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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 becomes NPA)

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.

Paytm payment 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.