 17.2 clearly presents the total deposits mobilized during the current year 2011–2012
and the previous year 2010–2011.
Table 17.2 Total deposits of the SBI

(` in crore)
S.No. Deposits As on 31–03–2012 As on 31–03–2011
(current year) (previous year)
1. Demand deposits:
(a) From banks 6970 8700
(b) From others 91,480 122,495
2. Savings bank deposits 369,156 331,326
3. Term deposits:
(a) From banks 17,406 13,540
(b) From others 558,635 458,872
Total 1,043,647 933,933
Source: State Bank of India Annual Report 2011–2012, 149.
Table 17.3 clearly presents the total loans and advances granted during the current year
2011–2012 and the previous year 2010–2011.
Table 17.3 Total loans and advances of the SBI

(` in crore)
S.No. Advance As on 31–03–2012 As on 31–03–2011
1. Advances in India:
(a) Priority sector 250,177 231,598
(b) Public sector 54,707 48,924
(c) Banks 180 455
(d) Others 428,437 367,698
(Contd.)
Table 17.3 Total loans and advances of the SBI (Contd.)

(` in crore)
S.No. Advance As on 31–03–2012 As on 31–03–2011
2. Advances outside India:
(a) Due from banks 17,086 22,424
(b) Due from others
(i) Bills purchased and discounted 21,568 14,796
(ii) Syndicated loans 47,400 36,738
(iii) Others 48,024 34,086
867,579 756,719
Source: State Bank of India Annual Report 2011–2012, 153.

1. The State Bank of India was established and came into force on
(a) July 1, 1935 (b) July 1, 1945
(c) July 1, 1955 (d) July 1, 1965
2. Presidency Banks consist of
(a) Bank of Bengal (b) Bank of Bombay
(c) Bank of Madras (d) All of the above
3. The Presidency Banks came into force in the year
(a) 1768 (b) 1876
(c) 1867 (d) 1786
4. The Presidency Banks were merged in 1921 and renamed as the
(a) State Bank of India (b) Imperial Bank of India
(c) Reserve Bank of India (d) None of the above
5. The Imperial Bank of India was nationalised on
(a) December 20, 1934 (b) December 20, 1944
(c) December 20, 1954 (d) December 20, 1964
6. After its nationalization, the Imperial Bank was renamed in 1955 as
(a) State Bank of India (b) Presidency Bank
(c) Reserve Bank of India (d) None of the above
7. The State Bank of India was established with an authorized capital of
(c) ` 20 crore (d) ` 25 crore
8. The State Bank of India is managed by a Central Board of Directors consisting of
(a) 10 members (b) 15 members
(c) 20 members (d) 30 members
9. The Central Board of Directors of the State Bank of India consists of
(a) Chairman (1) (b) Vice chairman (1)
(c) Managing Directors (2) (d) Directors (16)
10. The Chairman and vice chairman of the State Bank of India are appointed by the
(a) Central Government
(b) Reserve Bank of India
(c) Central Government in consultation with the RBI
(d) None of the above
11. The chairman, vice chairman and managing directors shall hold office for a period of
(a) not exceeding 3 years (b) not exceeding 4 years
(c) not exceeding 5 years (d) not exceeding 6 years
12. The directors (6) elected by the shareholders and directors (8) nominated by the Central
Government will hold office for a period of
(a) 2 years (b) 3 years
(c) 4 years (d) 5 years
13. The State Bank of India issues letters of credit to
(a) exporters only (b) importers only
(c) both exporters and importers (d) none of the above
14. A document issued by the importer’s bank in favour of the exporters giving him authority
to draw bills up to a particular amount is termed
(a) certificate of deposits (b) bills of exchange
(c) letter of credit (d) packing credit card
15. The State Bank of India has
(a) 5 associate banks (b) 6 associate banks
(c) 7 associate banks (d) 8 associate banks
16. At the end of June 1955, the State Bank of India had
(a) 277 branches (b) 377 branches
(c) 477 branches (d) 577 branches
17. The total deposits of the State Bank of India in 1955 were
(a) ` 168 crore (b) ` 178 crore
(c) ` 188 crore (d) ` 198 crore
18. The total credit advances of the State Bank of India and its associates at the end of
June 1955 were
(a) ` 110 crore (b) ` 210 crore
(c) ` 310 crore (d) ` 410 crore
19. At the time of its inception in 1955, the State Bank of India has involved in
(a) direct financing of agriculture (b) indirect financing of agriculture
20. In 1969, the Small Farmers and the Farm Graduate Schemes were introduced by the
(a) State Bank of India (b) Reserve Bank of India
(c) Commercial Banks (d) None of the above
21. The name of the agricultural credit card introduced by the State Bank of India was
(a) SBI Green Card (b) SBI Red Card
(c) SBI Blue Card (d) SBI White Card
Answers
1. (c) 2. (d) 3. (b) 4. (b) 5. (c)

6. (a) 7. (c) 8. (c) 9. (e) 10. (c)
11. (c) 12. (c) 13. (a) 14. (c) 15. (c)
16. (c) 17. (c) 18. (a) 19. (b) 20. (a)
21. (a)
Review Questions
1.
What are the important functions performed by the State Bank of India?
2.
Discuss the origin of the State Bank of India.
3.
Give the capital structure of the State Bank of India.
4.
Give the management of the State Bank of India.
5.
Discuss the role of the State Bank of India in the economic development of the country.
6.
Write a note on the following:
• Branch expansion of the State Bank of India
• Deposit mobilization of the State Bank of India
• Credit expansion of the State Bank of India
Chapter 18
Commercial Banks and

Economic Development
18.1 Introduction
A sound banking system is essential for economic development of a country. Modern commercial
banks play a vital role in the economic development of the country. In a developing country like
India, commercial banks are not merely profit- making financing institutions but the active agents
of economic development. They provide invaluable services to trade, commerce and industry.
The primary function of a modern commercial bank is to mobilize savings of the people and
channelize them into productive purposes. The modern commercial banks encourage the habit
of thrift among the public and thereby mobilize dormant funds and direct them into productive
purposes. In the absence of a sound commercial banking system, savings of the public cannot
easily be mobilized and channelized into productive purposes. Thus, the economic development
of any country, whether developed or developing, or underdeveloped, depends mostly on a
well-developed or sound commercial banking system.
18.2 Need for a Sound Banking System

A well-developed or sound commercial banking system is a prerequisite for the economic
development of any country. The following aspects require special emphasis:
• The system of branch banking should be adopted by the government in such a way that
the number of branches in rural and semiurban areas should be increased.
• The system of unit banking should also be developed in such a way that the local
financial requirements of trade and industry should be met with.
• The commercial banks should provide cheap remittance facilities to enable the transfer
of funds from one place to another.
245
• The credit/loan policy of the commercial banks should be rationalized in the sense that
the loans should be given only for productive purposes but not for speculative purposes.
• Medium-and long-term credit to agriculture and small scale industries may be granted
by commercial banks.
• To popularize the use of cheques among the public, an efficient system of bank clearing
is essential.
• The system of recruitment may be rationalized in such a way that appointments in banks
should be made strictly on merit.
18.3 Role of Commercial Banks in the Economic

Development of India
Modern commercial banks play a dynamic role in the economic development of a country
like India. The contribution of such banks for economic development is significant. The role
of modern commercial banks in the economic development of India can be summarized as:
• Mobilization of savings
• Capital formation
• Monetization
• Innovations
• Monetary policy
• Priority sector finance
• Agricultural finance
• Industrial finance
• Export finance
• Promotion of banking habit
• Promotion of regional development
18.3.1 Mobilization of Savings
Modern commercial banks play a significant role in mobilizing savings of the people. Savings
of the people can be mobilized by accepting deposits in various forms. Deposits are of two
types, namely, primary (cash) deposits and derivative (derived) deposits. Commercial banks
create credit on the basis of primary deposits. Credit facilities can also be extended by the
commercial banks for meeting the growing demands of trade, commerce and industry. In this
way, the economic development can be achieved by the commercial banks. Thus, mobilization
of savings is the primary function of the commercial banks towards the achievement of the
economic development of the country.
18.3.2 Capital Formation
Modern commercial banks promote capital formation which, in turn, determines the economic
development of a country. They promote capital formation by encouraging the people to save
Commercial Banks and Economic Development 247
more and thereby mobilizing the savings for productive purposes. This will lead to economic
development. A sound commercial banking system is essential to mobilize the idle savings to
the people and to channelize the mobilized savings for productive purposes. Thus commercial
banks play an important role in this direction to attain economic development.
18.3.3 Monetization
An underdeveloped country is characterized by the existence of a large non-monetized sector.

The existence of non-monetized sector is a hindrance in the economic development of the
country. Hence modern commercial banks can promote the process of monetization (debt into
money) in the economy by opening up of large number of branches in rural and semiurban
areas in the country.
18.3.4 Innovations
Innovations are the basic determinant of economic development. The innovations cannot be
made by entrepreneurs without the help of banks. Modern commercial banks extend credit
facilities to entrepreneurs for productive investment and innovations. These investments and
innovations are mostly bank-financed. The commercial banks provide adequate and cheap credit
facilities to the entrepreneurs so as to undertake new ventures and to introduce innovations.
The entrepreneurs are usually encouraged by banks to adopt new methods of production and
to increase productive capacity to attain economic development. Thus commercial banks play
an important role in the economic development of the country through innovations.
18.3.5 Monetary Policy
Monetary policy is the policy of the central monetary authority, i.e., the Reserve Bank of India
(RBI). Economic development of any country requires a suitable monetary policy. A sound
banking system is a prerequisite for the effective implementation of the monetary policy. In
other words, monetary policy cannot be implemented without a well-developed commercial
banking system. Commercial banks generally operate in the money market and cooperate in
the implementation of monetary policy. In India, commercial banks should follow cheap money
policy (low rate of interest) which can promote the economic development. Thus commercial
banks play an important role in the economic development of the country through effective
implementation of the monetary policy.
18.3.6 Priority Sector Finance
Modern commercial banks extend financial assistance to priority sectors such as agriculture,
small scale industries and small business. They have special concern for financing these priority
sectors only after bank nationalization in 1969 with the prime aim of economic development.
The priority sector includes agriculture, small scale industry, small business, retail traders,
professionals, educational loans, housing loans, consumer loans, micro finance, investment in
venture capital, etc. Thus commercial banks play a vital role in the economic development
of the country by extending financing accommodation to the priority sectors in general and
agriculture, small scale industries and small business in particular.
18.3.7 Agricultural Finance
Economic development of low income economies needs the development of the basic occupation
like agriculture. In India, agriculture was the neglected sector prior to bank nationalization.
Since 1969, agricultural sector has been given top priority in extending financial assistance by
commercial banks. They provide finance to agriculture for development and modernization.
They grant term credit to agriculture at low rate of interest. In recent years, the State Bank
of India and the commercial banks grant short-term, medium-term and long-term financial
assistance to agriculture and industry. Thus commercial banks play an active role in the
economic development of the country by granting liberal financial assistance in the form of
loans to develop and modernize agriculture.
18.3.8 Industrial Finance
In a developing country like India, commercial banks encourage industrial development by

granting long-term finance. Industrial development of the country requires finance. Commercial
banks provide term loans to industries to secure enough capital for their expansion and
modernization. Thus commercial banks play an important role in the economic development
of the country by granting long-term financial assistance to start new industries and to promote
industrial development.
18.3.9 Export Finance
In India, commercial banks promote exports by extending export finance to the exporters. Export
promotion becomes an important ways and means of generating export surplus. Generation of
export surplus is an important prerequisite for economic development of the country. During
the period of financial crisis and unfavourable balance of payments in the country, commercial
banks help export promotion by way of granting financial assistance to the exporters. Thus
commercial banks play a vital role in the economic development of the country by extending
finance to the exporters.
18.3.10 Promotion of Banking Habits
Commercial banks also play an important role in the promotion of banking habits among the
people. They try to promote the habit of saving by announcing various incentives to those who
save. They also serve as a link between the savers and the investors. Thus commercial banks
play an important role in the economic development of the country like India by promoting
the habit of thrift among the people.
Commercial Banks and Economic Development 249
18.3.11 Promotion of Regional Development
Commercial banks play a significant role in the promotion of regional development of the
country. They simply transfer excess funds from the developed regions to the underdeveloped
regions where the funds are scarce. Such a transfer of funds between regions will promote
economic development of the country. Thus commercial banks play a dynamic role in the
economic development of the country by promoting regional development.

1. Commercial Banks
(a) encourage the habit of thrift
(b) discourage the habit of thrift
(c) encourage unproductive investment
(d) discourage productive investment
2. The contribution of modern commercial banks for economic development in India is
(a) significant (b) insignificant
(c) moderate (d) none of the above
3. Commercial banks create credit on the basis of
(a) primary deposits (b) secondary deposits
4. Which of the following is not the function of a modern commercial bank?
(a) Mobilize savings (b) Promote capital formation
(c) Promote monetization (d) Printing notes
5. Investments and innovations made by entrepreneurs are mostly
(a) bank-financed only (b) self-financed only
6. For the promotion of economic development in India, commercial banks should follow
(a) cheap money policy (b) dear money policy
7. Priority sectors in particular consists of
(a) agriculture (b) small scale industries
(c) small businesses (d) all of the above
8. Commercial banks in India encourage industrial development by granting
(a) short-term finance (b) medium-term finance
(c) long-term finance (d) both short-and long-term finance
9. The role played by modern commercial banks in the promotion of regional development
of the country is
(a) dynamic (b) static
(c) moderate (d) insignificant
Answers
1. (a) 2. (a) 3. (a) 4. (d) 5. (a)

6. (a) 7. (c) 8. (c) 9. (a)
Review Questions
1. What is the need for a sound banking system in a country?
2. Discuss the role of commercial banks in the economic development of India.
3. Write a note on ‘Priority Sector Finance’ by commercial banks.
Chapter 19
India’s Lead Bank Scheme
19.1 Origin of Lead Bank Scheme

The Lead Bank Scheme was formulated by the Reserve Bank of India in December 1969 to
help the commercial banks’ march towards villages. The introduction of the Lead Bank Scheme
in India was based on the recommendations of the National Development Council Study Group
under the chairmanship of Professor D.R. Gadgil and the Committee of Bankers on Branch
Expansion Programmes of Public Sector Banks under the chairmanship of Nariman appointed
by the Reserve Bank of India.
Under the Lead Bank Scheme, all the districts in the country have been allocated among the
public sector banks (14 nationalized commercial banks, State Bank of India and its Associates).
The Lead Bank was entrusted with the task of formulating a comprehensive plan for the banking
structure in their respective districts. In other words, under this scheme the Lead Banks are
expected to evolve district-wise plans for branch expansion, deposit mobilization and credit
distribution after conducting economic surveys of the districts. Under this Scheme, a bank
provides not only the banking facilities in districts where it is assigned the lead bank role but
also helps in their all round development. Initially, 398 districts in the country were allotted
to the public sector banks and a few private sector banks. They are expected to play the role
of leaders in banking development.
19.2 Objectives of Lead Bank Scheme

The Lead Bank Scheme in India has the following five main objectives:
1. To bring about a coordination between cooperative banks, commercial banks and financial
institutions in their respective districts.
2. To make initial surveys in the district entrusted to the lead banks and find out the
unbanked areas in the district and the credit needs and the savings potentialities of the
people in the districts allotted to them.
251
3. To suggest the authorities concerned to open branches in the unbanked areas identified
in a phased manner.
4. To have a close involvement in the district for identifying the credit gaps essentially
needed for rural development, agriculture and small scale industries.
5. To adopt an area approach to evolve plans and programmes for the development of an
adequate banking and credit structure in the rural areas.
To have a better understanding of the objectives and implementation of the Lead Bank
Scheme in India, a three-tier programme has been launched. First one is a one-day conference
for development planners at the national level to discuss the various policy issues involved. The
second one is a two-or three-day workshop for the government and bank officials at the state
level to concentrate on specific problems of the state. The third one is a three-day workshop
for government officials and branch managers/lead bank officials at the district levels.
19.3 Functions of Lead Bank Scheme

