Ever wondered where banks get their money from? How does the economy run? In today’s chapter of Classes with News18. We will learn about money and banking.
What is money?
Let’s start with the basics first. What is money? At a fundamental level, money is a standardized medium of exchange. A certain unit in money holds a certain value and a rise in price can dilute the power of money. For example, at a time Rs 5 was enough to buy you a bottle of water, however, its value decreases if the price of the bottle rises.
So, what’s the difference between a bottle of water or gold and money? Since each has a value?
Things other than money too can hold value, such as gold, landed property, houses, or even bonds, however, they may not be easily convertible to other commodities. While other valuables draw their worth in terms of money. Money draws value from its ability to exchange. For example, Rs 5 is less powerful than Rs 100 as you can get more things in exchange for Rs 100 than Rs 5.
The most commonly used form of money is currency notes and coins. These are called fiat money. Every country has its own currency. They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction. Other payment modes like cheques are a mode of exchange and can be considered money, however, they are not legal tenders as they can be refused by anyone as a mode of payment. Hence, demand deposits are not legal tenders.
Current account deposits, held by the public in commercial banks are also considered money since cheques drawn on these accounts are used to settle transactions. Such deposits are called demand deposits as they are payable by the bank on demand from the account holder.
Where Does Money Come From?
In a modern economy, money consists mainly of currency notes and coins issued by the monetary authority of a country. In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India. While RBI can mint notes, coins are issued by the Government of India.
The Indian government is solely responsible for minting coins. To deter counterfeiting and fraud, the Indian government withdrew the 500 and 1,000 rupee notes from circulation in 2016.
Coins are minted at the four mints: Alipore in South Kolkata, Saifabad in Hyderabad, Cherlapally in Hyderabad, and Noida in Uttar Pradesh. Although the government handles minting coins, the Reserve Bank issues them for circulation
Where Does Minted Money Go?
The money created by banks is held in two types: the currency held with the public and a section of money is deposited with the banks for saving purposes.
Money goes beyond the currency we hold with us. The total amount of money goes beyond the currency in circulation. Money possessed by the public at a particular point in time is called the money supply of the country, however, that is not all the money that a country holds. Money held by banks is also considered part of the money.
The amount of money held by the public and that with the banks’ changes based on the situations prevailing in the country. This is called CDR or currency deposit ratio. The currency deposit ratio is the ratio of money held by the public in currency to that they hold in bank deposits. It increases during the festive season as people convert deposits to cash balances for meeting extra expenditures during such periods. The preference of the public for holding cash balances vis-´a-vis deposits in banks also affects the money supply.
What do Banks do With Money?
The money that people deposit with banks is further divided into two parts. First, banks hold a part of the money in reserves; second, banks loan some money to people who need it for different purposes - study, buy property, open a business etc.
Banks use this reserve to meet the demand for cash by account holders. If at a given time everyone comes to the bank, to withdraw their money, banks would not be able to refund everything. Thus, RBI has fixed a limit that banks have to keep with themselves. It is called the reserve deposit ratio (RDR). It is the proportion of the total deposits commercial banks keep as reserves. RBI uses a certain interest rate called the Bank Rate to control the value of the reserve deposit ratio.
Commercial banks can borrow money from RBI at the bank rate when they run short of reserves. A high bank rate makes such borrowing from RBI costly. To avoid the expenses, the commercial banks try to maintain a healthy reserve and hence do not give out everything as a loan.
How do commercial banks earn?
To ensure people deposit their money with banks, commercial banks offer interest or extra money on the principal sum. The extra money acts as an incentive for people who treat this money as a saving mode. The rate at which commercial banks pay interest on customer deposits is called the borrowing rate
Commercial Banks accept deposits from the public and lend out this money as a loan. The rate at which banks lend out the money is called the ‘lending rate’. The difference between the money earned from the loan (lending rate) and the money given as interest (borrowing rate) is called ‘spread’. This spread is the profit that is appropriated by the banks.
How is money generated?
“When a bank lends a portion of its excess reserves, it provides borrowers with the ability to conduct transactions and, as a result, increases the country’s money supply. Because the borrowers also have a debt obligation to the bank, the loan does not make them richer. This simply means that the banking system’s creation of money increases the economy’s liquidity rather than its wealth", explains class 11 NCERT.
When a bank gives out a loan, it credits the account of the borrower and brings in more money to the bank. This money is further circulated into other beneficiary banking accounts and stays in the banking system as client deposits. With every loan given out, the banking system thus creates new money that can chase goods and services.
But when a bank lent out money to a person who does not pay back the interest on the loans, it is called a bad debt or non-performing asset (NPA). If this debt is large in relation to the total lending of the bank, then the bank is at a loss. This impacts people whose money is deposited in the bank as the bank is not in a position to pay interest to them. India is currently dealing with major bank losses or NPAs.
Test Your Knowledge
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To learn about other topics taught in school, explained by News18, here is a list of other Classes With News18: Queries Related to Civics Chapter on ‘Elections’ | Sex Versus Gender | Decode Indian Judicial System | Understanding Union Budget | Natural Disasters | Parliaments Across the World | Wonderland of Letters | Civil Wars | Cryptocurrencies | Consumer Rights & Safety | Democracy vs Republic | Silk Route |