Demand for Money and Supply of Money

• Money is required to conduct transactions.
• Value (quantum) of transactions determines how much money people want to keep.
• Larger volume of transactions leads to larger demand for money.
• Quantum of transactions depends on income.
• Rise in income leads to rise in demand for money.

• People may keep their savings as money instead of in an interest-paying bank.
• Demand for money also depends on rate of interest.
• When interest rates increase, people become less interested in holding money.
• Holding money means holding less of interest-earning deposits and receiving less interest.
• Therefore, at higher interest rates, demand for money falls.

• In a modern economy, money consists of cash and bank deposits.
• Different measures of money exist depending on which deposits are included.
• Money is created by the central bank and the commercial banking system.

India's central bank is the Reserve Bank of India (RBI), established in 1935.

Functions

• Issues the country's currency.
• Controls money supply through:
  • Bank Rate
  • Open Market Operations (OMO)
  • Reserve Ratios
• Banker to the Government.
• Custodian of foreign exchange reserves.
• Banker to commercial banks.

High-Powered Money (Monetary Base)

The currency issued by the RBI is called:

• High-Powered Money
• Reserve Money
• Monetary Base

It may be held by the public or commercial banks and forms the basis for credit creation.

Commercial banks are part of the money-creating system.

Functions

• Accept deposits from the public.
• Lend a part of these deposits to borrowers.
• Earn profit through the Spread.

Spread = Lending Interest Rate − Deposit Interest Rate

The Lala story explains credit creation.

• People deposited gold with Lala, who issued paper receipts.
• These receipts began circulating as money.
• Although Lala held 100 kg of gold, he lent 25 kg to Ramu.
• Ramu paid Ali, who redeposited the gold with Lala and received receipts.
• Thus, receipts (money) increased to 125 kg even though actual gold remained 100 kg.

This illustrates how modern commercial banks create money through lending.

Commercial banks act as financial intermediaries between savers and borrowers.

People deposit money because:

• Banks pay interest.
• Deposits are safer than holding cash.
• Cheques and debit cards make payments easier and safer.

Banks:

• Keep a portion of deposits as reserves.
• Lend the remaining amount to earn interest.
• Must maintain enough reserves to meet withdrawal demands and retain depositors' confidence.

Thus, banks balance:

• Profit (maximum lending)
• Liquidity (ability to repay depositors)

• Demand for money depends on income (transactions) and rate of interest.
• Higher income → higher demand for money; higher interest rate → lower demand for money.
• Money supply consists of cash and bank deposits.
• Central Bank (RBI) issues currency and controls money supply (high-powered money).
• Commercial banks create money through deposit and credit creation.