CURRENCY AND BANKING UNIT-I

 

                         Unit 1- Currency Banking

What is Money and its Functions of Money

 There are number of functions of money that can be seen easily in the business world. But before discussing the functions of money, lets define the money. Money has been defined by different authors in different ways, which is discussed as under:-

1. According to Walker “Money is that what money does”.
2. According to Kent “Anything which is widely used as a medium of exchange and standard of value is money”.

From the above cited definitions, it is clear that Functions of Money or an objective of money is to perform the duties of medium of exchange among different parties. In old days people were use coins as a medium of exchange, but in today’s world money is doing this job for us. Also through barter system people meet the needs of his day to day lives.

Functions of Money

Following are the utmost important functions of money. You must be well familiar with all of them.

• It serves as a medium of exchange.
• It is used as a store of value.
• It is a standard for measuring values.
• Money serves as a standard for deferred payments.
• It transfers value.

1. Money as a Medium of Exchange

The most important function of money is to serves as a medium of exchange. As a medium of exchange, money solves all the difficulties of barter. There is no necessity for a double coincidence of wants in a money economy.

2. Money as a Standard Measure of Value

Where money serves as a medium of exchange incidentally measures the value of things for which it is exchanged. In a money economy, it is easy to compare the relative’s value of commodities and serves which are dissimilar and entirely different from one another. In matters of exchange, a common standard of value makes the transaction easy and also fair. So this is also from one of the utmost important functions of money.

3. Money as a Standard for Deferred Payments

Money also serves as a standard of payment made after a lapse of time. Lending and borrowing, therefore must take place in terms of a commodity which will, reasonably speaking, keep its value stable over time. By serving as a standard measure of payments, money makes borrowing and lending less risky. Thus it helps in stimulating all kinds of economic activity, which depends upon on borrowed money or credit.

4. Money as a Store of Value

Money serves as a store of value. It enables a person to keep a portion of his assets liquid. Liquid assets are those which can be used for any purpose at any time. You may buy things by using these modes of money. Money is best kept as a store of value to be used as and when need arises.

5. Money as a Means of Transferring Value

Means of transferring value from place to another or between two persons is another one of the important functions of money. One can sell one immovable and movable belongings at one place and with the money acquired can buy then elsewhere. Value will thus be transferred.

The Significance of Money

Money is of vital importance to the operation of the national and international economy. Money plays an important role in the daily life of a person whether he is a consumer, a producer, a businessman, an academician, a politician or an administrator.

An individual need not be an economics to be actu­ally aware that money plays an important role in modern life; he need think only of his own experience. We study below the importance of money in a modern economy.

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.

Static Role of Money:

In its static role, the importance of money lies in removing the difficulties of barter in the following ways:

 ((i) 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.

(ii) By acting as a unit of account, money becomes a comes a common measure of value. The use о money as a standard of value eliminates the necessity of quoting the price of apples in terms of organes, the price of organes 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.

(iii) 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.

(iv) 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.

(v) 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.

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.

1) 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.

(2) 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.

(3) In Specialization 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.

 (4) 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.

(5) 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.

(6) 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.

(7) 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.

(8) 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.

(9) 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.

(10) 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.

(11) 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.

                        Different Types of Money

Money can be described as a generally accepted medium of exchange for goods and services. Virtually anything can be considered money, as long as it performs the three major functions of money (i.e. medium of exchange, store of value, unit of account). With this in mind, it is not surprising that there were different types of money throughout history. To give you a brief overview, we are going to take a look at the four most relevant ones below: commodity money, fiat money, fiduciary money, and commercial bank money.

Commodity Money

Commodity money is the simplest and most likely also the oldest type of money. It builds on scarce natural resources that act as a medium of exchange, store of value, and unit of account. Commodity money is closely related to (and originates from) a barter system, where goods and services are directly exchanged for other goods and services. Commodity money facilitates this process, because it acts as a generally accepted medium of exchange. The important thing to note about commodity money is that its value is defined by the intrinsic value of the commodity itself. In other words, the commodity itself becomes the money. Examples of commodity money include gold coins, beads, shells, spices, etc.

Fiat Money

Fiat money gets its value from a government order (i.e. fiat). That means, the government declares fiat money to be legal tender, which requires all people and firms within the country to accept it as a means of payment. If they fail to do so, they may be fined or even put in prison. Unlike commodity money, fiat money is not backed by any physical commodity. By definition, its intrinsic value is significantly lower than its face value. Hence, the value of fiat money is derived from the relationship between supply and demand. In fact, most modern economies are based on a fiat money system. Examples of fiat money include coins and bills.

Fiduciary Money

Fiduciary money depends for its value on the confidence that it will be generally accepted as a medium of exchange. Unlike fiat money, it is not declared legal tender by the government, which means people are not required by law to accept it as a means of payment. Instead, the issuer of fiduciary money promises to exchange it back for a commodity or fiat money if requested by the bearer. As long as people are confident that this promise will not be broken, they can use fiduciary money just like regular fiat or commodity money. Examples of fiduciary money include cheques, bank notes, or drafts.

 Commercial Bank Money

Commercial bank money can be described as claims against financial institutions that can be used to purchase goods or services. It represents the portion of a currency that is made of debt generated by commercial banks. More specifically, commercial bank money is created through what we call fractional reserve banking. Fractional reserve banking describes a process where commercial banks give out loans worth more than the value of the actual currency they hold. At this point just note that in essence, commercial bank money is debt generated by commercial banks that can be exchanged for “real” money or to buy goods and services.

Forms of Money

According to the nature and uses there are different forms of money. Some of them are very briefly explained below.

a) Money of Account:

Money of account refers to the unit in which the transactions of an economy are settled. It may vary from economy to economy. For example, in U.S economy transactions are accounted in Dollar, in Indian economy it is in Rupees, in European economy it is in Euro and so on. The entire transactions of such economies are delivering by money of account.

b) Legal Tender Money

Legal tender money is one which is sanctioned legally, since it ensures the acceptability of money. That is any amount of debt can be paid by the money. Generally legal tender money includes both notes (with high face value) and coins (with less face value). In India paper currency or notes have the quality of unlimited legal tender while coins lack. That is coins cannot used to pay huge amounts, it creates difficulties. In such a case the money receiver can reject the payment. So, it shows limited legal tender of the money.

c) Standard Money

If the entire value of an economy’s transactions is measured in a particular label, then we can say it as standard money. For example; Dollar, Euro, Rupee, Yen etc are standard money forms, and the goods and service s are measured based on these standard money. It includes all the coins and notes. So, it performs the quality of legal tender money.

d) Full Bodied Money

Full bodied money is a form of money which is based on the intrinsic value. That is the face value of the money will equal to the metallic value contained in the money. Actually this form of money was widely used in olden times.

e) Token Money

This is the advanced form of full bodied money. Token money is a form of money in which the face value is greater than the metallic value. Today almost all the money is coming under this form. We use paper notes of high values, but the metal value of the paper is very less.

f) Bank Money / Deposit Money

Bank money refers to the deposits in the bank. Generally there are two types of deposits like time deposits and demand deposits. Time deposits are deposited by the people based on a specific maturity date. At the same time demand deposits are widely assisting the business people and allow to deposit and withdrew at any time.

g) Inside Money and Outside Money

Today, people are borrowing loans and advances from financial institutions. That is the private debt of inside the economy. This is actually meant by inside money. In other words inside money is the quantity of money which created from endogenous private sector, and it is the debt of private units.

