Money, Banking and Monetary Policy
Money, Banking and Monetary Policy
This domain covers the functions and measures of money, commercial bank credit creation, and the RBI's monetary policy instruments. The exam tests definitions of money supply, the money multiplier, and the use of repo rate, CRR, SLR and open market operations.
Core rules
- Money acts as a medium of exchange, unit of account, store of value and standard of deferred payment. Its main drawback is that inflation erodes purchasing power.
- Money supply measures: M1 = currency with the public + demand deposits + other deposits with RBI; M2 = M1 + savings deposits with post office savings banks; M3 = M1 + net time deposits; M4 = M3 + total post office deposits. M1 is narrow money; M3 is broad money.
- Commercial banks create credit through lending. The credit multiplier = 1 ÷ reserve ratio. If the reserve ratio is 10%, a fresh deposit of ₹1,000 can create total deposits up to ₹10,000.
- RBI instruments: repo rate (lending to banks), reverse repo (absorbing liquidity), CRR (cash reserve ratio), SLR (statutory liquidity ratio), open market operations and margin requirements.
- To control inflation, RBI raises repo rate, CRR and SLR and sells securities. To counter recession, it lowers them and buys securities.
Worked example
A bank receives a new deposit of ₹5,000. The reserve ratio is 20%. Required reserves = ₹1,000; excess reserves = ₹4,000. The credit multiplier is 1 ÷ 0.20 = 5. Total deposit creation in the banking system = ₹5,000 × 5 = ₹25,000, of which ₹5,000 is the original deposit and ₹20,000 is newly created credit. Actual creation may be lower if banks hold excess reserves or the public holds more currency.
Traps
CRR and SLR are reserve requirements, not interest rates charged to borrowers. Repo rate is not the rate RBI pays banks. Do not count currency held by banks as part of money supply with the public. The multiplier works on excess reserves, not on total deposits. Remember that M3, not M1, is the broad measure.