A lead bank performs the following ten major functions:
1. It makes surveys on the resources and potential for banking development by identifying
unbanked areas in its district.
2. It finds out the number of industrial and commercial units and other establishments
which do not have banking accounts or which depend mainly on the money lenders.
3. It establishes branches in a phased manner.
4. It identifies and studies the local problems.
5. It examines the facilities for marketing of agricultural and industrial products, storage
and warehousing, and connecting credit with marketing.
6. It keeps adequate stock of fertilizers, agricultural inputs and other services required to
meet the local needs.
7. It makes recruitment and imparts training to bank employees for counselling.
8. It offers technical advice to small borrowers and farmers in the priority sectors covered
by credit insurance schemes.
9. It helps the other primary lending agencies by providing financial assistance.
10. It maintains liaison with the government and government-aided agencies.
19.4 Benefits Expected from Lead Bank Scheme

The following are the important benefits expected from the Lead Bank Scheme in India:
• The whole country will have a well-knit banking system by commercial and cooperative
banks.
• Branch expansion and supervision of the work of the bank branches would become more
effective.
• There would be integration of banking activities and the credit requirements of the
district to ensure an affective development of the district concerned.
India’s Lead Bank Scheme 253
• It would easily identify the major bottlenecks on the development of the system and
induce suitable agencies to suggest measures for removing these bottlenecks.
19.5 Working of Lead Bank Scheme

The lead bank does not have a monopoly over the banking business in the districts allotted to
it, though it acts as the leader of all other banks in those districts. The lead bank jointly with
other banks and the districts, and local authorities sponsors the banking development in the lead
districts allotted to it, so as to help in their overall economic development. To make the overall
economic development of the districts, the lead bank in cooperation with other institutions and
local authorities will integrate credit business in each district with other economic activities
such as production and marketing in their district.
The Reserve Bank of India has advised the lead banks to prepare District Action Plans
for their lead districts and implement the plans. The first phase of the implementation of the
District Action Plans was completed by July, 1978. Due to lack of uniformity in the plans, the
RBI suggested the lead banks to prepare new Credit Plans for the period 1980–1982. As per
the guidelines suggested by the RBI, the following objectives of the lead banks are stressed:
• Finance only the labour-intensive schemes which are generating employment.
• Assisting weaker sections of the community in the lead districts by all means to improve
their conditions.
• Enabling to increase the land productivity and other sectors which reduce unemployment
percentage.
The RBI has further suggested that the District Credit Plans should be linked with credit-
based development schemes. For this purpose, a District Credit Plan should be accompanied
by a separate action-oriented Annual Plan. A greater degree of uniformity has been observed
in the preparation of the District Credit Plans and the Annual Plans.
A new strategy of rural lending known as the Service Area Approach which is a part of
the Lead Bank Scheme came into force on April 1, 1989 for improving the quality of rural
lending by the commercial banks and regional rural banks.
Under the Lead Bank Scheme, all the districts of the country have been allocated among
the public sector banks and a few other private banks. As per 2002 survey, the number of lead
bank districts was 510 and the number of states and union territories was 35.
19.6 Criticisms of Lead Bank Scheme

The Lead Bank Scheme in India is criticized on the following grounds:
• The Scheme is rather ambiguous and unwarranted in the sense that the lead banks do
not have any power to play the role of Planning Commission of the district, i.e., whether
they can open branches in the unbanked lead districts or not. They simply identify the
credit gaps and provide bank facilities.
• Lead banks are not at all suitable for making techno-economic survey of the lead districts.
• Extension of banking facilities through lead banks does not assure the success of the
Lead Bank Scheme.
• The Lead Bank Scheme faces some practical difficulties such as language, posting in
far off places, lack of personal touch, etc.
19.7 Suggestions for the Improvement of Lead Bank

Scheme
The following constructive suggestions are given for the improvement of the Lead Bank
Scheme:
• The Credit Plan should be a comprehensive plan indicating credit targets for institutional
credit agencies in the lead district on a block-wise, sector-wise, scheme-wise and bank-
wise basis.
• The lead banks are required to evolve schemes to accelerate their involvement in their
respective areas.
• The Lead Bank Manager should not be one of the separable. He should be well trained
in plan preparation. He should be empowered to seek the required information on an
ongoing scheme.
• The Lead Bank Manager should be given the task of coordinaton, preparation and
implementation of credit plans. He should be given more authority and made more
accountable.
• The District Development Manager of the NABARD should be a member of the credit
planning team.
• Financial inclusion should be a part of the credit planning activity.
• The lead bank office should be equipped with required staff and equipment to undertake
the monitoring activity.
• The Lead District Manager should have a good relationship or contact with the regional
managers of all the banks.

1. Lead Bank Scheme was formulated by the
(a) Reserve Bank of India (b) State Bank of India
(c) Commercial Bank (d) Regional Rural Bank
2. The Lead Bank Scheme was introduced in India in the year
(a) December 1969 (b) December 1959
(c) December 1949 (d) December 1979
3. The introduction of the Lead Bank Scheme in India was based on the recommendations
of the
(a) Gadgil Committee (b) Nariman Committee
(c) Both (a) and (b) (d) Dantwala Committee
India’s Lead Bank Scheme 255
4. Under the Lead Bank Scheme, the Lead Banks are expected to evolve
(a) district-wise plans (b) block-wise plans
(c) village-wise plans (d) town-wise plans
5. Which of the following programme has been launched to implement the Lead Bank
Scheme in India?
(a) A one-day national conference for development planners
(b) A two-or-three-day state level workshop for government and bank officials
(c) A three-day district level workshop for government officials and branch managers
(d) All of the above
6. Who has advised the Lead Banks to prepare District Action Plans for their lead districts?
(a) Reserve Bank of India (b) State Bank of India
(c) Commercial Bank (d) Regional Rural Bank
7. The Service Area Approach is a new strategy of rural lending which came into force
since
(a) April 1, 1959 (b) April 1, 1969
(c) April 1, 1979 (d) April 1, 1989
Answers
1. (a) 2. (a) 3. (c) 4. (a) 5. (d)

6. (a) 7. (d)
Review Questions
1. Discuss the origin of the Lead Bank Scheme.
2. Bring out the objectives of the Lead Bank Scheme.
3. What are the main functions of the Lead Bank Scheme?
4. What are the important benefits expected from the Lead Bank Scheme?
5. Discuss the working of the Lead Bank Scheme in India.
6. What are the criticisms levelled against the functioning of the Lead Bank Scheme in
India?
7. Suggest measures for the improvement of the Lead Bank Scheme.
Chapter 20
An Introduction to
Central Banking
20.1 Origin of a Central Bank

The term ‘Central Banking’ came into existence since the time of World War I. Central bank
has become an entirely separate branch of banking. In every country of the world, central banks
were originally started as privately-owned and privately-managed joint stock banks. They have
developed their own code of rules and practices.
A central bank is the apex institution of the monetary and banking system of a country. It
occupies a pivotal position. Every country has a central bank which controls its entire banking
system. Today, there is hardly any country in the world which does not have a central bank
of its own.
At present, a central bank is considered as an organ of the government. It undertakes the
major operations of the government. And also, it supports the economic policy of the government.
It is responsible for the formulation of monetary policy in the country. Thus, the central bank
of a country plays a leading role in organizing, running, supervising, regulating and developing
the monetary and fiscal policies of the government.
20.2 Definitions of a Central Bank

A central bank is usually defined on the basis of the functions which characterize a bank as
the central bank. Economists have defined central bank differently, based on the functions
performed by the central bank. A few definitions are given below.
F.W. Muller defines, “a central bank as a banking mechanism designed so as to influence
the volume and cost of commercial bank credit as well as the quality of bank assets”.
According to A.C.L. Day, “a central bank is to help control and stabilize the monetary
and banking system”.
256
An Introduction to Central Banking 257
R.P. Kent’s definition says, “a central bank is an institution charged with the responsibility
of managing the expansion and contraction of the volume of money in the interest of the
general public welfare”.
According to P.A. Samuelson, “a central bank is a bank of bankers. Its duty is to control the
monetary base and through the control of this high-powered money, to control the community’s
supply of money”.
R.S. Sayers says, “a central bank’s business is to control the commercial banks in such a
way as to promote the general monetary policy of the state”.
All the above definitions of a central bank emphasize one or the other function of the
central bank and not all the functions. They suffer from lack comprehensiveness.
Professor M.H. De Kock in his famous book Central Banking has defined, “a central bank
being generally recognised as a bank which constitutes the apex of the monetary and banking
structure of its country and which performs the following six functions:
1. The regulation of currency in accordance with the requirements of business and the
general public.
2. The custody of the cash reserves of the commercial banks.
3. The custody and management of the nation’s reserves of international currency.
4. The performance of general banking and agency services for the state.
5. Rediscounting of bills and granting of accommodation to commercial banks.
6. The settlement of clearance balances between the banks.
20.3 Objectives of a Central Bank

A central bank must have a set of flexible objectives which are helpful not only for the regulation
and control of the economy but also for the promotion of economic development and growth.
Up to World War I, the primary objective of a central bank was to maintain rigid exchange
rate stability in accordance with the rules of the Gold Standard. Under the gold standard, the
objective of a central bank was to stabilize the economy, i.e., to maintain the external value of
the domestic currency stable (external stability). After the abandonment of the gold standard, the
objective of a central bank was to maintain internal price stability (internal stability). During
the great depression, the basic objective of a central bank was to maintain full employment
and to eliminate unemployment.
The need of a central bank in a country arises from the following:
• To exercise control on credit creation of the commercial banks.
• To issue the paper currency based strictly on economic considerations.
• To help the commercial banks to tide over economic crisis.
• To implement successfully the monetary and financial policies of the government.
20.4 Principles of a Central Bank

De Kock says that the guiding principle of a central bank is that it should act only in the
public interest and for the welfare of the country as a whole and without regard to profit as
primary consideration.
The following are some of the principles of a central bank:

• A central bank should work exclusively in the interest of the public. The central bank
should not consider profit as the primary consideration but it should only be the secondary
consideration.
• A central bank should help in the maintenance of monetary and financial stability in the
country. For this purpose, it should act as the leader of the money market and supervises,
controls and regulates the activities of the commercial banking system.
• There should be perfect cooperation between the central bank and the government of
the country.
• A central bank should not compete with the member banks in receiving deposits from
the public or lending loans and advances to the public (needy borrowers).
20.5 Evolution of Central Banking

Prior to the commencement of the twentieth century, there had been no clearly defined concept
of central banking. A gradual evolution had been taking place in various countries over a long
period of years.
The Riksbank of Sweden is the oldest bank, founded in 1656 and recognized as a State
Bank in 1668, followed in the footsteps of the Bank of England and gradually developed into
a Central Bank.
The Bank of England, established in 1694, is the first Bank of Issue to assume the position
of a central bank and to develop the fundamentals of the art of central banking. Therefore,
Bank of England is generally known as the ‘Mother of Central Banks’.
By the end of the nineteenth century, a large number of central banks had been established.
The Bank of France (1800), the Bank of Netherlands (1814), the Bank of Norway (1817), the
Bank of Spain (1856), the Bank of Russia (1860), the Reichs Bank of Germany (1875), and
the Bank of Japan (1882) are some of the leading central banks established in the world.
The United States of America (USA) established a central banking system in the form of
twelve Federal Reserve Banks in 1914. Moreover, the International Financial Conference, which
was held at Brussels in 1920, passed a resolution to the effect that ‘in countries where there
is as Central Bank of Issue one should be established’ not only with a view to facilitating the
restoration and maintenance of stability in their monetary and banking systems, but also in the
interest of world cooperation.
As result, between 1921 and 1942, as many as thirty new central banks were brought into
existence. The Bank of Poland (1924), the Central Bank of China (1928), the Reserve Bank of
India (1935) and the Central Bank of Ireland (1942) are some of the important central banks
established.
The old central banks were predominantly shareholders’ banks. The Reserve Bank of India
was also set up as a shareholders’ bank but was nationalized in 1949. The Bank of England
was nationalized in 1945. At present, majority of the central banks are owned entirely by their
respective governments. Today, there is no country in the world which has not set up a central
bank of its own.
20.6 Comparison between Central Banking and

Commercial Banking
There are similarities and dissimilarities between central banking and commercial banking.
Similarities
The similarities between central banking and commercial banking are as follows:
• Both the central bank and the commercial banks are dealing in money in some form or
other in the sense that the central bank creates money, whereas the commercial banks
deal in money.
• Both the central bank and the commercial banks are creating credit in the sense that the
central bank creates credit when it issues proper currency without keeping equivalent
securities as reserves, whereas the commercial banks create credit on the basis of their
derivative deposits.
• Both the central bank and the commercial banks do not extend loans against immovable
properties because it will create non-liquidity in their assets.
• Both the central bank and the commercial banks extend short-term loans only because
it helps them to maintain liquidity in their resources.
Dissimilarities
The dissimilarities or differences between central banking and commercial banking are as follows:
• A central bank is the apex institution which exercises control over the entire banking
operations of the country, while a commercial bank is only a constituent unit of the
banking system.
• The central bank is normally owned by the state, while the commercial banks are mostly
privately-owned.
• The central bank possesses the monopoly of note issue, while the commercial banks do
not enjoy such a right now.
• The central bank is not a profit-making institution, while the commercial banks are
primarily profit-making institutions.
• The central bank does not directly deal with the public, while the commercial banks
deal directly with the general public.
• The central bank acts not only as a banker and an advisor to the government but also
as a bankers’ bank, while the commercial banks act as the bankers and the advisors to
the general public only.
• The central bank has special relation with the commercial banks by giving special powers
to control, supervise and regular the working of the latter, while the commercial banks
act in accordance with the directives issued by the central bank.
• The central bank acts as the bankers’ bank; lender of the last resort and also clearing
house for the commercial banks, while the commercial banks do not perform such
functions.
• The central bank is the custodian of the foreign exchange reserves of the country, while
the commercial banks do not deal in foreign exchange.
• The central bank does not compete with commercial banks, while the commercial banks
are likely to compete with each other in order to maximize their business profits.

1. Central bank is a
(a) profit-motivated bank (b) service-motivated bank
(c) goal-oriented bank (d) approach-oriented bank
2. Central bank is
(a) an apex institution (b) an organ of the government
(c) an effective leader of money market (d) all of the above
3. The central bank of our country is
(a) Reserve Bank of India (b) Federal Bank of India
(c) Bank of England (d) State Bank of India
4. The basic objective of a central bank during the great depression was to
(a) maintain full employment (b) eliminate unemployment
(c) both (a) and (b) (d) none of these
5. Which bank is generally known as the “Mother of Central Bank”?
(a) Bank of France (b) Bank of Spain
(c) Bank of England (d) Bank of Japan
6. How many central banks are in the USA?
(a) 10 (b) 11
(c) 12 (d) 13
7. The name of the central banks of the USA is
(a) Federal Reserve Banks (b) Social Reserve Banks
(c) Political Reserve Banks (d) Economic Reserve Banks
8. The Federal Reserve Banks were established by the USA in
(a) 1911 (b) 1912
(c) 1913 (d) 1914
9. Reserve Bank of India was established in the year
(a) 1925 (b) 1935
(c) 1945 (d) 1955
10. The central bank does not directly deal with the
(a) public (b) commercial banks
(c) State Bank of India (d) Lead Banks
Answers
1. (b) 2. (d) 3. (a) 4. (c) 5. (c)

6. (c) 7. (a) 8. (d) 9. (b) 10. (a)
Review Questions
1. Discuss the origin of a central bank.
2. Define a central bank.
3. What are the objectives of a central bank?
4. What are the principles of a central bank?
5. Bring out the evolution of central banking.
6. Bring out the similarities and dissimilarities between central banking and commercial
banking.
Chapter 21
Functions of a Central Bank
21.1 Main Functions

The functions of a central bank differ from country to country in accordance with the prevailing
economic situation.
According to De Kock, there are six functions performed by the central bank in almost
all countries. They are:
1. The central bank enjoys monopoly of note issue.
2. It acts as a banker, an agent and an advisor to the government.
3. It acts as a bankers’ bank.
4. It is the custodian of the nation’s gold and foreign exchange reserves.
5. It publishes economic statistics and other useful information.
6. It acts as the controller of credit.
To the list of central banking functions enumerated by De Kock, we may add still another
important function of the central bank. The central bank is acting as the promoter of economic
development and growth in several countries of the world. Let us explain the various functions
performed by the central bank as follows:
21.1.1 Monopoly of Note Issue
The central bank enjoys monopoly of note issue. It means that the central bank has the monopoly
of issuing currency notes and coins. Though the coins are minted in the government mint,
the central bank is empowered to issue them on circulation. Government lays down rules and
regulations regarding note issue.
There are different methods of note issue which are being followed in different countries,
such as the fixed fiduciary system, maximum fiduciary system, proportional reserve system
and minimum reserve system. The fixed fiduciary system is followed by the central banks of
Japan and Norway. The maximum fiduciary system is in existence in Russia, France, Finland,
etc. The proportional reserve system is being followed by the central banks of Holland, USA,
262
Functions of a Central Bank 263
Belgium and Switzerland. The minimum reserve system is followed in most part of the world
including India.
According to the minimum reserve system, the central bank in India, i.e., the RBI must
maintain atleast a reserve of ` 200 crore in gold and foreign exchange against note issue. Of
this, the value of gold reserve must not be less than ` 115 crore. The rest of the note issue
must be backed by rupee coin, government securities and eligible bills.
There are two departments in the central bank in respect of note issue— Issue and
Banking Departments. The notes are issued by the Issue Department on demand by the Banking
Department. Whenever the currency notes are issued to the Banking Department, the
Issue Department gets cash reserves against the currency issued. The following merits have
accrued from the system of note issue by the central bank:
• It provides uniformity in note issue, which is essential for the smooth flow of trade in
the domestic market.
• It can expand or contract the supply of money according to the needs of the economy.
• It can enforce control over the functions of commercial banks.
• It earns profit out of the issue of currency notes and coins. A part of this profit goes to
the government.
21.1.2 Bankers’ Bank
The central bank acts as a banker to the other banks in the country. Commercial banks and
other banks maintain accounts with the central bank. They keep a portion of their deposits
with the central bank either by custom or by law.
As per the law, the commercial banks are required to maintain a certain fixed percentage
of their time and demand deposits with the central bank. The central bank, in turn, allocates
transfer of funds from one bank to another for the clearance of cheques on the basis of these
deposits. Thus, the central bank acts as the custodian of cash reserves of commercial banks.
21.1.3 Banker to the Government
The central bank acts as a banker to the government. Government maintains an account with the
central bank. It keeps its surplus funds with the central bank. The central bank makes payments
according to the orders of the government. It safeguards the gold stock of the government.
The central bank acts as a financial agent to the government. It advances loans to the
government for short period of ninety days. These loans are called “ways and means advances”. It
helps the government to raise loans from the public. It pays interest on behalf of the government.
It repays loans on behalf of the government. It maintains a register of stockholders and registers
all transfers of government securities. In other words, it manages the public debt. The central
bank also acts as an advisor to the government. It advises the government on all monetary
and economic matters such as balance of trade and payments, deficit financing, controlling of
inflation and deflation, devaluation or revaluation of money, etc. In India, the Reserve Bank
of India is acting as a banker, an agent and an advisor to the government.
21.1.4 Lender of the Last Resort
The central bank acts as the lender of the last resort. It helps all commercial banks financially
in times of need. It renders financial assistance to commercial banks by way of rediscounting
eligible bills or granting loans against government securities. The central bank lends to commercial
banks in times of need when it is satisfied that the commercial banks have failed to secure
funds from other sources. This is what is meant by the term ‘lender of the last resort’. This
lending by the central bank is done in two ways—either through the front door or back door.
By the term ‘through the front door’ we mean the discount given to the commercial banks at
the bank rate. If it is given at the market rate, then it is called ‘through the back door’.
21.1.5 Bank of Clearance
The central bank acts as a clearing house for the commercial banks. It manages clearing
houses in important cities like Bombay, Calcutta, Madras, Hyderabad, etc. This function helps
the commercial banks to settle their inter-bank indebtedness without paying or receiving
cash. The balance payable by one bank to another at the clearing house is adjusted by transfer
of the amount from the accounts of the former to the latter’s account in the central bank.
The transfer is made by making entries in their accounts on the account registers. Under this
clearing house function of the central bank, the commercial banks can save their time as well
as money spent.
21.1.6 Custodian of Foreign Exchange Reserves
The central bank acts as the custodian of the foreign exchange reserves of the country. It buys
and sells gold and foreign currencies from and to other countries. It also fixes the exchange
rate of internal currency to that of the international currencies. The management of the
foreign exchange reserves is maintained by the central bank by providing foreign exchange
to importers, businessmen, students and others visiting abroad in accordance with the rules of
the government.
21.1.7 Custodian of National Reserves
The central bank maintains gold, silver and foreign currencies. These reserves can be used to
meet emergencies.
21.1.8 Maintenance of Exchange Rates
The central bank is entrusted with the responsibility of maintaining exchange rates fixed by the
government. It purchases or sells foreign currencies at fixed rates for this purpose. It operates
exchange control under the orders of the government.
Functions of a Central Bank 265
21.1.9 Promotional and Developmental Functions
In recent years, central banks in a number of countries are performing a number of functions to
promote rapid economic development of their countries. They are encouraging the establishment
for providing finance to agriculture, industry and foreign trade. They are also provided with
finance. The central bank in India (RBI) helps agriculturists indirectly by granting short-term
and medium-term loans to State Cooperative Banks and long-term loans to Land Development
Banks. Besides, Deposit Insurance Corporation of India was started to ensure bank deposits.
These deposit insurance will help the banks to secure more deposits which can be used for
further economic development of the country.
21.1.10 Controller of Credit
The central bank acts as the controller of credit created by the commercial banks. If the
commercial banks create credit excessively, the prices rise and inflation occurs. People with fixed
income, salaried persons and workers suffer heavily. Similarly, if there is undue contraction of
credit, prices fall heavily. As a result, unemployment increases greatly. So the central bank is
granted powers to control the credit created by the commercial banks in the country.
There are various methods of credit control like bank rate policy, open market operations,
variation of cash reserve ratio, rationing of credit, moral suasion, direct action and regulation
of consumer credit.

1. Who enjoys the monopoly of note issue?
(a) Central bank (b) Commercial bank
(c) Scheduled bank (d) Cooperative bank
2. Which of the following system of note issue is being followed in India?
(a) Fixed fiduciary system (b) Maximum fiduciary system
3. The fixed fiduciary system is being followed in
(a) Japan (b) Norway
(c) Japan and Norway (d) Sweden
4. The maximum fiduciary system is being followed in
(a) Russia (b) France
(c) Finland (d) All of the above
5. The proportional reserve system of note issue was in practice in India for the period of
(a) 1935–1956 (b) 1945–1956
(c) 1955–1966 (d) 1965–1976
6. According to the minimum reserve system of note issue, the Reserve Bank of India
must maintain a minimum reserve of
(a) ` 150 crore (b) ` 115 crore
7. The minimum reserve system of note issue has been adopted by the RBI in India
(a) since 1957 (b) since 1947
(c) since 1967 (d) since 1977
8. According to the minimum reserve system of note issue, the value of gold reserve should
not be less than
(c) ` 150 crore (d) ` 180 crore
9. The central bank prov ides ‘ways and means advances’ to the government for a short
period of
(a) 30 days (b) 60 days
(c) 90 days (d) 120 days
10. The RBI acts as
(a) a banker (b) an agent
(c) an advisor (d) all of the above
11. Who is the lender of the last resort in India?
(a) RBI (b) SBI
(c) Commercial bank (d) Lead bank
12. When the discount is given to the commercial banks by the central bank at the market
rate, it is called
(a) back-door lending (b) front-door lending
(c) direct lending (d) indirect lending
13. When the discount is given to the commercial banks by the central bank at the bank
rate, it is called
(a) back-door lending (b) front-door lending
(c) direct lending (d) indirect lending
14. Under which function of the central bank, the commercial banks can settle their inter-
bank indebtedness without paying or receiving cash?
(a) Banker’s bank (b) Banker to the government
(c) Bank of clearance (d) Bank of credit control
Answers
1. (a) 2. (d) 3. (c) 4. (d) 5. (a)

6. (c) 7. (a) 8. (a) 9. (c) 10. (d)
11. (a) 12. (a) 13. (b) 14. (c)
Review Questions
1. What are the main functions of a central bank?
2. Write a brief note on ‘Monopoly of note issue’.
3. Write a note on ‘Minimum Reserve System’.
4. Write a brief account of the lender of the last resort functions of a central bank.
Chapter 22
Credit Control Methods
22.1 Meaning of Credit Control

By credit control, we mean the control of the lending policy of commercial banks by the
central bank.
22.2 Need of Credit Control

The lending operations of commercial banks are controlled to achieve certain objectives. They are:
• To establish stability in the internal price level.
• To bring out stability in the foreign exchange rates.
• To control the operations of the business cycle.
• To prevent undue outflow of gold to other countries.
• To bring out stability in the money market.
• To meet the credit requirements of trade, business industry.
• To prepare for war through expansion of credit to meet the financial needs of the
government.
• To promote integrated development and growth of all the sectors of the economy.
22.3 Methods of Credit Control

The methods of credit control are broadly divided into: quantitative credit control methods and
qualitative credit control methods. The quantitative methods aim at controlling the quantity
and cost of credit through various methods. On the contrary, the qualitative methods aim at
controlling the direction and use of credit through various methods.
267
22.3.1 Quantitative Credit Control Methods
The quantitative credit control methods include bank rate policy, open market operations and
variation of cash reserve ratio.
Bank rate policy

Bank rate refers to the rate at which the central bank rediscounts the first class bills of exchange,
and government securities of the commercial banks. The central bank makes use of the bank
rate policy either to expand or to contract the credit by the commercial banks.
When the central bank feels that inflation in the country is on account of excessive credit
created by the commercial banks, it will raise the bank rate. The market rates of interest will
also rise. At the higher rate of interest, borrowers reduce their borrowings. They are discouraged
to invest. Employment and income fall. The demand for various goods decreases. As a result,
prices begin to fall.
When the central bank feels that deflation in the country is on account of contraction
of credit created by the commercial banks, it will reduce the bank rate. The market rates of
interest will also fall. At the lower rate of interest, borrowers will be encouraged to borrow
more and invest more. Employment and income fall. The demand for various goods increases.
As a result, prices begin to rise.

Open market operations refers to the buying and selling of government securities bills and
bonds in the open market by the central bank. When the central bank feels that inflation in
the country is on account of excessive credit created by the commercial banks, it will sell
government securities and bonds in the open market. The borrowers (commercial banks) of
these securities will pay the central bank by issuing cheques on their banks. As a result, cash
reserves of commercial banks fall. The commercial bank will be forced to reduce loans. They
will stop granting fresh loans and recall loans already granted. Investment, employment and
income fall. The demand for goods falls. As a result, prices begin to fall.
Similarly, when the central bank feels that deflation in the country is on account of undue
contraction of credit, it will buy government securities and bonds in the open market. The
sellers (commercial banks) will deposit the amounts in their banks. As a result, cash reserves of
commercial banks increase. The commercial banks are now in a position to grant more credit.
Expansion of credit leads to more investment, employment and income. The demand for goals
will be more. As a result, prices begin to rise.
Variation of cash reserve ratio

Cash reserve ratio refers to the minimum reserves kept by the commercial banks with the central
bank. The cash reserves may be a percentage of their time and demand deposits separately or of
total deposits. Normally, the commercial banks have more reserves than required as minimum
reserves with the central bank. This is the basis of credit creation of the commercial banks.
When the central bank feels that the inflation in the country is on account of excessive
credit created by the commercial banks, it will raise the cash reserve ratio, i.e., the commercial
Credit Control Methods 269
banks have to keep more cash reserves with the central bank. They are also compelled to reduce
credit loans on account of fall in cash reserves. They will recall loans in order to increase their
cash balances. Contraction of credit will lead to a decrease in investment, employment and
income. The demand for goods fall. As a result, prices tend to fall.
Similarly, when the central bank feels that deflation exists in the country is on account of
undue contraction of credit, it will reduce the cash reserve ratio. Commercial banks have to
keep less cash reserve with the central bank. They lend more. Expansion of credit leads to an
increase in investment, employment and income. The demand for goods increases. As a result,
prices tend to rise.
22.3.2 Qualitative Credit Control Methods
The qualitative credit control methods are also known as ‘selective credit control methods’.
The qualitative credit control methods include prescribing margin requirements, regulation of
consumer credit, rationing of credit, moral suasion and direct action.
Prescribing margin requirements

‘Margin’ means the differences between the market value of securities or commodities and the
loan value, expressed in percentage. The ‘margin requirements’ were introduced to curtail the
credit facilities granted to the speculative demands, hoarding and black marketing purposes.
Under this method, the central bank prescribes the margin to be kept for loans against stock
exchange securities like shares or also against commodities.
When the prices of shares are rising on account of the activities of speculators, the central
bank raises the margin. This reduces the capacity of the speculators to carry on speculation as
they can borrow less money on the security of shares or commodities. This checks undue rise
in prices of shares or commodities.
Similarly, the central bank reduces the margin in times of falling prices of shares or
commodities to encourage the demand for shares or commodities. This method is effective in
checking stock or commodities exchange boom or depression.
Regulation of consumer credit

Under this method, credit granted to consumers for the purchase of durable goods is regulated.
When there is inflation in the country, the central bank will make the terms of credit stiffer,
i.e., during inflation, the central bank raises the percentage of the price to be paid at the time
of delivery, and reduces the number of instalments and increases the amount of each instalment.
This reduces the demand for durable goods. Thus inflationary pressure is reduced.
Similarly, when there is deflation in the country, the central bank will make the terms of
credit easier. It reduces the percentage of price to be paid at the time of delivery, increases the
number of instalments and reduces the amount of each instalment. This increases the demand
for durable goods. Thus deflationary pressure is solved.
Rationing of credit
Under this method, the central bank controls credit by rationing it among its various uses.
The central bank may fix a ceiling on the total amount of loans and advances granted by
the commercial banks; the banks cannot extend loans and advances beyond the ceiling. The
central bank is empowered to either increase or decrease the ceiling in response to the varying
economic requirements. This method plays an important part in planned economies like USSR.
Moral suasion
Moral suasion is the method of soft-speaking to and soft-handling of commercial banks by the
central bank. Under this method, the central bank requests commercial banks not to apply for
further accommodation. Similarly, it may request the commercial banks not to extend more
credit to the public.
The application and successful operation of this method depend mainly on the weightage
given by the commercial banks on the request of the central bank. In other words, the success
of this method depends on the prestige enjoyed by the central bank and degree of cooperation
extended by the commercial banks.
Direct action
Under this method, the directives or instructions are being issued to the commercial banks
from time to time and directing them to follow certain credit policy by the central bank. For
instance, a commercial bank may lead too much over and above its capacity for lending, or a
commercial bank may borrow from the central bank well beyond the given limit. In this case,
the central bank would impose a penal rate of interest on the borrowing bank, or it may even
refuse grant of further loans or rediscounting facilities. This method is very effective.

1. Credit control means
(a) control of lending policy of commercial banks
(b) control of investment policy of commercial banks
(c) control of purchasing policy of commercial banks
2. Credit control is needed for
(a) bringing stability in the money market
(b) preventing undue outflow of gold
(c) establishing internal price stability
3. Quantitative credit control methods include
(a) bank rate policy (b) open market operations
(c) variation in cash reserve ratio (d) all of the above
4. The quantitative methods of credit control aim at
(a) controlling quantity of credit (b) controlling cost of credit
5. The qualitative methods of credit control include
(a) moral suasion (b) rationing of credit
(c) direct action (d) all of the above
Credit Control Methods 271
6. The selective credit control methods are otherwise called
(a) quantitative credit controls (b) qualitative credit controls
7. The qualitative credit control methods aim at
(a) controlling the direction of credit (b) controlling the use of credit
(c) both (a) and (b) (d) None of these
8. Bank rate is the rate of the
(c) lead bank (d) regional rural bank
9. When the central bank feels that inflation in the country is on account of excessive
credit created by the commercial banks, it will
(a) raise the bank rate (b) reduce the bank rate
(c) neither raise nor reduce the bank rate (d) none of the above
(a) sell securities in the open market (b) buy securities in the open market
(c) neither sell nor buy securities (d) none of the above
11. Open market operation means
(a) buying of government securities and bonds
(b) selling of government securities and bonds
(c) both (a) and (b)
12. Cash reserve ratio means the minimum reserves kept by the
(c) lead bank (d) none of the above
13. The cash reserves kept by the commercial banks with the central bank is a percentage
of their
(a) time deposits (b) demand deposits
(c) total deposits (d) none of the above
(a) raise the CRR (b) reduce the CRR
(c) neither raise nor reduce the CRR (d) all of the above
15. Under the regulation of consumer credit method, credit granted to consumers is regulated
by the central bank for the purchase of
(a) perishable goods (b) durable goods
(c) capital goods (d) all of the above
16. Rationing of credit as a method of credit control adopted by the central bank plays an
important part in
(a) planned economies (b) low income economies
(c) underdeveloped economies (d) unplanned economies
17. Under which method of credit control, the central bank requests commercial banks not
to extend excessive credit to the public?
(a) rationing of credit (b) regulation of credit
(c) moral suasion (d) direct action
18. Under the direct action method of credit control, the central bank will
(a) refuse grant of further loans (b) impose penal rate of interest
Answers
1. (a) 2. (d) 3. (d) 4. (c) 5. (d)

6. (b) 7. (c) 8. (a) 9. (a) 10. (a)
11. (c) 12. (b) 13. (c) 14. (a) 15. (b)
16. (a) 17. (c) 18. (c)
Review Questions
1. What do you mean by credit control?
2. What are the objectives of credit control?
3. Explain briefly the various quantitative and qualitative credit control methods.
4. Write a short note on ‘bank rate policy’.
5. Distinguish between CRR and SLR.
6. Write a short note on ‘moral suasion’.
Chapter 23
Central Banking System in India
23.1 Banking System

According to sayers, the banking system plays a dynamic role in a developing economy. Central
banks assist economic development in three ways, namely, direct financing, indirect financing
and creation of infrastructure.
23.1.1 Direct Financing
Direct financing involves lending to commercial banks, providing agricultural credit and long-
term industrial finance, etc.
23.1.2 Indirect Financing
Indirect financing involves the creation of development financial institutions like State Cooperative
Banks (SCBs), Land Mortgage Banks (LMBs), Industrial Financial Corporation (IFC), State
Financial Corporations (SFCs), Industrial Development Bank of India (IDBI) and Deposit
Insurance Corporation of India (DICI) for insuring bank deposits. This helps banks to secure
confidence of the public, and develops banking habit in the minds of the people.
23.1.3 Creation of Infrastructure
It is being assisted by the creation of local money and capital markets and by strengthening
the functions of commercial banks. In a developing economy, the central bank has to play
an important role in the process of development. In the underdeveloped economies, money
and capital markets are underdeveloped and the banking system is not properly organized.
Thus, the promotion of organized and well-integrated money and capital markets becomes the
important function of a central bank in a developing economy. A modern central bank is an
institution responsible for the maintenance of economic stability. Traditionally, the central bank
273
performs regulatory functions only. In modern times, it performs a variety of developmental

or promotional functions.
In developing economies, some priority sectors like agriculture, small scale industries,
etc. have suffered due to unsatisfactory organization for the supply of credit to these sectors.
The central bank has the responsibility to improve the position by making special efforts for
providing credit facilities to these priority sectors on relatively easy terms. The central bank also
is required to make adequate arrangements for the expansion of long-term finance for industries.
23.2 Objectives of Central Banking System

The important objectives of central banking system in a developing economy are:
1. To assist in the mobilization of savings and promote capital formation.
2. To promote the spread of monetization through the development of an integrated
commercial banking system.
3. To extend adequate provision of credit necessary for production and trade.
4. To help in maintaining general price stability.
In a developing economy, the central bank is not only a regulatory authority, but also an
agency for economic growth. The central banks in developing economies are taking steps to set
up a sound system of commercial banking to meet the requirements of agriculture, industry and
trade. They are also taking measures to spread banking facilities in neither to inaccessible areas.
They are strengthening money and capital markets in these economies. The central banks are
also making their contributions to economic development by providing cheap and liberal credit.
23.3 Evolution of the Reserve Bank of India

The Reserve Bank of India (RBI) was established on April 1, 1935 under the RBI Act, 1934.
The RBI was nationalized on January 1, 1949. The RBI was established as a shareholder’s
bank with a share capital of ` 5 crore. The Government of India had also contributed an equal
amount for the reserve fund of the bank. The share capital of ` 5 crore was divided into five
lakh shares of ` 100 each.
The headquarters of the RBI is located at Bombay. The Bank has opened local offices at
New Delhi, Calcutta, Madras, Bangalore, Kanpur, Ahmedabad, Hyderabad, Patna and Nagpur.
The State Bank of India acts as the agent of the Reserve Bank at those places where the RBI
does not maintain its own offices.
The Central Board of Directors controls the operations of the RBI. This Board consists
of twenty members. They are: 1 governor who is the chairman of the RBI; 4 deputy
governors; 4 directors nominated by the government under Section 8(1)(b) of the RBI Act
of 1934; 9 directors appointed under Section 8(1)(c) of the Act; 1 director nominated under
Section 8(1)(d) of the Act; and 1 official appointed by the government, who is to attend the
meetings of the Central Board of Directors and he who does not enjoy the right to vote in the
meetings of the Board.
Central Banking System in India 275
23.4 Objectives of the Reserve Bank of India

The main objectives of the RBI are:
1. To regulate the issue of Indian currency and to stabilize its value.
2. To control the commercial banking system and to strengthen it.
3. To regulate the currency and credit system by adopting an appropriate credit system by
adopting an appropriate credit policy.
4. To maintain the exchange value of the Indian currency.
5. To develop the Indian money market to meet international standards.
6. To manage the foreign exchange reserves of the country.
7. To conduct the banking and financial operations of the government.
8. To perform developmental and promotional functions.
9. To publish statistical information relating to money, credit, foreign exchange reserves
in the country.
10. To remove the structural instability of the banking sectors.
23.5 Functions of the Reserve Bank of India

The seven important functions of the RBI are:
1. It enjoys monopoly of note issue.
2. It acts as a banker to the government.
3. It acts as a banker to the other banks.
4. It manages clearing houses in important cities.
5. It controls credit created by commercial banks.
6. It maintains foreign exchange rates.
7. It plays an important role in the economic development of the country.
Let us now explain the above functions of the RBI in detail as follows:
It enjoys monopoly of note issue: RBI is given the sole right to issue currency notes in the
country. No other bank is allowed to issue currency notes. In other words, the RBI enjoys the
monopoly of note issue. In India, RBI is the sole authority for the issue of currency other than
one rupee notes and coins and small coins which are issued by the Government of India. It
issues currency notes and keeps reserves as per the RBI Act.
The RBI is maintaining two separate departments for this purpose—the issue department
and the banking department. The issue department is solely responsible for the issue of currency
notes.
For the period 1935–1956, India had ‘proportional reserve system’ of note issue. In 1956,
this system of note issue was replaced by the ‘minimum reserve system’. Under the minimum
reserve system, the RBI must maintain at least a reserve of ` 200, i.e., in gold and foreign
securities against note issue. Out of this, the value of gold coin and bullion should not be
less than ` 115 crore. The value of foreign securities should not be less than ` 85 crore. The
rest of the note issue should be backed by assets like government securities, eligible bills and
promissory notes payable in India.
The issue of currency into circulation and its withdrawal from circulation take place through
the Banking Department of the RBI. Though one rupee notes and coins, and small coins are
issued by the Government of India, their distribution to the public is the sole responsibility of
the RBI.
It acts as a banker to the government: The Government of India maintains an account with
the RBI. It keeps its surplus funds with the RBI. The RBI receives taxes on behalf of the
government and pays money as per the orders of the government. Similarly, state governments
have accounts with the RBI. The RBI helps both the central and state governments to raise
loans from the public. It pays interest and repays or converts loans on behalf of the central
and state governments. The RBI grants loans for short periods (not exceeding 90 days) to the
central and state governments. These loans are called “ways and means advances”. It provides
remittance facilities to the government. The RBI gives advice to the government on financial and
economic matters. In short, the RBI acts as a banker, an agent and an advisor to the government.
It acts as a banker to the other banks: Commercial and cooperative banks have accounts with
the RBI. As per the Act, every scheduled commercial bank must keep 3 per cent of its deposits
with the RBI. This reserve ratio may change between 3 per cent and 15 per cent. This enables
the RBI to regulate and control the credit created by commercial banks. The RBI acts as the
lender of the last resort. It grants short-term loans to commercial banks against eligible securities
in times of need. Similarly, it rediscounts eligible bills of exchange brought by commercial
banks. The RBI lends only when it is satisfied that the commercial banks have tried all other
sources and failed to secure sufficient funds. This is called the lender of the last resort.
The RBI provides remittance facilities at low rates. This enables the commercial banks
to transfer funds from one place to another easily, quickly and cheaply. The RBI also gives
valuable advice to the commercial banks. In short, the RBI acts as a philosopher, a guide and
a friend of the commercial banks.
It manages clearing houses in important cities: The RBI manages clearing houses in
important cities like Bombay, Calcutta, Madras, Ahmedabad, etc. This function of the RBI
helps the commercial banks to settle their inter-bank indebtedness without paying or receiving
cash. The balance payable by one bank to another at the clearing house is adjusted by transfer
of the amount from the accounts of the former to the latter’s account in the RBI. As a result,
commercial banks can carry on their business with lower cash reserves.
It controls credit created by commercial banks: The RBI has been granted powers to control
the activities of the commercial banks in the country. It has various methods of credit control
like bank rate, open market operations, variation of cash reserve ratio, and selective credit
controls. The RBI has power to determine the lending policy to be followed by a particular
commercial bank or all banks in general. It can also direct the commercial banks on the purpose
for which loans may or may not be extended, the margins to be maintained and the interest to
be charged. It has powers of licensing, inspection and calling for information.
It maintains foreign exchange rates: The RBI acts as the custodian of the nation’s foreign
exchange reserves. The exchange rate between the Indian rupee and a foreign currency is
determined by the government. The RBI has to maintain the rate of exchange by purchasing
or selling foreign currency at a fixed rate. It operates the exchange control system.
It plays an important role in the economic development of the country: RBI has a separate
Agricultural Credit Department. It is providing financial assistance on a large scale to commercial
and cooperative banks. This is done to help farmers to secure necessary finance for carrying
on agricultural activities more efficiently.
RBI has taken an active part in the establishment industrial development banks in the
country. It has also started Deposit Insurance Corporation for insurance bank deposits in
the country. In this way, the RBI is playing an important part in the economic development
of the country.
23.6 Credit Control Methods of the RBI

The RBI has been granted wide powers to control the credit created by the commercial banks.
It possesses both quantitative and qualitative methods of credit control. It has employed these
methods of credit control many a time to control inflation in the country. The uses of various
methods of credit control in India are explained as follows:
23.6.1 Bank Rate
Bank rate is the rate at which the central bank grants loans to commercial banks against
approved government securities or rediscounts bills of exchange. From 1935 to 1951, the bank
rate maintained by the RBI was at 3 per cent. The RBI did not raise the bank rate in spite of
heavy stress and strain.
With effect from April 29, 2003, the bank rate has been maintained by the RBI at 6
per cent. If the bank rate is raised by the RBI, the other rates of interest in the money market
will also raise. Similarly, if the bank rate is reduced by the RBI, the other rates of interest in
the money market will fall.
When the RBI feels that inflation in the country is on account of excessive credit created
by the commercial banks, it will raise the bank rate. On the other hand, when the RBI feels
that deflation or depression in the country is an account of contraction of credit created by the
commercial banks, it will reduce the bank rate.
23.6.2 Open Market Operations
Open market operations consist of buying and selling of government securities by the RBI.
This method of credit control is not of much importance as there is no well-developed market
for government securities.
When the RBI feels that inflation in the country is due to excessive credit, it will sell
government securities in the open market. On the other hand, when the RBI feels that deflation
or depression in the country is due to contraction of credit, it will buy government securities
in the open market.
23.6.3 Variation of Cash Reserve Ratio
Cash reserve ratio (CRR) refers to a certain percentage of the total deposits (both time and
demand deposits) of every commercial bank to be kept with the RBI as reserve. The RBI has
the power to change the CRR when there is a need.
The RBI used this method of credit control for the first time in March 1960. It directed
all the scheduled commercial banks to keep 25 per cent of the increase in their deposits in
addition to the minimum statutory liquidity ratio (SLR). From May 6, 1960, the CRR increased
to 50 per cent. The scheduled commercial banks were paid interest on these additional special
deposits. This was done by the RBI to check inflation and reduce the power of banks to create
further credit. Later the measure was withdrawn completely from January 13, 1961. The RBI
raised the CRR from 3 per cent to 5 per cent in 1873 to check heavy rise in prices.
With effect from October 2, 2004, the cash reserve ratio (CRR) has been maintained by
the RBI at 5 per cent.
With effect from October 22, 1997, the statutory liquidity ratio (SLR) has been maintained
by every commercial bank at 25 per cent.
23.6.4 Moral Suasion
The RBI Governor calls for a meeting of the bankers and appeals them not to extend
further credit to certain industries and restrict credit in general. The RBI issues circulars
requesting the commercial banks to follow a certain policy with regard to lending. The advice
of the RBI is generally accepted by the bankers. The success of this method of credit control
depends on the prestige enjoyed by the RBI and the degree of cooperation extended by the
commercial banks.
23.6.5 Direct Action
The RBI takes action against those commercial banks which are following unsound credit
policies. It may charge a penal rate of interest on loans granted in excess of a prescribed
amount. It may often refuse grant of further loans or rediscounting facilities. This method is
very effective.
23.6.6 Prescribing Margins
The RBI prescribes the margin to be kept for loans against securities like shares or commodities.
When the prices of shares or commodities are rising on account of speculative activities, the
RBI raises the margin. On the other hand, the RBI reduces the margin in times of falling prices
to encourage demand for shares or commodities. This method has been successfully employed
by the Federal Reserve Banks in USA. In India, the RBI also employs this method of selective
credit control from 1960.
23.7 Radcliffe Committee

According to Radcliffe Committee, there are two effects of a change in the bank rate. They are:
1. Incentive effect
2. General liquidity effect.
The views of the Radcliffe Committee on interest rate are as follows:
23.7.1 Incentive Effect
If the rate of interest rises as a result of an upward revision of the bank rate, the cost of credit
goes up. Therefore, the cost of holdings commodities and capital goods will go up and the
margin of profit will go down. A change in the interest rate apparently produces an incentive
effect. This means that when the rate of interest is high, investment goes down. The investors
will try to reduce investment as it is costlier now. Therefore, many investment projects will be
postponed for want of cheap credit. This is so, because when the rate of interest is high, the
burden on the investors would also be high. Thus, a high rate of interest has an unfavourable
incentive effect which will reduce further investment.
The Radcliffe Committee, however, thinks that in actual practice, investment is interest-
inelastic. As a cost factor, the rate of interest is a very minor cost. Investors will depend more
on other facilities such as the availability of raw materials, market and so on, for the purpose
of investment. Thus, the interest incentive effect of a change in the discount rate on investment
is practically nil. Capital investment does not really depend on the rate of interest prevailing
in the market.
23.7.2 General Liquidity Effect
The second effect of a change in the rate of interest is known as the general liquidity effect.
According to the Radcliffe Committee, the principal means of monetary action is the structure
of interest rate or liquidity of the whole economy. A change in the rate of interest will work
through the general liquidity effect. The general liquidity effect concerns the behaviour of the
lenders. For example, when the rate of interest is raised, the prices of various assets will come
down, and the lenders will not be in a position to sell out those assets for fear of running into
capital loss. Thus, the availability of credit in the market (general liquidity) will be reduced.
The opposite will be the effect when the rate of interest is lowered. Therefore, the financial
situation or the liquidity position in an economy will depend on the rate of interest.
According to Radcliffe Committee, the general liquidity effect is weightier than the incentive
effect of a change in the rate of interest. However, taking these two effects together, it can
be said that a change in the rate of interest will have some impact on the general credit and
economic activity.