                                         E-money

Electronic money or e-money in short is the money balance recorded electronically on a stored-value card or remotely on a server. The Bank for International Settlements defines e-money as ‘stored value or prepaid payment mechanisms for executing payments via point-of-sale terminals, direct transfers between two devices, or even open computer networks such as the Internet’. E-money is usually associated with so-called smart cards issued by companies such as Mondex and Visa Cash.

Electronic money is a floating claim that is not linked to any particular account. Examples of e-money are bank deposits, electronic fund transfer, payment processors, and digital currencies.

The term ‘stored-value card’ means the funds and/or data are 'physically' stored on the card, in the form of binary-coded data. With prepaid cards, the data is maintained on the card issuer's computers. Typical stored-value cards include: prepaid calling cards, gift cards, payroll card, loyalty cards, travel cards.

E-money can also be stored on (and used via) mobile phones or in a payment account on the Internet. Most common and widely used mobile subsystems are Google Wallet and Apple pay.

The fast introduction of e-money has lead to governmental regulatory activities. Hong Kong was among the first jurisdiction to regulate e-money, by allowing only licensed banks to issue stored-value cards. Since 2001, the European Union has implemented a directive on the taking up, pursuit and prudential supervision of the business of electronic money institutions (E-Money Directive - 2009/110/EC).

Electronic currencies can be divided into soft currency and hard currency. Hard electronic currency is one that only supports non-reversible transaction. Reversing transaction, even in case of a legitimate error is not possible. They are more oriented to cash transactions. Examples for hard currencies are: Western Union, KlickEx, or Bitcoin. On the other hand, soft electronic currency is one that allows reversal of payments in a case of fraud or disputes. Examples are PayPal and credit cards.

     The Fisher’s Quantity Theory of Money (Assumptions and   Criticisms)

The quantity theory of money states that the quantity of money is the main determinant of the price level or the value of money. Any change in the quantity of money produces an exactly proportionate change in the price level.In the words of Irving Fisher, “Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa.” If the quantity of money is doubled, the price level will also double and the value of money will be one half. On the other hand, if the quantity of money is reduced by one half, the price level will also be reduced by one half and the value of money will be twice.

Fisher has explained his theory in terms of his equation of exchange:

PT=MV+ M’ V’

Where P = price level, or 1 IP = the value of money;

M = the total quantity of legal tender money;

V = the velocity of circulation of M;

M’ – the total quantity of credit money;

V’ = the velocity of circulation of M

T = the total amount of goods and services exchanged for money or transactions performed by money.

This equation equates the demand for money (PT) to supply of money (MV=M’V). The total volume of transactions multiplied by the price level (PT) represents the demand for money.

According to Fisher, PT is SPQ. In other words, price level (P) multiplied by quantity bought (Q) by the community (S) gives the total demand for money. This equals the total supply of money in the community consisting of the quantity of actual money M and its velocity of circulation V plus the total quantity of credit money M’ and its velocity of circulation V’. Thus the total value of purchases (PT) in a year is measured by MV+M’V’. Thus the equation of exchange is PT=MV+M’V’. In order to find out the effect of the quantity of money on the price level or the value of money, we write the equation as

P= MV+M’V’

Fisher points out the price level (P) (M+M’) provided the volume of tra remain unchanged. The truth of this proposition is evident from the fact that if M and M’ are doubled, while V, V and T remain constant, P is also doubled, but the value of money (1/P) is reduced to half.

Fisher’s quantity theory of money is explained with the help of Figure 65.1. (A) and (B). Panel A of the figure shows the effect of changes in the quantity of money on the price level. To begin with, when the quantity of money is M, the price level is P.

When the quantity of money is doubled to M₂, the price level is also doubled to P₂. Further, when the quantity of money is increased four-fold to M₄, the price level also increases by four times to P₄. This relationship is expressed by the curve P = f (M) from the origin at 45°.

In panel В of the figure, the inverse relation between the quantity of money and the value of money is depicted where the value of money is taken on the vertical axis. When the quantity of money is M₁ the value of money is HP. But with the doubling of the quantity of money to M₂, the value of money becomes one-half of what it was before, 1/P₂. And with the quantity of money increasing by four-fold to M₄, the value of money is reduced by 1/P₄. This inverse relationship between the quantity of money and the value of money is shown by downward sloping curve 1/P = f (M).

Assumptions of the Theory:

Fisher’s theory is based on the following assumptions:

1. P is passive factor in the equation of exchange which is affected by the other factors.

2. The proportion of M’ to M remains constant.

3. V and V are assumed to be constant and are independent of changes in M and M’.

4. T also remains constant and is independent of other factors such as M, M, V and V.

5. It is assumed that the demand for money is proportional to the value of transactions.

6. The supply of money is assumed as an exogenously determined constant.

7. The theory is applicable in the long run.

8. It is based on the assumption of the existence of full employment in the economy.

Criticisms of the Theory:

The Fisherian quantity theory has been subjected to severe criticisms by economists.

1. Truism:

According to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of exchange is a simple truism because it states that the total quantity of money (MV+M’V’) paid for goods and services must equal their value (PT). But it cannot be accepted today that a certain percentage change in the quantity of money leads to the same percentage change in the price level.

2. Other things not equal:

The direct and proportionate relation between quantity of money and price level in Fisher’s equation is based on the assumption that “other things remain unchanged”. But in real life, V, V and T are not constant. Moreover, they are not independent of M, M’ and P. Rather, all elements in Fisher’s equation are interrelated and interdependent. For instance, a change in M may cause a change in V.

Consequently, the price level may change more in proportion to a change in the quantity of money. Similarly, a change in P may cause a change in M. Rise in the price level may necessitate the issue of more money. Moreover, the volume of transactions T is also affected by changes in P. When prices rise or fall, the volume of business transactions also rises or falls. Further, the assumptions that the proportion M’ to M is constant, has not been borne out by facts. Not only this, M and M’ are not independent of T. An increase in the volume of business transactions requires an increase in the supply of money (M and M’).

