In a modern economy, money acts as a universally accepted instrument to facilitate exchange. Without money, economic transactions rely on direct barter, which is highly inefficient.
Economic exchanges without the mediation of money are called barter exchanges. This system has several major drawbacks:
Money overcomes the limitations of barter by performing three primary functions:
Modern economies are increasingly moving toward a cashless society, where financial transactions are conducted digitally rather than through physical banknotes or coins. In India, key initiatives driving financial inclusion and digital payments include:
The demand for money represents the desire of individuals and firms to hold liquid cash balances instead of interest-earning assets. This is driven by two primary motives.
People hold cash to carry out day-to-day transactions because receipt of income and expenditure patterns do not perfectly align. The transaction demand for money ($M^d_T$) is positively related to the level of nominal income and real GDP:
Where $T$ is the total value of transactions and $k$ is a positive fraction. This can also be expressed in terms of the velocity of circulation of money ($v$), which is the number of times a unit of money changes hands during a unit period:
In terms of nominal GDP ($PY$), the transaction demand is written as:
An individual can hold wealth in the form of money or bonds. Bonds yield interest but their market price fluctuates. The price of a bond is inversely related to the market rate of interest:
Where $PV$ is the present value (market price) of the bond and $r$ is the market interest rate. Speculative demand for money ($M^d_S$) arises because wealth holders speculate on future interest rate movements:
The speculative demand function is formulated as:
If the market rate of interest falls to an extremely low level ($r = r_{\text{min}}$), everyone expects it to rise in the future. Nobody wants to hold bonds, and everyone prefers to hold cash. At this point, the speculative demand for money becomes infinitely elastic. This extreme state is called a liquidity trap.
Total demand for money ($M^d$) is the sum of transaction demand and speculative demand:
Money supply is a stock variable representing the total stock of money in circulation among the public at a particular point in time. It is created by the joint action of the Central Bank and Commercial Banks.
Commercial banks can create credit (money) far in excess of their initial deposits because they operate on the assumption that not all depositors will withdraw their funds at the same time. When a bank grants a loan, it does not give cash; instead, it opens a demand deposit account in the borrower's name, thereby expanding the money supply.
The limits to credit creation are determined by the Central Bank through reserve requirements:
The total amount of deposits that the banking system can create from an initial deposit is determined by the money multiplier:
For example, if the CRR is 20% ($0.2$), the money multiplier is $5$. An initial deposit of Rs 100 can support total deposits of Rs 500 ($5 \times 100$), allowing the bank to extend loans up to Rs 400.
| Round | Deposit in Bank (Rs) | Required Reserve (20%) (Rs) | Loan Made by Bank (Rs) |
|---|---|---|---|
| 1 | 100.00 | 20.00 | 80.00 |
| 2 | 180.00 | 36.00 | 64.00 |
| ... | ... | ... | ... |
| Last | 500.00 | 100.00 | 400.00 |
The Reserve Bank of India (RBI) regulates the money supply and credit availability in the economy using quantitative and qualitative instruments.
These tools control the overall volume of credit and money supply in the economy:
These tools regulate the direction of credit to specific sectors of the economy:
The RBI publishes four alternative measures of money supply, categorized by their degree of liquidity.
The measures are defined as follows:
In November 2016, the Government of India undertook demonetisation, declaring high-denomination notes (Rs 500 and Rs 1000) invalid as legal tender. The primary objectives were: