Introductory Macroeconomics Chapter 3 Money And Banking

Meaning of barter. ‘Direct exchange of goods against goods without use of money is called barter exchange’. Alternatively economic exchanges without the medium of money are referred to as barter exchanges. An economy based on barter exchange (i.e., exchange of goods for goods) is called C.C. economy, i.e., commodity for commodity exchange economy. In such an economy, a person gives his surplus goods and gets in return the goods he needs. For example, when a weaver gives cloth to the farmer in return for getting wheat from the farmer, this is called barter exchange. Similarly, the farmer can get other goods of his requirements like shoes, cow, plough, spade, etc. by giving his surplus wheat (or rice or maize). Thus system of barter exchange fulfils to some extent the requirement of both the parties involved in exchange. However as the transactions increased, inconveniences and difficulties of barter exchange also increased involving rising trading costs. Trading costs are nothing but costs of engaging in trade. Its two components are – search cost and disutility of waiting. Remember, search cost is the high cost of searching suitable persons to exchange goods and disutility of waiting refers to time period spent on searching the required person. This ultimately led to evolution of money as medium of exchange.
Following are some of the drawbacks or inconveniences of barter.
or
 Inconveniences (problems) of barter exchange.
(i) Lack of double coincidence of wants. Double coincidence of wants means what one person wants to sell and buy must coincide with what some other person wants to buy and sell. ‘Simultaneous fulfillment of mutual wants by buyers and seller's is known as double coincidence of wants. There is lack of double coincidence in the wants of buyers and sellers in barter exchange. The producer of jute may want shoes in exchange for his jute. But he may find it difficult to get a shoemaker who is also willing to exchange his shoes for jute. Thus a seller has to find out a person who wants to buy seller's goods and at the same time who must have what the seller wants. This is called double coincidence of wants which is the main drawback of barter exchange.
(ii) Lack of common measure of value. In barter, there is no common measure (unit) of value. Even if buyer and seller of each other commodity happen to meet, the problem arises in what proportion the two goods are to be exchanged. Each article must have as many different values as there are other articles for which it is to be exchanged. When thousands of articles are produced and exchanged, there will be unlimited number of exchange ratios. Absence of a common denominator in order to express exchange ratios create many difficulties. Money obviates these difficulties and acts as a convenient unit of value and account.
(iii) Lack of standard of deferred payment. There is problem of future (or deferred) payments. It is difficult to engage in contracts which involve future payments due to lack of any satisfactory unit. As a result future payments are to be stated in term of specific goods or services. But there could be disagreement about quality of the goods, specific type of the goods and change in the value of the goods.
(iv) Difficulty in storing wealth (or generalised purchasing power). It is difficult for the people to store wealth or generalise purchasing power for future use in the form of goods like cattle, wheat, potatoes, etc. Holding of stocks of such goods involve costly storage and deterioration.
(v) Lack of divisibility. How to exchange goods of equal value? The shoemaker wants a loaf in exchange of his shoes but exchange value of a piece of loaf is but a fraction of a pair of shoes. Shoes cannot be sub-divided without destroying their values. Similarly, if a person wants to purchase cloth equal to the value of the half his cow, he cannot do so Without killing his cow. Thus lack of divisibility makes barter exchange impossible.
In order to overcome the above disadvantages of the barter system, money was invented by the society.

(a) Meaning of money. Money is any thing serving as a medium of exchange. Most definitions of money are based on different ‘functions of money’ as their starting point. ‘Money is that which money does’. According to Prof. Walker, ‘Money is as money does.’ This means that the term money should be used to include anything which performs the functions of money, viz., medium of exchange, measure of value, unit of account etc. Since general acceptability is the fundamental characteristic of money, therefore, money may be defined as ‘anything which is generally accepted by the people in exchange of goods and services or in repayment of debts.’
(b) Functions of money. In general terms, main function of money in an economic system is “to facilitate the exchange of goods and services and help in carrying out trade smoothly.” Its basic characteristic is general acceptability. Functions of money are reflected in the well known following couplet:

Thus conventionally money performs the following four functions (primary and secondary) each of which overcomes one or the other difficulty of barter. Medium of exchange and measure of value are primary functions because they are of prime importance whereas Standard of deferred payment and Store of value are called secondary functions as they are derived from primary functions.
1.    Money as the Medium of Exchange. Money came into use to remove the inconveniences of barter as money has separated the act of purchase from sale. Medium of exchange is the basic or primary function of money. People exchange goods and services through the medium of money. Money acts as a medium of exchange or as a medium of payments. Money by itself has no utility (except perhaps to the miser). It is only an intermediary. The use of money facilitates exchange, exchange promotes specialisation, specialisation increases productivity and efficiency. A good monetary system is, therefore, of immense utility to human society. Money is also called a bearer of options or generalised purchasing power because it provides freedom of choice to buy things he wants most from those who offer best bargain.
2.    Money as a Unit of Account or Measure of Value. Money serves as unit of account or a measure of value. Money is the measuring rod, i.e., it is the unit in which the values of other goods and services are measured in terms of money and expressed accordingly. Different goods produced in the country are measured in different units, e.g., cloth in metres, milk in litres, sugar in kilograms. Without a common unit of measure, exchange of goods and services becomes very difficult. Values of all goods and services can be expressed in a single common unit called money. Again without a measure of value, there can be no pricing process. Without a pricing process, organised marketing and production is not possible. Thus, the use of money as a measure of value is the basis of specialised production. The measuring rod of money is also indispensable to all forms of economic planning. Consumers compare the values of alternative purchases in terms of money. Producers compare the relative costliness of the factors of production in terms of money and also plan their output on the basis of the money yield. It is, therefore, highly important that the value of money should be stable.
3.    Money as the Standard of Deferred Payments. Deferred payments are payments which are made sometime in future. Debts are usually expressed in terms of the money of account. Loans are taken and repaid in terms of money. The use of money as the standard of deferred or delayed payments immensely simplifies borrowing and lending operations because money maintains a constant value through time. Thus money facilitates the formation of capital markets and the work of financial intermediaries like Stock Exchange, Investment Trust and Banks. Money is the link which connects the values of today with those of the future. It has become possible because value of money is stable and it has general acceptability and durability.
4.    Money as a Store of Value. Wealth can be stored in terms of money for future. It serves as a store value of goods in liquid form. By spending it we can get any commodity in future. Keynes places great emphasis on this function of money. Holding money is equivalent to keeping a reserve of liquid assets because it can be easily converted into other things. People, therefore, normally wish to keep a part of their wealth in the form of money because savings (storing of value) in terms of goods is very difficult. Wheat or any other product which will command a value cannot be stored for a long period. The desire for money (cash) is known as liquidity preference. Clearly money is the best form of store of value.
Another Function ‘Liquidity of Money’ is added these days. Liquidity means ''convertibility in cash''. Thus the ability to convert an asset into money/cash quickly and without loss of value is called liquidity of asset. An asset is highly liquid if it can be exchanged promptly and without loss. Modern economists are laying stress on liquidity of money. Since by definition, money is the most generally accepted commodity, it is also the most liquid of all resources. Possession of money enables one to get hold of almost any commodity in any place and money never locks a buyer. It is this peculiarity which distinguishes money from all other commodities. A preference for liquidity is preference for money.
Money, thus, acts as common medium of exchange, a common measure of value, as stamlard of deferred payments and a store of value.
Importance (significance) of money. Money occupies a unique position in a modern capitalist economy In its absence, the whole prosperous economic life would collapse like a pack of cards. The advantages or uses of money can be best understood by considering the system in which money is absent. Although uses of money are manifold but a few of its important advantages are given below :
1.    It helps in removing drawbacks of barter. How? Let us discuss it in the context of drawbacks of barter and functions of money.
(i) Money as medium of exchange solves the barter's problem of lack of double coincidence of wants as money has facilitated separation of purchase from sale. You can sell goods for money to whoever wants it and with this money you can buy goods from whoever wants to sell them. Money is accepted as medium of exchange. People exchange goods and services through medium of money when they buy goods or sell products. Thus money acts as intermediary which solves barter's problem of lack of double coincidence of wants.
(ii)    Money as measure (unit) of value or a unit of account solves the barter problem of lack of common measure (unit) of value. Money measures exchange value of commodities and makes keeping of business accounts possible.
(iii)    Money as standard of deferred payments helps to solve the barter problem of lack of standard of deferred payment. Again it helps to make contracts which involve future payments.
(iv)    Money as store of value solves the barter problem of lack of storing wealth (or generalised purchasing power). Moreover money in convenient denominations (like Indian coins of 5, 10, 20, 50, 100 paise and currency notes of र 2, 5, 10, 100, 500, 1000) solves the barter problem of absence or lack of divisibility.
Doubtlessly money helps in removing the difficulties of barter system as explained above.
2.    It facilitates exchange of goods and services and helps in carrying on trade smoothly. The present highly complicated economic system will not exist without money.
3.    Money helps in maximising consumers' satisfaction and producers' profits. It helps and promotes saving.
4.    Money promotes specialisation which increases productivity and efficiency.
5.    It facilitates planning of both production and consumption.
6.    Money can be utilised in reviving the economy from depression.
7.    Money enables production to take place in advance of consumption.
8.    It is the institution of money which has proved a valuable social instruments of promoting economic welfare. The whole economic science is based on money; economic motives and activities are measured by money. In fact, money makes its appearance in every phase of economics. In the words of Marshall:
“Money is the centre around which economic science clusters.”

Narrow and broad definitions of money. H.G. Johnson has classified definition of money into narrow definition and broad definition.
1.    Narrow definition of money (M = C + DD). It is based on ‘medium of payment’ function only. It is narrow definition of money when money is identified with medium of payment function only and its other functions are overlooked. Thus anything which is used as medium of payment is included in narrow definition of money (M). Accordingly it includes currency (C) and demand deposits (DD). Thus M = C + DD (this is also known as traditional approach to constituents of money supply).
2.    Broad definition of money (M = C + DD + TD + SD). It is broad definition of money when scope of money is extended to include ‘store of value’ function in addition to medium of exchange function. These have a high degree of moneyness or liquidity and are widely used as store of value. In addition to currency and demand deposits, (i.e. narrow money), items like ‘time deposits (TD) and savings deposits (SD) at banks and post offices’ are also included in broad money because such financial assets have a high degree of moneyness or liquidity which can be converted in to demand deposits/cheques on a short notice. Thus M = C + DD + TD + SD (this is also known as Modern Approach to constituents of money supply).

Standard and Token Coins. Standard coins refer to those coins whose face (printed) value is equal to its intrinsic value. Intrinsic value refers to the value of the metal the coin is made of and face value refers to the value marked on the face of the coin. For example, if value of the metal used in a five rupee coin is equal to five rupees, it will be called a standard coin and recognised as full-bodied money. It is also called commodity value of money.
Full-bodied money is the money whose value as a commodity (of which it is made of) for non-monetary purposes is as great as its value as money.
Token coins (or token money) refers to money whose face value is much greater than its intrinsic value. All Indian coins like those of र 5, र 2, र 1, etc. are token coins since their value as money is far above the value of metal contained in the coins. Likewise money value of a five hundred rupee note is token money. These are made of inferior metals like nickel, copper, aluminium, etc. Thus token coins are economical as they cost less than their market value. Token money is also called money value of money.

Relationship between speculative demand for money and rate of interest. Speculative demand for money is inversely related to rate of interest, i.e., higher the rate of interest, smaller will be speculative demand for money and vice versa as proved above. Therefore, curve of speculative demand for money is downward sloping to right as shown in the following Fig. (a). There are two situations:
(i) If market rate of interest is very high and everyone expects it to fail in future (i.e., rise in price of bond) thereby anticipating capital gain from bond-holding, people will convert their money into bonds. Thus speculative demand for money is low. In Fig. (a) at very high rate of interest, say 15%, people convert their entire money holding into bonds indicating speculative demand for money to be zero. (Remember, rise in bond price means gain to the bond-holder —similar to gain of a property dealer when price of property rises. Such a gain occurring from rising price of bond is called Capital Gain.).
(ii) On the contrary, if rate of interest is low and people expect it to rise in future (i.e., fall in price of bond) anticipating capital loss from bond-holding, people convert their bonds into money in order to avoid future capital loss. They hold up money balance thinking that income from non-monetary assets like bond will be low and so the cost of money holding will also be low. Thus speculative demand for money becomes very high so much so that when rate of interest declines to minimum, say 3% as shown in Fig.(a), speculative demand for money becomes infinite (perfectly elastic). This pushes the economy into liquidity trap and the speculative demand curve becomes flat as shown in (a).

Total demand for money  (M^d) consists of transaction demand (including precautionary demand) for money  as a function of income and speculative (or asset) demand for money  as a function of rate of interest. Symbolically:

India at present follows the Paper Currency Standard because here standard currency is made of paper. This is also referred to as Managed Currency Standard as any amount of notes can be issued with the minimum backup of gold worth र 115 crores. Remember, a monetary system refers to the form of standard money used in the economy. It is legal money through which government discharges its obligations. The standard money which is used in India is made of paper. In India the monetary authority is Reserve Bank of India (RBI) which has adopted a standard currency made of paper. That is why India is said to be on a paper currency standard. Following points need to be noted in this regard.
(i) Paper currency is the main currency of the country. It is unlimited legal tender which means that it can be used to settle debts and make payments up to an unlimited amount. Coins made of cheap and light metals are used for making smaller payments. Again these coins are limited legal tender because they can be used for making payments and setting debts only up till a limited amount. For instance, it would be inconvenient to settle a debt of र 2,000 with 50 paise and 25 paise coins.
(ii) RBI has the sole monopoly to issue currency notes in India from र 2 and above. The central government (Ministry of Finance) issues the one-rupee note and all coins but the responsibility for putting them into circulation rests with the RBI.
(iii) The system which governs note issue in India is the Minimum Reserve system according to which the Central Bank keeps a minimum reserve of gold and foreign exchange and on this basis can issue notes to any limit. Since paper currency is not convertible into precious metal gold which is backing it, therefore, the currency is said to be inconvertible.

Meaning of money supply. The supply of money means the total stock of all the forms of money (paper money, coins and demand deposits of banks) in circulation which are held by the public at any particular point of time. Thus money supply is the stock of money in circulation on a specific day. Two points need to be noted in this connection: (i) Supply of money is a stock variable (not flow variable) because it is related to a point of time (not to period of time), (ii) Supply of money always refers to the stock of money held by the public in spendable form. The stock of money held by government and banking system are not included as they are suppliers or producers of money. Thus money supply refers to total volume of money circulating in public at a point of time. Broadly it includes currency held by public and net demand deposits in banks.
Remember, sources of money supply are (i) government (which issues one Rupee note and all other coins), (ii) RBI (which issues currency), and (iii) Commercial banks (which create credit on the basis of demand deposits).

Measures of money supply (money stock). In India there are four concepts of money supply. Reserve Bank of India uses four alternative measures of money supply called as M₁, M₂, M₃, and M₄. Each measure is briefly explained below. Among these measures, M₁ is the most commonly used measure of money supply because its components are regarded as most liquid assets.
(i) M₁ = C + DD + OD. Here C denotes currency (paper money and coins) held by public, DD stands for demand deposits in banks (inter-bank deposits are not included) and OD stands for other deposits with RBI. Demand deposits are deposits which can be withdrawn at any time on demand by account holders. Current account deposits are included in demand deposits. But savings account deposits are not included in DD because certain conditions are imposed on amount of withdrawal and number of withdrawals. OD stands for other deposits with the RBI which includes demand deposits of Public Financial Institutions (like Industrial Finance Corporation), demand deposits of foreign central banks and international financial institutions (like IMF).
(ii) M₂ = M₁ (detailed above) + Savings deposits with Post Office Saving Banks. (This is a broader concept of money supply as compared to M₁).
(iii)    M₃ = M₁ + Net Time-deposits with Commercial Banks (Data of 2003–2004 is shown below). (This is also a broader concept of money supply as compared to M₁).
(iv)    M₄ = M₃ + Total deposits with Post Office Saving Organisation (excluding NSC).
(This is still broader – broader than even M₃).
In fact, a great deal of debate is still going on as to what constitutes money supply. Savings deposits of post offices are not a part of money supply because they do not serve as medium of exchange due to lack of cheque facility. Similarly, fixed deposits in commercial banks is not counted as money. M₁ and M₂ are known as narrow money whereas M₃ and M₄ are known as broad money. In practice, M₃ is widely used as measure of money supply which is also called aggregate monetary resources of the society. All the above four measures represent different degrees of liquidity, with M₁ being the most liquid and M₄being the least liquid of all. It may be noted that liquidity means ability to convert an asset into money quickly and without loss of value. According to government of India ‘Economic Survey 2004’, the position of M₃ on March 31, 2004 was as under.

High Powered Money. The Total liability of the monetary authority of the country, RBI, is called the high powered money or monetary base. It is the money created/produced by RBI and government of India. It consists of currency (notes and coins) in circulation with the public and vault cash of commercial banks and deposits held by government and commercial banks with RBI. It is high powered money because these are liability of RBI to refund deposits on demand from the deposit holders. Again if a person presents a currency note to RBI, the latter has to pay him value equal to the amount printed on the note. Remember, RBI acquires assets against these liabilities.
In short, RBI regulates money supply by controlling stock of high powered money, bank rate and reserve requirements of commercial banks.
Money creation by RBI. Suppose RBI wishes to increase money supply. For this it will inject additional high powered money into the economy. Let us assume that RBI purchases gold worth र 100 crores. It issues currency and makes payment for gold. This results in an increase in currency in circulation equal to र 100 crores. Further suppose that RBI purchases securities worth र 400 crores in the open market. It will issue a cheque of र 400 crores to the seller of the securities. The seller encashes the cheque at his account in, say, Canara Bank which receives this amount. Clearly currency held by the public, thus, goes up. Here comes the part played by money multiplier.

Banking Companies Act 1949 defines, “Banking means the accepting for the purpose of lending or investments of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheques, draft, order or otherwise”.
Clearly the two essential features of a bank are (i) Acceptance of chequable deposits from the public, and (ii) lending. One function like borrowing (in the form of deposits) or lending alone does not make a financial institution a bank. For example, since Post Office Saving Banks do not perform the essential function of lending, although they accept deposits, they are not banks in the real sense of the term. Similarly, financial institutions like UTI, LIC, etc. are not banks, because they do not accept chequable deposits although they lend to others.

Functions of Commercial Banks.
The two most distinctive functions of a commercial bank are borrowing and lending, i.e., acceptance of deposits and lending of money to projects to earn interest. In short, banks borrow to lend. The rate of interest offered by the banks to depositors is called the borrowing rate while the rate at which banks lend out is called lending rate. The difference between the two rates is called ‘spread’ which is profit appropriated by the banks. Mind all financial institutions are not commercial bank as only those which perform dual functions of (i) accepting deposits and (ii) giving loans are termed as commercial banks. Functions of commercial banks are as under :
1. It accepts deposits. A commercial bank accepts deposits in the form of current, saving and fixed deposits. It collects the surplus balance of the individuals and firms and finances the temporary needs of commercial transactions. The first task is, therefore, the collecting of the savings of the public. This the bank does by accepting deposits from its customers. Deposits are lifeline of banks. Deposits are of 3 types as under.
(i) Current account deposits. Such deposits are payable on demand and are therefore, called demand deposits. These can be withdrawn by the depositors any number of times depending upon the balance in the account. The bank does not pay any interest on these deposits but provides cheque facilities. These accounts are generally maintained by businessmen and industrialists who receive and make business payments of large amounts through cheques.
(ii) Fixed deposits (Time deposits). Fixed deposits have a fixed period to maturity and are referred to as time deposits. These are deposits for a fixed term, i.e., period of time ranging from a few days to a few years. These are neither payable on demand nor they enjoy cheque facilities. They can be withdrawn only after the maturity of the specified fixed period. They carry higher rate of interest. They are not treated as a part of money supply. Recurring deposit in which a regular deposit of an agreed sum is made is also a variant of fixed deposits.
(iii) Saving account deposits. These are deposits whose main objective is to save. They combine the features of both current account and fixed deposits. They are payable on demand and also withdrawable by cheque. But bank gives this facility with some restrictions, e.g., a bank may allow five or seven cheques in a month. Interest paid on saving account deposits is lesser than that of fixed deposit.
Difference between demand deposits and time (term) deposits.
Two traditional forms of deposits are demand deposit and term (time) deposit. (i) Deposits which are payable by banks on demand from depositors are called demand deposits, e.g., Current A/c deposits are called demand deposits which are payable on demand either through cheque or otherwise. Term deposits are called time deposit because they are payable only after the expiry of the specified period. (ii) Demand deposits do not carry interest whereas time deposits carry a fixed rate of interest. (iii) Demand deposits are highly liquid whereas time deposits are less liquid. (iv) Demand deposits are chequable deposits whereas time deposits are not. A chequable deposit is any deposit account on which a cheque can be written.
2.    It gives loans and advances. The second major function of a commercial bank is to give loans and advances particularly to businessmen and entrepreneurs and thereby earn interest. This is, in fact, the main source of income of the bank. A bank keeps a certain portion of the deposits with itself as reserve and gives (lends) the balance to the borrowers as loans and advances in the following forms.
(i) Cash Credit. An eligible borrower is first sanctioned a credit limit and within that limit he is allowed to withdraw a certain amount on a given security. The withdrawing power depends upon the borrower's current assets, the stock statement of which is submitted by him to the bank as the basis of security. Interest is charged by the bank on the drawn or utilised portion of credit (loan).
(ii)    Demand Loans. A loan which can be recalled on demand is called demand loan. There is no stated maturity. The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower. Those like security brokers whose credit needs fluctuate generally take such loans on personal security and financial assets.
(iii)    Short-term Loans. Short-term loans are given against some security as personal loans to finance working capital or as priority sector advances. The entire amount is repaid either in one instalment or in a number of instalments over the period of loan.
Investment. Commercial banks invest their surplus funds in three types of securities (i) Government securities, (ii) Other approved securities, and (iii) Other securities. Banks earn interest on these securities.
Other functions : Apart from the above-mentioned two primary (major) functions, other functions performed by commercial banks are as follows:
3.    Overdraft facility. An overdraft is an advance given by allowing a customer keeping current account to overdraw his current account up to an agreed limit. It is a facility to a depositor for overdrawing the amount than the balance amount in his account. In other words, depositors of current account make arrangement with the banks that in case a cheque has been drawn by them which is not covered by the deposit, then the bank should grant overdraft and honour the cheque. The security for overdraft is generally financial assets like shares, debentures, life insurance policies of the account holder.
Difference between overdraft facility and loan. (i) Overdraft is made without security in current account but loans are given against security. (ii) In case of loan, the borrower has to pay interests on full amount sanctioned but in case of overdraft, borrower is given the facility of borrowing only as much as he requires. (iii) Whereas the borrower of loan pays interest on amount outstanding against him but customer of overdraft pays interest on the daily balance.
4.    Discounting bills of exchange or Hundis. A Bill of exchange represents a promise to pay a fixed amount of money at a specified point of time in future. It can also be encashed earlier through the discounting process of a commercial bank. In other words, a bill of exchange is a document acknowledging an amount of money owed in consideration of goods received. It is a paper asset signed by debtor and the creditor for a fixed amount payable on a fixed date. It works like this. Suppose A buys goods from B, he may not pay B immediately but instead give B a bill of exchange stating the amount of money owed and the time when A will settle the debt. Suppose B wants the money immediately, he will present the bill of exchange (Hundi) to the bank for discounting. The bank will deduct the commission and pay to B the present value of the bill. When the bill matures after specified period, the bank will get payment from A.
5.    Agency functions of the Bank. The bank acts as an agent of its customers and gets commission for performing agency functions as under.
(i) Transfer of funds. It provides facility for cheap and easy remittance of funds from place to place through demand drafts, mail transfers, telegraphic transfers, etc.
(ii)    Collection of funds. It collects funds through cheques, bills, hundis and demand drafts on behalf of its customers.
(iii)    Payments of various items. It makes payment of taxes, insurance premium, bills, etc. as per directions of its customers.
(iv)    Purchase and sale of shares and securities. It buys, sells and keeps in safe custody securities and shares on behalf of its customers.
(v) Collection of dividends, interest on shares and debentures are made on behalf of its customers.
(vi)    Acts as Trustee and Executor of property of its customers on advice of its customers.
(vii)    Letters of References. It gives information about, economic position of its customers to traders and provides the similar information about other traders to its customers.
6.    Financing of Foreign Trade. Commercial banks finance the foreign trade of the country by accepting or collecting bills of exchange drawn by customers.
7.    Performing General Utility Services. The bank provides many general utility services. Some of which are as under:
(i)    Issuance of traveller's cheques and gift cheques.
(ii)    Locker facility. The customers can keep their ornaments and important documents in lockers for safe custody.
(iii)    Underwriting securities issued by government, public or private bodies.
(iv)    Purchase and sale of foreign exchange (Currency).
(v) Letters of credit are issued by the banks to their customers certifying their credit worthiness.

Commercial banks create credit in the form of demand deposits. Remember ‘demand deposits’ and ‘currency with public’ are two basic components of money supply. Broadly, when a bank receives cash deposits from the public, it keeps a fraction of deposit as cash reserve and uses the remaining amount for giving loans to earn interest income. This fraction is called Legal Reserve Ratio (LRR) (which has two components — CRR and SLR). LRR is the minimum ratio (fraction) of demand deposits fixed by Central Bank which is legally compulsory for every commercial bank to keep as cash reserves. In the process of lending money, banks are able to create credit through secondary deposits many times more than the initial deposit (primary deposit). How? (Primary deposits are cash deposits whereas secondary deposits arise due to loans given by the banks to people.)
Process of money (credit) creation. Suppose a man, say x, deposits र 2000, with a bank and the LRR is 10% which means the bank keeps only the minimum required र 200 as cash reserve. The bank can use the remaining amount र 1800 (= 2000 - 200) for giving loan to someone. (Mind, loan is never given in cash but it is reflected as demand deposit in favour of borrower.) The bank lends र 1800 to, say y, who is actually not given loan but only (demand deposit) account is opened in his name and the amount is credited to his account. This is the first round of credit creation in the form of secondary deposit (र 1800) which equals 90% of primary (initial) deposit. Again 10% of Y‘s deposit (i.e., र 180) is kept by the bank as cash reserve and the balance र 1620 (= 1800 – 180) is advanced to, say z. The bank gets new demand deposit. This is second round of credit creation which is 90% of first round of increase of र 1800. The third round of credit creation will be 90% of second round of र 1620. This is not the end of the story. The process of credit creation goes on continuously till derivative deposit (secondary deposit) becomes zero. In the end volume of total credit created in this way becomes multiple of initial (primary) deposit. The quantitative outcome is called money multiplier. If the bank succeeds in creating total credit of say, र 18,000, it means bank has created 9 times of primary (initial) deposit of र 2000. This is what is meant by credit creation. In short money (or credit) creation by commercial banks is determined by (i) amount of initial (primary) deposits, and (ii) LRR. The multiple is called credit creation or money multiplier. Symbolically:
Credit creation = 
Money multiplier. It means the multiple by which total deposit increases due to initial (primary) deposit. Money creation (or credit creation) is the inverse of LRR.
If LRR = 10%, i.e., 0.1, then money multiplier 
Smaller the LRR, larger would be the size of money multiplier.
The following tree diagram depicts broad classification of commercial banks in India.

Meaning of Central Bank. The Central Bank is the apex institution of monetary system of a country. It is banker to the other banks and to government, it issues notes, controls money supply and credit, and maintains monetary stability.
Central Banks have been established in all financially developed countries. They are known by different names in different countries. In India the Central Bank is known as Reserve Bank of India which was established in 1935 as a shareholder bank and nationalised on first January, 1949. In U.K. it is called Bank of England and in Russia it is known as Gosbank.
Necessity of Central Bank. Since the first world war, the most important development in the field of monetary system is the emergence of Central Banks with added prestige and power. Now-a-days the institution of Central Bank is considered indispensable in every country. Now there is hardly a civilised country which does not possess a Central Bank. Central Banks are necessary because of the following reasons.
(i)    Monetary System requires Management. “Money will not manage itself,” said Begehot long ago. Even gold standard was not fully automatic. The paper standard which is in operation in every country now, has to be directed by some central authority.
(ii)    Banking System requires Control and Regulation. The banks of a country, being private institutions, act by profit motive. Because they are competitive concerns, they cannot follow a common policy according to national requirements. The result is either creation of too much credit sometimes or too little at other times. Therefore, a central coordinating authority, which will compel them to follow the appropriate policy under economic situation is necessary. Hence an institution is established which is called Central Bank.

Functions of a Central Bank. Main functions of a Central Bank are to act as governor of the machinery of credit in order to secure stability of prices. It regulates the volume of credit and currency, pumping in more money when market is dry of cash, and pumping out money when there is excess of credit. Broadly, a central bank has two departments, namely, issue department and banking department. We discuss below its main functions.
1.    Issue of Currency. The central bank is given the sole monopoly of issuing currency in order to secure control over volume of currency and credit. These notes circulate throughout the country as legal tender money. Note-issuing is governed by Minimum Reserve System i.e. while issuing currency notes, a minimum fixed amount of gold and foreign currency is kept by Central Bank. It has to keep a reserve in the form of gold and foreign securities as per statutory rules against the notes issued by it. It may be noted that RBI issues all currency notes in India except one rupee note. Again it is under directions of RBI that one rupee notes and small coins are issued by government mints. Remember, central government of a country is usually authorised to borrow money from the central bank. When central government expenditure exceeds government revenue and Govt, is unable to reduce its expenditure, then it borrows from RBI. This is done by selling security bills to RBI which creates new currency notes for the purpose. This is called monetisation of budget deficit or deficit financing. The government spends new currency and puts it into circulation to meet its expenditure.
2.    Banker to the Government. Central Bank functions as a banker to the government— both central and state governments. It carries out all banking business of the government. Governments keep their cash balances in the current account with the central bank. Similarly, central bank accepts receipts and makes payment on behalf of the governments. Also central bank carries out exchange, remittance and other banking operations on behalf of the government. Central bank gives loans and advances to governments for temporary periods, as and when necessary, and it also manages the public debt of the country.
3.    Bankers’ Bank and Supervisor. There are usually hundreds of banks in a country. There should be some agency to regulate and supervise their proper functioning. This duty is discharged by the central bank. Central bank acts as banker's bank in three capacities : (i) it is custodian of their cash reserves. Banks of the country are required to keep a certain percentage of their deposits with the central bank; and in this way the central bank is the ultimate holder of the cash reserves of commercial banks. (ii) Central bank is lender of last resort. Whenever banks are short of funds, they can take loans from the central bank and get their trade bills discounted. Thus Central Bank is a source of great strength to the banking system. (iii) It acts as a bank of central clearance, settlements and transfers. Its moral persuasion is usually very effective so far as commercial banks are concerned.
4.    Controller of Credit and Money Supply. It is an important function of a Central Bank to control credit and money supply through its monetary policy. There are two parts of monetary policy, viz., currency and credit. Central Bank has monopoly of issuing notes and thereby can control the volumes of currency. Main objective of credit control function of a Central Bank is stabilising of price level. It controls credit and money supply by adopting quantitative measures and qualitative measures, namely, (i) Bank Rate, (ii) Open Market Operations, and (iii) CRR which influence credit availability and credit creation.Credit creation refers to lending by commercial banks. Following are instruments of monetary policy of RBI.
Instruments of monetary policy:
(i) Bank rate (D 2009; 10C). Bank rate is the rate of interest at which Central Bank lends to commercial banks. Clearly by raising the bank rate, Central Bank raises the cost of borrowing. This forces the commercial banks to raise, in turn, the rate of interest from the public. As lending rate rises, demand for loans for investment and other purposes falls. Thus increase in bank rate by Central Bank adversely affects credit creation by commercial banks. A decrease in bank rate will have opposite effect. Presently — Feburary 2012 — Bank rate (also called Repo Rate) is 8.5% and Reverse Repo Rate (rate at which banks park their surplus funds with RBI) is 7.5%.
(ii) Open market operations. These refer to buying and selling of Government securities by Central Bank. This is done to influence the money supply in the country. Remember, sale of Government securities to commercial banks means flow of money into Central Bank which reduces cash reserves with the banks with the result credit availability of commercial banks is curtailed/controlled.
(iii) Cash Reserve Ratio (CRR). Every commercial bank under law has to deposit with Central Bank a minimum percentage of its demand deposit and time deposit. This percentage is called as CRR. A high CRR means smaller deposits and lesser loans. Higher the CRR, lesser is the banks capacity to create credit. By changing CRR, Central bank controls the lending capacity and credit availability of banks. At present CRR is 5.5% w.e.f. 28th January 2012. Statutory Liquidity Ratio (SLR) is another instrument adopted by RBI to control credit.
5.    Lender of Last Resort. When commercial banks have exhausted all resources to supplement their funds at times of liquidity crisis, they approach Central Bank as a last resort. As lender of last resort Central Bank gives guarantee of solvency and provides financial accommodation to commercial banks (i) by rediscounting their eligible securities and bills of exchange, and (ii) by providing loans against their securities. This saves banks from possible failure and banking system from a possible breakdown. On the other hand, Central Bank, by providing temporary financial accommodation, saves the financial structure of the country from collapse.
6.    Exchange Control. Another duty of a Central Bank is to see that the external value of currency is maintained. For instance, in India, the Reserve Bank of India takes steps to ensure external value of a rupee. It adopts suitable measures to attain this object. The exchange control system is one such measure. Under exchange control system, every citizen of India has to deposit all foreign currency or exchange that he receives with the Reserve Bank of India; and whatever foreign exchange he might need has to be secured from the Reserve Bank by making an application in the prescribed form.
7.    Custodian of Foreign Exchange or Balance. It has been mentioned above that a Central Bank is the custodian of foreign exchange resources and nation’s gold. It keeps a close watch on external value of its currency and undertakes exchange management control. All the foreign currency received by the citizen has to be deposited with the Central Bank; and if citizens want to make payment in foreign currency, they have to apply to the Central Bank. Central Bank also keeps gold and bullion reserves.
8.    Clearing House Function. Banks receive cheque drawn on the other banks from their customers which they have to realise from drawee banks. Similarly, cheques on a particular bank are drawn and pass into the hands of other banks which have to realise them from the drawee banks. Independent and separate realization to each cheque would take a lot of time; and. therefore, Central Bank provides clearing facilities, i.e., facilities for banks to come together everyday and set off their chequing claims.
9.    Collection and Publication of Data. It has also been entrusted with the tasks of collection and compilation of statistical information relating to banking and other financial sectors of economy.