3. Constants Relate to Different Time:

Prof. Halm criticises Fisher for multiplying M and V because M relates to a point of time and V to a period of time. The former is a static concept and the latter a dynamic. It is therefore, technically inconsistent to multiply two non-comparable factors.

4. Fails to Measure Value of Money:

Fisher’s equation does not measure the purchasing power of money but only cash transactions, that is, the volume of business transactions of all kinds or what Fisher calls the volume of trade in the community during a year. But the purchasing power of money (or value of money) relates to transactions for the purchase of goods and services for consumption. Thus the quantity theory fails to measure the value of money.

5. Weak Theory:

According to Crowther, the quantity theory is weak in many respects. First, it cannot explain ’why’ there are fluctuations in the price level in the short run. Second, it gives undue importance to the price level as if changes in prices were the most critical and important phenomenon of the economic system. Third, it places a misleading emphasis on the quantity of money as the principal cause of changes in the price level during the trade cycle.

Prices may not rise despite increase in the quantity of money during depression; and they may not decline with reduction in the quantity of money during boom. Further, low prices during depression are not caused by shortage of quantity of money, and high prices during prosperity are not caused by abundance of quantity of money. Thus, “the quantity theory is at best an imperfect guide to the causes of the trade cycle in the short period” according to Crowther.

6. Neglects Interest Rate:

One of the main weaknesses of Fisher’s quantity theory of money is that it neglects the role of the rate of interest as one of the causative factors between money and prices. Fisher’s equation of exchange is related to an equilibrium situation in which rate of interest is independent of the quantity of money.

7. Unrealistic Assumptions:

Keynes in his General Theory severely criticised the Fisherian quantity theory of money for its unrealistic assumptions. First, the quantity theory of money for its unrealistic assumptions. First, the quantity theory of money is unrealistic because it analyses the relation between M and P in the long run. Thus it neglects the short run factors which influence this relationship. Second, Fisher’s equation holds good under the assumption of full employment. But Keynes regards full employment as a special situation. The general situation is one of the under-employment equilibrium. Third, Keynes does not believe that the relationship between the quantity of money and the price level is direct and proportional.

Rather, it is an indirect one via the rate of interest and the level of output. According to Keynes, “So long as there is unemployment, output and employment will change in the same proportion as the quantity of money, and when there is full employment, prices will change in the same proportion as the quantity of money.” Thus Keynes integrated the theory of output with value theory and monetary theory and criticised Fisher for dividing economics “into two compartments with no doors and windows between the theory of value and theory of money and prices.”

8. V not Constant:

Further, Keynes pointed out that when there is underemployment equilibrium, the velocity of circulation of money V is highly unstable and would change with changes in the stock of money or money income. Thus it was unrealistic for Fisher to assume V to be constant and independent of M.

9. Neglects Store of Value Function:

Another weakness of the quantity theory of money is that it concentrates on the supply of money and assumes the demand for money to be constant. In order words, it neglects the store-of-value function of money and considers only the medium-of-exchange function of money. Thus the theory is one-sided.

10. Neglects Real Balance Effect:

Don Patinkin has critcised Fisher for failure to make use of the real balance effect, that is, the real value of cash balances. A fall in the price level raises the real value of cash balances which leads to increased spending and hence to rise in income, output and employment in the economy. According to Patinkin, Fisher gives undue importance to the quantity of money and neglects the role of real money balances.

11. Static:

Fisher’s theory is static in nature because of its such unrealistic assumptions as long run, full employment, etc. It is, therefore, not applicable to a modern dynamic economy.

 Monetary Standards: Bimetallism, Monometallism and Paper Standard

Gold Parity Standard:

The latest to enter the list of gold standards is the gold parity standard. This is the type which is supposed to prevail under the aegis of the International Monetary Fund. Under this system, no gold coins are put in circulation. Gold does not serve as a medium of exchange. The internal currency consists largely of notes and some form of metallic money but certainly not of gold; nor is these notes convertible neither into coins as under the full gold standard, nor into gold bullion as under the bullion standard, nor into particular foreign currency based on gold as under the gold exchange standard.

But the only respect in which gold comes into play under this system is that the currency authority takes upon itself the obligation of maintaining the exchange rate of the domestic currency stable in terms of a certain quantity of gold. This is the type of gold standard which the member countries of the I.M.F. are supposed to have. On January 16, 1975, however, the I.M.F. decided to abolish the official price of gold. This put an end to the role that gold had played for 30 years in the international monetary system.

Advantages of Gold Standard:

Several advantages are claimed for the gold standard, especially when it is adopted by a number of countries, i.e., international gold standard:

(i) It is an objective system and is not subject to changing policies of the government or the currency authority.

(ii) It enables the country to maintain the purchasing power of its currency over long periods. This is so because the currency and credit structure is ultimately based on gold in the possession of the currency authority.

(iii) Exchange-rate Stability. Another important advantage claimed for the gold standard is that it preserves and maintains the external value of the currency (rate of exchange) within narrow limits. As a matter of fact, within the gold standard system, it provides fixed exchanges, which is a great boon to traders and investors. International division of labour is greatly facilitated.

(iv) It gives, in fact, all the advantages of a common international currency. It establishes an international measure of value. As Marshall pointed out, “the change to a gold basis is like a movement towards bringing the railway gauge on the side branches of the world’s railway into unison with the main lines”. This greatly facilitates foreign trade, because fluctuations in rates of exchange hamper international trade.

(v) Automatic Adjustment of Balance of Payments. It is further claimed that gold standard helps to adjust the balance of payments between countries automatically. How this happens may be illustrated by a simple example. Suppose Great Britain and the U.S.A. are both on gold standard and only trade with each other and that a balance of payments is due from Great Britain to the U.S.A. Gold will be exported from the former to the latter.

The Bank, of England, which is the Central bank of the country, will lose gold. It will contract currency in Great Britain and bring about a fall in the price level there. Price level in the U.S.A. will rise due to larger gold reserves and the resultant expansion of currency and credit. Great Britain will thus become a good’ market to buy from and a bad market to sell in.

Conversely, the U.S.A. will become a good market to sell in and a bad market to buy from. British exports will be encouraged and imports discouraged. The U.S. exports will be discouraged and imports encouraged. The balance of payments will tend to move in favour of Great Britain until equilibrium is reached. It is in this way that the movement of gold, by affecting prices and trade, keeps equilibrium among gold standard countries. More of this later.

(vi) Gold Standard inspires confidence and contributes to national prestige, for “so long as nine people out of ten in every county think the gold -standard is the best, it is the best.”

 

 

Disadvantages:

1. Costly:

Gold Standard is costly and the cost is unnecessary. We only want a medium of exchange; why should it be made of gold? It is a luxury. ‘The yellow metal could tickle the fancy of savages only’.

2. Not Stable:

Even the value of gold has not been found to be absolutely stable over long periods.

