Money and Banking Class 12 Notes: CBSE Economics Chapter 3

Money: Money is the most often used means of exchange. It is an economic unit that serves as a universally accepted means of exchange in a transactional economy. Money offers the benefit of lowering transaction costs, particularly the double coincidence of wants. There can be no exchange of commodities and thus no role for money in an economy consisting of only one person.

Barter Exchange: It is a trade in which one product or service is exchanged for another. It is the oldest form of commerce. Individuals and businesses exchange goods and services based on equivalent prices and good estimates. Individuals and businesses barter goods and services with one another based on similar pricing and quality assessments. Bartering, on a larger scale, can result in the most efficient use of resources by exchanging items in quantities that have equivalent values. Bartering can also assist economies in reaching equilibrium, which happens when supply and demand are equal.

Disadvantages of Barter Exchange:

1. A lack of a standardised means of measuring value.

2. There is a lack of desire for duplication.

3. A scarcity of common value measures.

4. Inadequate store of value.

5. Deferred payment standards are lacking.

6. Inability to divide.

Functions of Money: The functions of money are broadly classified as

1. Primary functions.

i. A mode of exchange.

ii. A common measure of value or a common unit of value.

2. Secondary functions: 

i. Value storage.

ii. Value transfer.

iii. Deferred payment standard.

Demand of Money: It is referred to as an individual's liquidity preference, which is the decision to hold money in liquid form, i.e., cash, to earn interest or as a precaution. Money demand is impacted by several factors such as inflation, income, interest rates, and future uncertainty. The two important motives for the demand of money: transaction, and speculative motives, are commonly used to describe how these elements affect money demand.

i. Transaction Motive: The drive to hold cash amounts is referred to as the transaction's motive. The fact that most transactions involve an exchange of money is the transaction motive for demanding money. Money will be demanded because it is necessary to have money available for transactions. The aggregate quantity of transactions in an economy tends to increase as income grows. As a result, as income or GDP rises, so does the demand for money in transactions.

ii. Speculative Motive: It refers to funds retained by investors to capitalise on potential investment opportunities in the economy. When retaining money is thought to be less hazardous than lending it or investing it in another asset, the speculative motive for demanding money emerges.

Aggregate Money Demand: In an economy, the entire demand for money is made up of transaction demand and speculative demand. The former is proportionate to real GDP and the price level, whereas the latter is inversely related to the market interest rate.

$\mathrm{M}^{\mathrm{d}}=\mathrm{M}_{\mathrm{T}}^{\mathrm{d}}+\mathrm{M}_{\mathrm{s}}^{\mathrm{d}}$

Where,
$\mathrm{M}_{\mathrm{d}} =\text { Money Demand }$

$\mathrm{M}_{\mathrm{T}}^{\mathrm{d}} =\text { Transaction Demand }$

$\mathrm{M}_{\mathrm{S}}^{\mathrm{d}} =\text { Speculative Money Demand }$

Fiat money: It is the currency that a government declares to be legal tender but is not backed by a physical asset. The value of fiat money is calculated by the link between supply and demand rather than the worth of the commodity used to make the money.

Supply of Money: It refers to the total money held by the public at a particular point in time in an economy. The supply of money does not include the cash balances held by the national and state governments, as well as the stock of money held by the country's banking system, because these are not in active circulation in the country.

Measures of Money Supply: 

i. $\mathrm{M}_{1}$: It is the first and basic measure of the money supply. It includes currency held by the public, demand deposits of commercial banks, and other deposits with the Reserve Bank of India (RBI).

$\mathrm{M}_{1} = \text { Currency and coins with public( C) + Demand deposits of the public with the banks(DD) } +\text { Other deposits (OD) }$

ii. $\mathrm{M}_{2}$:  It is also known as narrow money along with M1. It includes Savings deposits with Post Office saving banks.

$\mathrm{M}_{2}=\mathrm{M}_{1}+\text { Savings deposits with Post Office saving banks }$

iii. $\mathrm{M}_{3}$:  It also includes time deposits with a commercial bank and is known as broad money.

$\mathrm{M}_{3}=\mathrm{M}_{1}+\text { Net time deposits with commercial banks }$

iv. $\mathrm{M}_{4}$:  It includes the total deposits excluding National Saving Certificates and is also known as broad money along with M3.

$\left.\mathrm{M}_{4}=\mathrm{M}_{3}+\text { Total post office deposits excluding National Saving Certificates( } \mathrm{NSC}\right)$

Banking Systems:

1. Commercial Bank: A commercial bank is a type of financial organisation that handles all transactions involving the deposit and withdrawal of money for the public, as well as the provision of loans for investment purposes and other similar activities. These banks are profit-making enterprises that conduct business only to make a profit. State Bank of India and Canara Bank are some examples. 

