currency & banking poly copy.docx

Currency &

Banking

Year-II

INSTRUCTOR- : NEELABH KUMAR

| Currency & Banking 1

Unit 1


Introduction to Money

Money: An asset that is generally accepted as payment for goods and services or repayment

of debt.

There are two aspects of money, firstly it is a unit of account and secondly it is legal tender.

Statistical definitions of money (ECB)

a. M1: M1 is the first level of the money supply and includes the most liquid forms of

money: currency and demand deposits.

Currency: We generally think of currency as including the coins and paper money

spent on the purchase of goods and services.

Demand Deposits: are those deposits which are repayable on demand at commercial

banks. The holder of the account only needs to execute a demand (write a cheque)

and the money may be withdrawn immediately, on demand, without prior notice to

the bank. Of course the bank will not honour the demand if there are insufficient

funds in the account to meet the demand.

M1: Currency in circulation and overnight deposits. Currency= banknotes + coins.

b. M2: M2 is the second level of the money supply measurement. M2 adds time deposits,

and money market accounts to the M1 calculation.

Time Deposits: are those deposits which are not repayable on demand at commercial

banks. In this kind of deposits money is locked for a fixed period of time.

Money Market Accounts. Money market accounts are accounts that offer interest

rate returns that are competitive with short-term investments such as short term U.S.

Treasury bills. The investor in money market accounts can write checks against these

funds, however the number of checks that may be written are generally limited to

three per month

M2: M1 + deposits with agreed maturity of up to 2 years, and deposits redeemable at

a period of notice up to 3 months.


c. M3: M2 + repurchase agreements, money market fund shares, and units as well as debt

securities with a maturity of up to and including two years,

Forms of money

In the modern monetary systems, there are three forms of money in actual use: (i) Metallic

Money, (ii) Paper Money, and (iii) Credit Money. The first two kinds of money are in the

form of currency money and the last one is credit or bank money.

1. Metallic Money

Metallic money refers to coins made out of various metals like gold, silver, bronze, nickel,

etc. A coin is a piece of metal of a given size, shape, weight and fineness whose value is

certified by the State.

The right of minting coins is the monopoly of the State. The department of government

minting coins is called the Mint. Coins are of two types:

a. A coin is regarded as a standard coin or full-bodied coin if its "face value" (i.e., the

exchange value fixed by the issuing authority and printed on it) is equal to its

"intrinsic value", i.e., the worth of the metallic content of the coin. In the past, coins

made from precious metals like gold and silver were regarded as standard coins and

the monetary systems adopting them were referred to as "gold and silver standards."

b. A token coin refers to a coin having the face value of more than its intrinsic value

Token coins are usually made of cheap metals like nickel, copper or bronze. They are

generally of lower denominations. Token coins are issued primarily as a form of

subsidiary money which is to be used for small change only. They are useful as a

convenient means for the payment of small sums.

Since all types of coins are issued by the state authorities either the Treasury or the Central

Bank of the country they are regarded as legal tender.


Legal tender is a medium of payment allowed by law or recognized by a legal system to be valid

for meeting a financial obligation.[1] Paper currency and coins are common forms of legal tender

in many countries. In India, the status of legal tender is given only to the Indian rupee.

2. Paper Money:

Paper money consists of currency notes issued by the State Treasury or the Central Bank of

the country. In India, one rupee notes are issued by the Minister of Finance of the

Government of India, while all other currency notes of higher denominations are issued by

the Reserve Bank of India.

In modern era, the use of paper money is widespread owing to its following advantages:

a. Paper money is economical. Obviously, paper is much cheaper than any metal.

b. Paper money economises the use of precious and scarce metals by serving as

representative money.

c. It is very convenient to carry paper money from place to place.

d. It is also easy to store paper notes. Currency notes of lakhs of rupees can be stored in

a small vault.

e. It is easier to count paper notes than metallic coins.

f. Supply of paper money is easily adjustable as per the need of the economy. Thus,

paper money is of great monetary and fiscal advantages to the government.

However, paper money has also some disadvantages such as:

a. There is the danger of over issue of notes as they can be easily printed and their

supply depends upon the whim of the government. An excessive money supply may

lead to rising prices or inflation thereby reducing the value (purchasing power) of

money.

b. Paper money lacks general acceptability if the people lose confidence in the

government for one reason or the other.

c. Durability of paper money is much less than metallic money.

d. Paper money can circulate within the domestic economy only. For making foreign

exchange payments, paper money is not acceptable unless it is a key currency like the

dollar.


http://en.wikipedia.org/wiki/Coin

http://en.wikipedia.org/wiki/Currency

http://en.wikipedia.org/wiki/Legal_tender#cite_note-1

http://en.wikipedia.org/wiki/Payment

3. Credit Money:

In modern economic societies, with the development of banking activity, along with paper

money, another form of convertible money has developed in the form of credit money or

bank money.

Bank demand deposits, withdrawal by issuing cheques, have started functioning as money,

and cheques are now conventionally accepted as a mode of payment by the business

community in general.

It must be noted that a cheque by itself is just a credit instrument. Actually it is the bank

deposit behind the cheque that serves as money.

Bank money today constitutes a major part of money supply in advanced countries. In many

countries such as America, it amounts to nearly 90 per cent of the total money supply. In

poor countries, the proportion of currency money widely exceeds that of bank money.

Indeed, in a modern economy, currency money and bank money together constitute the total

stock of money or money supply. Currency money is a legal tender and has general

acceptability, whereas bank deposits are conventional money and lack general acceptability.

Functions of Money

The entire functions can be classified under three heads like primary functions, secondary

functions and contingent functions. Each of them is very briefly described below.

A. Primary Functions

a. Measure of value: Money is used as a tool to measure the value of goods and

services. In olden times commodities were used as money. But it lacks the quality of

measuring the value of goods and services. Money as a unit of account helps in

comparing the relative values of goods and services.


b. Medium of exchange: Medium of exchange is simply refers, using of money for

buying and selling. Now, we use money to purchase something and the same money

can be further use for anything what the shopkeeper wants. That is economic

transactions or exchanges are delivering through the medium of money.

B. Secondary Functions: Secondary functions of money include two functions like money

as a store of value and as a standard of differed payments.

a. Store of value: This function refers to the transferring of present purchasing power to

coming days or months. That is people hold money for aiming future. Since, money

has high liquidity people like to store value in terms of money.

b. Standard of deferred payments: Since the value of money is less stable (normally)

today’s credit transactions are accounted in money, but the debt may paid only in

future. Here the current credit transactions are measured in money with a future

value. This function of money may not true in economic instability conditions like

inflation, deflation etc.

C. Contingent Functions

a. Money assist to transfer of value

b. Medium for making compensations

c. Money determines total production and consumption etc.

d. National Income or total output of an economy are measure in money

e. The amount of is the base for determining the solvency of a person or a firm

Features of money

a. General Acceptability: Everybody must be prepared to accept the money in use. This is

the most important quality of money. People accept a thing as money which is used by

everybody as a medium of exchange. Gold and silver are considered good money


materials because they have alternative uses and are generally accepted. Paper notes are

accepted as money when they are issued by the central bank and/or the government and

largely legal tender money. Cheques and bills of exchange are not generally accepted.

Hence they are not money.

b. Durability: Money in circulation must be durable, that is, it should last for a reasonable

time without deterioration. Animals and perishable commodities are not good money

materials because they do not possess durability. In this sense, gold, silver, alloy, brass

etc. are the best materials which are used as money. Paper notes are less durable than

these metals. But they are money because they are legal tender.

c. Portability: Money should be easy to carry in both large and small amounts and should be

easily carried and transferred from one place to another. It should contain large value in

small bulk. Gold and silver possess this quality. Hence they are good money materials.

But they involve risk in carrying or transferring then, from one place to another therefore,

paper is considered as a better material and is used in the form of notes.

d. Cognizability: Everybody must easily recognize it by sight or touch as it the money in

use. Coins and currency notes of different denominations in different designs and sizes

meet this quality of good money.

e. Divisibility. Money should be easily divisible into a range of denominations in order to

ensure that goods of different prices can be purchased with the exact money or that

change can easily be given where money of a higher denomination is offered.

f. Scarcity: Money must be relatively scarce if it is to be acceptable

g. Homogeneity: This means that every money note or coin has the same buying power and

is identical in all respects to every other notes or coin of the same denomination.

Similarly, paper notes of one denomination must have the same quality of paper, design

and size.


h. Stability: Money should be stable in value because it has to serve as a measure of value.

Gold and silver possess this quality because they are not available in abundance. They are

neither very scarce because being durable, they can be easily stocked. Their supplies can

thus be increased or decreased when required. So they act as a store of value because

their value is stable. But governments prefer paper money to gold and silver because it is

cheap and easily available. Its value is kept stable by keeping control over its issue. It is

another thing that the central bank of a country is seldom able to exercise complete

control over its issue which makes paper money unstable in value.

Significance or Role of Money:

Money is of vital importance to an economy due to its static and dynamic roles. Its static role

emerges from its static or traditional functions. In its dynamic role, money plays an important

part in the life of every citizen and in the economic system as a whole.

1. Static Role of Money: In its static role, the importance of money lies in removing the

difficulties of barter in the following ways:

a. By serving as a medium of exchange, money removes the need for double coincidence

of wants and the inconveniences and difficulties associated with barter. The

introduction of money as a medium of exchange breaks up the single transactions of

barter into separate transactions of sales and purchases, thereby eliminating the double

coincidence of wants. Instead о exchanging commodities directly with commodities

i.e. С ↔ С, commodities as С → M → C, where С refers to commodities and M to

money.

b. By acting as a unit of account, money becomes a comes a common measure of value.

The use оf money as a standard of value eliminates the necessity of quoting the price

of apples in terms of or ganes, the price of or ganes in terms of nuts, and so on. Money

is the standard of measuring value and value expressed in money is price. The prices


of different commodities are expressed in terms of so many units of dollars, rupees,

pounds, etc. depending on the nature of monetary unit in a country. The measurement

of the values of goods and services in the monetary unit facilitates the problem of

measuring the exchange values of goods in the market.

c. Money acts as a standard of deferred payments. Under barter, it was easy to take loans

in goats or grains but difficult to make repayments in such perishable articles in the

future. Money has simplified both taking and repayment of loans because the unit of

account is durable. It also overcomes the difficulty of indivisibility of commodities.

d. By acting as a store of value, money removes the problem of storing of commodities

under barter. Money being the most liquid asset can be kept for long periods without

deterioration or wastage.

e. Under barter, it was difficult to transfer value in the form of animals, grains, etc. from

one place to another. Money removes this difficulty of barter by facilitating the

transfer of value from one place to another. A person can transfer his money through

draft, bill of exchange, etc. and his assets by selling them for cash at one place and

buying them at another place.

2. Dynamic Role of Money:

In its dynamic role, money plays an important part in the daily life of a person whether he is

a consumer, a producer, a businessman, an academician, a politician or an administrator.

Besides, it influences the economy in a number of ways.

a. To the Consumer: Money possesses much significance for the consumer. The

consumer receives his income in the form of money rather than in goods and services.

With money in hands, he can get any commodity and service he likes, in whatever

equaliser of marginal utilities for the consumer. The main aim of a consumer is to


maximise his satisfaction by spending his limited income on different goods which he

wants to purchase.

Since prices of goods indicate their marginal utilities and are expressed in money,

money helps in equalising the marginal utilities of goods. This is done by substituting

goods with higher utilities for others having lower utilities. Thus money enables a

consumer to make a rational distribution of his income on various commodities of his

choice.

b. To the Producer: Money is of equal importance to the producer. He keeps his account

of the values of inputs and outputs in money. The raw materials purchased, the wages

paid to workers, the capital borrowed, the rent paid, the expenses on advertisements,

etc. are all expenses of production which are entered in his account books. The sale of

products in money terms are his sale proceeds.

The difference between the two gives him profit. Thus a producer easily calculates

not only his costs of production and receipts but also profit with the help of money.

Further, money helps in the general flow of goods and services from agricultural,

industrial and tertiary sectors of the economy because all these activities are

performed in terms of money.

c. In Specialisation and Divisions of Labour: Money plays an important role in large

scale specialisation and division of labour in modern production. Money helps the

capitalist today wages to a large number of worker engaged in specialised jobs on the

basis of division of labour. Each worker is paid money wages in accordance with the

nature of work done by him. Thus money facilitates specialisation and division of

labour in modern production.

These, in turn, help in the growth of industries. It is, in fact, through money that

production on a large scale is possible. All inputs like raw materials, labour,

machinery, etc. are purchased with money and all output is sold in exchange for


money. As rightly pointed out by Prof. Pigou, “In the modern world industry is

closely enfolded in a garment of money.”

d. As the Basis of Credit: The entire modern business is based on credit and credit is

based on money. All monetary transactions consist of cheques, drafts, bills of

exchange etc. These are credit instruments which are not money. It is the bank

deposits that are money. Banks issue such credit instruments and create credit. Credit

creation, in turn, plays a major role in transferring funds from depositors to investors.

Thus credit expands investment on the basis of public saving lying in bank deposits

and helps in maintaining a circular flow of income within the economy.

e. As a Means to capital Formation: By transforming savings into investment, money

acts as a means to capital formation. Money is a liquid asset which can be stored and

storing of money implies savings, and savings are kept in bank deposits to earn

interest on them. Banks, in turn, lend these savings to businessmen for investment in

capital equipment, buying of raw materials, labour, etc. from different sources and

places. This makes capital mobile and leads to capital formation and economic

growth.

f. As an Index of Economic Growth: Money is also an index of economic growth. The

various indicators of growth are national income, per capita income and economic

welfare. These are calculated and measured in money terms. Changes in the value of

money or prices also reflect the growth of an economy. Fall in the value of money (or

rise in prices) means that the economy is not progressing in real terms. On the other

hand, a continuous rise in the value of money (or fall in prices) reflects retardation of

the economy. Somewhat stable prices imply a growing economy. Thus money is an

index of economic growth.

g. In the Distribution and Calculation of Income: The rewards to the various factors of

production in a modern economy are paid in money. A worker gets his wages,


capitalist his interest, a landlord his rent, and an entrepreneur his profit. But all are

paid their rewards in money. An organiser is able to calculate the marginal

productivity of each factor in terms of money and pay it accordingly. For this, he

equalises the marginal productivity of each factor with its price. Its price is, in fact, its

marginal productivity expressed in terms of money. As payments are made to various

factors of production in money, the calculation of national income becomes easy.

h. In National and International Trade: Money facilitates both national and international

trade. The use of money as a medium of exchange, as a store of value and as a

transfer of value has made it possible to sell commodities not only within a country

but also internationally. To facilitate trade, money has helped in establishing money

and capital markets. There are banks, financial institutions, stock exchanges, produce

exchanges, international financial institutions, etc. which operate on the basis of the

money economy and they help in both national and international trade. Further, trade

relations among different countries have led to international cooperation. As a result,

the developed countries have been helping the growth of underdeveloped countries by

giving them loans and technical assistance. This has been made possible because the

value of foreign aid received and its repayment by the developing countries is

measured in money.

i. In Solving the Central Problems of an Economy: Money helps in solving the central

problems of an economy; what to produce, for whom to produce, how to produce and

in what quantities. This is because on the basis of its functions money facilitates the

flow of goods and services among consumers, producers and the government.

j. To the Government: Money is of immense importance to the government. Money

facilitates the buying and collection of taxes, fines, fees and prices of services

rendered by the government to the people. It simplifies the floating and management

of public debt and government expenditure on development and non-developmental

activities. It would be impossible for modern governments to carry on their functions

without the use of money. Not only this, modern governments are welfare states


which aim at improving the standard of living of the people by removing poverty,

inequalities and unemployment, and achieving growth with stability. Money helps in

achieving these goals of economic policy through its various instruments.

k. To the Society: Money confers many social advantages. It is on the basis of money

that the superstructure of credit is built in the society which simplifies consumption,

production, exchange and distribution. It promotes national unity when people use the

same currency in every nook and corner of the country. It acts as a lubricant for the

social life of the people, and oils the wheels of material progress. Money is at the

back of social prestige and political power.