3. Not Elastic:

Under the gold standard, currency cannot be expanded in response to the requirements of trade. The supply of currency depends on the supply of gold. But the supply of gold depends on the success of mining operations which may have nothing to do with the factors affecting the growth of trade and industry.

4. Not Automatic:

Recently, even the gold standard has been a managed standard. The central banking technique has been applied deliberately to control the working of the gold standard. It is thus no longer automatic as it was claimed to be.

5. Sacrifices Internal Stability:

Gold standard has also been charged with sacrificing internal stability to external (exchange) stability. It is the interna­tional aspect of the gold standard which has been paid more attention to.

6. Gold Movements Affect Investments.

Another disadvantage is that “gold movements lead to changes in interest rates; so that investment is stimulated or checked solely in order to expand or reduce money income”— (Benham).

7. No Independence.

Independent policy under this system is not possi­ble. A country on a gold standard cannot follow an independent policy. In order to maintain the gold standard or to restore it (as in Great Britain after World War I), it may have to deflate its currency against its will. Deflation spells ruin to the economy of a country. It brings, in its wake, large-scale unemploy­ment, closing of works and untold suffering attendant on depression.

Working and Abandonment of the Gold Standard:

Gold standard worked, on the whole, smoothly till the war of 1914-18, because the countries concerned did play the game of the gold standard. It had to be suspended during the war and was restored in most countries when the war was over although many countries now went in not for the full-blooded gold currency standard, but for its other versions, viz., gold exchange standard or gold bullion standard. The economic environment had, however, changed so much that within a decade of its restoration, the gold standard broke down in country after country and had to be abandoned.

Why Gold Standard Broke Down:

The break-down of the gold standard is attributed to several causes:

(i) In the inter-war period, gold came to be unevenly distributed among the countries of the world, the U.S. and France monopolizing the bulk of it. The result was that the supply of gold was insufficient in other countries to enable them to maintain gold standard.

(iii) Stringent restrictions on foreign trade, especially imports, created balance of payment problems for many countries. Not having enough gold to cover the gap, they abandoned the gold standard.

(ii) Gold standard was suspended in Great Britain in 1931 when it could not stand large-scale withdrawal of gold from it by France.

(iv) The gold receiving countries, like the U.S.A., did not play the gold standard game. That is, they did not observe the rules of the gold standard by expanding their currency corresponding to the receipts of gold to avoid inflation and imports. This would have resulted in gold leaving the country for which they were not prepared.

(v) Owing to enormous growth of international indebtedness and huge amounts of interest payments and strong trade unions resisting wage-cuts, the economic structure of the various countries had become rigid. The result was that the prices no longer moved in the, direction warranted by gold movements. In these, circumstances, gold standard ceased to be workable.

(vi) Gold standard had become a ‘fair weather friend’ and collapsed when-ever there was an economic crisis. It was not considered advisable to cling to such a system.

(vii) Since gold movements (which are associated with a gold standard), caused inconvenient changes in interest rates and resulted in economic fluctuations, gold standard had become untenable.

(viii) In the inter-war period, a large volume of short-term capital moved for safety and profit from country to country. Big flows of this ‘hot money’ some-times necessitated large gold movements out of the country. Countries with slender gold reserves were unable to stand such movements and maintain the gold standard.

Future of Gold Standard:

It is unlikely that, after the experiences of the inter-war period, gold standard will be established in the conventional sense by any country of the world. The experience of the inter-war period, however, showed that the gold standard required quite a fair degree of management and still greater degree of co-operation of the gold standard countries for its smooth working.

“The gold standard will work if every nation is content to march in step with every other.” Unless the rules of the gold standard are observed, it cannot function successfully. Also, the rigidities of the economic system stood in the way of proper adjustment of price levels and costs necessary for its successful working.

Rules of Gold Standard:

These rules were as under:

(i) There should be no restrictions imposed on the free movement of goods between the countries, so that disequilibrium in the balance of payments can be adjusted mainly through the movement of goods.

(ii) Economic structure should be elastic, so that prices and wages readily respond to gold movements.

(iii) The government or the Central bank should not do anything to neutralize the effects of gold movements so that currency is allowed to expand or contract in response to gold movements.

These rules were honoured more in the breach than in their observance. The break-down of the gold standard was, therefore, inevitable. There is little hope of these rules being observed in the future. It requires a high degree of international co-operation. But with this co-operation, a managed system can be devised in which gold will not play a prominent role.

People have lost faith in the capacity of gold to maintain stability either of price level or of exchange. Gold has ceased to enjoy its old prestige; managed currency, on the other hand, has been successfully tried in several countries (e.g., the U.K.).

Towards the end of the Second World War, the world statesmen met at Bretton Woods in the U.S.A. to thrash out suitable monetary system for the postwar world. The result was the creation of the International Monetary Fund.

The fund is supposed to achieve all the advantages of a gold standard without its disadvantages by international co-operation. In it gold still played a role but not such a dominant role as it did under the gold standard. But since 1975, even that dominant role has been taken away. Thus gold standard of the old type has no future.

(c) Paper Gold Standard or the SDR Standard:

The latest to enter the list of monetary systems is the Paper Gold standard or the SDR Standard. The IMF system or the Gold Parity Standard had all the merits minus the demerits of the gold standard. It ensured exchange stability without the country having to undergo the expense of maintaining a costly currency system. The IMF also sought to provide multilateralism. It facilitated convertibility of currencies and provided adequate and convenient currency reserve (in the form of U.S. $) for the use of member countries.

However, the fast changing circumstances necessitated changes in the IMF system. In September 1967, the Board of Governors of the IMF approved a plan for a new type of international asset known as the SDRs (Special Drawing Rights). Under this Scheme, the IMF is empowered to allocate to various member countries Special Drawing Rights (SDRs) on a specified basis, which in effect amounts to raising the limit up to which a member country can draw from the IMF in time of need.

Besides, the SDRs supplement gold dollars and pounds sterling which most countries now use as monetary reserves. Thus, SDRs can be used unconditionally by the participating countries to meet their liabilities, and they are not backed by gold.

The resources of the new scheme are not a pool of currencies but simply the obligation of participating members to accept the SDRs for the settlement of obligations among themselves. Thus, SDRs serve as international money as good as other reserve currencies.

In January 1975, the IMF abolished the official price of gold and SDRs have become instead the basis of the present international monetary standard. Since the SDRs are not convertible into gold, the SDR standard may alternatively be designated as Paper Gold Standard.

Characteristics of a Sound Monetary Standard:

We are now in a position to offer remarks as to which monetary or currency standard out of those discussed above is the best. One may easily say, copying Alexander Pope: “About forms let fools contest; that which is administered best is the best.” There is no doubt that almost every system has been in operation in one country or the other at different times and with varying success.

