BANKING

Bank
It is an institution which receives funds from the public
and gives loans and advances to those who need them.

Commercial Bank
It is an institution that accepts deposits from the general
public and gives loans with the sole purpose to earn
profit.

Q. Explain the process of money creation by

commercial banks with the help of a
numerical example.
OR
Q. How does the commercial bank creates
money?
OR
Do you consider a commercial bank creator of
money in the economy?
Answer: The currency created by the central bank is
called high powered money. Commercial banks receive
deposits from the public. The banks use the money in
these deposits to give loans. The functions of commercial
banking system are the basis of deposit creation.

THE PROCESS OF MONEY CREATION

Let us assume that the entire commercial banking system
is one unit. Let us call this one unit simply banks. One
who makes payment does it by writing Cheque. The one

who receives payment deposits the same in his deposit

a/c

Deposit creation by commercial banks

ROUNDS
DEPOSITS
LOANS
CASH
RESERVES
INITIAL
100
80
20
ROUND I
80
64
16
ROUND II
64
51.20
12.80
TOTAL
500
400
100
Suppose initially people deposit Rs100, the bank use this money
for giving loans. But the banks use the whole of deposit for this
purpose. It is legally compulsory for the banks to keep a certain
minimum fraction of these deposits as cash. The fraction is called
Legal Reserve Ratio (LRR). The LRR is fixed by the Central Bank. It
has two components, a part of LRR is to be kept with the Central
Bank and this part of the ration is called Cash Reserve Ratio(CRR).
The other part is kept by the bank themselves and is called
Statutory Liquidity Ratio(SLR).
Suppose the initial deposit in bank is Rs100 and the LRR 20%.
Further suppose that banks keep only the minimum required
Rs20 as cash reserve. Banks are now free to lend the remainder
Rs80. Suppose they lend Rs80, banks open an account in the
name of the borrowers who are free to withdraw the amount
whenever they like. Now since all the transactions are routed
through the banks, the money spent by the borrowers comes
back into the banks in the deposit accounts of those who have
received this payment. This increases demand deposits in bank
by Rs80. When banks receive new deposit of Rs 80, the banks
keep 20% of it as cash reserve and use the remaining Rs64(8016) for giving loans. The borrowers use these loans for making
payments. The money comes back into the accounts of those who
have received the payments. Bank deposit again rise but by
smaller amount of Rs64. The total deposit creation comes to
Rs500.

Money Multiplier
Money Multiplier =

1
LRR

Ex: Multiplier= 1 =5
0.2
It is the number of times the total deposits would be of the initial
deposits determined by the LRR.
The Total Money Creation= Initial deposit x 1
LRR

What are the functions of Central Bank of an

Economy. Explain?
Answer:

1)Currency Authority :
It is the sole authority for the issue of currency in the country. The
central bank is permitted to issue notes to any extend provided a
minimum reserve in the form of gold and foreign securities. In our
country, RBI has to keep a reserve of Rs200 cores in which there
is gold of Rs115 cores and foreign securities of Rs85 cores.
Putting and withdrawing currency into and from circulation is also
the job of its banking department.
Ex: When the government incurs a deficit in the budget, it
borrows from the Central Bank. This is done by selling treasury
bills to the Central Bank.

2)Banker to the government:

The central bank acts as a banker to the government of both
central and state. It carries out all the banking business of the
government and the government keeps its cash balances on
current a/c with the central bank. The central bank also provides
short term credit to the government, so that the government can
meet any deficit in its a/c. As governments banker the central
bank also has the responsibility of managing the public debt. This
means that the central bank has to manage all new issues of the
government loans. It also advices the government in banking and
financial matters.

3)Bankers Bank and Supervisor:

As banker to banks, the central bank holds a part of the cash
reserves of banks, lends them short term funds and provides
them centralized clearing and remittance facilities. The banks are
required to deposit a stipulated ratio of their net total liabilities
(CRR ) with the central bank. The purpose of this stipulation is to
use the reserves as an instrument of monetary and credit control.
The pool of fund with the central bank serves as a source from
which it can make advances to banks temporarily in need of
funds, acting in its capacity as Lender of last resort. The central
bank supervises and regulates and controls commercial banks.

What are the instruments of monetary policy of RBI?

OR
How does RBI stabilize money supply against exogenous
shocks?
OR
How does the central bank of an economy control credit
creation by commercial banks?
OR
What are Open Market Operations? How do these work as
a method of credit control?
OR
State the quantitative methods of credit control by the
Central Bank of the country
4) Controller of credit: The various credit policies of
monetary instruments used by the central Bank of the country
can be divided into:
a) Quantitative instruments.
b) Qualitative instruments.

Quantitative instruments
I)Bank Rate Policy- It is the rate at which central bank lends
funds to banks against approved securities or bills of exchange.
During times of inflation the central bank will increase the bank
rate. This will reduce the ability of banks to create credit, as
borrowing from the central bank becomes costlier for the
commercial banks. This will in turn discourage businessman and
others from taking loans, thus reducing the volume of credit.
During times of deflation, the central bank will reduce the bank
rate in such a way that it increases the ability of the commercial
bank to create credit. It will encourage businessman and others
from taking loans, thus increasing the volume of credit in the
economy.

ii)Open Market Operations- It is the buying and selling of

Government Securities by the central Bank from or the public or
banks.
During times of inflation, the central bank will sell the
Government Securities to banks or public, thus reducing their
reserves.
During times of deflation, the central bank will buy the
Government Securities from the banks or public, thus increasing
their volume of credit in the economy.
When the central bank buys securities from the banks, it gives the
bank a Cheque drawn on itself in payment for the securities.
When the Cheque clears, the central bank increases the reserves
of the bank by particular amount. This directly increases the
banks ability to give credit and thus increase the money supply.
When the bank gives the central bank a Cheque for the securities
the central bank collects the amount by reducing the banks
reserves by the particular amount. This directly reduces the
banks ability to give credit and therefore decreases the money
supply in the economy.

iii) Legal Reserve Ratio- Banks are required to maintain

reserves with the central Banks on two accounts:

a)Cash Reserve Ratio(CRR)

b)Statutory Liquidity Ratio(SLR)

a) CRRThe banks are required to deposit with the central bank a

percentage of their net, demand and time liabilities. Varying the
CRR is a tool of monetary and credit control and increase in CRR
has the effect of reducing the banks excess reserves and thus
certain their ability to give credit or vice versa.

b)SLRThe SLR requires the banks to maintain a specified percentage of

their net, demand and time liabilities in the form of designated
liquid assets which may be I)excess reserves ii)current account
balances with the other banks. Varying the SLR effects the
freedom of banks to sell Government Securities or borrow against
them from the Central Bank. Increasing the SLR reduces the
ability of banks to give credit and vice versa.

Qualitative instruments.
I)Imposing margin requirement on the secured
loansA margin is the difference between the amount of the loan and
the market value of the security offered by the borrower against
the loan. If the margin imposed by the central bank is 40% then
the bank is allowed to give a loan only up to 60% of the value of
the commodity. High margin requirements discourage speculative
activities with bank credit and therefore divert resources from
unproductive speculative activities to productive investments.

ii)Moral suasionThis is a combination of persuasion and pressure that the central

bank applies on the other banks in order to get them to fall in line
with its policy. This is exercised by discussion, letter, speeches
etc... The central bank frequently announces its policy position.

iii)Selective credit controlsThese can be applied in both positive as well as negative manner.
Application of selective credit controls in positive manner would
mean using measures to channel credit to particular sectors
usually the priority sectors. Application of Selective credit controls
in negative manner would mean using measures to restrict the
flow of credit to particular sectors.

iv) Custodian of foreign exchange reservesThe central bank is the custodian of a countries stock of gold and
international currencies. The central bank maintains the stability
of exchange of rates fixed by the government. All earnings in
foreign exchange transactions are to be deposited with the
central bank and are routed through it. By the sale and purchase
of foreign currencies in the market, central bank can bring the
external value of the currency at par with their internal values and
help the government to pursue a coordinated policy towards
balance of payment situation in a country.