(i) Money as medium exchange solves problem of lack of double coincidence.
(ii) Money as measure of value solves problem of absence of common measure.
(iii) Money as store of value solves problem of storing wealth.
(iv) Money as standard of deferred payment solves difficulty of borrowing and lending.

‘Money is what the law says it is’.

Following four measures of money stock are used.
M₁ = C + DD + OD
M₂ = M₁ + Savings deposits in Post Office Saving Banks.
M₃ = M₁ + Net time-deposits of banks.
M₄ = M₁ + total deposits with Post Office Saving Organisation.

(i) Accepting deposits. (ii) Giving loans and advances. (iii) Providing overdraft facility. (iv) Discounting bills of exchange. (v) Performing agency functions. (vi) Performing general utility services for benefit of customers.

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The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the government mint but they are put into circulation through the central bank.
However, the currency issued by the central bank is its monetary liability. In other words, the central bank is obliged to back the currency issued by it by assets of equal value such as gold coins and bullions, foreign exchange. In addition to issuing currency to the general public, the central bank also issues currency to the central government of the country.
Or

Central banks act as bankers, fiscal agents and advisers to their respective governments. As a banker to the government, the central bank keeps the deposits of the central and state governments and makes payments on behalf of governments. But it does not pay interest on governments deposits. It buys and sells foreign currencies on behalf of the government. It keeps the stock of gold of the government. Thus it is the custodian of government money and wealth. As a fiscal agent, the central bank makes short-term loans to the government for a period not exceeding 90 days. It floats loans, pays interest on them, and finally repays them on behalf of the government. Thus it manages the entire public debt. The central bank also advises the government on such economic and money matters as controlling inflation or deflation, devaluation or revaluation of the currency, deficit financing, balance of payments, etc.

With the Jan Dhan Yojna a greater number of individuals are brought under the ambit of banking system. Those individuals who earlier did not have savings account now have access to banking facilities and have opened savings account with the commercial banks.
In this way, the commercial banks are able to tap greater savings which in turn can be used to lend loans for investment purposes. Thus, the yojna indirectly helps in increasing the investment and production in the economy which in turn would help in improving the national income.

Demand Deposits also known as Current Account deposits refer to those deposits that provide the depositor the liberty to withdraw money at any point of time. That is, the account holder of the demand deposits can demand these deposits at any point of time as per their discretion and convenience. Such deposits do not offer any rate of interest. 

A store of value is the function of an asset that can be saved, retrieved and exchanged at a later time, and be predictably useful when retrieved. It is an important function of money. This implies that wealth in the form of money can be stored easily as a medium of exchange for future use. For example, money can be stored in banks for meeting emergency and future needs. The importance of the money as store of value is explained in the following points.
1) Money is not perishable and its storage costs are also considerably lower.
2) It is also acceptable to anyone at any point of time.
3) Wealth can be stored in the form of money for future use.
4) In the barter system, it was very difficult to store goods, especially perishable goods for the purpose of value storage. This limitation of barter system is overcome by the money due to its potential to store value.
5) The contractual or future payments were very difficult to be made in barter system. Money helps people to demand and forward loans and to make future and deferred payments along with interests.

Money, as a medium of exchange, means that it can be used to make payments for all transactions of goods and services. It is the most essential function of money. Money has the quality of general acceptability so, all exchanges take place in terms of money. In other words, money eliminates the need for double coincidence of wants for an exchange to take place and can be performed independently of each other. Moreover, money has widened the domain and scope of market. Significance of ‘medium of exchange’ function of money are:
1. This function has removed the major difficulty of lack of double coincidence of wants and inconveniences associated with the barter system.
2. Use of money allows purchase and sale to be conducted independently of one another.
3. This function of money facilitates trade and helps in conducting transactions in an economy.
4. Money has no power to satisfy human wants, but it commands power to purchase those things, which have utility to satisfy human wants.

By money supply we mean the total stock of monetary media of exchange available to a society for use in connection with the economic activity of the country. Supply of money refers to the total stock of money (in the form of currency notes and coins) held by the people of an economy at a particular point of time. The following are the components of money.

(i) Currency Component: It includes,
a) Currency notes in circulation issued by the Reserve Bank of India.
b) The number of rupee notes and coins in circulation.
c) Small coins in circulation.

(ii) Deposit Component: The other important components of money supply are demand deposits of the public with the banks. These demand deposits held by the public are also called bank money or deposit money. Deposits with the banks are broadly divided into two types: demand deposits and time deposits.

Demand deposits in the banks are those deposits which can be withdrawn by drawing cheques on them. Through cheques, these deposits can be transferred to others for making payments from which goods and services have been purchased. Whereas time deposit is a deposit in a bank account that cannot be withdrawn before a set date or for which notice of withdrawal is required.

Lender of last resort function of Central Bank implies that the Central Bank is under the obligation to provide funds against securities to the commercial bank as and when needed by them. When a commercial bank faces a financial crisis and fails to obtain funds from other sources, then the central bank provides them with the financial assistance in the form of credit. This role of the central bank saves the commercial bank from being bankrupt. Thus, the central bank plays the role of a guarantor for the commercial banks and maintains a sound and healthy banking system in the economy.

Demand Deposits also known as Current Account deposits refer to those deposits that provide the depositor the liberty to withdraw money at any point of time. That is, the account holder of the demand deposits can demand these deposits at any point of time as per their discretion and convenience. Such deposits do not offer any rate of interest. 

Double coincidence of wants implies that the needs of any two individuals should complement each other for the exchange to take place. Money as medium of exchange has removed the double coincidence of wants. Under monetary system money is exchanged for goods and services
A man with the wheat who wants to purchase oil, need not have to find a person having oil and needs wheat. He can sell his wheat in the market for money and then purchase oil with the money thus obtained.