1. A modern central bank is an institution responsible for the maintenance of
(a) economic stability (b) price stability
(c) exchange rate stability (d) all of the above
2. Central banks assist economic development by way of
(a) direct financing (b) indirect financing
(c) creation of infrastructure (d) all of the above
3. The main objectives of the central banking system in a developing economy like India
are
(a) mobilization of savings (b) promotion of capital formation
(c) promotion of monetization (d) maintenance of price stability
4. The Reserve Bank of India was established on April 1, 1935 under the RBI Act of
(a) 1924 (b) 1934
(c) 1944 (d) 1954
5. The RBI was nationalized on
(a) January 1, 1939 (b) January 1, 1949
(c) January 1, 1959 (d) January 1, 1969
6. The RBI was established in 1935 with a share capital of
7. The headquarters of the RBI is located at
(a) Bombay (Mumbai) (b) Calcutta (Kolkata)
(c) New Delhi (d) Hyderabad
8. The operations of the RBI are being controlled by the
(a) Central Board of Directors (b) State Board of Directors
(c) Central Board of Governors (d) State Board of Governors
9. The Central Board of Directors which controls the operations of the RBI consists of
10. The Governor of the RBI is the
(a) Chairman of the RBI (b) Secretary of the RBI
(c) Treasurer of the RBI (d) Vice-Chairman of the RBI
11. The present Governor of the RBI is
(a) D. Subbarao (b) D. Robertson
(c) D. Renga Reddy (d) D. X
12. The RBI aims at
(a) controlling the commercial banking system
(b) developing the money market
(c) stabilizing the value of currency
13. Which of the following term loans granted by the central bank to the commercial banks
against eligible securities in times of need?
(a) Short-term loans (b) Long-term loans
(c) Both (a) and (b) (d) Medium-term loans
14. The RBI acts as a
(a) philosopher of commercial banks (b) guide of commercial banks
(c) friend of commercial banks (d) all of the above
15. The RBI has a separate Agricultural Credit Department for providing financial assistance
on a large scale to
(a) commercial banks (b) cooperative banks
16. The rediscounting bills of exchange is the function of the
(a) RBI (b) SBI
(c) Commercial banks (d) Lead bank
17. Every commercial bank should keep a certain percentage of its total deposits as reserve
with itself is called
(a) statutory liquidity ratio (b) cash reserve ratio
(c) both (a) and (b) (d) None of the above
18. According to the Radcliffe Committee, a change in the bank rate is of the following
effect:
(a) Incentive effect (b) General liquidity effect
19. A high rate of interest has
(a) an unfavourable incentive effect (b) a favourable incentive effect
(c) neither (a) nor (b) (d) either (a) or (b)
20. According to Radcliffe Committee, an actual practice investment is
(a) interest-elastic (b) interest-inelastic
21. The general liquidity effect concerns the behaviour of the
(a) borrowers (b) lenders
(c) both (a) and (b) (d) government
22. According to the Radcliffe Committee, which of the following is weightier in the rate
of interest
(a) incentive effect (b) general liquidity effect
Answers
1. (a) 2. (d) 3. (e) 4. (b) 5. (b)

6. (c) 7. (a) 8. (a) 9. (c) 10. (a)
11. (a) 12. (d) 13. (a) 14. (d) 15. (c)
16. (a) 17. (a) 18. (c) 19. (a) 20. (b)
21. (b) 22. (b)
Review Questions
1. What are the three main ways by which the Central Bank assists economic development
in India?
2. Distinguish between the direct and indirect financing.
3. Bring out the important objectives of central banking system in India.
4. Bring out the evolution of the RBI.
5. What are the main objectives of the RBI?
6. Explain briefly the various functions performed by the RBI.
7. Discuss the various credit control methods adopted by the RBI.
8. Explain briefly the two effects of a change in the bank rate, according to Radcliffe
Committee.
9. Write a brief note on ‘incentive effect’.
10. Write a short note on ‘general liquidity effect’.
Chapter 24
Reserve Bank of India and

Economic Development
24.1 Introduction
The Reserve Bank of India (RBI) plays a very important role in the economic development
of India on the following lines:
India has adopted planning for securing rapid economic development. The RBI should
actively assist rapid economic development by adopting suitable policies. Economic development
cannot be rapid unless the value of money is kept at a stable level. That is why, the RBI has
been employing bank rate, open market operations, variation of cash reserve ratio and selective
credit controls to check rise in prices. In short, the main aim of the RBI now is to promote
rapid economic development with stability. Therefore, the RBI has played an important role
in promoting special institutions for providing finance to industries and agriculture. It has also
introduced various schemes for securing rapid economic development.
24.2 RBI and Agricultural Finance

There is a separate department for agricultural finance in the RBI called Agricultural Credit
Department. This Department initially provides agricultural finance through cooperative societies.
When the cooperative societies were found to be less effective in mobilization of savings
and lending to the rural needy people, the All India Rural Credit Survey Committee was
appointed to learn the extent of rural credit requirements of the people. The Committee had
recommended for the opening of commercial bank branches in the rural areas for more credit
finances. On these lines, the commercial banks were directed to open branches in rural areas
for the purpose of rural finances.
283
Further, the RBI has set up two funds for indirect agricultural finance through cooperative
societies and state governments. They are:
1. National Agricultural Credit (Long-term Operations) Fund
2. National Agricultural Credit (Stabilization) Fund
They were constituted on February 3, 1956 and June 30, 1956 respectively. The long-term
Operations Fund provides loans to State Governments, State cooperative Banks and Central
Land Development Banks.
The Stabilization Fund provides medium-term loans to State Cooperative Banks. In 1963,
the Agricultural Refinance Corporation was formed as a wholly owned subsidiary of the RBI.
Its main objective is to provide medium-term and long-term loans for reclamation and land
preparation, minor irrigation projects, agriculture, fisheries, dairies, purchase of machinery,
cultivation of different and special crops, etc.
It also provides 100 per cent refinance facilities for schemes sponsored by Small Farmers
Development Agencies (SFDA)/Marginal Farmers and Agricultural Labourers (MFAL) Agency.
The Regional Rural Banks and the NABARD were set-up on September 26, 1975 and
July 12, 1982 respectively.
The RBI has always participated in the government sponsored programmes for rural
credit and development. For instance, RBI has helped the government schemes of Agricultural
District Programme, High Yielding Varieties Intensive Programme, Intensive Agricultural Area
Programme, etc.
24.3 RBI and Industrial Finance

There is a separate department for industrial finance in the RBI called the Industrial Finance
Department. This Department provides industrial finance and takes care of the supervision of
the State Financial Corporations. The credit facilities are given to the small scale industries and
large scale industries according to their industrial needs. There are different financial institutions
incorporated for this purpose. They are: Industrial Finance Corporation (IFC), established in
1948; State Financial Corporations (SFCs), established in 1952 in different states of the country.
The RBI contributed to the share capital of IFC and SFCs. The IFC provides financial assistance
to public limited companies and cooperative societies engaged in the manufacture of goods,
mining, shipping, generation and distribution of power. The SFCs provide financial assistance to
medium and small scale industries in their own states. The RBI is closely associated with the
working of these corporations. In 1958, the Refinance Corporation for Industry was established
to grant medium-term loans to industries by providing refinance against such loans. The RBI
established the Industrial Development Bank of India (IDBI) to coordinate and supplement the
operations of other industrial banks in the country.
The RBI grants financial assistance to IDBI, IFC and SFCs. It is also maintaining National
Industrial Credit (Long-term Operations) Fund. The RBI has granted loans and advances to
the IDBI out of this fund.
Reserve Bank of India and Economic Development 285
24.4 RBI and Housing Finance

The National Housing Bank was formulated in July, 1988 with the share capital of ` 100 crore
subscribed to by the RBI. The main objectives of the NHB are:
1. To promote and develop specialized housing financial institutions for mobilizing resources
and extending credit for housing.
2. To provide refinance facilities to housing financial institutions.
3. To provide guarantee and underwriting facilities to housing financial institutions.
4. To provide guidelines for housing financial institutions.
5. To coordinate the working of all agencies connected with housing.
6. To extend housing credit facilities for the economically weaker sections of the society.
24.5 RBI and Export Finance

In India, promotion of exports is another task handled by the RBI. The commercial banks are
given special and concessional rediscounting facilities by the RBI to encourage them to provide
adequate credit for exports. Bill Market Scheme (introduced in 1952) and Export Bill Credit
Scheme (introduced in 1953) are the two examples of such concessions given to the banks. In
1969, the Preshipment Credit Scheme was introduced for the benefit of the exporters. Under this
Scheme, the banks were given refinances from the RBI for preshipment advances made to the
exporters. The Dutydrawback Credit Scheme was introduced in 1976 for granting interest-free
refinances for the commercial banks from the RBI. In 1982, the Export–Import Bank (Exim
Bank) was set up to develop the export sector.
24.6 RBI and Promotion of Banking Habits

The RBI has taken a number of steps to promote banking habit among the people. It has
encouraged absorption and amalgamation of small banks in order to strengthen the banking
system in India.
The RBI has always insisted on the credit priorities to the weaker sections of the society
as to abolish sectoral imbalance or inequalities in the society.
The RBI has established the Deposit Insurance Corporation in order to insure bank deposits.
This measure has infused greater confidence among the depositors. Even if a bank fails, the
depositor is guaranteed of full payment up to ` 10,000. Most of the depositors are small
depositors. So this measure has promoted banking habit among the people.

1. The main aim of the RBI is to
(a) maintain internal price stability (b) promote economic development
(c) secure international liquidity (d) maintain exchange rate stability
2. Initially, the Agricultural Credit Department of the RBI provides agricultural finance
(a) through cooperative societies (b) directly
(c) through land development banks (d) all of the above
3. The National Agricultural Credit (Long-term Operations) Fund was set up by the RBI
for providing indirect agricultural finance through cooperatives on
(a) February 3, 1956 (b) March 3, 1956
(c) April 3, 1956 (d) May 3, 1956
4. The National Agricultural Credit (Stabilization) Fund was set up by the RBI for providing
indirect agricultural finance through cooperatives and state governments on
(a) June 30, 1956 (b) June 30, 1966
(c) June 30, 1976 (d) June 30, 1986
5. The main objective of the National Agricultural Credit (Stabilization) Fund is to provide
(a) short-term loans (b) medium-term loans
(c) long-term loans (d) both (b) and (c)
6. The Agricultural Refinance Corporation was formed in 1963 with the main objective of
providing
(a) short-term loans (b) medium-term loans
(c) long-term loans (d) both (b) and (c)
7. The Industrial Finance Department of the RBI provides industrial finance to
(a) small scale industries (b) large scale industries
(c) both (a) and (b) (d) medium scale industries
8. The Industrial Finance Corporation was established in
(a) 1938 (b) 1948
(c) 1958 (d) 1968
9. The State Financial Corporations were established in
(a) 1942 (b) 1952
(c) 1962 (d) 1972
10. Which of the following was established to coordinate the operations of the other industrial
banks in the country?
(a) IDBI (b) IFC
(c) SFCs (d) All of the above
11. The RBI grants financial assistance to
(a) IDBI (b) IFC
(c) SFCs (d) All of the above
12. The National Housing Bank was formulated with a share capital of ` 100 crore in
(a) July 1968 (b) July 1978
(c) July 1988 (d) July 1998
13. The Preshipment Credit Scheme was introduced in 1969 for the benefit of
(a) importers (b) exporters
Reserve Bank of India and Economic Development 287
14. The Export–Import Bank of India was set up for the development of export sector in
the country by the
(a) RBI (b) SBI
(c) IDBI (d) IBRD
Answers
1. (b) 2. (a) 3. (a) 4. (a) 5. (b)

6. (d) 7. (c) 8. (b) 9. (b) 10. (a)
11. (d) 12. (c) 13. (b) 14. (a)
Review Questions
1. Explain the role of the RBI
• In agricultural finance
• In industrial finance
• In housing finance
• In export finance.
Chapter 25
Central Banking System in

the USA
25.1 Origin
Until 1913, there was no central bank in the United States of America (USA). The Federal
Reserve Act was passed in 1913. As a result, the Federal Reserve System was established
in the year 1914. The establishment of the Federal Reserve System in 1914 is one of the
great landmarks in the American banking history. The Central Bank of the USA is called
the Federal Reserve Banks. The Federal Reserve Banks (FRBs) were actually established in
November 1914.
25.2 Structure of the Federal Reserve System

The Federal Reserve Act provided that the continental United States should be divided into 12
Federal Reserve Districts, each to have a Federal Reserve Bank. Each Federal Reserve Bank
is named after the city in which it is located. Federal Reserve Banks are located in Boston,
New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas
city (MO), Dallas, and San Francisco. To facilitate their operations, some of the Federal Reserve
Banks have established branches in their districts.
Each of the 12 Federal Reserve Banks has many member banks, which are those commercial
banks in the district that have met at least the minimum requirements and have been accepted
for membership in the Federal Reserve System. As a member of the Federal Reserve System,
a commercial bank has both obligations and privileges. It must subscribe to stock in its Federal
Reserve Bank and holds all its legal reserves in the form of cash at vault or deposits at its
Federal Reserve Bank. On the other hand, it enjoys the privilege of borrowing from its Federal
Reserve Bank and of using the other facilities of the system.
288
Central Banking System in the USA 289
25.3 Organization of the Federal Reserve System

The Board of Governors is the central controlling authority in the entire Federal Reserve System
of the USA. This Board is composed of seven members (called Governors) appointed by the
President of the United States with the advice and consent of the Senate. Each member serves
for a term of 14 years and is not eligible for reappointment after a full term. Not more than
one member of the Board may be selected from any one Federal Reserve District. In making
appointments, the President is to have due regard to a fair representation of the financial,
agricultural, industrial and commercial interests of the country. The President Designates one
of the members as Chairman of the Board and another as Vice-chairman.
The following are the most important powers of the Board of Governors
1. To exercise general supervision over the Federal Reserve Banks.
2. To approve or disapprove appointments to the positions of President.
3. To supervise the issue and retirement of federal reserve notes by each Federal Reserve
Bank.
4. To permit one Reserve Bank to lend to another.
5. To determine the types of loans that the Reserve Banks may make.
6. To approve or disapprove discount rates established by the Reserve Banks.
7. To regulate loans on securities.
Most decisions on the conduct of monetary policy are made by the Federal Open Market
Committee (FOMC) (1936). The FOMC was created by amendments to the Federal Reserve
Act in order to clarify the location of authority and to centralize the control of open market
operations of the Federal Reserve System (FRS).
The FOMC is composed of 12 members; 7 of these are members of the Board of Governors
and 5 are representatives of the Reserve Banks. The Committee meets once in a month in
Washington, D.C and discusses the current situation almost daily by telephone. The Federal
Reserve Bulletin publishes the minutes of these monthly meetings after a short delay.
25.4 Functions of the Federal Reserve System

The Federal Reserve System in the USA has performed the following functions in order to
regulate monetary and credit conditions in the country:
1. It has greatly enhanced the speed, convenience and cheapness of clearing and collecting
checks and other similar instruments.
2. It transfers funds and certain types of securities by wire. Until 1970s, the Wire Transfer
System consisted of telegraphic linkages among the Board of Governors. This system
was replaced in the early1970s by a system of interconnected computers. In this new
system, almost all large payments are now transferred by wire.
3. It acts as a banker to the government. Among the functions performed by the Federal
Reserve Bank as principal bank to the government are the following:
(i) Financial Advisor to the Government.