A good system, however, should have the following characteristics:

(i) It must be simple so that people can easily understand it. The currency has to be used by all the people. If it is complicated, the people will not understand it and will not be able to work it well.

(ii) A good currency system must help to keep prices reasonably stable, thus toning down extreme fluctuations in the purchasing power of the currency. Rapid price changes are harmful to trade, industry and the people at large.

(iii) It must also maintain the external value of the currency of the country. If the ratio of the rupee with the foreign currencies is maintained stable, India’s foreign trade would flourish. Economists have, however, come to hold now that the stability of internal prices is to be preferred to the stability of foreign exchange ratio.

(iv) The system must be economical. The gold standard is a very costly standard. That is the reason why it had to be given up. A paper currency system supported by a type of standard money and money of account in which the people of the country have full confidence is an ideal system.

(v) The system should be automatically elastic so that the currency should expand when needed and contract when the need is over. Only an elastic currency can best answer the needs of trade and industry. When, as a result of rapid economic development, trade expands, the currency must expand sufficiently.

(vi) Finally, the currency system must inspire confidence. If the people have no faith in it, they will not accept it.

Indian System:

The Indian currency system as a whole commands the confidence of the people of India. It is economical and reasonably steady internally and internationally. It is also elastic. We can then safely assert that it is a good monetary standard.

Managed Currency

A currency with an exchange rate set or influenced by a government. Often, the local government makes this intervention, but this is not always the case. For example, in 1994, the American government bought large quantities of Mexican pesos to stop the rapid loss of the peso's value.

Strictly speaking, even a central bank's intervention to raise or lower interest rates creates a managed currency. However, because most floating currencies manage their regimes with occasional central bank involvement, the term applies mainly to frequent or dramatic interventions. See also: 1994 Mexican economic crisis, Floating currency, Fixed exchange rate.

Advantages and Disadvantages of Managed Currency Standard

Advantages:

Paper currency standard or managed currency system which prevails in the modern economy has several advantages and disadvantages. Its main advantage is that under it the quantity of money can be easily increased according to economic needs of the country.

When any country is under gold standard, it cannot increase the quantity of money unless the quantity of gold with it increases, despite the fact that the country needs expansion in money supply badly for purpose of promoting economic growth.

Therefore, paper or fiat currency standard, which delinks the creation of money from gold, facilitates expansion in the quantity of money for promoting economic growth. The process of eco­nomic growth brings about an increase in output of goods and services in agriculture, industry, trans­port and communication.

As a result, there is need for financing these activities so that transactions involving a larger amount of goods and services take place easily. But this requires the availability of the sufficient amount of money. If the required amount of money is not forthcoming, as is the case under gold and silver standards, then the process of economic growth will be retarded.

In times of depression there is need to increase the aggregate demand in the economy so that the state of full employment is reached. The best way to increase aggregate demand is the creation or new money by the Government and spending it on various public works. Following the increase in aggre­gate demand, production will expand and employment for workers will increase causing their in­comes to rise.

But, as we have seen above, only under paper currency standard, the quantity of money can be increased easily, whereas under gold standard, without the increase in the quantity of gold, money supply cannot be increased. In this way we see that paper currency standard is helpful to overcome depression and to achieve the objective of full employment.

On the other hand, when inflation occurs in the economy the Government can make a surplus budget and in this way it can withdraw the extra money from the public. This will lower the aggregate demand which will help in controlling inflation. With the appropriate monetary and fiscal policies price stability can be achieved.

But these appropriate monetary and fiscal policies are possible only under paper currency standard. J.M. Keynes also supported the managed currency standard on the ground that, as compared to gold standard or any other monetary standard, this is very elastic and under it the quantity of money can be varied according to the needs of the economy.

Unlike the gold and silver standard, paper currency is not a fair weather friend. This standard is very helpful to the Government in situations of crisis such as war, drought, etc. when it needs extra quantity of money. By creating new paper money the Government can conduct the war successfully. With the newly created money the Government can buy real resources and goods when sufficient quantity of money cannot be procured through taxes.

Under gold and silver standards, money cannot be increased unless the quantity of gold or silver increases. This is true that under paper currency standard Governments are tempted to issue excessive notes which results in inflation. But if proper controls are applied and production of goods expands, the issue of more money within reasonable limits to match the extra output does not result in inflation.

Besides, paper currency standard is very economical. As compared to the prices of metals, the price of paper is very low. Even those countries can adopt this standard who has no or few resources of gold and silver.

Besides this, with the adoption of paper currency standard the gold and silver are saved which can be used for industrial and productive purposes. Lastly, under the paper currency standard, rate of foreign exchange automatically changes according to the conditions of demand and supply and therefore disequilibrium in the balance of trade is automatically removed.

According to a foreign exchange specialist, Agnas, “the beauty of paper system is that as soon as any disequilibrium between demand and supply occurs, sharp fluctuation in the price of foreign exchange immediately takes place which by its immediate action on both exports and imports rapidly restores equilibrium.”

Disadvantages

But paper currency standard has several disadvantages too. First, it creates foreign exchange instability. Due to excessive changes in the foreign exchange rate, the prices of exports and imports of a country go on changing rapidly which affects foreign exchange earnings of the country. As a result of this, the country has to continually face foreign exchange instability and this instability is very dangerous for those countries who predominantly depend on foreign trade.

These days when most of the countries of the world have floated their currencies (i.e., foreign exchange rate is left to be deter­mined by demand and supply), foreign exchange instability has assumed serious proportions. There­fore, many suggestions have been put forward to reform the international monetary system so that the problem of foreign exchange instability is avoided. Secondly, it is also asserted that even internal economic stability cannot be achieved with paper currency standard. The over-issue of paper cur­rency can lead to inflation in the economy.

This has been actually so in India where too much new paper money has been created to finance ever increasing Government expenditure. This has caused serious inflationary pressures in the Indian economy. Thus, the paper currency standard can give rise to both internal and foreign exchange instability.

However, for this paper currency system should not be blamed. Desired benefits from paper currency system can be obtained if the Government properly manages it. If the adoption of paper currency system causes instability in the economy, the Govern­ment is responsible for it and not the paper currency system.

The paper currency system is very elastic and its main advantage is that the quantity of money can be increased or decreased according to the requirements of the economy. But if improper use of its elastic nature is made by the Government by creating excessive quantity of money, the Government should be blamed and not the standard.

Major Principles of Note Issue

There are various principles of issue of currency notes. Two com­mon principles are the banking principle and the current principle. These two principles governed the issue of notes in former times, but at present various other principles have been evolved.

We may well start with the two ancient principles of note issue:

1. The Banking Principle:

It is not at all necessary to establish clear-cut rules and regulations regarding reserve. This is the essence of the banking principle. The banking school argued that, given that bank notes were convertible into gold, there was no need to regulate note issue because the fact of convertibility would prevent any serious over-issue. Moreover, it was pointless to try to regular the issue of bank notes because the demand for currency would be met by an expansion of bank deposits, which would have the same effect as an expansion of the note issue.

The only major advantage of this principle is that the monetary system, based on this principle, would be economic and elastic. There is no need for gold or silver backing to support the issue of currency notes.

Disadvantages:

However, the system would be quite unsafe. Since mone­tary authority can issue money notes at will and without limit, its value is likely to fall in case of over-issue. This, in its turn, is likely to make people lose their confidence in the currency system.

Consequently, there would always remain the danger of a flight from currency at the slightest sign of trouble. This means that in case of a slight loss of confidence (in the event of a fall in the value of currency notes) people would prefer to sell currency notes and demand metallic coins in exchange.

So, the Greham’s Law is likely to operate. Economic history amply demonstrates that the usual tendency of every note issuing authority throughout the world has been to issue notes in excess of requirements, unless checked by law.

2. The Currency Principle:

In contrast with the banking school, the currency school argued that the check offered by convertibility would not operate in time to prevent serious commer­cial disruption. According to this principle, bank notes should be regarded as though they are the gold specie they in fact represent, and consequently the quantity of issue should fluctuate in line with the balance of payments.

According to the former school of thought, notes are not required for their own sake but for use in industry and trade and therefore have to be put into circulation so as to form the basis of credit (apart from acting as a medium of exchange).

However, the note-issuing authority must always guard against the over-issue of notes, in which case there is need to convert notes into coins, what type of money is to be kept as reserve to back the issue of notes so as to meet its demand should be left completely to the discretion of the note-issuing authority.

The currency principle has both advantages and disadvantages:

Advantages:

The only advantage to be secured from the principle is safety. If notes are issued by following this principle the monetary or currency system of the country would be quite safe and would therefore win complete confidence of the people.

Disadvantages:

However, the currency system based on this principle would be wasteful and uneconomic. The reason is easy to find out. Since a huge amount of metal has to be kept as reserve to provide the necessary backing the system would appear to be unproductive and costly, too.

The second disadvantage of the principle is that currency (monetary) system based on gold would inherently inelastic in as much as the volume of notes could be increased or decreased according to the changing require­ments of the country.

Instead the quantity of money in circulation world depend entirely on the existing stock of gold (or any other precious metal) chosen to from the reserve base of the system. If the economy is not at full employment the quantity of money would be grossly inadequate to step up aggregate demand to such a level as to enable the economy achieve full employment.

In other words, in most real life situations of less-than-full employment the stock of money in circulation would be less than what is required to produce the economy’s potential (i.e., full employment) output.

Five Alternative Systems of Note Issue:

In practice, every country has developed its own method of controlling the issue of currency notes. But no country in the world which has gone to the extent of adopting a hundred percent reserve as dictated by the currency principle.

The various systems of note issue prevailing in different countries of the world can be divided into five broad categories.

These are as follows:

1. The Fixed Fiduciary System:

This is one of the oldest systems of controlling note issues. Under this system, a country can issue a certain quantity of notes without any reserve, (i.e., without gold or silver backing). The upper limit to this quantity is called fiduciary limits beyond which there has to be a hundred percent metallic reserve. Over the years, the system was following many other countries. However, the fiduciary limit had to be raised from time to time in order to meet the growing needs of trade and industry.

The system has both merits and drawbacks:

Advantages:

This method enables the central bank to exercise strict control over note issue which is important for controlling inflation or maintaining stability in the value of a currency. So, this method instills confidence among people as it did when it operated in the U.K. in the past.

Disadvantages:

However, this method has several drawbacks:

(i) Wast­age:

Firstly, the system appeared to be uneconomical as it locked up a huge quantity of gold unnecessarily.

(ii) Inelasticity:

Secondly, the system proved to be inelastic. Money supply could not be increased easily even when trade and industry expanded.

2. The Maximum Limit System:

This system was adopted in France and was in operation upto 1928 (just a year before the great crash of 1929). Under the system the State fixed an upper limit to note-issue without any reserve. But any issue of notes beyond the limit was possible only after obtaining necessary legal sanction, i.e., permission from the legislature.

Advantages:

Two advantages of the system are:

(i) Freedom:

The most important thing to be said in favour of the system is that under it the note- issuing authority enjoys complete freedom (or full discretion) as regards reserve.

(ii) Economy:

Secondly, the system is economical in the sense that the reserve of gold kept in an unproductive from can be reduced to a minimum.

Disadvantages:

Two disadvantages of the system are:

(i) Inelasticity:

If the upper limit to note issue is fixed at a very low level the system of such issue suffers from inherent inelasticity. This is likely to create problems in periods of expanding economic activity.

(ii) Inflation:

In contrast, if the limit is fixed at too high a level there is the danger of price inflation — too much money chasing too few goods.

3. The Proportional (Fractional) Reserve System:

Most countries of the world have now adopted the fractional reserve system. Under this system note issue is conditioned by gold backing (varying from 25 to 40%). This means that a certain portion of note-issue has to be backed by gold reserve.

The remaining part of the note issue has to be covered by government securities (which are highly liquid assets) and approved commercial papers. There is also the general provision that subject to certain conditions and penalties the reserve rate may be permitted to fall below the legal minimum.

Advantages:

Two main advantages of this system are:

(i) Simplicity:

The first thing to be said in favour of the proportional reserve system is that it is simple to operate.

(ii) Elasticity:

The second advantage offered by the system is that it is elastic.

Disadvantages:

The main disadvantages of this system are:

(i) Uneco­nomic nature:

The most important defect of the system is that it is not economical. The reason is that an unproductive gold reserve has to be kept.

(ii) Multiplier effect:

Secondly, the system creates reverse multiplier effect. In the event of a fall in the central bank’s stock of gold, the note-issue contracts more than in proportion. This is likely to have contractionary effects on trade and industry. At the end the economy is likely to be in a cumulative deflationary spiral.

(iii) Inadequacy:

Finally, the system proves to be useless in times of financial crisis because the gold reserve is considerably less than the total note-issue.

If people lose confidence in currency notes in times of crisis, the reserve becomes grossly inadequate to liquidate all the notes. If the system is able to generate confidence among people, the reserve is unnecessary. However, as a general rule, it seems that the existence of a partial reserve is quite sufficient to create confidence among the people at large.

4. The Proportional Reserve Not Based on Gold:

In most developing countries like India there is no doubt a legal provision for maintaining a certain percentage of note-issue in the form of reserve, which can be held partly in gold and partly in foreign currencies. Such a system was set up in India in 1956.

Advantages:

Three main advantages are:

(i) Economy:

The chief advan­tage of the system is that it is economy. The reason is that a part of the reserve can be held in the form of (foreign) interest bearing securities.

