Money Market

Economics

Barter System

The barter system refers to the direct exchange of goods and services without the involvement of money. This was the earliest form of trade practiced in human history. For instance, a person could exchange milk for rice, or wheat for cloth. Essentially, one commodity was traded for another based on mutual needs.

However, the barter system had several significant limitations:

  1. Lack of a Common Measure of Value: There was no standard way to determine how much of one good was worth in terms of another. For example, how much rice equals one meter of cloth?
  2. Absence of Double Coincidence of Wants: This means that for a transaction to occur, both parties needed to want what the other was offering. For example, if one person wanted cloth and offered rice, but the person with cloth didn’t want rice, the exchange couldn’t take place.
  3. Storage Issues: Many goods used in barter (like grains, milk, or livestock) could not be stored easily for long periods, making them unsuitable for large-scale or long-term trade.
  4. Lack of Divisibility: Certain goods could not be divided without losing value or usability. For example, splitting a cow for trade isn’t practical.

These inefficiencies led to the eventual discovery and adoption of money as a universal medium of exchange.

Money

Money is anything that is generally accepted as a medium of exchange for goods and services. It enables efficient trade by eliminating the shortcomings of the barter system.

It is considered the most liquid asset, meaning it can be easily exchanged for goods and services without loss of value or delay. This universality of acceptance gives money its critical role in modern economies.

Functions of Money

  1. Medium of Exchange: Money facilitates the buying and selling of goods and services without the need for direct barter.
  2. Common Measure of Value: All goods and services are priced in terms of money, allowing for consistent valuation and comparison.
  3. Store of Value: Money can be saved and used in the future. It holds value over time, enabling people to defer consumption.
  4. Standard of Deferred Payment: Money allows for future payments or credit transactions. For example, loans taken today can be repaid in installments over time using money.

Opportunity Cost of Holding Money

Money that is held as cash does not earn interest. If the same amount were invested, say in a fixed deposit, it would generate returns. Hence, the opportunity cost of holding money is the potential interest or return foregone.

Motives for Holding Money

  1. Transaction Motive: People hold money to meet day-to-day expenses and regular transactions.
  2. Speculative Motive: Money is held to take advantage of future investment opportunities, such as changes in interest rates or prices of financial assets.
  3. Precautionary Motive: Money is also held as a safeguard against unexpected emergencies, like illness, accidents, or sudden job loss.

Note: Besides physical currency (notes and coins), demand deposits in banks (e.g., savings or current accounts) are also considered money because cheques and digital instruments drawn on these accounts can settle payments.

Promise from RBI Governor

Every Indian currency note carries a promise by the Governor of the Reserve Bank of India (RBI). This promise ensures that the note will be accepted as valid payment equal to the amount printed on it. The same principle applies to coins.

Fiat Money & Legal Tender

Monetary Aggregates (Measures of Money Supply)

Monetary aggregates are categorized based on liquidity and functionality.

M1 (Narrow Money)

M1 = C + DD + OD

Since M1 includes most liquid forms of money, it is called narrow money.

M2 (Narrow Money)

M2 = M1 + Savings Deposits with Post Office Banks

M3 (Broad Money)

M3 = M1 + Time Deposits with Commercial Banks

M4 (Broad Money)

M4 = M3 + Total Deposits with Post Office Banks
(excluding National Savings Certificates, Kisan Vikas Patra, etc.)

Though cheques can be drawn on demand deposits, they can be refused by payees. Hence, they are not legal tender, unlike currency notes and coins.

Types of Deposits Held by Banks

Demand Deposits: Withdrawable at any time without prior notice. Includes: - Savings Accounts - Current Accounts - Highly liquid and usable for daily transactions.

Time Deposits: Withdrawable only after maturity (or with a penalty). Includes: - Fixed Deposits (FDs) - Recurring Deposits (RDs) - Partial liquidity, often used for savings and interest income.

Other Deposits: Deposits held by financial institutions or foreign central banks with the RBI.

Monetary System in India

India follows the Minimum Reserve System (MRS) for currency issuance. This replaced the Proportional Reserve System in 1956.

Minimum Reserve Requirements:

RBI must maintain a minimum reserve of ₹200 crore:

Beyond this minimum, RBI can issue unlimited currency backed by:

Credit Creation by Banks

Assets and Liabilities:

Fractional Reserve Banking:

Money Multiplier

Lender of Last Resort

In times of financial crisis or liquidity shortage, the RBI provides emergency funds to banks to prevent collapse. This role is termed as the Lender of Last Resort, helping prevent bank runs and maintaining trust in the banking system.

Money in Circulation

Digital Currency

Digital currency exists only in electronic form and is stored or exchanged via digital systems.

Examples:

Cryptocurrency vs Digital Currency

Feature Cryptocurrency Digital Currency (CBDC)
Issuing Authority Decentralized (not regulated) Centralized (issued by RBI or CB)
Transparency Public ledger (blockchain) Private ledger
Legal Status No legal backing Legal tender
Control Community-mined, peer-to-peer Regulated by Central Bank

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Subject: Economics

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