1 Summary Economics Class 40 ## FIAT MONEY (5:05 PM): - "Fiat" means 'by order'. - It means that it serves as money by the order of the government. - This type of money is issued without backing an equivalent amount of gold/silver. - There is no obligation on any person to accept this money as a medium of exchange. ## Legal Tender: - This is compulsory to accept this type of money to settle any monetary obligation. - It is money that is recognized by the law of the land as valid for payment of debt. - **RBI Act 1934**gives the central bank the sole right to issue banknotes. - Every bank note shall be a legal tender at any place in India in payment for the amount expressed therein. - So the government can issue fiat money, and declare it to be a legal tender. - Coins are issued by the Government of India under the **Coinage Act 1906.** - The one-rupee note is issued by the **Ministry of Finance**(Government of India) under the **Currency Ordinance 1940.** ## Types of Legal Tenders: - **Unlimited Legal Tender:** - Currency notes are unlimited legal tender and can be used for dues of any size. - **Limited Legal Tender:** - It is compulsory to accept this as a means of payment, but only up to a certain limit. - **For example-**50 paise coins cannot be used to make payments of more than 10 rupees. - | | | --- | | - **Gold Standard-**28 gram 1-ounce gold was pegged equal to 35 USA dollars. - $ was also made **convertible-**The USA Federal Reserve was to give 1 ounce of gold in return for every 35 US dollars. - The gold reserves hence affected the amount of USA dollars printed. - Rest countries could get their currencies converted to US dollars. - The gold standard system continued till 1971. - After 1971, USA dollars were not pegged to gold and could print as many dollars as it wished. | ## Non- Legal Tender/Option money: - **Fiduciary money:** - This type of money is accepted based on trust between the payee and the payer. - **For example-** Cheques. ## Near Money/Quasi money: - It refers to highly liquid assets which can be quickly converted into cash. - These are generally non-cash assets that are liquid but cannot be used directly for transactions. - **For example-**Money in fixed deposits. ## Crypto Currency: - This is a type of digital asset that is traded online. - Because of their decentralized structure, they can exist independently of government or central authority. - Cryptocurrencies are not widely accepted as money due to their legal tender status. - **El Salvador** is the first country to accept crypto coins as legal tenders. ## ASSETS & LIABILITIES RBI (5:30 PM): - When RBI is issuing money, its assets should match its liabilities. ## Assets: - Government securities through which the government borrows money from RBI and returns principal and interest. - Gold coins that RBI is holding. - Foreign Securities. - RBI buys coins and 1 rupee notes from the government which it circulates as an agent of the government. ## Liabilities of RBI: - Total currency notes, except coins and 1 rupee notes( they are a liability if the central government). - Currency held by the public. - Currency held by banks in vault cash. - Other deposits in RBI. ## Money Supply: - It refers to the total volume of money held by the public at a particular point in time in an economy. - Here public only includes money users and not money creators. - It is a **stock concept**as it is concerned with a particular point in time. ## Stock Variable: - Measured at a particular point in time. - It does not have a time dimension. - It is a static concept. - **For example-**money supply, balance in the bank account, etc. ## Flow Variable: - It refers to a variable that is measured over a period of time. - It has a time dimension, as its magnitude can be measured over a period of time. - It is a dynamic concept. - **For example-** National income. - | | | --- | | **Bill Discounting:** - Under discounting, a company will sell its invoice (to be paid) to another financier (a bank or financial institution) which will pay the outstanding amount at a due date. - This is used if the buyer will pay after some time, but the seller needs immediate payment. - A negotiable bill may be generated as per the invoice of the goods sold. - This can work as a mechanism for short-term borrowing. - **Rediscounting** the bills will happen if some other entity (bank or financial institution) buys the bill before its due date. | ## FRACTIONAL RESERVE SYSTEM (6:00 PM): - This system means that a fraction of the deposits received by the banks must be kept as reserves with the bank. - If we assume that all banks function as a single unit, and all transactions happen only through banks. - Let us assume that initially 1000 rupees was put into the system. - As all transactions happen only through the banks, all the loaned-out money will be deposited back into the bank as a deposit - | | | | | --- | --- | --- | | **Deposit** | **Loans Given** | **The legal Reserve Ratio ( CRR, SLR, etc.)