(ii) Elasticity:

It is highly elastic in nature.

(iii) Exchange rate stability:

Finally, it enables the central bank to maintain stability in the external value of the country’s currency. When, for instance, a country suffers from a deficit in the balance of payments the external value of its currency tends to fall.

This can be prevented by selling foreign currencies. In contrast, when a country enjoys a surplus in its balance of payments, the external value of the country’s currency tends to rise. In such a situation the rate of exchange can be kept steady by purchasing foreign currencies.

Disadvantages:

The disadvantage of this system is inflation: The most serious weakness of the system is that it has an inherent inflationary potential. If money supply increases due to inflow of foreign exchange (when the balance of payments position is favourable) but the supply of goods and services fails to increase proportionately prices will rise and the value of money will fall.

Conclusion:

On the balance it seems that foreign exchange reserves, if judiciously used, can be a source of strength, not weakness, of the monetary system. But it is not always proper to hold the foreign balance as part of the legal reserve against note issue. It is necessary to draw a distinction between reserves held for exchange rate stabilization and reserves held as reserve against notes issued for internal circulation.

5. The Minimum Reserve System:

Finally, we may refer to the minimum reserve system under which the central bank can issue notes without limit against government securities and approved commercial papers but is under the legal obligation to keep a minimum reserves of gold and foreign currencies. Such a system has been operating in India since 1956.

Advantages:

Two main advantages of this system are:

(i) Elasticity and flexibility:

The most important advantage of the system that it imparts a high degree of elasticity and flexibility to the system of note-issue. The power to issue notes can be used for deficit spending if and when it is needed for development purposes.

India adopted this system for a two-fold reason:

(a) To use foreign securities (formerly kept as reserve against note-issue) in order to meet the foreign exchange requirements of the. Five Year Plans and

(b) to facilitate inflationary financing.

(ii) Raising resources:

Secondly, the minimum reserve system is particularly suitable for developing countries like India which have relied on the planning system for achieving faster economic growth. The need to raise resources to finance the plans is much more important in such countries than keeping a huge amount of unpro­ductive reserves with the central bank.

Disadvantages:

Two disadvantages of the system are:

(i) Inflationary potential:

Prima facie, the system is highly dangerous because of its inherent inflationary potential. It breeds inflation by making it quite easy for the government to raise reserves by printing paper currency.

(ii) Public option:

Secondly, the system completely ignores the role of currency reserves in maintaining people’s confidence in the monetary system of the country.

Critics point out that the system will prove to be successful only under a strong government (free from corruption) which is determined to follow a sound economic policy and is successful in tilting public opinion in its favor.

Conclusion:

It is very difficult to say which of the above systems of regulating note issue is the best. It all depends on the particular economic circumstances of the country concerned. An ideal system is one which seeks to secure four major objectives: (1) economy, (2) elasticity, (3) safety and (4) stability. The emerging trend today in most developing countries is towards the adoption of a reserve system which is sufficiently flexible to meet their developmental needs.                    

Indian Money Market

The Indian money market cannot be considered as an integrated unit. It can be broadly divided into two different parts, i.e., the unorganised and organised segments. There are lot of differences between unorganised and organised segment of Indian money market. While the unorganised sector is constituted by money lenders and the indigenous bankers but the organised sector is again constituted by the nationalised and private sector commercial banks, the foreign banks, co-operative banks and the Reserve Bank of India (RBI). The unorganised segment of the Indian money market is not a homogenous and integrated sector but the organised sector of the Indian money market is a fairly integrated one.

Structure of Indian money market:

Unorganised segment of the Indian money market is composed of unregulated non-bank financial inter­mediaries, indigenous bankers and money lenders which exist even in the small towns and big cities. Their lending activities are mostly restricted to small towns and villages. The persons who normally borrow from this unorganised sector include farmers, artisans small traders and small scale producers who do not have any access to modern banks.

The following are some of the constituents of unorganised money market in India.

(i) Indigenous Bankers:

Indigenous bankers include those individuals and private firms which are engaged in receiving deposits and giving loans and thereby acting like a mini bank. Their activities are not at all regulated. During the ancient and medieval periods, these indigenous bankers were very active. But with the growth of modern banking, particularly after the advent of British, the business of the indigenous bankers received a setback.

Moreover, with the growth of commercial banks and co-operative banks the area of operations of indigenous bankers has again contracted further. Even today, a few thousands of indigenous bankers are still operating in the western and southern parts of the country and engaging themselves in the traditional banking business.

Indigenous bankers are classified into four main sub groups, i.e., Gujarati Shroffs, Multani-or Shikarpuri Shroffs, Chettiars and Marwari, Kayast. Gujarati Shroffs are mostly operating in Mumbai, Kolkata and in industrial and trading cities of Gujarat. The Multani or Shikarpuri Shroffs are operating mainly in Mumbai and Chennai. The Chettiars are mostly found in the South.

The Marwari Shroffs are mostly active in Mumbai, Kolkata, tea gardens of Assam and also in different other parts of North-East India. Among the four aforesaid groups, the Gujarati indigenous bankers are considered as the most powerful groups in respect of its volume of business.

The indigenous bankers are mostly engaged in both banking and non-banking business which they do not want to separate. Their lending operations remain mostly unregulated and unsupervised. They charge high rate of interest and they are not influenced by bank rate policy of the Reserve Bank of India.

(ii) Unregulated Non-Bank Financial Intermediaries:

There are different types of unregulated non-bank financial intermediaries in India. They are mostly constituted by loan or finance companies, chit funds and ‘nidhis’. A good number of finance companies in India are engaged in collecting substantial amount of funds in the form of deposits, borrowings and other receipts.

They normally give loans to wholesale traders, retailers, artisans, and different self-employed persons at a high rate of interest ranging between 36 to 48 per cent.

There are various types of chit funds in India. They are doing business in almost all the states but the major portion of their business is concentrated in Tamil Nadu and Kerala. Moreover, there are ‘nidhis’ operating in South India which are a kind of mutual benefit funds restricted to its members.

(iii) Moneylenders:

Moneylenders are advancing loans to small borrowers like marginal and small farmers, agricultural laborers, artisans, factory and mine workers, low paid staffs, small traders etc. at very high rates of interest and also adopt various malpractices for manipulating loan records of these poor borrowers.

There are broadly three types of moneylenders:

(i) Professional moneylenders dealing solely with money lending;

(ii) Itinerant moneylenders such as Kabulis and Pathans and

(iii) Non-professional moneylenders.

The area of operation of the moneylenders is very much localised and their methods of operation is also not uniform. The money lending operation of the moneylenders is totally unregulated and unsupervised which leads to worst exploitation of the small borrowers.