(ii) Principal Depository of Federal Government Funds.
(iii) Agent for issuing and retiring treasury securities.
(iv) Agent in other transactions involving purchases and sale of securities for trust
funds and other accounts controlled by the government.
(v) Agent for the government in purchasing and selling gold and foreign exchange.
(vi) Lender to the government treasury. The power of the Federal Reserve to lend
directly to the treasury is limited by law.
4. The Federal Reserve Banks are prepared to rediscount eligible papers brought them by
member banks and to make advances on the security of such paper. Thus, they act as
the lender of the last resort.
5. The Federal Reserve Banks act as bankers to the member banks. Their activities in this
area show up in two balance sheet items. They are:
(i) The total of member bank checking accounts is shown as ‘member bank deposits’.
(ii) Member banks may borrow from their banks. The amount of this borrowing is
shown in ‘member bank borrowings’.
25.5 Credit Controls of the Federal Reserve System

The various instruments of monetary management in the hands of the Federal Reserve Banks
are general credit controls and selective credit controls.
25.5.1 General Credit Controls
The general credit controls are those directed towards regulating the total supply of money or
credit without necessarily regulating the allocation of credit among its various possible borrowers.
The Federal Reserve Banks’ power to regulate the total volume of money and bank credit
are of two broad types. They are:
(i) Various powers to regulate the magnitude and cost of member bank reserves.
(ii) Power to determine and alter member bank reserve requirements.

Open market operations (OMOs) constitute the most important tool of the Federal Reserve
Bank in regulating the cost and the volume of member bank deposits or reserves.
When the manager of the open market account purchases government securities from a
dealer, the dealer is paid with a check on the Federal Reserve Bank of New York. The dealer
must pay these funds to the seller of the securities. If the seller is a commercial bank, the
immediate effect is to increase the volume of bank reserves. If the seller is someone other
than a bank, the effect is to increase directly both the money supply and the volume of bank
reserves, because the seller will deposit the check with his or her bank, which will deposit it
at a Federal Reserve Bank.
Sales of government securities by the manager of the open market account have the opposite
effect. If the buyer is a commercial bank, the effect is to reduce bank reserves. If the buyer is
someone other than a bank, the effect is to reduce directly both bank reserves and money supply.
Federal Reserve Banks’ open market operations are of two principal types:
(i) Outright purchases and sales
(ii) Repurchase agreements
‘Outright purchases and sales’ are ordinary transactions in which neither the buyer nor the
seller makes a commitment to rebuy or resell. The transaction is final. The Federal Reserve Bank
buys securities from a dealer, with an agreement that the dealer will repurchase the securities
within a stipulated period which never exceeds 15 days and is typically less than 7 days.
Discount rate policy

The discount policy of Federal Reserve Bank refers to the terms and conditions on which it
will lend. It remains of considerable importance. Member banks may borrow funds by means
of either discounts or advances. Discounting entails the sale (rediscount) of ‘eligible paper’ to
a Federal Reserve Bank. An advance is a loan to a bank on its own promissory note, secured
by adequate collateral securities. The original notion in setting-up the Federal Reserve System
was that most borrowing would take the form of rediscounting of short-term self-liquidating
commercial paper.
Member bank reserve requirements

Changes in member bank reserve requirements are a powerful instrument for monetary
management. A change of even a fraction of a percentage point can have a marked effect on
monetary and credit conditions.
The changes in reserve requirements were well adapted only to two limited purposes:
(i) Absorbing large excess reserves or offsetting large losses of reserves by the banking
system.
(ii) Announcing important policy decisions to both the public and the banks.
Nowadays, the changes in reserve requirements have become increasingly common.
Furthermore, the introduction of marginal reserve requirement changes has added a need
dimension to monetary policy of the government.
25.5.2 Selective Credit Controls
The selective credit controls are those intended to regulate or influence the allocation of credit.
The selective credit controls can either be negative or positive. Negative controls seek to decrease
the supply or increase the cost of credit for certain specified purposes. Positive controls seek
to increase the supply or decrease the cost of credit for specified purposes.
The Federal Reserve Bank sometimes employs moral suasion as an instrument of general
monetary management to influence the total borrowings at the Federal Reserve Bank and the
behaviour of the total supply of money and bank credit. Moral suasion is also used for selective
purposes, especially with banks currently borrowing from the Federal Reserve Banks.

1. There was no central bank in the USA until
(a) 1911 (b) 1912
(c) 1913 (d) 1914
2. The Federal Reserve Act was passed in
(a) 1911 (b) 1912
(c) 1913 (d) 1914
3. The Federal Reserve System was established in the year
(a) 1911 (b) 1912
(c) 1913 (d) 1914
4. The Federal Reserve Banks are the central bank of the
(a) USA (b) USSR
(c) UK (d) UAE
5. The Federal Reserve banks were actually established in
(a) November 1911 (b) November 1912
(c) November 1913 (d) November 1914
6. How many central banks are in USA?
(a) 10 (b) 11
(c) 12 (d) 13
7. The controlling authority of the entire Federal Reserve System of the USA is
(a) Board of Directors (b) Board of Governors
(c) Board of Executives (d) Board of Attorneys
8. The Board of Governors of the Federal Reserve System in the USA is composed of
9. The Federal Reserve Bank’s open market operations are
(a) outright purchases (b) outright sales
(c) repurchase agreements (d) all of the above
10. Selective credit controls adopted by the Federal Reserve Banks can be
(a) negative (b) positive
(c) either negative or positive (d) neither negative nor positive
11. Negative controls seek to
(a) increase the supply of credit
(b) decrease the supply of credit
(c) increase the cost of credit
(d) decrease the supply or increase the cost of credit
12. Positive controls seek to
(a) decrease the supply of credit
(b) increase the supply of credit
(c) decrease the cost of credit
(d) increase the supply or decrease the cost of credit
Answers
1. (c) 2. (c) 3. (d) 4. (a) 5. (d)

6. (c) 7. (b) 8. (c) 9. (d) 10. (c)
11. (d) 12. (d)
Review Questions
1. Bring out the origin of central banking in the USA.
2. Give the structure of the Federal Reserve System in the USA.
3. Write down the organization of the Federal Reserve System in the USA.
4. Bring out the important powers of the Board of Governors of Federal Reserve System
of the USA.
5. Explain the various functions performed by the Federal Reserve System in the USA.
6. Explain briefly the credit control instrument of the Federal Reserve System in the USA.
Chapter 26
Central Banking System in

the UK
26.1 Origin
The Central Bank of the United Kingdom (UK) is called the Bank of England. It was established
in 1694 by the Act of Parliament. It was originally a joint stock company. It was given the
privilege of limited liability.
The Bank of England was founded in 1694 by a number of merchants of the city of London
for the purpose of lending money to King William III, who acquired it to finance his military
activities on the continent of Europe.
The affairs of the Bank of England are regulated by a governor, a deputy governor, and
sixteen directors appointed by the Crown. The governor and deputy governors hold office for
5 years. The directors hold office for 4 years. Four of the directors retiring every year. And
not more than four of them may be full-time officers. All of these officers are eligible for
reappointment. There is no provision for compulsory retirement. Normally, no person over 65
years of age will be appointed.
The effective managing body of the Bank of England consists of a governor, a deputy
governor, and four full-time executive directors. For the more urgent and secret matters, the
governor has at hand the ‘Committee of Treasury’. This Committee consists of a governor,
a deputy governor and five directors chosen by all the directors in a secret ballot. By long
tradition, this is the Senior Committee of the Bank.
The Bank of England remains a Corporate Body whose powers are regulated by its charters,
just as an ordinary joint stock company’s powers are regulated by its Memorandum of Association.
26.2 Operations of the Bank of England

The important operations of the Bank of England are discussed in terms of the following:
• Bankers’ deposits
294
Central Banking System in the UK 295
• Public deposits
• Other deposits
Bankers’ deposits: Bankers’ deposits represent the balances held by the London Clearing
Banks at the Bank of England.
Public deposits: At the gateway between the public and private sectors, the Bank of England
holds the principal banking account of the government. Its balance appears among the Bank’s
liabilities as public deposits.
Other deposits: Other deposits include other accounts which are the balances of other customers.
These other accounts include some that represent a vestige of ordinary banking business for
private customers.
26.3 Cash Basis of the Banking System

The importance of the Bank of England’s liabilities and assets rests on their relevance to the
cash basis of the banking system. Let us now explain how the Bank of England is the source
of cash. In this, there are four steps:
1. Cash has to be defined and classified into notes and bankers’ deposits at the Bank of
England.
2. Relations between these two kinds of cash and the operation of the Bank of England
as the banker are outlined.
3. Regulation of the note issue.
4. The other facet of the Bank’s position as bankers’ bank—its operation as lender of the
last resort—must be explained.
There are two forms of cash:
(i) Any more widely accepted form of money into which people may wish to change
their less widely acceptable bank deposits. The liquidity of a bank is its ability to
exchange deposits for cash of the first form when demanded by the public.
(ii) Anything that a commercial bank considers as liquid as the first form.
26.3.1 Cash of the First Form
Cash of the first form consists of all legal tender money—silver and copper coins and Bank
of England notes—this being the mostly widely acceptable form of money.
26.3.2 Cash of the Second Form
Cash of the second form consists of the bankers’ deposits at the Bank of England. The Bankers’
deposits are as useful to the commercial banks as are Bank of England notes. With Bank notes
and Bankers’ deposits, the position can be quite different. If these liabilities of the Bank of
England are increased, there may be an important increase in the supply of money.
26.4 Schools of Thought on the Issue of Bank Notes

There were two Schools of Thought on the issue of notes. They were the Currency School
and the Banking School.
26.4.1 The Currency School
The Currency School believed that the only way to prevent an excessive issue of notes was
to insist that the note issue should be fully backed by gold, or if a fiduciary issue (an issue of
notes not backed by gold) was permitted, any further increase in the note issue supported by an
equivalent amount of gold, or if a fiduciary issue (an issue of notes not backed by gold) was
permitted, any further increase in the note issue supported by an equivalent amount of gold.
26.4.2 The Banking School
The Banking School believed that the note issue should not be rigidly restricted in this way,
but that it should be made variable to suit the particular needs of business at the time.
The Currency School tended to overemphasize the dangers attendant on an excessive issue
of notes, while the Banking School was inclined to minimize them. The Bank of England is
the only bank in England with the right to issue bank notes.
During the 18th century, cheques began to supersede bank notes as the chief means of
payment to businessmen and private banks of the city of London. Down to 1826, the Bank of
England had been their only joint stock bank in England. An Act was passed in 1826. This
Act permitted other joint stock banks to be established provided they were not situated within
65 miles of London. These new banks were given the right to issue their own notes. At the
same time, the Bank of England was prohibited from issuing notes of denominations of less
than 5 pounds.
The Bank Charter Act of 1833 again gave the Bank of England notes the status of legal
tender. At the same time, the restriction on the interest rate was removed. When the Bank
Charter Act of 1844 was passed, there was a large number of banks in England which issued
bank notes.
The Act of 1844 divided the work of the Bank of England into two departments—Issue
and Banking Departments. The Issue Department was concerned solely with the note issue and
the Banking Department was to carry out all other functions of the Bank.
In the later banking crisis of the 19th century, the Bank of England began to develop as
a Central Bank. By the last quarter of the 19th century, it had become accustomed to exercise
its powers of control over the commercial banks.
26.5 Instruments of Banks Monetary Policy

There are two traditional instruments of monetary policy of the Bank of England. They are:
bank rate and open market operations.
26.5.1 Bank Rate
Bank rate is the minimum rate at which the Bank of England is prepared to discount first class
or bank bills of exchange. If the bank rate is raised, the rate of interest paid by the commercial
banks on deposit accounts will be raised. It is the rate at which these banks lend to their
customers and at which they will discount bills of exchange brought to them by the members
of the money market in England. The opposite effect will occur when the bank rate is lowered.
26.5.2 Open Market Operations
Open market operations refer to buying and selling of securities in the open market. If the Bank
of England purchases securities in the open market, the effect at the clearing house will be to
cause the Bank of England itself to be indebted to all the other banks. In this case, settlement
will be made by crediting the balances of all these banks at the Bank of England with the
amounts involved. But the commercial banks regard their balances at the Bank of England as
cash and so the actions of the Bank in the open market will have raised the cash ratio of the
other banks. Then this makes it possible for the commercial banks to adopt a more liberal
lending policy and thereby to expand total bank deposits.
Similarly, if the Bank of England sells securities in the open market, the effect at the
clearing house will be to cause the commercial banks to be indebted to the Bank of England.
In this case, settlement will involve a reduction in bankers’ deposits. This reduction in their
cash will cause them to reduce their lending, and so in time their deposits.