** assumed to be 20% | | 1000 | 800 | 200 | | 800 | 640 | 160 | | 640 | 512 | 128 | - This table will go on till we get the initial deposit entered as a reserve. - New money is also entering the bank. - | | | | | --- | --- | --- | | **Deposit** | **Loans Given** | **LRR** | | 5000 | 4000 | 1000 | - So banks created 5000 rupees from the initial deposit of 1000 rupees. - This happened due to the money multiplier effect. ## Money Multiplier & Money Creation: - Through this concept, banks are able to create credit that is in far excess of the initial deposits. ## Assumptions: - I. Entire commercial banking system is one unit and it is termed as a bank. - II. All the receipts and payments are routed through the bank. - Money Multiplier = 1/Legal Reserve Ratio. - The money multiplier is the amount of money that banks are able to create in the form of deposits. - In the above example, the total deposits become five times the initial deposits. - 5 times is the value of the money multiplier. - Deposit creation will come to an end when total reserves become equal to initial deposits. - Less reserve ratio, or LRR would mean banks will have more money to give out as loans. - So money multiplier will be higher in this case. ## MEASURES OF MONEY SUPPLY (6:30 PM): - | | | | | | | | --- | --- | --- | --- | --- | --- | | **Indicator** | **Currency & Coins (CU)** | **Bank's (DD)Demand Deposits (CASA)** | **Bank's (TD)Time Deposits (FDRD)** | **Post Office's(DD) Demand Deposits (CASA)** | **Post Office's (TD)Time Deposits (FDRD)** | | M1 | Includes | Includes | Excludes | Excludes | Excludes | | M2 | Includes | Includes | Excludes | Includes | Excludes | | M3 | Includes | Includes | Includes | Excludes | Excludes | | M4 | Includes | Includes | Includes | Includes | Includes | - M1= CU + DD of banks + Other deposits with RBI. - M2 = M1 + Post Office savings deposits. - M3= M1 + Term Deposits of banks = CU + NDTL + Other deposits with RBI. - M4= M3 + Total Post Office Deposits. - Deposits here include only deposits from the public and not interbank deposits. - Cash Reserves of commercial banks are not treated as a component of the money supply. - Because the cash held by the creators, and suppliers of money (RBI, Government, and Banks) is never treated as a component of the money supply. - M1 is the most liquid and M4 is the least liquid. - M1 & M2 are part of narrow money and M3 & M4 are part of broad money. - M3 is the most commonly used measure of the money supply. ## Currency Deposit Ratio(CDR): - CDR = Currency held by the public/Deposits of the public in the banks. - If CDR =1, it will mean that whenever an individual gets an amount of cash(say rupees 100), then he will keep rupees 50 as cash and 50 as a deposit in banks. ## TYPES OF DEPOSITS (7:10 PM): - **Demand Deposits:** - Funds held in demand deposits can be withdrawn at any time on demand. - They can be demanded back by the account holder at any time and there is no fixed term of maturity of these. - **For example-** CASA deposits- Current Accounts & Savings Accounts. - Funds held in time deposits can be withdrawn only by giving advance notice to the depositing institution. - The deposits are held for a specific time period or maturity. - **For example** Recurring Deposits and Fixed Deposits( FD) - **Recurring deposits:** - They are suitable for people who do not have a lumpsum amount of savings but are ready to save a small amount every month, quarterly, or half-yearly. - Such deposits earn interest on the amount already deposited as applicable to FD. ## Reserve Money: - It is also called base money because reserve money represents the base level for the money supply. - Components of reserve money include Currency in circulation, banker's deposits with RBI, and other deposits with RBI. - Other deposits are minor components and they include deposits of primary dealers, quasi-government entities, foreign institutions/entities, etc. ## Stressed Assets Classification: | | | | | --- | --- | --- | | Special Mention Accounts (SMA) -0 | Special Mention Accounts (SMA) -1 | Special Mention Accounts (SMA) -2 | | Principal and interest not paid for 1-30 days | Principal and interest not paid for 31-60 days | Principal and interest not paid for 61-90 days( loan becomesNPA) | ## BANKING REFORMS IN INDIA (7:35 PM): - **Scheduled Banks:** - The banks which have obtained banking licenses from RBI under **Banking Regulation Act** 1949. - These banks have submitted to greater regulations, in return for more freedom to do banking operations. - They are placed in the second schedule of the Banking Regulation Act 1948, hence the name. - Banking reforms have largely revolved around **two aspects:** - Keeping the banking/financial system of India robust & include more and more people in the banking net( financial inclusion). - **Financial Inclusion** was felt inevitable to ensure the financial security of the poor farmers. - The institutionalization of credit was expected to push the farmers away from the clutches of the moneylenders. - Achieving financial inclusion and socialistic re-distribution were the driving factors behind **Banks' Nationalization.** - Nationalization of banks was felt necessary because private banks were not interested in setting up branches in rural or far-flung areas due to profitability concerns. - In 1969, 14 banks were nationalized and 6 more banks were nationalized in 1980. - The **Jan Dhan Yojana**aims to achieve financial inclusion. - Financial inclusion helps in channeling money into the formal banking system. - To improve financial inclusion, the government and RBI have taken steps such as the Nationalization of banks, promotion of cooperative banking, setting up of Regional Rural Banks, etc. ## Regional Rural Banks( RRB) - They are based on the **Regional Rural Banks Act 1976,** after the recommendations of the **Narasimhan Committee** on rural credit. - They have been set up since the 1970s. - These are  set up in rural areas through the contribution of three parties: | | | | --- | --- | | Partner Entity | Ownership | | Central Government | 50% | | State Government | 15% | | Sponsor Bank | 35% | - **Universal Bank:** - The bank has the full-fledged banking functions of lending, taking deposits without limits. - **Differentiated Banks:** - They only perform specific functions of the banks. - Some major examples are: - **I. Small Finance Bank**: - They were recommended by the **Usha Thorat committee**in order to ensure financial inclusion. - They are designated small not as per their area of operation, but as per their scale of operations. - 75 % of the loans which the banks will extend can be of Rs 1 lakh only. - They are supposed to comply with all regulations and prudential norms like CRR, SLR CRAR, etc. - **II. Payment banks:** - These banks were introduced on the recommendation of the **Nachiket Mor committee.** - Banks are set up with the primary function of facilitating payments and reducing the cost of payments. - The money with payment banks can be invested in some safe avenues like gold and government bonds - These payment banks are not entitled to advancing loans. | | | --- | | Paytmpayment banks might appear giving out loans or have fixed deposits but they only add as intermediaries for other banks for such functions. | - So they can not issue credit cards and PSL norms are not applicable to them. - They can take deposits up to two lakh rupees( initially it was one lakh). - So they can issue debit cards. - They must also maintain CRR and SLR. ## On Tap License: - On-tap licensing means that interested parties can apply to RBI for a banking license at any time in the year. - Earlier, such applications were to be submitted only within a fixed time frame as prescribed by RBI. - Differentiated banks were given on-tap licenses. ## MicroFinance Institutions (MFI): - The clients of an**MFI** are often small entrepreneurs in need of economic support to launch their businesses. - This type of client is considered too risky by traditional banks because they cannot provide real collateral. - The idea of MFI was given by Nobel laureate **Mohammad Yunus of Bangladesh (Grameen Bank).** - MFI could not be successful in India as it was in Bangladesh. - Indian MFIs got listed on exchanges and released their shares. - After that, shareholders' profits became more important than welfare. - The higher profit was to be obtained by higher loan recovery and higher interest on loans. - **National Crime Records Bureau** report in 2015 told that around 80% of farmers who committed suicides took loans from MFIs. ## Opportunity Costs: - Opportunity cost is the forgone benefit that would have been derived from an option not chosen. - **For example-**the opportunity cost of preparing for UPSC exams can be the completion of another professional degree/diploma. ## The topic for the next class is the continuation of the banking system.