Money, Banking and Inflation
Domain 8 covers the functions of money, the money supply, credit creation by commercial banks, the RBI instruments and the causes and effects of inflation.
Money and banking
- Money removes barter problems: double coincidence of wants, lack of a common measure, indivisibility, storage difficulty.
- Functions: primary (medium of exchange, unit of account), secondary (store of value, deferred payments), contingent (credit).
- Money supply measures in India: M1 = currency + demand deposits + other deposits with RBI; M2 = M1 + post office savings; M3 = M1 + time deposits; M4 = M3 + total post office deposits. M1 is narrow money, M3 broad money.
- Credit creation: total deposits = primary deposit x 1/reserve ratio. Leakages: cash holding, excess reserves, weak demand for loans.
- RBI tools: CRR, SLR, repo, reverse repo, bank rate, open market operations.
Inflation
- Demand-pull (too much money chasing too few goods) versus cost-push (rising input and wage costs).
- Types by rate: creeping, walking, running, galloping, hyperinflation.
- Effects: debtors and businessmen gain, creditors and fixed-income earners lose; exports become less competitive.
Worked example
Primary deposit = Rs 1,000; CRR = 10 percent. Credit multiplier = 1/0.10 = 10. Total credit creation = 1,000 x 10 = Rs 10,000, of which Rs 1,000 is the original deposit and Rs 9,000 is newly created credit.
Traps
- Mixing up CRR (cash balances with RBI) and SLR (liquid assets held by the bank itself).
- Saying inflation benefits creditors; it harms them.
- Writing that credit creation is unlimited; reserves and leakages limit it.
- Confusing repo (RBI lends to banks) with reverse repo (RBI absorbs liquidity).