Inflation

Inflation has been defined

a. As a phenomenon of rising Prices: inflation is a "state in which the value of money is

falling, i.e. the prices are rising."

b. As a Monetary Phenomenon: inflation a "too much money chasing too few goods

Modern View: Generally two types of inflation are distinguished: demand pull inflation and

cost push inflation. In the demand pull inflation, inflation and falling unemployment are

supposed to go together, while in cost push inflation, inflation and rising unemployment are

supposed to occur simultaneously,

Features of Inflation

a. Inflation is always accompanied by a rise in the price level. It is a process of

uninterrupted increase in prices.

b. Inflation is a monetary phenomenon and it is generally caused by excessive money

supply.


c. Inflation is essentially an economic phenomenon as it originates in the economic

system and is the result of action and interaction of economic forces. Inflation is a

dynamic process as observed over the period.

d. A cyclical movement of prices is not inflation.

e. Pure inflation starts after full employment.

f. Inflation may be demand-pull or cost-push.

g. Excess demand in relation to the supply of everything is the essence of inflation.

Types of Inflation

There are different types of inflation which can be classified as under:

A. On the Basis of Speed

a. Creeping Inflation: It is the mildest form of inflation. It is generally regarded as

conducive to economic development because it keeps the economy away from

stagnation. But, some economists consider creeping inflation as potentially dangerous

They are of the view that, if not properly controlled in time creeping inflation may

assume alarming proportions Under creeping inflation, price;, rise about 2 percent

annually.

b. Walking Inflation: When the price rise becomes more marked as compared to

creeping inflation. Under walking inflation, prices rise approximately by 5 percent

annually.

c. Running Inflation: Under running inflation, the prices increase at a still faster rate.

The price rise may be about 10 percent annually.

d. Galloping or Hyper-Inflation: This is the last stage of inflation which starts after the

level of full employment is reached. Keynes considers this type of inflation as the true

inflation under the galloping inflation, the prices rise every moment and there is no

upper limit to the price rise.

B. On the Basis of Inducement


a. Wage-Induced Inflation: When inflation rises due to a rise in wages, it is called wage-

induced inflation. In modern times, trade unions are able to secure higher wages for

workers unaccompanied by a simultaneous increase in labour productivity. This

increases the cost of production, and in turn, the price level.

b. Profit-Induced Inflation: If the producers, due to their monopoly position, tend to

mark-up their profit margin, it will lead to profit-induced inflation and higher profits

raise the cost of production which, in turn, pushes up the prices.

c. Scarcity-Induced Inflation: When the supply of goods does not increase on account of

natural calamities, the prices tend to rise. This may be called scarcity-induced

inflation.

d. Deficit-Induced Inflation: When a government covers the deficit in its budget,

through creating new money (a method known as deficit financing) the purchasing

power of the community increases without a simultaneous increase in production.

This leads to a rise in the price level which is referred to as deficit-induced inflation.

e. Deficit-induced inflation is more common in less developed countries, where, due to

lack of adequate resources, the government resorts to deficit financing to finance its

development plans.

f. Currency-Induced Inflation. When the supply of money exceeds the available output

of goods and services, it leads to an inflationary increase in prices. This is a case of

currency-induced inflation.

g. Credit-Induced Inflation. When prices increase on account of an expansion of credit

without increasing the quantity of money it is known as credit-induced inflation.


h. Foreign Trade-Induced Inflation: (a)When a country experiences a sudden rise in the

demand for its exportable against the inelastic supply of exportable in the domestic

market, this increases the demand and price level at home, (b) Trade gains and sudden

inflow of exchange remittances increase the demand and prices in the domestic

market. Both these factors lead to foreign trade-induced inflation.

C. On the Basis of Time

a. Peace-Time Inflation. By peace-time inflation we mean the rise in prices during

normal period of peace. This type of inflation occurs when, in a less-developed

economy, the government increases expenditure on development projects which

normally have longer gestation periods. It means a gap arises between the generation

of money income and the final availability of goods. This leads to a rise in prices.

b. War-Time Inflation. War-time inflation occurs during a period of war. During war

time, unproductive government expenditure increases and the prices rise because the

increase in output does not keep pace with the expansion of expenditure.

c. Post-War Inflation. Post-war inflation occurs after the end of the war when the pent-

up demand finds open expression. Heavy taxes, which were imposed on the people

during war time, are withdrawn during post-war period. As a result the disposable

income of the people abruptly increases without increase in the output. Hence the

prices shoot up.

D. On the Basis of Scope

a. Comprehensive Inflation. When the prices of all goods and services increase

throughout the economy, it is the case of comprehensive inflation. This leads to a rise

in the general price level.


b. Sporadic Inflation. Sporadic inflation is sectoral inflation, since, instead of affecting

whole economy, it affects a few sectors.

E. On the Basis of Government Reaction

a. Open Inflation. If the government takes no steps to check the price and the market

mechanism is allowed to function without any interference, it is called open inflation.

Under open inflation, market mechanism performs the function of allocating scarce

resources among competing industries. If there is shortage of any particular resource,

the market mechanism would raise its price and allocate it to those industries which

can afford to pay a higher price for it. The hyper-inflation in Germany after the First

World War is an example of open inflation.

b. Suppressed Inflation. If the government actively makes efforts to check the price rise

through price control and rationing, it is called suppressed inflation. These measures

can check inflation as long as their effect continues. Once these measures are

withdrawn, the demand for goods increases and the suppressed inflation becomes

open inflation. Thus, suppressed inflation means to defer current demand or to divert

demand from controlled goods to uncontrolled goods. Suppressed inflation results in

many evils, such as profiteering, black marketing, hoarding, corruption, etc. It also

leads to the diversion of economic resources from more essential goods to less

essential goods.

F. On the Basis of Employment Level

a. Partial Inflation. The price rise is as a result of expansion of money supply in the pre-

full employment stage is called partial inflation. The increase in the money supply

before full employment tends to mobilize the idle resources of the economy and thus

leads to the expansion of output and employment. There is only a slight rise in price

level under partial inflation.


b. Full Inflation. The increase in the money supply after the full employment level leads

to full inflation. In this case, output and employment will not increase and there will

be an uninterrupted rise in prices.

Causes of Inflation

Inflation is the result of disequilibrium between demand and supply forces and is attributed to

(a) an increase in the demand for goods and services in the country, and (b) a decrease in the

supply of goods in the economy.

A. Factors Causing Increase in Demand

1. Increase in Money Supply. An increase in the money supply leads to an increase in

money income. The increase in money income raises the monetary demand for goods

and services. The supply of money increases when (a) the government resorts to

deficit financing i.e. printing of more currency or (b) the banks expand credit.

2. Increase in Government Expenditure. An increase in the government expenditure as a

result of the outbreak of war, development and welfare activities causes an increase in

the aggregate demand for goods and services in the economy.

3. Increase in Private Expenditure. An expansion of private expenditure (both

consumption and investment) increases the aggregate demand in the economy.

During the period of good business expectations, the businessmen start investing

more and more funds in new enterprises, thus increasing the demand for factors of

production. This results in an increase in factor prices. The increased factor incomes

raise the expenditure on consumption goods.

4. Reduction in Taxation. Reduction in taxation can also be an important cause for the

generation of excess demand in economy. When the government reduces taxes, it

increases the disposable income of the people, which, in turn, raises the demand for

goods and services.


5. Increase in Exports. When the foreign demand for domestically produced goods

increases, it raises the earnings of exporting industries. This, in turn, will increase

demand for goods and services within the economy.

6. Increase in Population. A rapid growth of population raises level of aggregate

demand in the economy because of the increase in consumption, investment,

government expenditure and net foreign expenditure. This leads to an inflationary rise

in prices due to excessive demand.

7. Paying off Debts. When the government pays off its old debts to the public it results

in an increase of purchasing power with the public. This will be used to buy more

goods and services for consumption purposes, thus increasing the aggregate demand

in the economy. Black Money. Black money means the money earned through illegal

transactions and tax evasion. Such money is generally spent on conspicuous

consumption, while raising the aggregate demand and hence the price level. Factors

Causing Decrease in Supply

B. Various factors responsible for reducing the supply of goods and services in the

economy are given below:

1. Scarcity of Factors of Production. On the supply side, inflation may occur due to the

scarcity of factors of production, such as, labour capital equipment, raw materials, etc

these shortages are bound to reduce the production of goods and services for

consumption purposes and thereby the price level.

2. Hoarding. At a time of shortages and rising prices, there is a tendency on the part of

the traders and businessmen to hoard essential goods for earning profits in future.

This causes scarcity and rise in prices of these goods in the market

3. Trade Union Activities. Trade union activities are responsible for inflationary

pressures in two ways (a) Trade union activities (i.e. strikes) often lead to stoppage of

work, decline in production, and rise in prices (b) If trade unions succeed in raising


wages of the workers more than their productivity, this will push up the cost of

production, and lead the producers to raise the prices of their products.

4. Natural Calamities. Natural calamities also create inflationary conditions by reducing

the production in the economy. Floods and draughts adversely affect the supply of

products and raise their prices.

5. Increase in Exports. An increase in exports reduces the stock of goods available for

domestic consumption. This creates a situation of shortages in the economy giving

rise to inflationary pressures.

6. Law of Diminishing Returns. The law of diminishing returns operates when

production is increased by employing more and more variable factors with fixed

factors and given technology. As a result of this law, the cost per unit of production

increases, thus leading to a rise in the prices of production.

7. War. During the war period, economic resources are diverted to the production of war

materials. This reduces the normal supply of goods and services for civilian

consumption and this leads to the rise in price level.

8. International Causes. In modern times, a major cause of inflationary rise in prices in

most of the countries is the international rise in the prices of basic materials (e.g.

petrol) used in almost all the industrial materials.

Effects of Inflation

Inflation is good so long as it is well under control and increases output and employment. It

becomes harmful once it goes out of control.

A. Effects on Product: According to Keynes, moderate or creeping inflation has favorable

effect on production particularly when there are unemployed resources in the country

Rising prices increase the profit expectations of the entrepreneurs because the prices

increase more rapidly than the cost of production. They are induced to step up

investment, and, as a result, output and employment increase. Hyper or galloping

inflation, on the other hand, creates the uncertainty. Mild inflation is favorable to

production and employment particularly before full employment, hyper inflation is


generally harmful for the economy. The adverse effects of inflation or production are

stated below:

a. Disrupt Price System. Inflation disrupts the smooth working of the price mechanism,

creates rigidities and results in wrong allocation of resources

b. Reduces Saving. Inflation adversely affects saving and capital accumulation. When

prices increase, the purchasing power of money fall which means more money is

required to buy the same quantity of goods. This reduces saving.

c. Discourages Foreign Capital. Inflation not only reduces domestic saving, it also

discourages the inflow of foreign capital into the country. If the value of money falls

considerably, it may even drive out the foreign capital invested in the country.

d. Encourages Hoarding. When prices increase, hoarding of larger stocks of goods

become profitable. As a consequence of hoarding, available supply of goods in

relation to increasing monetary demand decreases. This results in black marketing

and causes further price-spiral.

e. Encourages Speculation Activities. Inflation promotes speculative activities on

account of uncertainty created by a continually rising prices. Instead of earning

profits though genuine productive activity, the businessmen find it easier to make

quick profits through speculative activities.

f. Reduces Volume of production. Inflation reduces the volume of production because

(a) capital accumulation has slowed down and (b) business uncertainty discourages

entrepreneurs from taking business risks in production.

g. Affects Pattern of Production. Inflation adversely affects the pattern of production by

diverting the resources from the production of essential goods to that of non-essential

goods or luxuries because the rich, whose incomes increase more rapidly demand

luxury goods.

h. Quality fall. Inflation creates a seller’s market in which sellers have command on

prices because of excessive demand. In such a market, anything can be sold. Since the

producer's interest is only higher profits, they will not care for the quality.


B. Effects on Distribution: Inflation results in redistribution of income and wealth because

the prices of all the factors of production do not increase in the same proportion.

Generally, the flexible income groups, such as businessmen, traders, merchants,

speculators gain during inflation due to wind-fall profits that arise because prices rise

faster than the cost of production. On the other hand, the fixed income groups, such as

workers, salaried persons, teachers, pensioners, interest and rent earners, are always the

losers during inflation because their incomes do not increase as fast as the prices.

Inflation is unjust because it puts economic burden on those sections of the society who

are least able to bear it. The effects of inflation on different groups of society are as

follows.

a. Debtors and Creditors. During inflation, the debtors are the gainers and the creditors

are the losers. The debtors stand to gain because they had borrowed when the

purchasing power of money was high and now return the loans when the purchasing

power of money is low due to inflation. The creditors, on the other hand, stand to lose

because they get back less in terms of goods and services than what they had lent.

b. Wage and Salary Earners. Wage and salary earners usually suffer during inflation

because (a) wages and salaries do not rise in the same proportion in which the prices

or the cost of living rises and (b) there is a lag between a rise in the price level and a

rise in wage and salary. Among workers, those who have formed trade unions, stand

to lose less than those who are unorganized.

c. Fixed Income Groups. The fixed-income groups are the worst sufferers during

inflation. Persons who live on past saving, pensioners, interest and rent earners suffer

during periods of rising prices because their incomes remain fixed.

d. Business Community. The business community, i.e., the producers, traders,

entrepreneurs, speculators, etc., stand to gain during inflation, (a) They earn windfall

profits because prices rise at a faster rate than the cost of production (b) They gain


because the prices of their inventories go up, thus increasing their profits, (c) They

also gain because they are normally borrowers of money for business purposes.

e. Investors. The effect of inflation on investors depends on in which asset the money is

invested. If the investors invest their money in equities, they are gainers because of

rise in profit. If the investors invest their money in debentures and fixed income

bearing securities bonds, etc, they are the loser because income remains fixed.

f. Farmers. Farmers generally gain during inflation because the prices of the farm

products increase faster than the cost of production, thus, leading to higher profits

during inflation.