2. Central Bank: In the banking system, the central bank is recognised as the highest financial institution. It is seen as an essential component of a country's economic and financial system. The central bank is an independent authority in charge of supervising, regulating, and stabilising the country's monetary and banking structures.

Money Creation by Banks: If the value of any of its constituents, such as CU, DD, or Time Deposits, changes, the money supply will alter. The public's preference for maintaining cash balances as opposed to bank deposits has an impact on the money supply. The following major ratios summarise these influences on the money supply.

1. The Currency Deposit Ratio: The currency deposit ratio (cdr) depicts the amount of currency held by individuals as a percentage of total deposits. For instance, CDR rises over the holiday season as people convert deposits to cash balances to cover extra expenses.

cdr = CU/DD

2. The Reserve Deposit Ratio: Banks keep a portion of the money customers keep in their bank accounts as reserve money and lend the rest to various investment initiatives. Reserve money is made up of two components: vault cash in banks and commercial bank deposits with the RBI. Banks use this reserve to meet account holders’ need for cash. The reserve deposit ratio (rdr) is the percentage of total deposits that commercial banks retain as reserves. 

Measures to bring forth a healthy Reserve deposit ratio:

I. Qualitative Measures

1. Cash Reserve Ratio (CRR): It is a portion of a bank's total deposits that the Reserve Bank of India requires to be kept with the latter as liquid cash reserves. When computing the base rate, one of the reference rates is the cash reserve ratio. The base rate is the lowest lending rate at which a bank is not permitted to lend money. The Reserve Bank of India sets the base rate. The rate is fixed, ensuring openness in the credit market when it comes to borrowing and lending.

2. Statutory Liquidity Ratio (SLR): It is essentially the reserve requirement that banks must maintain before extending credit to customers. Aside from the Cash Reserve Ratio (CRR), banks are required to keep a certain percentage of their net demand and time liabilities in liquid assets such as cash, gold, and unencumbered securities. Among other things, the statutory liquidity rate applies to dated securities issued under the market borrowing programme, treasury bills, and market stabilisation schemes (MSS). Banks must report their SLR maintenance to the RBI every other Friday, and penalties must be paid if the SLR is not maintained as required.

3. Bank Rate: A bank rate is the interest rate charged by a nation’s central bank to its domestic banks for them to borrow money. The interest rates charged by central banks are meant to stabilise the economy. The lending rates of commercial banks are affected by bank rates. Higher bank rates will result in higher bank lending rates. The central bank might raise the bank rate to reduce liquidity, and vice versa.

4. High-Powered Money: It is the money created by the RBI and the government, in which the public holds the currency, and the banks hold the cash reserves. It differs from money in that money consists of demand deposits, whereas cash reserves serve as a foundation for creating demand deposits.

High-powered money is the sum of commercial bank reserves and currency, which denotes the notes and coins held by the general public. The increase in bank deposits and the creation of a money supply are both based on high-powered money.

II. Qualitative Measures

1. Open Market Operation: It refers to the central bank's selling and purchase of securities on the open market to and from commercial banks or the general public. The open market operation is one of the quantitative techniques used by the Reserve Bank of India to smooth out liquidity conditions throughout the year and reduce the impact on interest and inflation rates. Changes in the Cash Reserve Ratio (CRR), bank rate, or open market operations are all examples of quantitative measures used to limit the size of the money supply.

2. Bank Rate Policy: The term "bank rate policy" refers to the central bank's manipulation of the discount rate to influence the economy's credit condition. The bank rate policy is based on the idea that changes in the bank rate are usually followed by comparable changes in the money market rate, making credit more expensive or less expensive and impacting demand and supply.

3. Sterilisation by RBI: Sterilising is the RBI's market-based technique for neutralising a portion or all of the monetary impact of foreign inflows. Sterilising is the RBI's market-based technique for neutralising a portion or all of the monetary impact of foreign inflows. The sterilising procedure is used to alter the value of one local currency compared to another and is launched in the foreign exchange market. Sterilisation in the traditional sense entails central banks buying and selling on open markets.

What is Money?

In the first half of Chapter 3 Macroeconomics Class 12 Notes, money is rightfully defined. Anything which is accepted as a medium of exchange and simultaneously acts as a measure, store of value and standard of deferred payment is termed ‘money’.

What are the Functions of Money?

The functions of money are classified into three categories namely primary functions, secondary functions and contingent functions.

Primary Functions:

• Medium of Exchange.

• A general gauge of value or unit of value.

Secondary Functions:

• Benchmark of deferred payment.

• Store of value.

• Transfer of value.

Contingent Functions:

• Basis of credit.

• Liquidity.

• Profit statement to the producers.