1. The Bank of England is the Central Bank of the
(a) UK (b) USA
(c) USSR (d) UAE
2. The Bank of England was established by the Act of Parliament in
(a) 1674 (b) 1684
(c) 1694 (d) 1664
3. The Bank of England was originally a
(a) shareholders bank (b) joint stock company
(c) cooperative society (d) all of the above
4. The day-to-day affairs of the Bank of England are regulated by
(a) a governor (b) a deputy governor
(c) sixteen directors (d) all of the above
5. The governor and deputy governors of the Bank of England hold office for
6. The directors of the Bank of England hold office for
7. The effective managing body of the Bank of England consists of

(a) a governor (b) a deputy governor
(c) four full-time executive directors (d) all of the above
8. The important operations of the Bank of England are dealt with
(a) banker’s deposits (b) public deposits
(c) other deposits (d) all of the above
9. The importance of the liabilities and assets of the Bank of England rests on their relevance
to the
(a) cash basis of the banking system (b) credit basis of the banking system
10. Which one of the following forms of cash found in the banking system of the UK?
(a) All legal tender money (b) Banker’s deposits
11. Which one of the following Schools of Thought was on the issue of bank notes by the
Bank of England?
(a) The Currency School (b) The Banking School
12. The Currency School of Thought tended to
(a) overemphasize the dangers of overissue
(b) underestimate the benefits of underissue
(c) both (a) and (b)
13. The Banking School of Thought tended to
(a) minimize the dangers of overissue (b) maximize the benefits of underissue
14. During the 18th century, which began to supersede bank notes as the chief means of
payment to businessmen to London?
(a) Cheque (b) Promissory note
(c) Bill of exchange (d) Treasury bills
15. Which one of the following is traditional instrument of monetary policy of the Bank of
England?
(a) Bank rate (b) Open market operations
(c) Both (a) and (b) (d) Cash reserve ratio
Answers
1. (a) 2. (c) 3. (b) 4. (d) 5. (c)

6. (b) 7. (d) 8. (d) 9. (a) 10. (c)
11. (c) 12. (a) 13. (a) 14. (a) 15. (c)
Review Questions
1. Bring out the origin of central banking system in the UK.
2. Discuss the important operations of the Bank of England.
3. What is the cash basis of the central banking system in the UK?
4. What are the two Schools of Thought on the issue of notes by the Bank of England?
5. What are the instruments of monetary policy of the Bank of England?
Chapter 27
International Financial
Institutions
27.1 International Monetary Fund (IMF)

The International Monetary Fund (IMF) was established on December 27, 1945. It started
its operation from March 1, 1947. The establishment of the IMF was the outcome of an
International Monetary Conference, popularly known as Bretton Woods Conference, which
was held in the USA in July 1944. The establishment of the IMF was a great landmark in the
history of international monetary system. It is an international organization that offers financial
and technical assistance to its member countries.
The purposes for which the IMF was established were to promote exchange rate stability,
temporary assistance to countries falling short of foreign exchanges and international sponsoring
of measures for correcting the disequilibrium in the balance of payments of its pool of central
bank reserves and national currencies which are available to its members under certain conditions.
It can be regarded as an extension of the central bank reserves of the member countries.
27.1.1 Objectives of the IMF
According to Article 1 of the IMF, the following are the important objectives of the IMF:
1. To promote international monetary cooperation among the member countries through a
permanent institution.
2. To ensure stability of foreign exchange rates for its member countries and the elimination
of restrictions on it.
3. To facilitate the expansion and balanced growth of international trade through the
removal of all the obstacles which retard international trade.
4. To assist in the establishment of a multilateral system of payments in respect of current
transactions between member countries.
300
International Financial Institutions 301
5. To help the member countries to correct the disequilibrium in their international balance
of payments by selling or lending foreign currencies to them.
6. To give confidence to its member countries by making the fund’s resources available
to them in times of need with adequate safeguards.
7. To help the member countries to eliminate foreign exchange restrictions with a view
to encouraging free flow of international trade.
8. To promote investment of capital in less-developed member countries.
9. To shorten the duration or lessen the degree of disequilibrium in the international balance
of payments of its member countries.
10. To help in the establishment of a system of multilateral convertibility of currencies,
i.e., the conversion of one currency into the currency of any other country.
27.1.2 Organization and Membership of the IMF
The IMF was constituted by subscriptions from its members agreeing to participate in the Fund
amounting to 8.8 billion (or 8800 million) dollars out of which India’s contribution was 400
million dollars. The subscription was to be partly in the form of gold and partly in domestic
currency. A member country is required to pay 25 per cent of its quota or 10 per cent of its net
official holdings of gold plus US dollars, whichever is smaller, in the form of gold and the rest
in their national currencies. The resources of the IMF are thus partly gold and partly currencies
of the member countries. The latter, i.e., the currencies of the member countries are being kept
in the central banks of the countries concerned. The resources of the Fund are thus obtained
from its member countries. They have to contribute their quotas. The quotas are determined on
the basis of the national income and the contribution of each country to the international trade.
The quotas determine the borrowing powers and voting rights of the participating countries.
The IMF was established with 44 members. India is the founder member of it. The number
of member countries of the IMF has increased to 185 as on January 18, 2007. By the end of
2007, the number reduced to 183.
27.1.3 Management of the IMF
The IMF is managed by an Executive Board of twelve Directors on which India, China, France,
USA and UK have a permanent seat each, two seats go to Latin America Republic while the
other five are filled by election. These twelve executive directors are the chief executives of
the IMF. They act as the chairmen or the operating heads of the Fund. The managing director
is fully responsible for its organization, appointment and dismissal.
There is another body to manage the IMF known as the Board of Governors. Every member
country can appoint one governor to participate in the meetings of the Board of Governors.
An alternate governor may also be appointed by each member country to participate in the
meetings of the Board of Governors and formulates the general policy of the IMF.
There is another Committee, known as the International Monetary and Financial Committee,
established in 1974 as an Interim Committee to advise the Board of Governors on the management
of the IMF. This Committee is composed of twenty-four Governors.
There is also another Committee, known as the Development Committee, established in

1974 to advise the Board of Governors on all aspects of the transfer of resources to developing
countries like India and to make suggestions for their implementation.
The headquarters of the IMF is located in the USA (Washington), which happens to have
the highest quota of capital in the IMF.
27.1.4 Functions of the IMF
The IMF performs the following six important functions:

1. Promotes foreign exchange rate stability.
2. Offers financial assistance to meet balance of payments difficulties.
3. Establishes and promotes a system of multilateral convertibility of currencies.
4. Renders technical assistance.
5. Provides solution to the problem of international liquidity.
6. Other functions.
Promotes foreign exchange rate stability: The first and the foremost function of the IMF is
to promote stability in the foreign exchange rates. The fixed exchange rates will facilitate the
expansion and balanced growth of international trade. Every member country should declare
the value of its currency in terms of gold or the US dollar before joining as a member, i.e.,
it should state how much of gold or US dollar is equal to its currency unit. This is called par
value. The exchange rate between two countries is determined on the basis of par values of
their currencies. Every country should purchase or sell gold at the par value declared by it. As
a result, the rates of exchange between the countries will be stable. The IMF permits adjustment
of exchange rates within certain limits.
Offers financial assistance to meet balance payments difficulties: Another important function
of the IMF is to offer financial assistance to meet temporary balance of payments difficulties
facing member countries. In other words, the IMF provides necessary foreign currencies to
member countries to meet temporary balance of payments difficulties. This enables them to correct
disequilibrium in the balance of payments. Every member country has the right to purchase
any foreign currency in exchange for its own currency. Suppose India wants US dollars. It can
secure the dollars from the IMF by giving its rupees in exchange. But the member country has
to repurchase its own rupee currency by giving gold or convertible foreign currencies when its
balance of payments position improves. These provisions prevent the member countries from
misusing their purchasing rights or financial assistance from the IMF.
Establishes and promotes a system of multilateral convertibility of currencies: Another
important function of the IMF is to establish and promote a system of multilateral convertibility
of currencies (i.e. conversion of the currency of one country into the currency of any other
country). According to the rules of the IMF, the member country can purchase the currency
of another country with its own currency up to a certain limit.
Renders technical assistance: Another important function of the IMF is to render technical
assistance to its member countries within its mandate. It has been rendering technical assistance
in three areas. They are:
1. Designing and implementing monetary and fiscal policies.
2. Drafting and reviewing financial and economic legislations, regulations and procedures.
3. Institution and capacity building in central banks, treasuries, customs and tax departments,
and statistical services. The IMF is rendering technical assistance through regional
centres, missions and overseas regional institutes.
Provides solution to the problem of international liquidity: Another important function of
the IMF is to provide solution to the problem of international liquidity. The Fund is mainly
responsible for maintaining a balance between the demand for and the supply of international
liquidity. Whenever the problems of international liquidity arise, the IMF has to solve them
be adopting different plans and proposal. For this purpose, a new international currency called
Special Drawing Rights (SDR) was introduced by the IMF in 1969. This SDR is popularly known
as ‘Paper Gold’. The SDR has solved partly the problem of shortage of international liquidity.
Other functions: The following three are the other functions performed by the IMF:
1. It serves as a short-term credit institution by providing short-term financial assistance
to its member countries when they face financial emergency.
2. It provides machinery for international consultations by bringing together the
representatives of the principal countries of the world and affords an excellent opportunity
for reconciling their conflicting claims.
3. It borrows from different countries, governments, central banks and private institutions
and thereby increases its fund by selling gold to its member countries.
Thus, the IMF can play a vital role in achieving international economic stability and in
promoting healthy international monetary relations.
27.1.5 India and IMF
India is one of the founder members of the IMF. It is the fifth largest member country holding
the largest quotas. In case of balance of payments difficulty, India has obtained loans from
the IMF. In other words, whenever there are balance of payments difficulties, India purchases
foreign currencies from the IMF by giving its own currency. India repurchases its own currency
whenever the balance of payments position improves. India is one of the frequent borrowers
from the IMF. Since Independence, India has been experiencing balance of payment difficulties.
India obtained loans in the form of foreign currencies of the value of 90 million dollars from
the Fund to meet the balance of payments difficulties before the devaluation of the Indian rupee
in September 1949. In 1952, India obtained further financial assistance from the Fund as there
was an increase in the trade deficit. During the Second Five Year Plan, the government got
short-term financial assistance in the form of foreign exchange from the Fund to the extent of
200 million dollars (` 95.2 crore). In short, the operation of the IMF can be summarized as:
When a country experiences adverse balance of payments with other countries, it can
approach the IMF and purchases the currencies it wants against the exchange of our own
currency. India uses the Fund’s resources only to meet the adverse balance of payments situation
to a large extent possible.
Further, the SDR is a new type of international monetary asset created in 1969 and approved
by the IMF with the main aim of increasing international liquidity. The SDR is allocated and
credited to a member country’s account. This SDR can be used for meeting the deficits in the
balance of payments. SDR is existing only in the Fund’s books and changing hands only in
the ledgers. The Fund’s member countries accept it as payment. Thus SDR is popularly known
as paper gold.
27.1.6 Advantages of the IMF
The following are the advantages derived by India from the IMF:
• India has got timely financial assistance in reducing the deficit in the balance of payments.
• India has been obtaining technical advice and assistance on important monetary and
fiscal problems.
• India has been obtaining foreign currencies against its own currency in times of need
to eradicate difficulties and to promote economic development of the country.
• India has been playing a vital role in formulating the policies of the IMF and occupies
a place of prestige in the Fund.
• Indian rupee has become independent and used as a full-fledged currency of the country.
• The membership of the IMF is a necessary condition for the membership of the World
Bank. India has obtained loans development purposes.
• India has obtained valuable advice from the Fund for financing of the various Five Year
Plans.
• Indian rupee has been linked with international exchange standard so that India’s payment
in any country of the world can easily be made.
• Indian personnel have been provided with short-term training programmes on monetary
and banking problems.
• India has enjoyed the advantage of getting assistance from the Fund for eliminating the
short-term disequilibrium in the balance of payments without disturbing the internal
price level.
27.1.7 Criticisms of the IMF
The following are the important criticisms levelled against the IMF:
• There is no scientific method of fixing the quota of the member countries.
• There is a limit for borrowing by the member countries.
• There is no scope to solve the problem of adverse balance of payments of the member
countries with the Fund’s limited amount of resources.
• There is no possibility of achieving the objective of free convertibility of currencies of
all the member countries.
• There is no chance of abolishing the system of multiple exchange rate which is being
followed by many countries at present.
• There is no scope for solving the international liquidity problem of the member countries
completely.
• There is no possibility of granting an increasing share of the developing countries in
the SDRs.
• The devaluation of Indian currency cannot be effective unless internal price level is kept
stable.
• The currency devaluation is advocated by the Fund which leads to inflation. During
inflation, devaluation of currency cannot be a success.
• The devaluation of Indian rupee occurred twice in 1949 and in 1966.
Devaluation of Indian Rupee in 1949

The first devaluation of Indian rupee was made on September 18, 1949 in terms of US
dollars. When Indian rupee was devalued, its exchange value decreased from 33.22 US cents
to 21 US cents. In terms of gold, the exchange value of Indian rupee also decreased from
0.268601 gram of fine gold to 0.186621 gram of fine gold. The causes for this devaluation of
Indian rupee were:
• A rising tendency of the price level.
• Competition from other sterling area countries.
• Balance of payments deficit due to heavy imports.
• Refusal to permit unlimited conversion of pound sterling into US dollars.
Devaluation of Indian Rupee in 1966

The second devaluation of Indian rupee was made on June 6, 1966. As a result, the exchange
value of Indian rupee against US dollars decreased from 1$ = ` 4.76 to 1$ = ` 7.50 in terms
of gold, the exchange value of Indian rupee also decreased from 0.1866 gram to 0.1185 gram
of fine gold. In terms of pound sterling, the exchange value of Indian rupee decreased from
1£ = ` 13.30 to 1£ = ` 21. The causes for this devaluation of Indian rupee were:
• Low level of foreign exchange reserves of the country.
• An increasing trend of the price level.
• A World Bank Mission and the IMF forced to devalue Indian rupee.
27.2 International Bank for Reconstruction and

Development (IBRD)
The International Bank for Reconstruction and Development (IBRD) was established on
December 27, 1945. It started its operation from June 25, 1946. It is popularly known as the
World Bank. It is one of the twins of the Bretton Woods Conference held in July 1944 (the
other being the IMF). The aim of its establishment is to remove the long-term disequilibrium
in the balance of payments of member countries by extending long-term loans to them for
reconstruction and development purposes.
27.2.1 Objectives of the IBRD
The following are the important objectives of the IBRD:

1. To provide financial assistance for reconstruction and development of territories of
member countries.
2. To promote private foreign investment by means of guarantees or participation in loans
and other investments made by private investors.
3. To encourage balanced growth of international trade by maintaining equilibrium in the
balance of payments.
4. To arrange for financial assistance to more useful and urgent projects in member
countries.
5. To help in raising productivity, standard of living and conditions of labour in member
countries.
6. To bring about a smooth transition from a wax-time economy to a peace-time economy.
27.2.2 Organization and Membership of the IBRD
The IBRD was constituted with an initial authorized capital of $10,000 million divided into
100,000 shares of $100,000 each. The subscription of a member country in the capital of the
IBRD is of three parts: 2 per cent in gold or US dollars, 18 per cent in its own currency and
the rest of 8 per cent called up by the IBRD whenever it requires it to meet its obligations.
The members of the IBRD are automatically the members of the IMF. The total membership
has increased from 44 in 1944 to 185 in 2007.
27.2.3 Management of the IBRD
The IBRD is managed by a Board of Directors consisting of one representative of each member
country. The Board meets once in a year. The IBRD delegated most of its powers to the Board
of Executive Directors consisting of seventeen directors, five of them are nominated by the
first five member countries holding the largest capital and the rest of twelve are elected by
other members. This Board of Executive Directors meets once in a month. It makes decisions
regarding policy matters. This Board approved the loans sanctioned by the IBRD. The president
of the IBRD looks after the day-to-day affairs of the Bank.
27.2.4 Sources of Funds to the IBRD
The IBRD secures funds in three forms, namely, capital, sale of bonds and net profit. Every
member country is required to pay 2 per cent of its quota in gold or US dollars and 18 per
cent in its currency. This amount is not enough for lending to member countries. So the
IBRD borrows from countries like USA, France and UK by selling its bonds. The USA had
purchased nearly half of the bonds issued by the IBRD. Borrowing from important countries
is the important source of funds to IBRD. Reserves maintained out of net profits secured by
the IBRD are also used for lending to its member countries.
27.2.5 Functions of the IBRD
The following five are the important functions performed by the IBRD:
1. Provides assistance for reconstruction and development.
2. Promotes private foreign investment.
3. Encourages balanced growth of international trade.
4. Gives technical assistance.
5. Other functions.
Provides assistance for reconstruction and development: The first and the foremost function
of the IBRD (World Bank) is to provide financial assistance to its member countries for the
reconstruction of countries destroyed by war. It grants loans and guarantees loans raised by
member countries in foreign countries. It facilitates investment of capital for productive purposes.
It also encourages the development of productive capacity in less-developed or economically-
backward member countries.
Promotes private foreign investment: Another important function of the IBRD or the World
Bank is to promote private foreign investment by encouraging individuals and institutions to
invest in foreign countries. This can be done by guaranteeing the loans raised by member
countries in foreign countries. Further, it also participates in loans and other investments made
by private investors. Thus the IBRD promotes private foreign investment through a free flow
of capital from one country to another.
Encourages balanced growth of international trade: Another important function of the
IBRD is to encourage balanced growth of international trade. This can be done through the
maintenance of equilibrium in the balance of payments and also through long-term foreign
investment. As a result, the productive capacity, standard of living and conditions of labour in
member countries improve.
Gives technical assistance: Another important function of the IBRD is to give technical
assistance to its member countries. It sends experts to carry out the survey of the resources of
the member countries and to find out the ways and means to mobilize and utilize the resources
a better manner. An Economic Development Institute was set up by the IBRD to give training
to the personnel from its member countries. Technical assistance is provided for formulating
suitable policies for economic development of its member countries.
Other functions: The following five are the other functions performed by the IBRD or the
World Bank:
1. It settles disputes of economic nature among the member countries.
2. It supplements private foreign investments through participating in direct loans out of
its own funds.
3. It encourages the development of productive resources in less-developed member
countries.
4. It has the power of supervision and control over its member countries to ensure that
funds are used properly against the project for which the loans have been sanctioned.
5. It grants medium-term and long-term financial assistance for reconstruction and

development purposes.
27.2.6 Advantages of the IBRD
The advantages of the IBRD are as follows:

• It grants loans at concessional rates to its member countries.
• It provides loans in reasonable terms and conditions with easy repayment facilities.
• It formulates and implements the development programmes in some member countries.
• It permits the borrowing countries to spend the borrowed funds as they like.
• It settles economic disputes among its member countries.
27.2.7 Criticisms of the IBRD
The following are the criticisms levelled against the functioning of the IBRD:
• It charged a very high rate of interest plus commissions and other charges.
• Its resources are not sufficient to meet the financial requirements of all member countries.
• It sometimes imposes strict conditions for granting loans to less-developed member
countries which find it very difficult to draw financial assistance. In other words, the
lending policy is rigid.
• It lends mostly for irrigation, power, communication, industry and transport projects.
• It does not give any general loan.
• It exercises too much control over the projects in the economy.

1. The International Monetary Fund is
(a) a national organization (b) an international organization
(c) a state organization (d) an intra-country organization
2. The IMF was established on
3. The IMF started its operation from
(a) March 1, 1944 (b) March 1, 1945
(c) March 1, 1946 (d) March 1, 1947
4. The IMF was established with
(a) 42 member countries (b) 43 member countries
(c) 44 member countries (d) 45 member countries
5. Who is fully responsible for the organization, appointment and dismissal of the IMF?
(a) Managing Director (b) Executive Director
(c) Chief Executive (d) Board of Governors
6. The headquarters of the IMF is located in
(a) Washington (USA) (b) London (UK)
(c) Berlin (USSR) (d) New Delhi (India)
7. The IMF provides financial assistance to meet the balance of payments difficulties
(a) permanently (b) temporarily
(c) fully (d) partly
8. The IMF is rendering technical assistance through
(a) regional centres (b) missions
(c) overseas regional institutes (d) all of the above
9. The Special Drawing Right (SDR) is
(a) a new international currency (b) a new national currency
(c) an old international currency (d) an old national currency
10. The SDR is popularly known as
(a) paper gold (b) standard gold
(c) special gold (d) bullion gold
11. The SDR was introduced by the IMF in
(a) 1949 (b) 1959
(c) 1969 (d) 1979
12. The SDR was introduced by the IMF for the purpose of solving the problem of
(a) national liquidity (b) international liquidity
(c) national security (d) international security
13. The IMF serves as a
(a) short-term credit institution (b) medium-term credit institution
(c) long-term credit institution (d) both (a) and (c)
14. Which of the following country is the founder member of the IMF?
(a) Kenya (b) India
(c) Italy (d) Thailand
15. In terms of holding the largest quotas in the IMF, India is the
(a) third largest member country (b) fourth largest member country
(c) fifth largest member country (d) sixth largest member country
16. The first devaluation of Indian rupee was made on
(a) September 18, 1949 (b) September 18, 1959
(c) September 18, 1969 (d) September 18, 1979
17. The first devaluation of Indian rupee was made in terms of
(a) US dollars (b) UK pound sterling
(c) Both (a) and (b) (d) USSR rouble
18. The second devaluation of Indian rupee was made on
(a) June 6, 1966 (b) June 6, 1956
(c) June 6, 1946 (d) June 6, 1976
19. The second devaluation of Indian rupee was made in terms of
(a) US dollars (b) UK pound sterling
(c) Both (a) and (b) (d) National Bank
20. The IBRD is popularly known as

(a) World Bank (b) Foreign Bank
(c) International Bank (d) National Bank
21. The IBRD was established on
22. The INRD serves as a
(a) short-term credit institution (b) long-term credit institution
(c) medium-term credit institution (d) both (a) and (b)
23. The IBRD aims at removing
(a) long-term disequilibrium in the balance of payments
(b) short-term disequilibrium in the balance of payments
(c) medium-term disequilibrium in the balance of payments
(d) both (a) and (b)
24. The IBRD was constituted with an initial authorized capital of
(a) 10,000 million dollars (b) 8000 million dollars
(c) 5000 million dollars (d) 3000 million dollars
25. The IBRD is managed by
(c) Board of Executive Directors (d) Board of Executive Governors
26. Which of the following approves the loans sanctioned by the IBRD?
(c) Board of Executive Directors (d) Board of Executive Governors
27. Who looks after the day-to-day affairs of the IBRD?
(a) President of the bank (b) Governor of the bank
(c) Director of the bank (d) Executive Director of the bank
28. The IBRD secures funds of the form
(a) capital (b) sale of bands
(c) net profit (d) all of the above
Answers
1. (b) 2. (a) 3. (d) 4. (c) 5. (a)

6. (a) 7. (b) 8. (d) 9. (a) 10. (a)
11. (c) 12. (b) 13. (a) 14. (b) 15. (c)
16. (a) 17. (a) 18. (a) 19. (c) 20. (a)
21. (a) 22. (b) 23. (a) 24. (a) 25. (a)
26. (c) 27. (a) 28. (d)
Review Questions
1. What are the objectives of the IMF?
2. Write down the organizations and management of the IMF.
3. Explain the various functions performed by the IMF.
4. Discuss briefly the role of IMF in India.
5. What are the advantages derived by India from the IMF?
6. What are the criticisms levelled against the functioning of the IMF?
7. Write a note on ‘devaluation of Indian rupee in 1949’.
8. Write a note on ‘devaluation of Indian rupee in 1966’.
9. What are the important objectives of the IBRD?
10. Write down the organization and management of the IBRD.
11. What are the sources of funds to the IBRD?
12. What are the important functions performed by the IBRD?
13. Bring out the advantages of the IBRD.
14. What are the criticisms levelled against the functioning of the IBRD?
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Subba Rao, P., Rao, M.M. and Rao, V.S.P., Currency and Banking, Tata McGraw-Hill,
New Delhi, 1992.
Sundaram, K.P.M., Money, Banking and International Trade, Sultan Chand & Sons,
New Delhi, 2000.
Vaish, M.C., Monetary Theory, Vikas Publishing House, New Delhi, 1978.
Index
Absolute value of money, 46 Characteristics of money, 9

Acceptance houses, 151 Chicago version of QTM, 89
Circular flow of money, 21
Closed economy, 112
Balance sheet, 219 Commercial bank, 204
assets side, 221 Commercial papers, 152
liabilities side, 220 Commodity money, 6
Bank, 191 Comprehensive inflation, 120
Bank money, 7 Consumer price index, 122
Bank nationalisation, 229 Cost-push inflation, 121
Bank of England, 294 Credit control, 267
Banking principle, 36 Credit creation, 210
Bank rate, 180, 277 Credit inflation, 121
Barter , 3 Credit money, 7
Baumol’s approach, 54 Creeping inflation, 119
Bill market scheme, 161 Currency inflation, 121
Bill of exchange, 152 Currency principle, 36
Bimetallism, 30 Current account deposit, 204
Branch banking system, 196
Broad money 59
Budgetary deficit, 65
Deficit-induced inflation, 121
Deflation, 132
Call loans, 152 Demand for money, 51
Capitalist economy, 19 Demand-pull inflation, 120
Capital market, 165 Depression phase, 140
Cash balance approach, 77 Derivative deposits, 211
Cash reserve ratio, 181, 278 Direct financing, 273
Cash transaction of money, 74 Discount houses, 151
Central bank, 256 Disinflation, 133
Certificates of deposits, 152 Don Patinkin’s real balance effect, 92
315
316 Index
Euro-Dollar market, 156 Investment policy, 225

Evils of money, 18 IS curve, 108
Keynesian equation, 79
Federal Reserve System, 288
Keynesian theory of money and prices, 86
Fiat money, 12
Fixed account deposit, 204
Fixed fiduciary system, 37 Lead bank scheme, 251
Flow concept, 51 Legal tender money, 13
Friedman’s approach, 55 Lender of the last resort, 264
Full-bodied money, 12 Limited legal tender money, 13
Full employment, 179 Liquidity, 225
preference theory of interest, 106
theory of money, 94
Galloping inflation, 119 LM curve, 109
General liquidity effect, 279 Loanable fund theory of interest, 104
Gold bullion standard, 31 Local authorities market, 156
Gold currency standard, 31 London money market, 154
Gold exchange standard, 32
Gold parity standard, 32
Gold reserve standard, 32 Marshallian equation, 78
Gold standard, 31 Maximum fiduciary system, 37
Gresham’s law, 39 Metallic money, 6
Gurley and Shaw’s thesis, 96 Milton Friedman’s QTM, 89
Minimum reserve system, 38
Mixed banking system, 197
High powered money, 61 Monetary policy, 176
Human wealth, 91 Monetary standard, 29
Hyper inflation, 119 Money, 6, 23
Money illusion, 23
Money of account, 11
Money proper, 12
IBRD, 305
Money market, 149
IMF, 300
Money multiplier, 62
Incentive effect, 279
Money supply function, 58, 64
Income theory of money, 82
Monometallism, 29
Index numbers, 47
Monopoly of note issue, 262
Indian capital market, 166
Moral suasion, 182, 270
Indian money market, 159
Indian stock market, 172
Indirect financing, 273 Narrow money, 58
Inflation, 117 Near money, 23
Inflationary gap, 127 Neutrality of money, 178
Inter-bank market, 156 New York money market, 157
Interest, 102 Non-human wealth, 91
classical theory, 103
Neo-classical theory, 104
Neo-Keynesian theory, 108 Okun’s law, 131
Wicksell's theory, 110 Open economy, 113
Index 317
Open inflation, 120 Stagflation, 131

Open market operations, 180, 277 State Bank of India, 236
Optional money, 13 Statutory liquidity ratio, 215
Origin of bank, 191 Stock concept, 56
Origin of money, 5 Stock market, 171
Stock market indices, 173
Supply of money, 56
Paper currency standard, 35 Suppressed inflation, 120
Paper money, 7
Patinkin’s real balance effect, 92
Peace-time inflation, 120 Term structure of rate of interest, 111
Phillips curve analysis, 129 Tobin’s approach, 54
Pigouian equation, 78 Token money, 12
Post-war inflation, 119 Trade cycle, 138
Precautionary motive, 52 climatic theory, 142
Primary deposits, 210 cobweb thoery, 144
Priority sector finance, 247 Hicksian theory, 144
Profitability, 226 innovation theory, 144
Promissory note, 151 Keynes' theory, 143
Proportional reserve system, 38 monetary theory, 143
Prosperity phase, 140 over-investment theory, 142
psychology theory, 142
under-consumption theory, 142
Radcliff committee, 279 Transaction motive, 51
Radcliff-Sayer’s thesis, 95 Transmission mechanism, 184
Ratchet inflation, 121 Treasury bills, 152
RBI, 274 True inflation, 121
Recession phase, 140
Recovery phase, 140
Reflation, 133 Unit banking system, 195
Relative value of money, 46 Unlimited legal tender money, 13
Reserve money, 61
Robertson’s equation, 79
Running inflation, 119 Value of commodity, 45
Value of money, 45
Velocity of circulation of money, 65
Savings account deposit, 204
SEBI, 168
Semi-inflation, 121 Walking inflation, 119
Socialist economy, 20 War-induced inflation, 121
Speculative motive, 52 War time inflation, 119
Sporadic inflation, 120 Wholesale price index, 122
MONEY
AND
BANKING E. Narayanan Nadar
I ntended for undergraduate students of Economics, Commerce and Management, this book discusses
the concepts and functions of monetary and banking system. It also incorporates the recent trends
and developments in the fields of money and banking.
Divided into twenty-seven chapters under two parts, the book is written in an easy-to-understand language.
Part I on Money discusses evolution, nature, value, role and significance of money; monetary standards;
monetary theories; and analysis of interest rates, inflation and deflation. It also describes trade cycles; money,
capital and stock markets; and monetary policy. Part II on Banking discusses evolution, structure and systems
of banking, functions, credit creation process, balance sheet, investment policy and nationalization of
commercial banks. It describes structure, management, functions and role of SBI and RBI in economic
development. Besides, it dwells on India’s lead bank scheme, credit control methods and central banking
systems in India, the UK and the USA. The book concludes with a discussion on international financial
institutions such as IMF and IBRD.
The text is supported with examples, tables and figures. Chapter-end multiple choice questions and review
questions are also provided.
Besides the undergraduate students, this book will also be useful to the postgraduate students of Economics,
Commerce and Management.
THE AUTHOR
E. NARAYANAN NADAR, Ph.D., is Associate Professor and Head, Postgraduate Department of Economics,
V.H.N. Senthikumara Nadar College (Autonomous), Virudhunagar, Tamil Nadu. He has about 34 years of
teaching and research experience. He has been a member of various academic and government bodies.
Dr. Nadar has authored two more books on Managerial Economics, 2nd ed. (with S. Vijayan) and Statistics,
published by PHI Learning.
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MONEY

Part I: MONEY

1.6 Kinds of Money 11

2. Monetary Standards 29–44

3. Value of Money 45–72

4. Monetary Theories 73–101

4.2.3 Superiority of Income Theory of Money over Quantity Theory

5. Analysis of Interest Rates 102–116

6. Analysis of Inflation and Deflation 117–137

7. Trade Cycles 138–148

8. Money Market 149–164

8.4 Institutions of Money Market 150

9. Capital and Stock Markets 165–175

10. Monetary Policy 176–187

Part II: BANKING

11. An Introduction to Banking 191–203

11.8.4 Savings Banks 200

12. Functions of Commercial Banks 204–209

13. Credit Creation Process of Commercial Banks 210–218

15. Investment Policy of Commercial Banks 225–228

16. Nationalization of Commercial Banks 229–235

17. State Bank of India 236–244

18. Commercial Banks and Economic Development 245–250

19. India’s Lead Bank Scheme 251–255

20. An Introduction to Central Banking 256–261

21. Functions of a Central Bank 262–266

22. Credit Control Methods 267–272

23. Central Banking System in India 273–282

23.1.2 Indirect Financing 273

24. Reserve Bank of India and Economic Development 283–287

25. Central Banking System in the USA 288–293

26. Central Banking System in the UK 294–299

27. International Financial Institutions 300–311

1.1 Meaning of Barter System

1.2 Inconveniences of Barter System

1.2.1 Lack of Double Coincidence of Wants

1.2.2 Lack of Common Measure of Value

Another inconvenience of barter system is that there is no common measure of value of

1.2.3 Lack of Divisibility of Goods

1.2.4 Lack of Common Store of Value

1.2.5 Lack of Deferred Payments

1.2.6 Lack of Specialization

1.2.7 Difficulty of Exchanging Services

1.2.8 Difficulty of Transporting Goods

1.2.9 Inconveniences of Borrowing and Lending

1.3 Origin and Evolution of Money

1.3.2 Evolution of Money

The different stages of the evolution of money are discussed below:

1.4 Meaning and Definitions of Money

1.5 Characteristics of Money

1.6 Kinds of Money

1.6.1 Money of Account

1.6.2 Money Proper

Legal tender money

1.7 Functions of Money

1.7.1 Primary Functions

1.7.2 Secondary Functions

Standard of deferred payments

1.7.3 Contingent Functions

Contingent functions of money include the following:

Measurement and distribution of national income

Equalization of marginal utilities

Basis of credit system