Thus inflation redistributes income and wealth in such a way as to harm the interests of the

consumers, creditors, small investors, laborers, middle class and fixed income groups and to

favor the businessmen, traders, debtors, farmer etc. Inflation, is society unjust because it

makes the rich richer and the poor poorer; it transfers wealth from those who have less of it

to those who have already too much of it.

C. Non-Economic Consequences: Inflation has far reaching social, moral and political

consequences:

a. Social Effects. Inflation is socially unjust and inequitable because it leads to

redistribution of income and wealth in favor of the rich. This widens the gap between

haves and have-nots and creates conflict and tension in the society.

b. Moral Effects. Inflation adversely affects business morality and ethics. It encourages

black marketing and enables the businessmen to reap wind-fall gains by undesirable

means In order to increase the profit margin the producers reduce the quality by

introduction of adulteration in their products.

c. Political Effect. Inflation also disrupts the political life of a country. It corrupts the

politicians and weakens the political discipline. Again, social inequality and moral

degradation resulting from inflationary pressures lead to general discontentment in

the public which may result in the loss of faith in the government. General


dissatisfaction among masses may sometimes result in political revolution or toppling

of the government.

In short, inflation is undesirable because of its all-round harmful consequences. It is

"economically unsound, politically dangerous and morally indefensible" It should be

avoidable if possible, and if it occurs, should be checked before it is too late.

Control of Inflation

Broadly, the measures against inflation can be divide into: (a) Monetary policy, (b) Fiscal

policy, (c) Direct controls, and (d) Other measures.

A) Monetary Policy

Monetary policy is adopted, by the monetary authority or the central bank of a country to

influence the supply of money and credit by changing interest rate structure and availability

of credit. Various monetary measures to control inflation are explained below:

a. Increasing Bank Rate: Bank rate is the rate at which central bank lends money to the

commercial banks. An increase in the bank rate leads to an increase in the interest rate

charged by commercial banks which, in turn, discourages borrowing by businessmen

and consumers. This will reduce money supply with public and thus control the

inflationary pressure.

b. Sale of Government Securities: By selling government securities in the open market,

the central bank directly reduces the cash reserves of the commercial banks because

the central bank must be paid from these cash reserves. The fall in the cash reserves

compels the banks to reduce their lending activities. This will reduce the money

supply and hence the inflationary pressures in the economy.

c. Higher Reserve Ratio. Another monetary measure to check inflation is to increase the

minimum reserve ratio. An increase in the minimum reserve ratio means that the

member banks are required to keep larger reserves with the central bank this reduces


the deposits of the banks and thus limits their power to create credit Restrictions on

credit expansion will control inflation.

d. Selective Credit Control. The purpose of selective credit control measures is to

influence specific type of credit. Such selective measures are particularly important

for developing economies in which, on the one hand, there is an increasing need for

credit expansion for growth purposes, and, on the other hand, there is also need for

checking inflationary tendencies. In such a situation, selective credit control measures

can direct the flow of credit from unproductive and inflation-prone sectors towards

the productive and growth oriented sectors. The main selective credit control

measures to control inflation are:

Consumer Credit Control. This method is adopted during inflation to curb excessive

spending by consumers. In advanced countries, most of the durable consumer goods,

such as, radio, Television, refrigerator, etc.; are purchased by the consumers on

installment credit. During inflation, loan facilities for installment buying are reduced

to minimum to check consumption spending. This is done by (a) raising the initial

payment, (b) covering the large number of goods, and (c) reducing the length of the

payment period.

Higher Margin Requirements. Margin requirement is the different between the market

value of the security and its maximum loan value. A bank does not advance loan

equal to the market value of the security, but less.

B) Fiscal Policy: Fiscal policy is the budgetary policy of the government relating to taxes,

public expenditure, public borrowing and deficit financing. The major anti-inflationary fiscal

measures include (a) increase in taxation, (b) reduction in public expenditure, (c) increase in

public borrowing, and (d) control of deficit financing

1. Increase in Taxation. Anti-inflationary tax policy should be directed towards

restricting demand without restricting production. Excise duties and sales tax on

various goods, for example, take away the buying power from the consumer goods

market without discouraging the expanding productive capacity of the economy.

Some economists, therefore, prefer progressive direct taxes because such taxes on the


one hand, reduce the disposable income of the people and, on the other hand, are

justified on the basis of social equity.

2. Reduction in Public Expenditure. During inflation, effective demand is very high due

to expansion of public and private spending. In order to check unregulated private

spending, the government should first of all reduce its unproductive expenditure." In

fact, during inflation, at the full employment level, the effective demand in relation to

the available supply of goods and services is reduced to the extent that government

expenditure is curtailed. Public expenditure being autonomous, an initial reduction in

it will lead to a multiple reduction in the total expenditure of the economy. But for

certain limitations of this measure: (a) It is not possible to reduce public expenditure

related to defence needs particularly during war times, (b) Heavy reduction in

government expenditure may come into clash with the planned long-run investment

programmes in a developing economy.

3. Public Borrowing. Public borrowing is another method of controlling inflation.

Through public borrowing, the government takes away from public excess purchasing

power. This will reduce aggregate demand and hence the price level. Ordinarily

public borrowing is voluntary, left to the free will of individuals. Voluntary public

borrowing may not bring to the government sufficient funds to effectively control the

inflationary pressures. In such conditions, compulsory public borrowing is necessary.

Through compulsory public borrowing a certain percentage of wages or salaries is

compulsorily deducted in exchange for saving bonds which become redeemable after

a few years. In this way, purchasing power can be curtailed for a definite period to

curb inflation. Compulsory public borrowing has certain limitations, (a) It involves

the element of compulsion on the public, (b) It results in frustration if the government

borrows from the poorer sections of the public who cannot contribute to this scheme,

(b) The government should avoid paying back the past loans during inflationary

period, otherwise it will generate further inflation.

4. Control of Deficit Financing. Deficit financing means financing the deficit budget (i.e.

excess of government expenditure over its revenue) through printing


C) Direct Controls: Direct controls refer to the regulatory measures undertaken with an

objective of converting an open inflation into a suppressed one. Direct control on prices and

rationing of scarce goods are the two such regulatory measures.

1. Direct Controls on Prices. The purpose of price control is to fix an upper limit

beyond which the price of particular commodity is not allowed and to that extent

inflation is suppressed.

2. Rationing. When the government fixes the quota of certain goods so that each

person gets only a limited quantity of the goods, it is called rationing. Rationing

becomes necessary when the essential consumer goods are relatively scarce. The

purpose of rationing is to divert consumption from those goods whose supply

needs to be restricted for some special reason, e.g. to make such commodities

available to a large number of people.

According to Kurihara, "rationing should aim at diverting consumption from

particular articles whose supply is below normal rather than at controlling

aggregate consumption". Thus, rationing aims at achieving the twin objectives

of price stability and distributive justice.

D) Other Measures

1. Expansion of Output. Inflation arises partly due to inadequacy of output. But, it is

difficult to increase output during inflationary period because the productive

resources have already been fully utilized. Under such condition when output as a

whole cannot be increased, steps should be taken to increase output of those goods

which are sensitive to inflationary pressures. This requires reallocation of resources

from the production of less inflation sensitive goods (i.e., luxury goods) to the

production of more inflation-sensitive goods (i.e. food, clothing and other essential

consumer goods) Such reallocation of resources will keep the prices of essential

consumer goods under check by raising their output.


2. Proper Wage Policy. In order to check inflation, it is necessary to control wages and

profits and to adopt appropriate wage and income policy. Wage increase should be

allowed to the workers only if their productivity increases; in this way, higher wages

will not lead to higher costs and hence higher prices.

3. Encouragement to Saving. Increase in private savings has disinflationary impact on

the economy. Private saving lead to the reduction of expenditure income of the

people, which in turn, curtail inflationary pressures. The government should

therefore take steps to encourage private savings.

4. Overvaluation. Overvaluation of domestic currency in terms of foreign currencies

also serves to control inflation in three ways:

(a) It will discourage exports and thus increase the availability of goods and

services in the domestic market (b) It will encourage imports from abroad and

thus add to the domestic stock of goods and services, (b) by reducing the

prices of foreign materials which are needed in domestic production, it will

control the upward cost-price spiral.

5. Population Control. In an overpopulated country, like India, the measures to check

the growth of population also produce anti-inflationary effects. Effective family

planning programmes ultimately reduce the increasing pressures on general demand

for goods and services, thus helping to keep the rising prices under control.

6. Indexing. Economists also suggest indexing as an anti-inflationary measure.

Indexing refers to monetary corrections by periodic adjustments in money incomes

of the people and in the value of financial assets, saving deposits, etc., held by the

public in accordance with changes in the prices. For example, if the annual price rise

is 10% the money incomes and the value of financial assets should be increased by

10% under the system of indexing.


Reflation

Reflation is the act of stimulating the economy by increasing the money supply or by

reducing taxes, seeking to bring the economy (specifically price level) back up to the long-

term trend, following a dip in the business cycle. It is the opposite of disinflation, which

seeks to return the economy back down to the long-term trend.

Reflation is an economic term referring to stimulating measures taken to lessen or stop the

effects of deflation. Reflationary measures can consist of fiscal policy (lowering taxes) or

monetary policy (changing money supply or lowering interest rates).

Deflation

“Deflation” is often confused with “disinflation.” While deflation represents a decrease in the

prices of goods and services throughout the economy, disinflation represents a situation

where inflation increases at a slower rate.

What Causes Deflation?

Although there are many reasons why deflation may take place, the following causes seem to

play the largest roles:

1. Change in Structure of Capital Markets: When many different companies are selling

the same goods or services, they will typically lower their prices as a means to

compete. Often, the capital structure of the economy will change and companies will

have easier access to debt and equity markets, which they can use to fund new

businesses or improve productivity.

There are multiple reasons why companies will have an easier time raising capital,

such as declining interest rates, changing banking policies, or a change in

investors’ aversion to risk. However, after they have utilized this new capital to


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increase productivity, they are going to have to reduce their prices to reflect the

increased supply of products, which can result in deflation.

2. Increased Productivity: Innovative solutions and new processes help increase

efficiency, which ultimately leads to lower prices. Although some innovations only

affect the productivity of certain industries, others may have a profound effect on the

entire economy.

3. Decrease in Currency Supply: As the currency supply decreases, prices will decrease

so that people can afford goods. How can currency supplies decrease? One common

reason is through central banking systems.

4. Austerity Measures: Deflation can be the result of decreased governmental, business,

or consumer spending, which means government spending cuts can lead to periods of

significant deflation. For example, when Spain initiated austerity measures in 2010,

pre-existing deflation began to spiral out of control.

5. Deflationary Spiral: Once deflation has shown its ugly head, it can be very difficult to

get the economy under control for a number of reasons. First of all, when consumers

start cutting spending, business profits decrease. Unfortunately, this means that

businesses have to reduce wages and cut their own purchases. In turn, this short-

circuits spending in other sectors, as other businesses and wage-earners have less

money to spend. As horrible as this sound, it continues to get worse and the cycle can

be very difficult to break.

Deflation may have any of the following impacts on an economy:

1. Reduced Business Revenues: Businesses must significantly reduce the prices of their

products in order to stay competitive. Obviously, as they reduce their prices, their

revenues start to drop. Business revenues frequently fall and recover, but deflationary

cycles tend to repeat themselves multiple times.


Unfortunately, this means businesses will need to increasingly cut their prices as the

period of deflation continues. Although these businesses operate with improved

production efficiency, their profit margins will eventually drop, as savings from

material costs are offset by reduced revenues.

2. Wage Cutbacks and Layoffs: When revenues start to drop, companies need to find

ways to reduce their expenses to meet their bottom line. They can make these cuts by

reducing wages and cutting positions. Understandably, this exacerbates the cycle of

inflation, as more would-be consumers have less to spend.

3. Changes in Customer Spending: The relationship between deflation and consumer

spending is complex and often difficult to predict. When the economy undergoes a

period of deflation, customers often take advantage of the substantially lower prices.

Initially, consumer spending may increase greatly; however, once businesses start

looking for ways to bolster their bottom line, consumers who have lost their jobs or

taken pay cuts must start reducing their spending as well. Of course, when they reduce

their spending, the cycle of deflation worsens.

4. Reduced Stake in Investments: When the economy goes through a series of deflation,

investors tend to view cash as one of their best possible investments. Investors will

watch their money grow simply by holding onto it. Additionally, the interest rates

investors earn often decrease significantly as central banks attempt to fight deflation by

reducing interest rates, which in turn reduces the amount of money they have available

for spending.

In the meantime, many other investments may yield a negative return or are highly

volatile, since investors are scared and companies aren’t posting profits. As investors

pull out of stocks, the stock market inevitably drops.


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5. Reduced Credit: When deflation rears its head, financial lenders quickly start to pull the

plugs on many of their lending operations for a variety of reasons. First of all, as assets

such as houses decline in value, customers cannot back their debt with the

same collateral. In the event a borrower is unable to make their debt obligations, the

lenders will be unable to recover their full investment through foreclosures or property

seizures.

Also, lenders realize the financial position of borrowers is more likely to change as

employers start cutting their workforce. Central banks will try to reduce interest rates to

encourage customers to borrow and spend more, but many of them will still not be

eligible for loans.

Method of Note Issue

1. Fixed Fiduciary System: Under this system the central bank of the country is

permitted to issue bank notes of a given amount without giving gold and silver cover.

The fixed quantity of notes allowed by law to be issued is to be backed by Govt.

securities only. This is named the fiduciary limit. The amounts of notes circulated in

excess of the fiduciary limit must be 100% backed by gold.

Advantages:

a. Elastic System: The first advantage of this system is that it makes the supply of

money elastic.

b. Safety: It also gives maximum safety because notes can not be issued in excess of the

fiduciary limit unless they are 100% covered by gold.

c. Check on Inflation: The inflation can be effectively checked.

Disadvantage:

a. High Fiduciary Limit: If fiduciary limit is high or it has been increased with the

passage of time then people will lose confidence in the currency.


2. Proportional Reserve System or Percentage System

According to this system the central bank is required by law to keep a fixed

percentage varying from 25 to 40 percent against the note issue. The essential feature

of this system is the provision of proportional metallic reserves against the notes in

circulation. The reserve ratio may be allowed to drop below the legal minimum.

Advantage and Disadvantage

a. Elastic System: The main advantage of this system is that it makes the supply of

money elastic.

b. Lock Up Of Gold: The defect with this system is that it locks up the gold reserves

unnecessarily. So we cannot use it for other purpose.

3. Exchange Management or Modified Proportional Reserve System

J.M. Keynes has suggested modified form of proportional reserve system and calls it

exchange management. According to this system the central bank is required by law

to keep the percentage required against the note issue in the form of gold, foreign bills

or cash at some foreign banks where gold standard prevails.

Principles of Note Issue

There are two principles of note issue. The first is the currency principle and the second is

banking principle. There are different views about these principles. One school of

thought says that there should be full convertibility of notes into gold bullion.

The second gives importance to the elasticity of supply.

1. Currency Principle:

According to the advocates of the currency principles, the paper money is an economical and

convenient substitute of metal money. They insist that paper money in circulation should be

backed by 100% gold reserves. There will always be availability of gold for the redemption


of notes when presented which creates stability in price level and exchange rates, because

every note issued is covered by gold behind it.

Merits

a. Safety and Security: It gives full safety and security to the paper currency.

b. No Danger Of Inflation: There is no danger of over-issue of the currency, which is an

effective check to the possibilities of inflation.

c. Public Confidence: The currency principle provides greater confidence to the public,

because it provides assurance in ease of convertibility of notes.

Demerits

a. Inelastic: It makes the supply of money highly inelastic, because the issuance of notes

is only possible on the availability of gold. So, the government cannot issue notes in

case of emergency.

b. Dependent: According to this principle, paper currency can only be primed and issued

if there is 1009b gold cover available against it. The issuance of currency thus

completely depends upon the availability of gold rather than the trade and

industry need.

c. Lock up of Gold: There is unnecessary lock up of gold for the currency, which may

be used for some other purposes.

d. Real World: It is not acceptable in the real world and has no support from all over the

world.

2. Banking Principle:

According to this principle, there is no need to have the reserve of gold and silver for the

issuance of notes. The banks are authorized to regulate the note issue keeping in view the

needs of trade and industry. The banks themselves maintain adequate reserves of gold for

meeting the obligations of notes. If there is an over issue of notes, the excess money will be

automatically presented for cash payment and thus the proper ratio will be maintained

between the supply of money and the gold reserves.


Merits

a. Elastic System: The banking principle is elastic because gold is not kept for current

percent value of notes issued.

b. Government needs: This system is fit for meeting the government needs in case of

emergencies.

c. Popularity: This system is popular all over the world. Every country is issuing money

under this system.

d. Surety: It also provides surety for the convertibility of notes.

Demerits

a. Over-Issue: In order to meet the demand for money, there may be a further issue of

notes beyond to a certain limit which leads to inflation.

b. Economic Crisis: During economic crisis the convertibility of notes may be refused.

c. Balance of Payment: This is not good for keeping the stable exchange rates.

Whenever there is a change in foreign, exchange rates, the balance of payment

position becomes more unfavourable.

Meaning of Monetary Standard

The term “monetary standard” refers to the monetary system of a country. Prof. Halm defines

monetary standard as the “principal method of regulating the quantity and the exchange value

of standard money.” When the standard money of a country is chosen in the form of some

metal, then the country is said to have metallic standard. There are three main types of

monetary standards. They are:

1. Monometallic or Single Standard

When only on metal is adopted as the standard money and is made legal tender for all

payments, the system is known as monometallism or single standard. For example, now

many countries have the Gold Standard. Suppose a country has adopted silver as the standard


money, then it is said to have Silver Standard. For example, England was on Silver Standard

until 1816.

2. Bimetallism or Double Standard

If two metals are adopted as standard money and if a legal ratio is established between the

value of the two metals, then the system known as bimetallism or double standard. In other

words, under this system, gold and silver circulated as legal tender money and there was a

legally fixed ratio of exchange between them. Usually, two metals used under bimetallism

are gold and silver.

Advantages

a. It would secure greater stability of prices. It there is monometallism, the supply of

only one metal could not satisfy the monetary demand satisfactorily. The increasing

demand for money should be accompanied by an increase in the supply of money.

Otherwise, there cannot be a stable price level. Therefore, if there is bimetallism, the

supply of two metals put together will be steadier than that of any one of them.

b. Bimetallism would promote stable exchange rates between countries using gold and

countries using silver.

c. The supply of gold would not be sufficient for the currency requirements if all

countries adopted gold standard, that is, if they adopted universal monometallism.

d. Bimetallism will keep world prices stable.

Disadvantages

a. There is a great difficulty in maintaining the mint ratio (legal ratio) between the two

metals because market ratio will often fluctuate.

b. Gresham’s law that bad money drives out good money will operate.

c. Bimetallism cannot work if only one country adopted it. All countries in the world

should adopt it.


d. It may result in a lot of confusion, particularly, if there are differences between the

legal ratio and market ratio of the two metals. So bimetallism may not remedy the

defects of gold standard; it may increase the difficulties.

3. Paper Currency Standard (Managed Currency Standard)

Under the system, as the name indicates, the currency of the country will be in paper. Paper

money consists of bank notes and government notes. Generally, under the system, the

currency system will be managed by the Central Bank of the country. Hence, the system

sometimes is referred to as managed paper currency standard. Almost all countries in the

world have managed currency standard. The paper currency has certain advantages and

disadvantages.

Advantages and Disadvantages of Paper Money

a. Paper money is economical. Its cost of production is negligible.

b. It is convenient to handle and it is easily portable.

c. It is homogeneous.

d. Its supply can be made elastic. And its value can be kept stable by proper

management.

e. Paper currency can function very effectively as money, provided; there is proper

control of it by the managing authority.

f. It is ideal for internal trade. But for international trade and payments, gold is still

found necessary.

However, paper money has two great disadvantages.

a. There is the danger of over-issue of paper money by the managing authorities. Over-

issue of currency will result in a rise in prices, adverse foreign exchange rates and

many other evils. The over-issue of paper money has ruined many countries in the

past.

b. Another disadvantage of paper money is that it will not have universal acceptance. It

is recognized as money only in the country where it is issued. For others, paper

money is just bits of paper. Gold, on the other hand, has universal acceptance.


Unit 2

Definition of 'Credit'

1. A contractual agreement in which a borrower receives something of value now and

agrees to repay the lender at some date in the future, generally with interest. The term

also refers to the borrowing capacity of an individual or company.


2. An accounting entry that either decreases assets or increases liabilities and equity on

the company's balance sheet. On the company's income statement, a debit will reduce

net income, while a credit will increase net income.

Credit is borrowed money that you can use to purchase goods and services when you need

them. You get credit from a credit grantor, whom you agree to pay back the amount you

spent, plus applicable finance charges, at an agreed-upon time.

There are four types of credit:

1. Revolving credit. With revolving credit, you are given a maximum credit limit, and you

can make charges up to that limit. Each month, you carry a balance (or revolve the debt) and

make a payment. Most credit cards are a form of revolving credit.

2. Charge cards. While they often look like revolving credit cards and are used in the same

way, charge accounts differ in that you must pay the total balance every month.

3. Service credit. Your agreements with service providers are all credit arrangements. You

receive electricity, cellular phone service, gym membership, etc., with the agreement that you

will pay for them each month. Not all service accounts are reported in your credit history.

4. Installment credit. With installment credit, a creditor loans you a specific amount of

money, and you agree to repay the money and interest in regular installments of a fixed

amount over a set period of time. Car loans and mortgages are two examples of installment

credit.

Importance of credit

• Immediate Possession of goods

• Convenience: Buy now and pay later.

• Emergencies

• Saving Money: Buy an item while it is on sale.


• Credit Rating: Establish a favorable credit rating.

• Growth of the Economy: Buying goods will help the economy expand.

• Credit is a most effective means of uniting capital and labor for the production of

wealth. It is not itself capital and cannot create capital, but it does greatly increase the

sum of wealth available as capital for profitable uses.

• Credit quickens exchanges.

• Credit serves directly as an instrument of exchange.

• Credit puts every man’s wealth at his disposal just when he wants to find and use it.

Factors influencing the volume of credit:

The credit and debit operations appear usually in economic and financial transactions. The

creditor surrenders something of value at one point of time in exchange for debtor promise to

pay in the future. There are times when the creditor is willing to lend and the borrower is

willing to borrow. This is the time of credit expansion. When the creditor and the debtor are

both shy and hesitate the exchange money for the promise of a future payment, it is then a

case of contraction of credit. The basic factors which determine the expansion and

contraction of credit in the country are as follows.

1. The Volume of Business Activity. If the business activity is brisk and the entrepreneurs

are reaping rich harvests of profit, the volume of credit will be large in the country. In

case the business activity slackens, and the level of prices is low in the country, the

volume of credit will be small.

2. Rate of Return on the Capital. If the marginal efficiency of invested capital is higher

than the current rate of interest, the entrepreneurs are moved to add to investment by

taking loans. The credit, therefore, expands when the rate of return is safe and secure.

When the credit is not self liquidating, the volume of credit contracts.


3. Level and distribution of Income. If the level of income is high and it is evenly

distributed in the country, the credit expands.

4. Stage of Economic Growth. If the country is in the long period of self sustained growth,

there is higher degree of specialization and interdependence in the economy. With the

widening of markets and larger business transactions, the volume of credit is large.

5. Speculative Activity. Credit expansion of contraction is directly related with speculative

activities of speculators. When speculation is ripe, the volume of credit expands and

when speculators undergo losses, the volume of credit contracts.

6. Faith in the Banking System and Government. If the banking system is working on a

sound footing and there are no failures of banks and no bad debts, the credit will expand.

It people lose faith in the banking institutions, the credit will contract.

7. Political Conditions. The modern business world is highly sensitive to the political

conditions prevailing in the country. If the country is waging a war or the war clouds

continue hovering over the heads, nobody will like to invest the funds in any enterprise

and so the credit will by shy. Similarly, if the governments continue changing after every

blue moon, the economic policies will not be stable and so the volume of credit will be

small. A stable government and peace in and outside the country helps in the expansion

of the credit.

8. Customs and Habits of the People. If people are in the habit of making payments

through the use of cheques drawn against their demand deposits, the credit expands. If the

payment is made through the use of currency, the volume of credit contracts.

9. Currency Conditions. Currency is used as a media of exchange because people have

faith and confidence in the issuing authority. If the currency depreciates due to over issue

of paper money, it creates an element of uncertainty in the business circles. When the

currency issued by the state and used as instrument of credit loses faith of the people, the

volume of credit is bound to-contract. A sound currency system, on the other hand, is

highly conducive to credit expansion.

Credit Creation of Bank


An important function of bank performed by the commercial banks is the creation of credit.

The process of banking must be considered in terms of monetary flows, that is continuous

depositing and withdrawal of cash from the bank. It is only this activity which has enabled

the bank to manufacture money. Therefore the banks are not only the purveyors of money but

manufactures of money.

Need of credit creation

• Commercial banks are called the factories of credit.

• They advance much more than what the collect from people in the form of deposits.

• Through the process of credit creation, commercial banks provide finance to all

sectors of the economy thus making them more developed than before.

Basic of credit creation

The basis of credit money is the bank deposits. The bank deposits are of two kinds.

a. Primary deposits

b. Derivative deposits

Primary deposits

Primary deposits arise or formed when cash or cheque is deposited by customers. When a

person deposits money or cheque, the bank will credit his account. The customer is free to

withdraw the amount whenever he wants by cheques. These deposits are called “primary

deposits” or “cash deposits.”

It is out of these primary deposits that the bank makes loans and advances to its customers.

The initiative is taken by the customers themselves. In this case, the role of the bank is

passive. So these deposits are also called “passive deposits.”

Derivative deposits

• Bank deposits also arise when a loan is granted or when a bank discounts a bill or

purchase government securities.


• Deposits which arise on account of granting loan or purchase of assets by a bank are

called “derivative deposits.”

• Since the bank play an active role in the creation of such deposits, they are also

known as “active deposits.”

• When the bank buys government securities, it does not pay the purchase price at once

in cash.

• It simply credits the account of the government with the purchase price.

• The government is free to withdraw the amount whenever it wants by cheque

• The power of commercial banks to expand deposits through loans, advances and

investments is known as “credit creation.”

Process of Credit Creation

• The banking system as a whole can create credit which is several times more than the

original increase in the deposits of a bank. This process is called the multiple-

expansion or multiple-creation of credit.

• Similarly, if there is withdrawal from any one bank, it leads to the process of

multiple-contraction of credit.

• Central bank is the first source of money supply in the form of currency in

circulation. The Reserve Bank of Indian is the note issuing authority of the country.

The RBI ensures availability of currency to meet the transaction needs of the economy. The

Total Volume of money in the economy should be adequate to facilitate the various types of

economic activities such as production, distribution and consumption.

The commercial banks are the second most important sources of money supply. The money

that commercial banks supply is called credit money.

The process of 'Credit Creation' begins with banks lending money out of primary deposits.

Primary deposits are those deposits which are deposited in banks. In fact banks cannot lend


the entire primary deposits as they are required to maintain a certain proportion of primary

deposits in the form of reserves with the RBI under RBI & Banking Regulation Act. After

maintaining the required reserves, the bank can lend the remaining portion of primary

deposits. Here bank's lend the money and the process of credit creation starts.

To conclude, we can say that credit creation by banks is one of the important & only sources

to generate income. And when the reserve requirement increased by the central bank it would

directly affect on the credit creation by bank because then the lendable funds with the bank

decreases and vice versa.

The extent to which the banks can create credit together could be found out with the help of

the credit multiplier formula. The formula is:

K = 1/r

Where ‘K’ is the credit multiplier

And r, the required reserves.

It should be noted here that the size of credit multiplier is inversely related to the percentage

of cash reserves the banks have to maintain. If the reserve ratio increases, the size of credit

multiplier is reduced and if the reserve ratio is reduced, the size of credit multiplier will

increase.

Limitation on Credit Creation

1. Amount of Cash: The power to create credit depends on the cash received by banks. If

banks receive more cash, they can create more credit. If they receive less cash they can

create less credit. Cash supply is controlled by the central bank of the country.

2. Cash Reserve Ratio: All deposits cannot be used for credit creation. Banks must keep

certain percentage of deposits in cash as reserve. The volume of bank credit depends also


on the cash reserve ratio the banks have to keep. If the cash reserve ratio is increased, the

volume of credit that the banks can create will fall. If the cash reserve ratio is lowered,

the bank credit will increase. The Central Bank has the power to prescribe and change the

cash reserve ratio to be kept by the commercial banks. Thus the central bank can change

the volume of credit by changing the cash reserve ratio.

3. Banking Habits of the People: The loan advanced to a customer should again come back

into banks as primary deposit. Then only there can be multiple expansion. This will

happen only when the banking habit among the people is well developed. They should

keep their money in the banks as deposits and use cheques for the settlement of

transactions.

4. Nature of Business Conditions in the Economy: Credit creation will depend upon the

nature of business conditions. Credit creation will be large during a period of prosperity,

while it will be smaller during a depression. During periods of prosperity, there will be

more demand for loans and advances for investment purposes. Many people approach

banks for loans and advances. Hence, the volume of bank credit will be high. During

periods of business depression, the amount of loans and advances will be small because

businessmen and industrialists may not come to borrow. Hence the volume of bank credit

will be low.

5. Leakages in Credit-Creation: There may be some leakages in the process of credit

creation. The funds may not flow smoothly from one bank to another. Some people may

keep a portion of their amount as idle cash.

6. Sound Securities: A bank creates credit in the process of acquiring sound and profitable

assets, like bills, and government securities. If people cannot offer sound securities, a

bank cannot create credit. Crowther says “a bank cannot create money out of thin air. It

transmutes other forms of wealth into money.”

7. Liquidity Preference: If people desire to hold more cash, the power of banks to create

credit is reduced.

8. Monetary Policy of the Central Bank: The extent of credit creation will largely depend

upon the monetary policy of the Central Bank of the country. The Central Bank has the

power to influence the volume of money in circulation and through this it can influence

the volume of credit created by the banks. The Central Bank has also certain powerful


weapons, like the bank rate, open market operations with the help of which it can

exercise control on the expansion and contraction of credit by the commercial bank.

Credit Control

Credit Control is an important tool used by the Reserve Bank of India, a major weapon of the

monetary policy used to control the demand and supply of money (liquidity) in the economy.

Why Credit Control is required: The basic and important needs of Credit Control in the

economy are:

To encourage the overall growth of the “priority sector” i.e. those sectors of the economy

which is recognized by the government as “prioritized

To keep a check over the channelization of credit so that credit is not delivered for

undesirable purposes.

To achieve the objective of controlling “Inflation” as well as “Deflation”.

To boost the economy by facilitating the flow of adequate volume of bank credit to

different sectors.

What are the methods of Credit Control?

There are two methods that the RBI uses to control the money supply in the economy-

(1) Qualitative Method: By qualitative methods means the control or management of the

uses of bank credit or manner of channelizing of cash and credit in the economy. Tools used

under this method are:

Marginal Requirement: Marginal Requirement of loan can be increased or

decreased to control the flow of credit for e.g. – a person mortgages his property

worth Rs. 1,00,000 against loan. The bank will give loan of Rs. 80,000 only. The


marginal requirement here is 20%. In case the flow of credit has to be increased, the

marginal requirement will be lowered.

Rationing of credit: Under this method there is a maximum limit to loans and

advances that can be made, which the commercial banks cannot exceed.

Publicity: RBI uses media for the publicity of its views on the current market

condition and its directions that will be required to be implemented by the

commercial banks to control the unrest.

Direct Action: Under the banking regulation Act, the central bank has the authority

to take strict action against any of the commercial banks that refuses to obey the

directions given by Reserve Bank of India.

Moral Suasion: This method is also known as “Moral Persuasion” as the method that

the Reserve Bank of India, being the apex bank uses here, is that of persuading the

commercial banks to follow its directions/orders on the flow of credit.

(2) Quantitative Method: By Quantitative Credit Control we mean the control of the total

quantity of credit. Different tools used under this method are:

Bank Rate: Bank Rate also known as the Discount Rate is the official minimum rate

at which the Central Bank of the country is ready to rediscount approved bills of

exchange or lend on approved securities.

When the commercial bank for instance, has lent or invested all its available funds

and has little or no cash over and above the prescribed minimum, it may ask the

central bank for funds. It may either re-discount some of its bills with the central bank

or it may borrow from the central bank against the collateral of its own promissory

notes. In either case, the central bank accommodates the commercial bank and

increases the latter’s cash reserves. This Rate is increased during the times of inflation

when the money supply in the economy has to be controlled.

Open Market Operations: Open Market Operations indicate the buying/selling of

government securities in the open market to balance the money supply in the


economy. During inflation, RBI sells the government securities to the commercial

banks and other financial institution. This reduces their cash lending and credit

creation capacities. Thus, Inflation can be controlled. During recessions, RBI

purchases government securities from commercial banks and other financial

institution. This leaves them with more cash balances for lending and increases their

credit creation capacities. Thus, recession can be overcome.

Repo Rates and Reverse Repo Rates: Repo is a swap deal involving immediate sale

of securities and a simultaneous re purchase of those securities at a future date at a

predetermined price. Commercial banks and financial institution also park their funds

with RBI at a certain rate; this rate is called the Reverse Repo Rate. Repo rates and

Reverse repo rate used by RBI to make liquidity adjustments in the market.

Cash Reserve Ratio: The money supply in the economy is influenced by the cash

reserve ratio. It is the ratio of a bank’s time and demand liabilities to be kept in

reserve with the RBI. A high CRR reduces the flow of money in the economy and is

used to control inflation. A low CRR increases the flow of money and is used to

overcome recession.

Statutory Liquidity Ratio: Under SLR, banks have to invest a certain percentage of

its time and demand liabilities in Government approved securities. The reduction in

SLR enhances the liquidity of commercial banks.

Deployment of Credit: The RBI has taken various measures to deploy credit in

different of the economy. The certain percentage of bank credit has been fixed for

various sectors like agriculture, export, etc.


Unit 3

Commercial Bank:

In modern economy commercial Banks play an important role in the financial sector. A Bank

is an institution dealing in money and credit. Credit money is the major component of money

supply in a modern economy. Commercial banks are the creators of credit. The strength of

economy of any country basically depends on a sound and solvent banking system.

A Commercial bank is a profit seeking business firms dealing in money or rather claims to

money. It safeguards the savings of the public and give loans and advances.


The Banking Companies Act of 1949 defines banking company as “accepting for the purpose

of lending or investment of deposit money from the public, repayable on demand or

otherwise and withdrawable by cheque, drafts, and order or otherwise”.

Functions of Commercial Banks

Commercial banks perform a variety of functions. All functions of commercial banks may be

broadly classified into two -primary functions and secondary functions.

Primary Functions

Primary functions consist of accepting deposits, lending money and investment of funds.

1. Accepting deposits: Bank receives idle savings of people in the form of deposits. It

borrows money in the form of deposits. These deposits may be of any of the following types:

(a) Current or demand deposit: In the case of current deposits money can be deposited and

withdrawn at any time. Money can be withdrawn only by means of cheques. Usually a bank

does not allow any interest on this kind of deposit because; bank cannot utilize these short

term deposits. This type of deposits is generally opened by business people for their

convenience. Current account holders should keep a minimum balance of Rs. 2000, to keep

the account running.

(b) Fixed or time deposits: These deposits are made for a fixed period. These can be

withdrawn only after the expiry of the fixed period for which the deposits have been made.

The bank gives higher rate of interest on this deposit. The rate of interest depends upon the

duration of deposit. The longer the period the higher will be the rate of interest. For the

evidence of the deposit, the banker issues a ‘Fixed Deposit Receipt’.

(c) Savings Deposits: As the name suggests, this deposit is meant for promotion of savings

and thrift among the people. In the case of savings deposits there are certain restrictions on

the number of withdrawals or on the amount that can be withdrawn per week. A minimum

balance of Rs. 100 should be maintained and if cheque book facility is allowed, the minimum


balance should be Rs. 1000. On the savings deposit, the rate of interest is less than that on the

fixed deposit.

(d) Recurring deposits: This is one form of savings deposit. In this type of deposit, at the end

of every week or month, a fixed amount is deposited regularly. The amount can be

withdrawn only after the expiry of the specified period. This deposit works on the maxim

‘little drops of water make a big ocean’. It may be opened for monthly installments in sums

of Rs. 100 or in multiples of Rs. 100 with a maximum of Rs. 1000.

2. Lending Money: Lending constitutes the second function f a commercial bank. Out of the

deposits received, a bank lends money to the traders and businessmen. Money is lent usually

for short periods only. A commercial bank lends in any one of the following ways:

(a) Loans: In case of loan, the banker advances a lump sum for a certain period at an agreed

rate of interest. The amount granted as loan is first credited in the borrower’s account. He can

withdraw this amount at any time. The interest is charged for the full amount sanctioned

whether he withdraws the money from this account or not. Loan is granted with or without

security.

(b) Cash credit: Cash credit is an arrangement by which the customer is allowed to borrow

money up to a certain limit. The customer can withdraw the amount as and when required.

Interest is charged only for the amount withdrawn and not for the whole amount as in the

case of loan.

(c) Overdraft: overdraft is an arrangement between a banker and his customer by which the

customer is allowed to withdraw over and above the credit balance in the current account up

to an agreed limit. The interest is charged only for the amount sanctioned. This is a

temporary financial assistance. It is given either on personal security or on the security of

assets.

(d) Discounting of bills: Bank grants advances to their customers by discounting bills of

exchange or pronote. In other words, money is lent on the security of bill of exchange or


pronote. The amount after deducting the interest (discount) from the amount of the bill is

credited in the account of the customer. Thus in this form of lending, the interest is received

by the banker in advance. Bank, sometimes, purchases the bills instead of discounting them.

3. Investment of funds: Another function is investing the funds in some securities. While

making investment a bank is required to observe three principles, namely liquidity,

profitability and safety. A bank invests its funds in government securities issued by central

government as well as state government. It also invests in other approved securities like the

units of UTI, shares of GIC and LIC, securities of State Electricity Board etc.

4. Credit Creation: -It is a unique function of Commercial Banks. When a bank advances

loan to its customer if doesn’t lend cash but opens an account in the borrowers name and

credits the amount of loan to that account. Thus, whenever a bank grants loan, it creates an

equal amount of bank deposits. Creation of deposits is called Credit Creation. In simple

words we can define Credit creation as multiple expansions of deposits. Creation of such

deposits will results an increase in the stock deposits. Creation of such deposits will results

an increase in the stock of money in an economy.

Secondary Functions

Secondary functions include agency services and general utility services

a. Agency Services: Modern commercial banks render a number of services to its

customers. It acts as an agent to its customers. The following are the important agency

services rendered by a commercial bank:

It collects the cheques, bills and pronotes for and on behalf of its customers

It collects certain incomes like dividend on shares, interest on securities etc., on behalf

of its customers.

It undertakes to purchase or sell securities for its customers.

It accepts bill of exchange on behalf of its customers.


It acts as a referee by supplying information regarding the financial position of its

customers when inquiries made by other business people and vice versa. It supplies

this information confidently.

It acts as an executor, administrator and trustee.

b. General Utility Services: General utility services are rendered not only to its costumers

but also to the general public. The following are the important general utility services

rendered by a commercial bank.

It facilitates easy and quick transfer of funds from one place to another place by

means of cheques, drafts, MT (Mail Transfer), TT (Telegraphic transfer)etc.

It issues letter of credit, traveller’s cheques, gift cheques etc.

It deals with foreign exchange transactions thereby helping the importers and

exporters.

It undertakes the safe custody of valuables. For this purpose safe deposit vaults are

maintained. Vault is a strong room for keeping the valuables safe.

Bank makes arrangements for transport, insurance and warehousing of goods.

It underwrites the shares and debentures of the newly promoted joint stock

companies.

Some commercial banks undertake merchant banking business equipment leasing

business.

It provides tax consultancy services. It gives advice on income tax and other personal

taxes. It prepares customers annual statement, files appeals etc.,

It provides consultancy services on technical, financial, and managerial and economic

aspects for the benefit of micro and small enterprises.

Modern Functions of a Commercial Bank

Changing cash for bank deposits and bank deposits for cash.

Transferring bank deposits between individuals and/or companies.

Exchanging deposits for bills of exchange, government bonds, secured and unsecured

promises of trade and industrial units.


Underwriting capital issues.

Providing 24 hours facility of payments through ATMs.

It issues credit cards, smart cards etc.

Types of Bank

1. On the Basis of Function

Central Bank:

This is the most important bank of the country. The central bank is the head, the leader and

the supervisor of the banking and monetary system of a country. It controls the flow of

money and credit in the country. It is not a profit seeking institution.

Commercial Bank:

These banks are profit seeking institutions. They receive deposits, advance loans and create

credit. These banks also perform the agency and utility services for the people.

Industrial Bank:

Industrial banks provide medium and long term loans to the industry. These banks solve the

special financial problems of the industry by providing funds for the purchase of raw

material, machinery etc.

Agricultural Bank:

This bank provides financial assistance to agriculture sector. Bank provides loans for

purchase of seeds, fertilizers and agricultural equipment. Agricultural bank provides short

term and long term loans to the farmers and land owners at lower rate of interest.

Investment Bank:

The main functions of these banks are the sales and purchase of shares, bonds and securities.

Saving Bank:


These banks collect saving of the people. These banks have been established to promote

saving habits among the people of low earning.

Exchange Banks

These are the banks which provide foreign exchange to the importers and exporters of the

country. These banks convert local currency into foreign currency and make foreign

payments.

Mortgage Banks:

These banks mortgage land, houses and other property and advance loans.

2. On the basis of ownership

Public Bank:

These banks owned and supervised by the government.

Private Bank:

These are private sector banks owned by corporations.

Cooperative Banks:

These banks provide services for the small scale business and provide short and medium term

loans.

3. On the basis of domicile

Domestic bank:

These are the banks that are registered with the country.

Foreign Banks:


These are the banks which are registered in foreign countries. E.g. Standard Chartered Bank,

Citi Bank.

Scheduled banks:

The banks which work under the control of Central banks are known as Scheduled Banks.

These banks must have paid up capital not less than Rs. 5 million.

Non Scheduled Banks:

The banks which are not working under the supervision of the central bank are known as Non

Schedule banks. These banks have minimum paid up capital of Rs. 50,000 but not more than

Rs. 5 million.

4. On the basis of incorporation

Chartered bank:

These are the banks which are established by the order of the king (royal Order). These banks

functions lay down by their charter.

Statutory Bank:

These banks are formed by the order of the head of state or by the special act of parliament.

The main object of these banks is the welfare of public and profit is not so important e.g.

SBI.

Unit banking system

Unit banking means a system of banking under which banking services are provided by a

single banking organization. Such a bank has a single office or place of work. It ha its own

governing body or board of directors. It has its own governing body or board of directors. It


functions independently and is not controlled by any other individual, firm or body corporate.

It also does not control any other bank.

Under this type of banking system an individual bank operates through an single office. The

size and area of operation is much smaller than in other types of banking system. It was

originated and grew in USA. The main reason for the development of unit banking system in

America is the fear of emergence of monopoly in banking business.

Branch banking system

Branch banking center or financial center refers to a single bank which operates through

various branches in a city or in different locations or out of the cities.

In this type of banking system a big bank as a single owner ship operates through a network

of branches spread all over the country. This type of banking system was initially developed

in England. Later on it become popular in other countries like Canada, India and Australia

etc.

Particulars Branch Banking Unit Banking

Operational

freedom

Less Operational freedom. More Operational freedom.

Loans and

advances

Loans and advances are based on merit,

irrespective of the status.

Loans and advances can be influenced by

authority and power.

Financial

resources

Larger financial resources in each branch. Larger financial resources in one branch

Decision-

making

Delay in Decision-making as they have to

depend on the head office.

Time is saved as Decision-making is in

the same branch.

Funds Funds are transferred from one branch to

another. Underutilisation of funds by a

branch would lead to regional imbalances

Funds are allocated in one branch and no

support of other branches. During

financial crisis, unit bank has to close

down. hence lead to regional imbalances

or no balance growth

Cost of High Less


supervision

Concentration

of power in the

hand of few

people

Yes No

Specialisation Division of labour is possible and hence

specialisation possible

Specialisation not possible due to lack of

trained staff and knowledge

Competition High competition with the branches Less competition within the bank

Profits Shared by the bank with its branches Used for the development of the bank

Specialised

knowledge of

the local

borrowers

Not possible and hence bad debits are high Possible and less risk of bad debts

Distribution of

Capital

Proper distribution of capital and power. No proper distribution of capital and

power.

Rate of interest Rate of interest is uniformed and specified

by the head office or based on instructions

from RBI.

Rate of interest is not uniformed as the

bank has own policies and rates.

Deposits and

assets

Deposits and assets are diversified,

scattered and hence risk is spread at

various places.

Deposits and assets are not diversified

and are at one place, hence risk is not

spread.

Mixed banking system:

When a bank combines the deposit as well as investment banking activities, it is called mixed

banking. In other words, when banks perform the dual function of commercial banking and

investment banking, i.e., provides long term lending to industries. It is called mixed banking.

If the banks provide both short term and long term loans to the industries it is called as mixed

banking system. German banks are the best examples of this type of banking system. These


banks accept both short term and long term deposits. Therefore they are able to provide both

short and long term loans required by the industry. The banks were facilitated to invest the

surplus funds for the industrial development of the country in this type of banking system.

Certain banks undertake both commercial and industrial banking. This system knows as

mixed banking. The feature of mixed banking is to attract deposits and raise capital and loans

from the public and make them available to industries for both short and long periods.

The need for mixed banking

1. The need for industrial revival was felt both by the government and the banks. Many

industrial units to which the banks had supplied short-term loans were not in a

position to repay. So the bank took a wise step to take debentures of such companies

in view of short-term loans instead of writing them off.

2. The deposits of commercial banks were fast increasing it was advisable for the banks

to advance loans for long periods

3. The growth of big industries led to a decrease in the dependence of bank finance as

they built up their own surplus funds to supplement their working capital. Thus banks

were deprived of their best customers. So they were compelled to grant long-term

loans to big industries and gradually start holding industrial securities

4. The government policy was for quick industrialization in countries like Germany and

Japan. Bank undertook the responsibility of supplying long-term finance to industries

for speedy industrialization

5. Stock exchange was increased for the marketability of securities of joint stock

companies. The bank companies as they could sell them in the stock exchange at any

time and convert them into cash.


Merits of mixed banking

1. It grants short-term loans for the purchase of raw materials and the payment of wages

and salaries and also grants long term loans for the purchase of plant and machinery

and other assets. Thus an industrial concern need not go to different types of banks

for its different types of requirements.

2. A commercial bank raises large funds from the public by way of deposits. Many

people do not like to subscribe shares and debentures of the industrial banks because

they prefer to keep their money in various deposits. Thus if a commercial bank

undertakes industrial banking, it will have large funds to provide substantial aid to

industries.

3. A mixed bank appoints experts to access the soundness of industrial unit and to

evaluate its securities. It can provide various other services to the industrial

undertaking like management of capital issues. On the basis of the advice given by

the experts it can subscribe to the shares and debentures of the companies and can

appoint its nominees on their board of directors.

4. The banks can join together into groups to share the risk of industrial finance. The

mixed bank s followed this practice and appointed their men on the board of directors

of companies. This helps the banks to have personal knowledge of the working of the

industrial enterprises.

5. Mixed bank provides valuable advice to its customers on investments in shares and

debentures since it has a personal knowledge of the working of number industrial

organizations. Thus mixed banking stimulates capital formation in the country.

6. Mixed banking facilities industrialization in developing countries. It does so by

providing both short term and long-term financial accommodation.

Demerits of Mixed banking

1. It reduces liquidity of the bank. A large part of the funds of the bank is raised from

deposits, which are repayable either on demand or after a short period.

2. When a bank grants long-term loans, its funds are locked up and consequently it may

not be able to pay the depositors when they demand back their money.


3. During periods of depression, banks suffer heavy losses when the securities of

companied lose their value because of fall in demand for the sale of securities held by

it. Banks with poor reserves may fail. This is a serious drawback of mixed banking.

4. During periods of boom, banks are tempted to over invest their funds in industries

beyond safe limits. The bank may indulge into speculation of shares in the hope of

earning higher profits. This carries great results into huge losses.

Thus the system of mixed banking has serious evils despite the fact that it has several

advantages. Many banks failed in France, America and other countries due to industrial

finance. The central bank of the country must be strong enough to guide and control the

operations of the mixed banks. In countries like India, mixed banking should be under taken

with great care.

In a nutshell it is a system of banking under which commercial banks provide both short and

long-term loans for commerce and industries.

Trade requires both short term loans whereas industries require short and long term loans.

Under the mixed banking system the commercial banks meet the short as well as long term

requirements of industries. Therefore, it is known as mixed banking. The German banking

system falls under this category. They are also referred to as universal banks.

The banks help the industrial units to appoint experts in various departments. There is

efficiency and economy in the operations. These banks also help the companies in mobilizing

larger financial resources by selling their shares to the public. Due to its long term

accommodation to industries there is a wide spread industrial development in the country.

Thus in case of specialized banking a commercial bank is not in a position to give a sound

advice for the purchase of securities. Thus mixed banking stimulated capital formation in the

country.

Central Bank


Central banking is a banking system in which a single bank has either complete or a

residuary monopoly of note issue”. In the statutes of the Bank for International Settlements, a

central bank is the bank in any country to which has been entrusted the duty of regulating the

volume of currency and credit in the country”.

Reserve Bank of India (RBI)

The RBI is the Central Bank of our country. It is the open Institution of India Financial and

monetary system. RBI came into existence on 1st April, 1935 as per the RBI act 1935. But

the bank was nationalised by the government after Independence. It became the public sector

bank from 1st January, 1949. Thus, RBI was established as per the Act 1935 and

empowerment took place in banking regulation Act 1949. RBI has 4 local boards basically in

North, South, East and West – Delhi, Chennai, Calcutta, and Mumbai.

Functions of Reserve Bank of India (RBI)

1. Traditional Functions

Traditional functions are those functions which every central bank of each nation performs

all over the world. Basically these functions are in line with the objectives with which the

bank is set up. It includes fundamental functions of the Central Bank. They comprise the

following tasks.

Issue of Currency Notes: The RBI has the sole right or authority or monopoly of

issuing currency notes except one rupee note and coins of smaller denomination. These

currency notes are legal tender issued by the RBI. Currently it is in denominations of

Rs. 5, 10, 20, 50, 100, 500, and 1,000. The RBI has powers not only to issue and

withdraw but even to exchange these currency notes for other denominations. It issues

these notes against the security of gold bullion, foreign securities, rupee coins,

exchange bills and promissory notes and government of India bonds.

Banker to other Banks: The RBI being an apex monitory institution has obligatory

powers to guide, help and direct other commercial banks in the country. The RBI can

control the volumes of banks reserves and allow other banks to create credit in that

proportion. Every commercial bank has to maintain a part of their reserves with its


parent's viz. the RBI. Similarly in need or in urgency these banks approach the RBI for

fund. Thus it is called as the lender of the last resort.

Banker to the Government: The RBI being the apex monitory body has to work as an

agent of the central and state governments. It performs various banking function such

as to accept deposits, taxes and make payments on behalf of the government. It works

as a representative of the government even at the international level. It maintains

government accounts, provides financial advice to the government. It manages

government public debts and maintains foreign exchange reserves on behalf of the

government. It provides overdraft facility to the government when it faces financial

crunch.

Exchange Rate Management: It is an essential function of the RBI. In order to

maintain stability in the external value of rupee, it has to prepare domestic policies in

that direction. Also it needs to prepare and implement the foreign exchange rate policy

which will help in attaining the exchange rate stability. In order to maintain the

exchange rate stability it has to bring demand and supply of the foreign currency (U.S

Dollar) close to each other.

Credit Control Function: Commercial bank in the country creates credit according to

the demand in the economy. But if this credit creation is unchecked or unregulated then

it leads the economy into inflationary cycles. On the other credit creation is below the

required limit then it harms the growth of the economy. As a central bank of the nation

the RBI has to look for growth with price stability. Thus it regulates the credit creation

capacity of commercial banks by using various credit control tools.

Supervisory Function: The RBI has been endowed with vast powers for supervising

the banking system in the country. It has powers to issue license for setting up new

banks, to open new branches, to decide minimum reserves, to inspect functioning of

commercial banks in India and abroad, and to guide and direct the commercial banks in

India. It can have periodical inspections an audit of the commercial banks in India.


2. Developmental / Promotional Functions of RBI

Along with the routine traditional functions, central banks especially in the developing

country like India have to perform numerous functions. These functions are country specific

functions and can change according to the requirements of that country. Some of the major

development functions of the RBI are given below.

Development of the Financial System: The financial system comprises the financial

institutions, financial markets and financial instruments. The sound and efficient

financial system is a precondition of the rapid economic development of the nation. The

RBI has encouraged establishment of main banking and non-banking institutions to

cater to the credit requirements of diverse sectors of the economy.

Development of Agriculture: In an agrarian economy like ours, the RBI has to provide

special attention for the credit need of agriculture and allied activities. It has

successfully rendered service in this direction by increasing the flow of credit to this

sector. It has earlier the Agriculture Refinance and Development Corporation (ARDC)

to look after the credit, National Bank for Agriculture and Rural Development

(NABARD) and Regional Rural Banks (RRBs).

Provision of Industrial Finance: Rapid industrial growth is the key to faster economic

development. In this regard, the adequate and timely availability of credit to small,

medium and large industry is very significant. In this regard the RBI has always been

instrumental in setting up special financial institutions such as ICICI Ltd. IDBI, SIDBI

and EXIM BANK etc.

Provisions of Training: The RBI has always tried to provide essential training to the

staff of the banking industry. The RBI has set up the bankers' training colleges at

several places. National Institute of Bank Management i.e. NIBM, Bankers Staff

College i.e. BSC and College of Agriculture Banking i.e. CAB are few to mention.

Collection of Data: Being the apex monetary authority of the country, the RBI collects

process and disseminates statistical data on several topics. It includes interest rate,


inflation, savings and investments etc. This data proves to be quite useful for

researchers and policy makers.

Publication of the Reports: The Reserve Bank has its separate publication division.

This division collects and publishes data on several sectors of the economy. The reports

and bulletins are regularly published by the RBI. It includes RBI weekly reports, RBI

Annual Report, Report on Trend and Progress of Commercial Banks India., etc. This

information is made available to the public also at cheaper rates.

Promotion of Banking Habits: As an apex organization, the RBI always tries to

promote the banking habits in the country. It institutionalizes savings and takes

measures for an expansion of the banking network. It has set up many institutions such

as the Deposit Insurance Corporation-1962, UTI-1964, IDBI-1964, NABARD- 1982,

NHB-1988, etc. These organizations develop and promote banking habits among the

people. During economic reforms it has taken many initiatives for encouraging and

promoting banking in India.

Promotion of Export through Refinance: The RBI always tries to encourage the

facilities for providing finance for foreign trade especially exports from India. The

Export-Import Bank of India (EXIM Bank India) and the Export Credit Guarantee

Corporation of India (ECGC) are supported by refinancing their lending for export

purpose.

3. Functions of RBI

RBI has authority to regulate and administer the entire banking and financial system.

Some of its supervisory functions are given below.

Granting license to banks: The RBI grants license to banks for carrying its business.

License is also given for opening extension counters, new branches, even to close down

existing branches.


Bank Inspection: The RBI grants license to banks working as per the directives and in

a prudent manner without undue risk. In addition to this it can ask for periodical

information from banks on various components of assets and liabilities.

Control over NBFIs: The Non-Bank Financial Institutions are not influenced by the

working of a monitory policy. However RBI has a right to issue directives to the NBFIs

from time to time regarding their functioning. Through periodic inspection, it can

control the NBFIs.

Implementation of the Deposit Insurance Scheme: The RBI has set up the Deposit

Insurance Guarantee Corporation in order to protect the deposits of small depositors.

All bank deposits below Rs. One lakh are insured with this corporation. The RBI work

to implement the Deposit Insurance Scheme in case of a bank failure.

Role of RBI in Credit Control (Tools and techniques of credit control / weapons of RBI

for credit control)

Probably the most important of all the functions performed by a central bank are that

of controlling the credit operations of commercial banks.

I) General / Quantitative Credit Control Methods:-

II) Selective / Qualitative Credit Control Methods:-

Reserve Rural Bank

Meaning

RRBs are oriented towards meeting the needs of the weaker sections of the rural population

consisting of small & marginal farmers, agricultural laborers, artisans & small entrepreneurs.

Rural banking in India came into existence since the establishment of banking sector in India.

Rural Banks in those days mainly focused upon the agro sector. Banking Regulation Act,

1949 brought cooperative Banks and Regional Rural Banks under the Reserve Bank’s


jurisdiction, while amendments to the Reserve Bank of India Act, Regional Rural Banks

(RRB) are regulated by the Rural Planning and Credit Department of Government of

India and supervised by NABARD. Capital share being 50% by the Central Government,

15% by the state government and 35% by the scheduled bank. Total authorized capital was

fixed at Rs.1 Crore which has since been raised to Rs 5 crores. RRBs started their

development process on 2nd October, 1975 with the formation of a single bank (Prathama

Grameen Bank)

Features of RRBs

As these banks were more suitable for rural development work, preference should be

given to them to open branches in rural banks.

The eligible business of commercial banks rural branches may be transferred to RRBs

The losses in initial years of RRBs may be met by shareholders & equity capital should

also be raised.

The various facilities provided by sponsor banks should continue for 10 years in each

case.

Concessionary refinance by RBI should be continued.

The control, regulatory and promotional responsibilities relating to RRBs should be

transferred from the Government of India to RBI or NABARD.

Regional Rural Banks were a new type of institution, which combined

Local feel and familiarity with rural possess problems which co-operative banks have.

Degree of business organization ability to mobilize deposit, access to money market and

modernized outlook which commercial banks have.

Working of RRBs

RRBs have done mainly two works:

Grant of Credit at cheap or concessional rates

Lending to individuals belonging to weaker sections without checking the viability of

the activity proposed to be undertaken.


Objectives of Regional Rural Banks

Regional Rural Banks were established with the following objectives in mind:

Taking the banking services to the doorstep of rural masses, particularly in hitherto

unbanked rural areas.

Making available institutional credit to the weaker sections of the society who had

by far little or no access to cheaper loans and had perforce been depending on the

private money lenders.

Mobilize rural savings and channelize them for supporting productive activities in

rural areas.

To create a supplementary channel for the flow the central money market to the

rural areas through refinances

Generating employment opportunities in rural areas and bringing down the cost of

providing credit to rural areas.

With these objectives in mind, knowledge of the local language by the staff is an important

qualification to make the bank accessible to the people.

Functions of RRBs are as follows

RRBs grant loans and advances to small farmers and agricultural laborers so that they can

start their own farming activities including purchase of land, seeds and manure.

RRBs provides banking services at the doorsteps of the rural people ,particularly in those

area which are not served by any commercial Bank

The RRBs charges a lower rate of Interest and thus they reduce the cost of credit in the

rural areas.

RRBs provide loan and other financial assistance to entrepreneurs in villages, sub-urban

areas and small towns. So that they become able to enlarge their business.


Loans to artisans to encourage them for the production of artistic and related goods.

Encourage the saving habit among the rural and semi-urban population.

State Bank of India

State Bank of India (SBI) is a multinational banking and financial services company based

in India. It is a government-owned corporation with its headquarters in Mumbai,

Maharashtra. As of December 2013, it had assets of US$388 billion and 17,000 branches,

including 190 foreign offices, making it the largest banking and financial services company

in India by assets.

State Bank of India is one of the Big Four banks of India, along with ICICI Bank, Punjab

National Bank and HDFC Bank.

The bank traces its ancestry to British India, through the Imperial Bank of India, to the

founding, in 1806, of the Bank of Calcutta, making it the oldest commercial bank in

the Indian Subcontinent. Bank of Madras merged into the other two "presidency banks" in

British India, Bank of Calcutta and Bank of Bombay, to form the Imperial Bank of India,

which in turn became the State Bank of India. Government of India owned the Imperial Bank

of India in 1955, with Reserve Bank of India (India's Central Bank) taking a 60% stake, and

renamed it the State Bank of India. In 2008, the government took over the stake held by the

Reserve Bank of India.

State Bank of India is a regional banking behemoth and has 20% market share in deposits

and loans among Indian commercial banks.

Operations

SBI provides a range of banking products through its network of branches in India

and overseas, including products aimed at non-resident Indians (NRIs). SBI has 14

regional hubs and 57 Zonal Offices that are located at important cities throughout

India.


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http://en.wikipedia.org/wiki/Bank_of_Bombay

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http://en.wikipedia.org/wiki/Bank_of_Calcutta

http://en.wikipedia.org/wiki/Imperial_Bank_of_India

http://en.wikipedia.org/wiki/British_Raj

http://en.wikipedia.org/wiki/HDFC_Bank

http://en.wikipedia.org/wiki/Punjab_National_Bank

http://en.wikipedia.org/wiki/Punjab_National_Bank

http://en.wikipedia.org/wiki/ICICI_Bank

http://en.wikipedia.org/wiki/Big_Four_(banks)#India

http://en.wikipedia.org/wiki/Mumbai,_Maharashtra

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http://en.wikipedia.org/wiki/Government-owned_corporation

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Domestic presence: SBI had 14,816 branches in India, as on 31 March 2013, of

which 9,851 (66%) were in Rural and Semi-urban areas.[1] In the financial year 2012-

13, its revenue was INR 200,560 Crores (US$ 36.9 billion), out of which domestic

operations contributed to 95.35% of revenue. Similarly, domestic operations

contributed to 88.37% of total profits for the same financial year.[1]

International presence

As of 28 June 2013, the bank had 180 overseas offices spread over 34 countries. It

has branches of the parent in Moscow, Colombo, Dhaka, Frankfurt, Hong Kong,

Tehran, Johannesburg, London, Los Angeles, Male in the Maldives, Muscat, Dubai,

New York, Osaka, Sydney, and Tokyo. It has offshore banking units in the Bahamas,

Bahrain, and Singapore, and representative offices in Bhutan and Cape Town. It also

has an ADB in Boston, USA.

In Nepal, SBI owns 55% of Nepal SBI Bank, which has branches throughout the

country. In Moscow, SBI owns 60% of Commercial Bank of India, with Canara Bank

owning the rest. In Indonesia, it owns 76% of PT Bank Indo Monex. The State Bank

of India already has a branch in Shanghai and plans to open one in Tianjin

Associate banks

SBI has five associate banks; all use the State Bank of India logo, which is a blue circle, and

all use the "State Bank of" name, followed by the regional headquarters' name:

State Bank of Bikaner & Jaipur

State Bank of Hyderabad

State Bank of Mysore

State Bank of Patiala

State Bank of Travancore

.

Non-banking subsidiaries

Apart from its five associate banks, SBI also has the following non-banking subsidiaries:


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http://en.wikipedia.org/wiki/State_Bank_of_Patiala

http://en.wikipedia.org/wiki/State_Bank_of_Mysore

http://en.wikipedia.org/wiki/State_Bank_of_Hyderabad

http://en.wikipedia.org/wiki/State_Bank_of_Bikaner_%26_Jaipur

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SBI Capital Markets Ltd

SBI Funds Management Pvt Ltd

SBI Factors & Commercial Services Pvt Ltd

SBI Cards & Payments Services Pvt. Ltd. (SBICPSL)

SBI DFHI Ltd

SBI Life Insurance Company Limited

SBI General Insurance

In March 2001, SBI (with 74% of the total capital), joined with BNP Paribas (with 26% of

the remaining capital), to form a joint venture life insurance company named SBI Life

Insurance company Ltd. In 2004, SBI DFHI (Discount and Finance House of India) was

founded with its headquarters in Mumbai.

Other SBI service points

As of 31 March 2014: SBI has 43,515 ATMs and SBI group (including associate banks) has

51,491 ATMs. SBI has become the first bank to install an ATM at Drass in the Jammu &

Kashmir Kargil region. This was the Bank's 27,032nd ATM on 27 July 2012.


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Unit 4

Foreign exchange

The term 'foreign exchange' is used in its narrow as well as broad senses:

1. Narrow Meaning:

In the narrow sense, foreign exchange simply means the money of a foreign country. Thus,

American dollars are foreign exchange to an Indian and Indian rupees arc foreign exchange

to an American. In practice, foreign exchange is often used to refer to a country's actual stock

of foreign currency, i.e., foreign currency notes or the means of obtaining such money

through traveler’s cheques or letters of credit.


2. Broader Meaning:

In the broader sense, the foreign exchange is related to the mechanism of foreign payments.

It refers to the system whereby one currency is exchanged for or converted into another.

Foreign exchange market is a market where foreign currencies are bought and sold by the

traders' to meet their obligations abroad.

Foreign exchange is the system by which commercial nations discharge their debts to each

other. In the words, Foreign exchange is the art and science of international monetary

exchange. The exchange of one currency for another or the conversion of one currency into

another currency is called as foreign exchange. Foreign exchange also refers to the global

market where currencies are traded virtually around-the-clock. The term foreign exchange is

usually abbreviated as "forex" and occasionally as "FX."

Foreign exchange market

Foreign exchange market: The foreign exchange market provides the physical and

institutional structure through which the money of one country is exchanged for that of

another country, the rate of exchange between currencies is determined, and foreign

exchange transactions are physically completed.

A foreign exchange transaction is an agreement between a buyer and a seller that a given

amount of one currency is to be delivered at a specified rate for some other currency. The

Currency Market: where money denominated in one currency is bought and sold with money

denominated in another currency.

It is the market where the currency of one country is exchanged for that of another country

and where the rate of exchange is determined. The genesis of foreign exchange market can be

traced to the need of foreign currencies arising from:

International trade

Foreign investment

Lending to borrowing from foreigners


In order to maintain the equilibrium in the foreign exchange market, the monetary authority

of the concerned country normally intervenes in to bring out the desired balance by:

Variation in the exchange rate

Change in the official reserves

Both

According to foreign exchange regulation act, foreign exchange means foreign currency and

includes:

All deposits, credits and balances payable in any foreign currency

The drafts, traveler’s cheques, letter of credit and bill of exchange expressed or drawn

in Indian currency, but payable in foreign currency.

All investments payable at the option of the holder thereof or any other party there to

either in Indian currency or in foreign currency partly in one and partly in other.

Features of foreign exchange market

Global market: it is a global market. It means foreign exchange buyer and seller

worldwide exist.

Currency traded: in the foreign currency market one country’s currencies can be

exchanged for the currencies of another country

Around the clock market; it is round the clock market meaning that the transactions

can take place any time within 24 hours of the day.

1 to 2 % transactions are for actual trade and rest or speculation: in this market 1 to 2

% transaction are for actual trade and most of the transactions is related to

speculation

In this market there is no physical transfer of money. In this foreign exchange market,

most markets have an electronic system for transfer of funds which save time and

energy.

Most of the transactions in this market are done with help of commercial banks.

It facilitates trade and investment

A party can never be a demander of one currency without being simultaneously the

supplier of another.


Functions of foreign exchange market

The foreign exchange market is the mechanism by which a person of firm transfers

purchasing power from one country to another, obtains or provides credit for international

trade transactions, and minimizes exposure to foreign exchange risk.

Provision for credit: because the movement of goods between countries takes time,

inventory in transit must be financed

Minimizing foreign exchange risk: each may prefer to earn a normal business profit

without exposure to an unexpected change in the anticipated profit because exchange

rate s suddenly changes. The foreign exchange market provides hedging facilities for

transferring foreign exchange risk to someone else.

Transfer of Purchasing Power: Transfer of purchasing power is necessary because

international transactions normally involve parties in countries with different national

currencies. Each party usually wants to deal in its own currency, but the transaction

can be invoiced in only one currency.

Major participants of foreign exchange market

The foreign exchange market consists of two tiers: the interbank or wholesale market,

and the client or retail market. Individual transactions in the interbank market usually

involve large sums that are multiples of a million USD or the equivalent value in

other currencies. By contrast, contracts between a bank and its client are usually for

specific amounts, sometimes down to the last penny.

Retail clients such as tourist, MNCs, importer, exporter and international

investors use the foreign exchange market to facilitate execution of

commercial or investment transactions. Some of these participants use the

foreign exchange market to hedge foreign exchange risk.

Foreign Exchange Dealers: Banks, and a few nonbank foreign exchange

dealers, operate in both the interbank and client markets. They profit from

buying foreign exchange at a bid price and reselling it at a slightly higher ask


price. Worldwide competitions among dealers narrows the spread between bid

and ask and so contributes to making the foreign exchange market efficient in

the same sense as securities markets. Dealers in the foreign exchange

departments of large international banks often function as market makers.

They stand willing to buy and sell those currencies in which they specialize by

maintaining an inventory position in those currencies.

Central banks: control on demand and supply of foreign currency through

varying exchange rate either fixed or floating exchange rate. Central banks

and treasuries use the market to acquire or spend their country's foreign

exchange reserves as well as to influence the price at which their own

currency is traded.

Foreign Exchange Brokers: Foreign exchange brokers are agents who

facilitate trading between dealers without themselves becoming principals in

the transaction. For this service, they charge a small commission, and

maintain access to hundreds of dealers worldwide via open telephone lines. It

is a broker's business to know at any moment exactly which dealers want to

buy or sell any currency. This knowledge enables the broker to find a

counterpart for a client quickly without revealing the identity of either party

until after an agreement has been reached.

Speculators: who buy or sell currencies when they expect movement in the

exchange rate in a particular direction. The movement of exchange rate in the

desired direction gives them the profit

Arbitrageurs: who exchange currencies because of varying rates of exchange

in different markets? The varying are the source of their profit

Hedgers: non banking entities such as traders that use the foreign exchange

market for the purpose of hedging without exposure to an unexpected change

in anticipated profit.

Spot and forward Market


Spot market: in this market currencies are traded for immediate delivery at the rate

existing on the day of transaction. For making book keeping entries , delivery takes

two working days after a transaction is complete

Forward market: In this contract are made to buy and sell currencies for a future

delivery, say after a fortnight, one month, and two months and so on. The rate of

exchange for the transaction is agreed upon on the very day the deal is finalized.

Exchange Rates

The rate, at which a currency is converted into another currency, is called the rate of

exchange. Such rates are arrived from the base rate, which is decided by market forces and is

quoted on a daily basis.

Factors causing fluctuation in Exchange Rate

Numerous factors determine exchange rates, and all are related to the trading

relationship between two countries. Remember, exchange rates are relative, and are

expressed as a comparison of the currencies of two countries. The following are some

of the principal determinants of the exchange rate between two countries. Note that

these factors are in no particular order; like many aspects of economics, the relative

importance of these factors is subject to much debate.

Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a rising

currency value, as its purchasing power increases relative to other currencies. Those

countries with higher inflation typically see depreciation in their currency in relation

to the currencies of their trading partners. This is also usually accompanied by higher

interest rates.

Differentials in Interest Rates


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Interest rates, inflation and exchange rates are all highly correlated. By manipulating

interest rates, central banks exert influence over both inflation and exchange rates,

and changing interest rates impact inflation and currency values. Higher interest rates

offer lenders in an economy a higher return relative to other countries. Therefore,

higher interest rates attract foreign capital and cause the exchange rate to rise. The

impact of higher interest rates is mitigated, however, if inflation in the country is

much higher than in others, or if additional factors serve to drive the currency down.

The opposite relationship exists for decreasing interest rates - that is, lower interest

rates tend to decrease exchange rates.

Current-Account Deficits

The current account is the balance of trade between a country and its trading partners,

reflecting all payments between countries for goods, services, interest and dividends.

A deficit in the current account shows the country is spending more on foreign trade

than it is earning, and that it is borrowing capital from foreign sources to make up the

deficit. In other words, the country requires more foreign currency than it receives

through sales of exports, and it supplies more of its own currency than foreigners

demand for its products. The excess demand for foreign currency lowers the country's

exchange rate until domestic goods and services are cheap enough for foreigners, and

foreign assets are too expensive to generate sales for domestic interests.

Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects

and governmental funding. While such activity stimulates the domestic economy,

nations with large public deficits and debts are less attractive to foreign investors. The

reason is that a large debt encourages inflation, and if inflation is high, the debt will

be serviced and ultimately paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt,

but increasing the money supply inevitably causes inflation. Moreover, if a

government is not able to service its deficit through domestic means (selling


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domestic bonds, increasing the money supply), then it must increase the supply of

securities for sale to foreigners, thereby lowering their prices. Finally, a large debt

may prove worrisome to foreigners if they believe the country risks defaulting on its

obligations. Foreigners will be less willing to own securities denominated in that

currency if the risk of default is great.

Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to

current accounts and the balance of payments. If the price of a country's exports rises

by a greater rate than that of its imports, its terms of trade have favorably improved.

The increasing terms of trade shows greater demand for the country's exports. This, in

turn, results in rising revenues from exports, which provides increased demand for the

country's currency (and an increase in the currency's value). If the price of exports

rises by a smaller rate than that of its imports, the currency's value will decrease in

relation to its trading partners.

Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic

performance in which to invest their capital. A country with such positive attributes

will draw investment funds away from other countries perceived to have more

political and economic risk. Political turmoil, for example, can cause a loss of

confidence in a currency and a movement of capital to the currencies of more stable

countries.

Speculation

If speculators believe the sterling will rise in the future, they will demand more now

to be able to make a profit. This increase in demand will cause the value to rise.


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Therefore movements in the exchange rate do not always reflect economic

fundamentals, but are often driven by the sentiments of the financial markets. For

example, if markets see news which makes an interest rate increase more likely, the

value of the pound will probably rise in anticipation.

Economic growth / recession

A recession may cause depreciation in the exchange rate because during a recession

interest rates usually fall. However, there is no hard and fast rule. It depends on

several factors. See: Impact of recession on currency.

Foreign exchange controls

Definition of 'Exchange Control’

It refers to types of controls that governments put in place to ban or restrict the amount of

foreign currency or local currency that is allowed to be traded or purchased. Common

exchange controls include banning the use of foreign currency and restricting the amount of

domestic currency that can be exchanged within the country.

Foreign exchange controls are various forms of controls imposed by a government on the

purchase/sale of foreign currencies by residents or on the purchase/sale of local currency by

nonresidents.

Common foreign exchange controls include:

Banning the use of foreign currency within the country

Banning locals from possessing foreign currency

Restricting currency exchange to government-approved exchangers

Fixed exchange rates

Restrictions on the amount of currency that may be imported or exported


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Objectives of exchange control

There are several objectives in practicing exchange controls. The main objects of foreign

exchange control may be stated as follows:

Conservation of Foreign Exchange: Exchange control may be introduced by the

monetary authority to conserve the gold, bullion, foreign exchange currencies, etc., i.e.,

foreign exchange resources, of the country. It may be necessary to ensure the availability

of sufficient amount of foreign exchange needed to buy essential foreign goods.

Check on Flight of Capita: Under the free exchange system there is the danger of huge

outflow of capital which may weaken the country's economy. Especially erratic shifting

of capital tends to accentuate the disequilibrium in the balance of payments and it also

adversely affects future growth of the country. Exchange control, however, offers a

prompt and effective means to prevent such capital outflows.

Correcting Disequilibrium in Balance of Payments: To correct the deficit in the

balance of payments, the country needs to put a curb on imports. For this purpose, the use

of Foreign exchange earnings by exporters for import of goods must be checked through

appropriate exchange control. Again, exchange control is essential to implement an

import policy very effectively. In short, exchange control may be introduced to protect

the country's balance of payments.

Stabilization of Exchange Rates: In a free exchange market, exchange rate is a

fluctuating phenomenon. Thus, exchange control may be adopted to maintain exchange

rates at an arbitrarily chosen fixed point.

Protecting the Interest of Home Producers: Exchange control may be used for giving

protection to domestic producers by restricting the competition from foreign traders

through import control.

Redemption of External Debt: The Government may use the exchange control device to

obtain foreign exchange needed for repaying or servicing of its foreign loans.

Effective Economic Planning: For successful economic planning, foreign trade has to be

coordinated with planned programmes and the outflow of capital should be restricted in

order to make it available to domestic industries. Thus, for mitigating the economic


repercussions of foreign trade endangering economic plans, exchange control becomes

inevitable.

Maintaining Over-value of Home Currency: Sometimes exchange control is used in

order to maintain the external value of the country's currency at an overvalued level. For

this purpose, the available foreign exchange resources are rationed for use of specific and

important purposes only and the government thereby, seeks to adjust total demand with

total supply of foreign currencies.

Generating Public Revenue: Under exchange control, by adopting multiple exchange

rates system, the Government can yield revenue income through difference of average

buying and selling rates, less costs of administration.

To prevent Spread of Depression: Depression in a big country may spread from

country to country via international economic relations. Exchange control may work as a

preventive against such spread of depression by controlling the main doors - imports and

exports.

Methods of Exchange Control

The various methods of exchange control may broadly be classified into two types, direct and

indirect. Direct methods of exchange control include those devices which are adopted by

governments to have an effective control over the exchange rate, while indirect methods are

designed to regulate international movements of goods.

1. Direct Methods of Exchange Control:

In direct exchange control, certain measures are adopted which effectuate immediate

direct restriction on foreign exchange from all sides - its quantum, use and allocation.

In general, direct exchange control includes measures like:

Intervention: It refers to the government's intervention or interference in the free

working of the exchange market with a view to overvalue or undervalue the country's

currency in terms of foreign money. The government or its agency - the central bank -

can intervene in the free market by resorting to buying and selling the home currency


against foreign currency in the foreign exchange market to support or depress the

exchange rate of its currency.

Pegging Operations: of the currency of the country to a chosen rate of exchange. Since

undervaluation or overvaluation is not the equilibrium rate, it has to be pegged. Thus,

pegging means keeping a fixed exchange value of a currency; however, intervention may

be practised by a government without resorting to pegging as such pegging down or

pegging up or government intervention in the foreign exchange market takes the form of.

Pegging operations take the form of buying and selling of the local currency by the

central bank of a country in exchange for the foreign currency in the foreign exchange

market, in order to maintain an exchange rate whether, it is overvalued or undervalued.

Pegging up means holding fixed overvaluation, i.e., to maintain the exchange rate at a

higher level. Pegging down means holding fixed undervaluation, i.e., to maintain the

exchange rate at a lower (depressed) level. In the case of pegging up, the central bank

shall have to keep itself ready to buy unlimited amount of local currency in exchange for

foreign currencies at a fixed rate, because overvaluation tends to increase the demand for

foreign currencies by creating import surplus.

In the case of pegging down, the central bank or central agency shall have to keep itself

ready to sell any amount to local currency by creating export surplus. Similarly, pegging

up involves holding of sufficient amount of foreign currencies while pegging down

involves holding of sufficient amount of local currency by the central bank. It goes

without saying that pegging up is more difficult to maintain as it requires huge amounts

of foreign currencies which is difficult to obtain. As such pegging up can be adopted

only as a temporary expedient.

It should be noted that intervention by a government in the foreign exchange market has

the effect of neutralizing the forces of demand and supply of foreign exchange. However,

it is generally assumed that government intervention or pegging up and pegging down


operations should be used as temporary expedients to remove fluctuations in the

exchange rate.

Exchange Restrictions: Exchange restrictions refer to the policy or measures adopted by

a government which restrict or compulsory reduce the flow of home currency in the

foreign exchange market. Exchange restrictions may be of three types:

(i) The government may centralize all trading in foreign exchange with itself or a

central authority, usually the central bank;

(ii) The government may prevent the exchange of local currency against foreign

currencies without its permission;

(iii) The government may order all foreign exchange transactions to be made through

its agency.

Exchange restrictions may take various forms, the most common of them being: (1) Blocked

accounts, (2) Multiple exchange rates.

Blocked Accounts: Under the condition of severe financial crisis, a debtor country may

adopt the scheme of blocking the accounts of its creditors. In 1931, Germany, for instance,

had done so in order to have exchange restrictions. Blocked accounts refer to bank deposits,

securities and other assets held by foreigners in a country which denies them conversion of

these into their home currency. Blocked accounts, thus, cannot be converted into the creditor

country's currency. Under the blocked accounts scheme, all those who have to make

payments to any foreign country will have to make them not to the foreign creditor directly

but to the central bank of the country which will keep the amount in the name of the foreign

creditor. This amount will not be available to the foreigners in their own currency, but can be

used by them for purchase in the controlling country. Blocked accounts system has two

drawbacks: (i) It reduces international trade to a minimum, and (ii) it leads to black-

marketing in foreign exchange.


Multiple Exchange Rates: In the early thirties, Germany had initiated the device of multiple

rates, as a weapon to improve her balance of payments position. Under this system, different

exchange rates are set for different classes and categories of exports and imports. Generally a

low rate, i.e., low prices of foreign money in terms of domestic currency, is confined to

imports of necessary items having an inelastic demand, while a high penalty rate is fixed for

the imports of luxury items. In short, the multiple exchange rates system implies official

price discriminatory policy in foreign exchange transactions.

By simply fixing a high exchange rate for a commodity, the government can check its

imports (when its elasticity of demand for import is greater than unity). Similarly, its imports

can be encouraged by fixing a low exchange rate.

Likewise, the export of a commodity can be encouraged by setting a high rate of exchange.

Thus, the device of multiple exchange rates can be effectively used by the government for

making short-term adjustments in the balance of payments, without resorting to quantitative

restrictions and licensing. Indeed, multiple exchange rates amount to discriminatory export

taxation and varying rates of tariffs on imports.

Thus, the main merit of the system of multiple exchange rates is that it allows more effective

control of the balance of payments. Secondly, it also contains disguised subsidies and tariffs,

which may encourage or discourage trade in certain goods and affect the level of foreign

trade. Apparently, buying foreign exchange at a rate above the equilibrium rate amounts to

subsidization of exports; while selling foreign exchange at a rate above the equilibrium rate

amounts to a tariff on imports.

Another merit of the system is that it enables the government to yield revenue by buying

foreign exchange at low prices in domestic money from exporters and then selling it at higher

prices to importers.

However, the system has the following drawbacks:


a. Instead of correcting the balance of payments, it adversely affects the growth of

international trade and the maximization of world output and welfare.

b. It puts too much arbitrary powers into the hands of the government to influence

foreign trade.

c. It creates undue complexities in calculation, due to different exchange rates for

different imports and exports which may be changed from time to time, resulting in

uncertainty in foreign trade.

d. The system has a formidable administrative problem of effective control. Utmost

vigilance has to be maintained against the undervaluation of export invoices and

overvaluation of import invoices and care should be taken to see that exporters do not

sell their proceeds of foreign exchange in the black-market and importers do make

specific and proper use of the allotted foreign exchange. Further, the system is also

likely to breed corruption.

Exchange Clearing Agreements: European countries had adopted this form of exchange

control in the Thirties. It was a system for the direct bilateral bartering of goods on a

national scale. Under this device, two countries engaged in trade pay to their respective

central banks the amounts payable to their respective foreign creditors.

These central banks then use the money in offsetting the corresponding claims after

fixing the value of the currencies by mutual agreement. And, importers have to deposit

their payment with the central bank can use such money to pay the domestic exporters.

This economizes exchange needs for trade. Therefore, exchange clearing device is

helpful to a country which has little or no foreign exchange reserves and which is more

interested in selling than buying. However, this system is essentially one of offsetting

each other's payments, and the basic assumption is that countries entering into such an

agreement should try to equalize their imports and exports so that, there will be no

necessity for either making or receiving payments from the other countries.


Following are the drawbacks of exchange clearing agreements:

a. There is a possibility of exploitation of an economically weaker country by a stronger

country.

b. The exchange clearing agreements involve bilateral transactions in foreign trade,

which cause a diversion of normal trade pattern and endanger the promotion of world

trade.

c. This device also reduces the volume of international trade. Besides, it attempts to do

away with the foreign exchange market.

d. The scheme requires that all payments have to be centralized.

Payment Agreements: To overcome the difficulties of the problems of waiting and

centralization of payments observed in clearing agreements, the device is formed as

payment agreements. Under this scheme, a creditor is paid as soon as informants.

Under this scheme, a creditor is paid as soon as information is received by the central

bank of the debtor country from the creditor country's central bank that its debtor has

discharged his obligation and vice versa. By designing the arrangement for mutual credit

facilities, thus, possibilities of delay are ruled out. Payment Agreements have the

advantage that direct relation between exporters and importers are maintained.

However, payment agreements suffer from two defects:

a. The agreement accounts could only be debited or credited for licensed payments.

b. The balances in the accounts could only be used for payment from one partner to

another.

Gold Policy: Through a suitable gold policy, the country can bring the desired exchange

control. For this, the country may resort to the manipulation of the buying and selling

prices of gold which affect the exchange rate of the country's currency. In 1936, for

instance, the U.K., France and U.S.A. signed the Tripartite Agreement in this regard for

fixing a suitable purchase and sale price of gold.


2. Indirect Methods of Exchange Control

Changes in Interest Rates: Changes in interest rate tend to influence indirectly the

foreign exchange rate. A rise in the interest rate of a country attracts liquid capital and

banking funds of foreigners. It will tend to keep their funds in their own country. All this

tends to increase the demand for local currency and consequently the exchange rate move

in its favor. It goes without saying that, a lowering of the rate of interest will have the

opposite effect.

Tariffs Duties and Import Quotas: The most important indirect method is the use of

tariffs and import quotas and other such quantitative restrictions on the volume of foreign

trade. Import duty reduces imports and with it rise the value of home currency relative to

foreign currency. Similarly, export duty restricts exports; as a result, the value of home

currency falls relative to foreign currencies. In short, when import duties and quotas are

imposed, the rate of exchange tends to go up in favor of the controlling country.

Export Bounties: Export bounties of subsidies increase exports. As such the external

value of the currency of the subsidy-giving country rises. It should be noted that import

duties and export bounties are treated as indirect instruments of exchange control only if

they are imposed with the object of conserving the foreign exchange. Otherwise, the

fundamental aim of import duty is merely to check imports and that of export bounty is to

encourage exports.

In fine, interest rates, import duty or export subsidy, each has its limitations. For instance,

import duty cannot go so far as to completely restrict imports. There is also the fear of

retaliation in regard to tariff policy. Similarly, the volume of subsidy depends upon the

support of public fund. Likewise, manipulation of exchange rate through changes in

interest rate may not be always effective. Moreover, rates of interest cannot be raised to

any limit without engendering depression.