Central bank functions as a banker to the government - both central and state governments. It carries out all banking business of the government. Government keeps their cash balances in the current account with the central bank. Similarly, central bank accepts and makes payment on behalf of the government.
Also central bank carries out exchange, remittance, and other banking operations on behalf of the government. Central bank gives loans and advances to governments for temporary periods, as and when necessary and it also manages the public debt of the country. At the same time, central government can borrow any amount of money from RBI by selling its rupees and securities to the later. 

Demand Deposits also known as Current Account deposits refer to those deposits that provide the depositor the liberty to withdraw money at any point of time. That is, the account holder of the demand deposits can demand these deposits at any point of time as per their discretion and convenience. Such deposits do not offer any rate of interest. 

A store of value is the function of an asset that can be saved, retrieved and exchanged at a later time, and be predictably useful when retrieved. It is an important function of money. This implies that wealth in the form of money can be stored easily as a medium of exchange for future use. For example, money can be stored in banks for meeting emergency and future needs.
The importance of the money as a store of value is explained in the following points:
1) Money is not perishable and its storage costs are also considerably lower.
2) It is also acceptable to anyone at any point of time.
3) Wealth can be stored in the form of money for future use.
4) In the barter system, it was very difficult to store goods, especially perishable goods for the purpose of value storage. This limitation of barter system is overcome by the money due to its potential to store value.
5) The contractual or future payments were very difficult to be made in barter system. Money helps people to demand and forward loans and to make future and deferred payments along with interests.

LRR (Legal Reserve Ratio) refers to that legal minimum fraction of deposits which the banks are mandate to keep as cash with themselves. The LRR is fixed by the Central Bank. It has two components:
1. Cash Reserve Ratio
2. Statutory Liquidity Ratio

Cash Reserve Ratio (CRR): It refers to the minimum amount of funds that a commercial bank has to maintain with the Reserve Bank of India, in the form of deposits. For example, suppose the total assets of a bank are worth Rs 200 crore and the minimum cash reserve ratio is 10%. Then the amount that the commercial bank has to maintain with RBI is Rs 20 crore. If this ratio rises to 20%, then the reserve with RBI increases to Rs 40 crore. Thus, less money will be left with the commercial bank for lending. This will eventually lead to considerable decrease in the money supply. On the contrary, a fall in CRR will lead to an increase in the money supply.

Statuary Liquidity Ratio (SLR): SLR is concerned with maintaining the minimum reserve of assets with RBI, whereas the cash reserve ratio is concerned with maintaining cash balance (reserve) with RBI. So, SLR is defined as the minimum percentage of assets to be maintained in the form of either fixed or liquid assets with RBI. The flow of credit is reduced by increasing this liquidity ratio and vice-versa. In the previous example, this can be understood as rise in SLR will restrict the banks to pump money in the economy, thereby contributing towards decrease in money supply. The reverse case happens if there is a fall in SLR, as it increases the money supply in the economy.

The central bank being the apex bank of a country, serve as a banker to all the commercial banks in the country. The reserves of the commercial banks are held by the central bank. These reserves serve as a pool from which the central bank advances money to the commercial banks in times of financial crisis. The central bank supervises, regulates the commercial banks and helps them in case of any financial exigencies.

Excess demand refers to the situation when aggregate demand (AD) is more than the aggregate supply (AS) corresponding to full employment level of output in the economy. It is the excess of anticipated expenditure over the value of full employment output.

Due to the excess of aggregate demand, there exists a difference (or gap) between the actual level of aggregate demand and full employment level of demand. This difference is termed as inflationary gap. This gap measures the amount of surplus in the level of aggregate demand. Graphically, it is represented by the vertical distance between the actual level of aggregate demand (AD_E) and the full employment level of output (AD_F). In the figure, EY denotes the aggregate demand at the full employment level of output and FY denotes the actual aggregate demand. The vertical distance between these two represents inflationary gap.
Following are the reasons for Excess Demand:
1. Rise in the Propensity to consume: Excess demand may arise because of increase in consumption expenditure due to rise in the propensity to consume or fall in propensity to save.
2. Reduction in taxes: It may also occur due to increase in disposable income and consumption demand because of decrease in taxes.
3. Increase in Government Expenditure: Rise in government demand for goods and services due to increase in public expenditure will also result in excess demand.
4. Increase in Investment. Excess demand can also arise when there is increase in investment due to decrease in rate of interest or increase in expected returns.
5. Fall in Imports: Decrease in imports due to higher international prices in comparison to domestic prices may also lead to excess demand.
6. Rise in Exports: Excess demand may also arise when demand for exports increases due to comparatively lower prices of domestic goods or due to decrease in the exchange rate for domestic currency.

Role of Open Market Operation in curbing the Excess Demand:
In order to curb the problem of excess demand, the government can opt for open market operations (OMO). Open market operations refer to sale and purchase of securities in the open market by the central bank. It directly influences the level of money supply in the economy. During excess demand, central bank offers securities for sale. Sale of securities reduces the reserves of commercial banks. It adversely affects the bank’s ability to create credit and decreases the level of aggregate demand in the economy.

Deficient demand refers to the situation when aggregate demand (AD) is less than the aggregate supply (AS) corresponding to full employment level of output in the economy.
The situation of deficient demand arises when planned aggregate expenditure falls short of aggregate supply at the full employment level. It gives rise to deflationary gap. Deflationary gap is the gap by which actual aggregate demand falls short of aggregate demand required to establish full employment equilibrium.

Reasons for deficient demand:
1. Decrease in Propensity to consume: A decrease in consumption expenditure, due to fall in the propensity to consume, leads to deficient demand in the economy.
2. Increase in taxes: AD may also fall due to imposition of higher taxes. It leads to decrease in disposable income and, as a result, the economy suffers from deficient demand.
3. Decrease in Government Expenditure: When government reduces its demand for goods and services due to fall in public expenditure, it leads to deficient demand.
4. Fall in Investment expenditure: Increase in the rate of interest or fall in the expected returns lead to decrease in the investment expenditure. It reduces the AD and gives rise to deficient demand.
5. Rise in Imports: When international prices are comparatively less than the domestic prices, then it may lead to a rise in imports, implying a cut in the aggregate demand.
6. Fall in Exports: Exports may fall due to comparatively higher prices of domestic goods or due to increase in the exchange rate for domestic currency. This will lead to deficient demand.

Role of Bank Rate in Correcting Deficit Demand:
The term ‘Bank Rate’ refers to the rate at which central bank lends money to commercial banks as the lender of last resort. During deficient demand, the central bank reduces the bank rate in order to expand credit. It leads to fall in the market rate of interest which induces people to borrow more funds. It ultimately leads to increase in the aggregate demand.

Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank

Money supply is the entire stock of currency and other liquid instruments held by the people of an economy at a particular point of time. The money supply can include cash, coins and balances held in checking and savings accounts.

Open Market Operations (OMO) refer to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. To curtail deficit demand, the central bank purchases securities in the open market. With purchase of securities, the central bank pumps in additional money into the economy. With the additional money the level of Aggregate Demand in the economy increases. Thus, the deficit demand is corrected.

Bank Rate as an Instrument to Correct Deficit Demand:
Bank rate refers to the rate at which the central bank provides loans to the commercial banks. To curtail deficit demand, the central bank lowers the bank rate. This implies that cost of borrowing for the commercial banks from the central bank reduces. The commercial banks in turn reduce the lending rate (the rate at which they provide loans) for their customers. This reduction in the lending rate raises the borrowing capacity of the public, thereby, encourages the demand for loans and credit. Consequently, the level of Aggregate Demand in the economy increases and deficit demand is corrected.

Bank Rate as an Instrument to Correct Excess Demand:
Bank rate is the rate at which the central bank provides loan to the commercial banks. To control excess demand, the central bank increases the bank rate. A rise in the bank rate increases the cost of borrowing for the commercial banks from the central bank. The commercial banks in turn raise the lending rate (the rate at which they provide loans) for their customers. This rise in the lending rate reduces the borrowing capacity of the public, thereby, discourages the demand for loans and credit. Consequently, the level of Aggregate Demand in the economy falls and excess demand is curtailed.

Open Market operations as an Instrument to Correct Excess Demand:
Open Market Operations refer to the buying and selling of securities either to the public or to the commercial banks in an open market. To curtail excess demand the central bank sells securities in the open market. By selling the securities in the open market, the central bank withdraws excess money from the economy. This results in a lower Aggregate Demand in the economy and excess demand is controlled.

Process of Creation of Money:
The process of money creation by the commercial banks starts as soon as people deposit money in their respective bank accounts. After receiving the deposits, as per the central bank guidelines, the commercial banks maintain a portion of total deposits in form of cash reserves. The remaining portion left after maintaining cash reserves of the total deposits is then lend by the commercial bank to the general public in form of credit, loans and advances. Now assuming that all transactions in the economy are routed through the commercial banks, then the money borrowed by the borrowers again comes back to the banks in form of deposits. The commercial banks again keep a portion of the deposits as reserves and lend the rest. The deposit of money by the people in the banks and the subsequent lending of loans by the commercial banks is a never-ending process. It is due to this continuous process that the commercial banks are able to create credit money a multiple time of the initial deposits.
The process of creation of money is explained with the help of the following numerical example.

Suppose, initially the public deposited Rs 10,000 with the banks. Assuming the Legal Reserve Ratio to be 20%, the banks keep Rs 2,000 as minimum cash reserves and lend the balance amount of Rs 8,000 (Rs 10,000 – Rs 2,000) in form of loans and advances to the general public.
Now, if all the transactions taking place in the economy are routed only through banks then, the money borrowed by the borrowers is again routed back to the banks in form of deposits. Hence, in the second round there is an increment in the deposits with the banks by Rs 8,000 and the total deposits with the banks now rises to Rs 18,000 (that is, Rs 10,000 + Rs 8,000). Now, out of the new deposits of Rs 8,000, the banks will keep 20% as reserves (that is, Rs 1600) and lend the remaining amount (that is, Rs 6,400). Again, this money will come back to the bank and in the third round, the total deposits rises to Rs 24,400 (i.e. Rs 18,000 + Rs 6,400).
The same process continues and with each round the total deposits with the banks increases. However; in every subsequent round the cash reserves diminishes. The process comes to an end when the total cash reserves (aggregate of cash reserves from the subsequent rounds) become equal to the initial deposits of Rs 10,000 that were initially held by the banks. As per the above schedule, with the initial deposits of Rs 10,000, the commercial banks have created money of Rs 50,000.

Repo rate is the rate at which commercial banks can borrow money from RBI to overcome the shortage of money. By varying the repo rates, the RBI can increase or decrease the supply of money. This rate relates to the loan offered by RBI with securities and only short term borrowings by the commercial banks.
Repo rate is used as the main instrument of credit control. When the Central Bank raises the repo rate, there will be an increase in the cost of borrowing which reduces commercial banks borrowing from the Central Bank. Consequently, the flow of money from the commercial banks to the public reduces. Therefore, the supply of money reduces and bank credit creation is controlled.

(c) Cash reserve ratio

People keep their wealth in the form of money because money is the most liquid form of wealth. Savings in the form of money is maintained for purchasing commodities in the future. In this case, the values of commodities are being stored. Hence, money acts as a store of value.  Wealth is stored in terms of goods as there was no money in existence. . For example, wheat and rice do not possess durability i.e. their quality deteriorates with passage of time. Storage of good requires time and efforts. Hence, it is not practically possible to store people’s purchasing power.
justification for store value of money:

i)money is the most and widely accepted as a common medium of exchange
ii)there is no loss in the value of money over time
iii)money can be stored conveneintly and does not involve any cost
iv) money abolished barter system and all the problems related to it.
or, 

Money supply means the total stock of money in circulation, in form of coins and currency notes, among the people at a particular point of time in an economy.

 There are various types of money supply and these are labeled as M0, M1, M2 and M3, according to the type and size of the account in which the instrument is kept.

M1 = Currency with the public + demand deposits with the commercial banks + deposits kept by commercial banks with the Reserve Bank.
or M1 = C + DD + OD
Demand deposits are not for any specific period of time. They can be withdrawn as and when required. Demand deposits are chequeable deposits.
2. M2 = M1 + Savings deposits with Post office Savings banks.
Saving deposit includes the features of both demand and term deposits.
3. M3 = M2 + Term deposits in Commercial banks. Term deposits are always for a specific period of time. They cannot withdraw
money as when required. They are not chequeable deposits as we cannot sign a cheque against these deposits.

4. M4 = M3 + Savings with the Post office other than in the form of National Saving Certificate.

Central Bank acts as Banker to the government in the following ways:
(i)The central bank is also a banker, agent and financial advisor to the government.
(ii)As a banker, it manages government accounts across the country. It buys and sells securities on behalf of the government as an agent of the government.
(iii)It helps the government in framing policies to regulate the money market by acting as an advisor to the government.
(iv) it also grants short term loans and credit to government.
or,

Reverse repo rate is the rate at which the RBI or the central bank borrows from the other commercial banks. It plays an effective role in controlling the money supply. For example, an increase in the average repo rate implies that the banks will get higher rate of interest from the RBI on their lendings. As a result the banks will lend more to the RBI and less to the public. Thus, resulting in a decrease in the money supply. Similarly, in the case the RBI decreases the reverse repo rate the banks will get a lower rate of interest on their borrowings. as result they can lend more to the public which will in turn increase the money supply.