• Ultimate satisfaction to the consumers.

• The foundation of the price mechanism.

• Source of distribution of income.

What is Barter Exchange and What are the Difficulties Involved in the Barter Exchange?

In the Macroeconomics class 12 Chapter 3 Notes, ‘barter exchange’ is defined as the direct exchange of commodities for commodities without using money as the medium of exchange.

Problems in the Barter Exchange:

• An inadequate common measure of value.

• Insufficient amount of double coincidence of wants.

• Absence of benchmark of deferred payments.

• Commodities cannot be divisible.

• Exchange of services cannot be possible in the Barter Exchange.

Supply of Money

In the Class 12 Macroeconomics Chapter 3 Notes, ‘supply of money’ refers to the aggregate stock of money (currency notes, coins and demand deposits of banks) in the distribution or are held by the public at a certain point in time.

The cash balance held by the Central or State Govt and the stock of money acquired by the banking system of a country is not included in the Supply of Money. Hence,

Measures of Money Supply = Currency possessed by the public + Net Demand Deposits possessed by commercial banks.

M1 = C + DD + OD

Where, 

C stands for currencies and coins possessed by the public.

DD stands for Demand Deposits in the name of the public with the banks.

OD stands for other deposits.

M2 = M1 + POSB deposits.

M3 = M1 + Time Deposits of Commercial Banks.

M4 = M3 + Total POSB Deposits excluding the deposit on National Savings Certificates.

What do you Mean by a Bank and Banking System?

As per Class 12 Economics Chapter Money And Banking Notes, the financial institution in which deposits are accepted from the public and loan facilities for investment are provided is termed a Commercial Bank. The main aim of the services provided by commercial banks is to earn profits.

What are the Functions of Commercial Banks?

Functions of commercial banks are classified into two categories namely primary functions and secondary functions.

Primary Functions:

• Recognising deposits.

• Giving loans.

• Discounting bill of exchange.

Secondary Functions:

a) Agency Functions:

• Fund transfer.

• Fund collection.

• Buying and selling of shares and securities on behalf of the customers.

• Playing the role of executor and trustee of a will.

• Playing the role of correspondent and representative of the customer and offering letters of credit to the customers.

b) General Utility Functions:

• Buying and selling of foreign exchange.

• Issuance of cheques of travellers.

• Secured custody of costly commodities in lockers.

• Endorsing of securities.

What is Central Bank and What are its Roles?

The apex institution of the financial system of a particular country is known as the Central Bank.

Roles of Central Bank:

• Bank of issue.

• Banker of the Government.

• Bank and Supervisor of the Bankers.

• Credit controlling authority.

• Lender of ultimate resort.

• Foreign exchange reserves are secured in the Central Bank.

5 Important Topics of Class 12 Chapter 3 you shouldn’t Miss!

Importance of Class 12 Economics Chapter 3 Revision Notes

• Revision notes for Class 12 Economics Chapter 3, "Money and Banking," are invaluable tools for effective exam preparation. 

• These notes distil the chapter's key concepts, such as the functions of money, the role of commercial and central banks, and the mechanisms of monetary policy, into concise, easy-to-understand summaries. 

• By focusing on the most important points, revision notes help students quickly review and reinforce their understanding of complex topics. 

• They also highlight important details that are often tested in exams, making them essential for scoring well.

Tips for Learning the Class 12 Economics Chapter 3 Money and Banking

• Start by understanding the fundamental functions of money, such as its role as a medium of exchange, a store of value, and a unit of account. This foundational knowledge will help you comprehend more complex concepts later in the chapter.

• Familiarise yourself with the different measures of money supply (M1, M2, M3, M4) and their significance in the economy. Knowing how these categories are defined and used will aid in understanding monetary policy.

• Pay close attention to how commercial banks operate, particularly the process of credit creation and its impact on the economy. Understanding the role of banks in money creation is important for understanding this chapter.

• Study the functions of the central bank, including tools like the cash reserve ratio (CRR), repo rate, and open market operations. Understanding how the central bank controls the money supply and maintains economic stability is key.

• Focus on the objectives and instruments of monetary policy. Learn how the central bank uses these tools to control inflation, influence interest rates, and stabilise the currency, which is essential for managing the economy.

• Some topics, like credit creation and money supply, involve numerical calculations. Practice these problems regularly to ensure you’re comfortable with the calculations required in exams.

Conclusion

Chapter 3 of Class 12 Economics, Money and Banking provides a thorough understanding of the critical role that money and financial institutions play in the economy. It explores the fundamental functions of money, the operations of commercial banks, and the pivotal role of central banks in regulating the money supply and ensuring economic stability. By understanding this chapter, students gain essential insights into how monetary systems function and how policies are crafted to maintain economic equilibrium.

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