Moneylenders have become a necessary evil in the absence of sufficient institutional sources of credit to the poorer sections of society. Although various measures have been introduced to control the activities of moneylenders but due to lack of political will, these are not enforced, leading to a exploitation of small borrowers.

Organized Sector of Indian Money Market:

The organised segments of the Indian money market is composed of the Reserve Bank of India (RBI), the State Bank of India, Commercial banks, Co-operative banks, foreign banks, finance corporations and the Discount or Finance House of India Limited. The segment of Indian money market is quite integrated and well organised.

Mumbai, Kolkata, Chennai, Delhi, Bangalore and Ahmedabad are the leading centres of the organised sectors of the Indian money market. The Mumbai money market is a well organised, having head offices of the RBI and different commercial banks, two leading well developed stock exchanges, the bullion exchange and fairly organised market for Government securities. All these have placed the Mumbai money market at par with New York money market of USA and London money market of England.

The main constituents of the organised sector of Indian money market include:

(i) The Call Money Market,

(ii) The Treasury Bill Market,

(iii) The Commercial Bill Market,

(iv) The Certificates of Deposits Market,

(v) Money Market for Mutual Funds and

(vi) The Commercial Paper Market.

(i) Call Money Market:

The call money market is a most common form of developed money market. It is a most sensitive segment of the financial system which reflects clearly any change in it. The call money market in India is very much centred at Mumbai, Chennai and Kolkata and out of which the Mumbai is the most important one. In such market, lending and borrowing operations are carried out for one day.

The call money market in also termed as inter-bank call money market. Normally, scheduled commercial banks, Co­operative banks and the Discount and Finance House of India (DFHI) operate in this market and in a special situation; the LIC, UTI, the GIC, the IDBI and the NABARD are permitted to operate as lenders in this call money market. In this market, brokers usually play an important role.

(ii) Treasury Bill Market:

Treasury bill markets are markets for treasury bills. In India such treasury bills are short term liability of the Central Government which are of 91 day and 364 day duration. Normally, the treasury bills should be issued so as to meet temporary revenue deficit over expenditure of a Government at some point of time. But, in India, the treasury bills are, nowadays, considered as a permanent source of funds for the Central Government.

In India, the RBI is the major holder of the treasury bills, which is around 90 per cent of the total. In India, ad-hoc treasury bills have now been replaced by ways and means Advances since April 1, 1997, so as to finance temporary deficits of the Central Government.

(iii) Commercial Bill Market:

The Commercial bill market is a kind of sub-market which normally deals with trade bills or the commercial bills. It is a kind of bill which is normally drawn by one merchant firm on the other and they arise out of commercial transactions.

The purpose for issuing a commercial bill is simply to reimburse the seller as and when the buyer delays payment. But, in India, the commercial bill market is not so developed. This is mainly due to popularity of the cash credit system in bank lending and the unwillingness on the part of large buyer to bind himself to payment schedule related to the commercial bill and also the lack of uniform approach in drawing bills.

Commercial bills are an instrument of credit which is very much useful to business firms and banks. In India, the outstanding amount of commercial bills rediscounted by the banks with different financial institutions at the end of March, 1996 was to the extent of only Rs 374 crore.

(iv) Certificate of Deposit (CD) Market:

The certificate of Deposit (CD) was introduced in India by the RBI in March 1989 with the sole objective of widening the range of money market instruments and also to attain higher flexibility in the development of short term surplus funds for the investors. Initially the CDs are issued by scheduled commercial banks in multiples of Rs 25 lakh and also to the extent of a minimum of Rs 1 crore.

Maturity period of CDs varied between three months and one year. In India, six financial institutions, viz., IDBI, ICICI, IFCI, IRBI, SIDBI and Export and Import Bank of India were permitted in 1993 to issue CDs for period varying between 1 to 3 years.

Banks normally pay high rates of interest on CDs. In 1995-96, the stringent conditions in the money market induced the bankers to mobilise a good amount of resources through CDs. Accordingly in recent years, the outstanding amount of CDs issued by the commercial banks has almost been doubled from Rs 8,017 crore in March, 1995 to Rs 16,316 crore as on 29th March, 1996.

(v) Commercial Paper Market:

In India, the Commercial Paper (CP) was introduced in the money market in January 1990. A listed company having working capital not less than Rs 5 crore can issue CP. Again the CP can be issued in multiples of Rs 25 lakhs subject to a minimum of Rs 1 crore for a maturity period varying between three to six months. CPs would be again freely transferable by endorsement and delivery.

(vi) Money Market Mutual Funds:

In India, the RBI has introduced a scheme of Money Market Mutual Funds (MMMFs) in April 1992. The main objective of this scheme was to arrange an additional short term avenue for the individual investors. This scheme has failed to receive much response as the initial guidelines were not attractive. Thus, in November, 1995, the RBI introduced some relaxations in order to make the scheme more attractive and flexible.

As per the existing guidelines, the banks, public financial institutions and the private financial institutions are allowed to set up MMMFs. In the mean time, the limits of investment in individual instruments by MMMF have already been deregulated. Since April 1996, the RBI has allowed MMMFs to issue units to corporate enterprises and others at par with the mutual funds introduced earlier.

As per the latest data available from Association of Mutual Funds, overall, the combined Assets Under Management (AUM) of all the mutual fund houses in country stood at Rs 5,06,692.6 crore. The top five mutual funds of the country include—Reliance MF, ICICI Prudential MF, UTI-MF, HDFC MF and Franklin Templeton MF. Reliance MF continued to be the most valued fund house in the country with assets under management (AUM) of Rs 90,937.94 crore at the end of March 31, 2008.

The industry body Assocham Chamber recently conducted a survey on “MF Growth Patterns” and accordingly observed that the Mutual Fund industry has growth 25 per cent between 1999 and 2007 to stand at Rs 4,67,000 crore and the trend would improve as MFs are becoming a preferred choice for both rural and urban retail investors.

The mutual fund sector would grow at compound annual rate of 30 per cent in next three years to become Rs 9,50,000 crore industry as predicted by the survey. The share of privately managed MF players in the total MF industry is expected to fall to 70 per cent from the current estimation of 82 per cent. The reduction would result from the alliance of the private players with overseas partners.

2. Characteristics and Defects of Indian Money Market:

The Indian money market has many distinctive characteristics but it also suffers from various defects.

Following are some and defects:

(i) Lack of Adequate Integration:

There is lack of adequate integration in the Indian money market. The organised and the unorganised sector of Indian money market are totally separate from each other and they have independent financial operations of their own. Therefore, activities of one sector have no impact on the activities of the other sector. It is very difficult to establish a national money market under such a background.

However, the Mumbai money market has been emerging as a strong money market in recent times. Moreover, various constituents of the Indian money market viz., commercial banks, Co-operative banks and foreign banks are competing among themselves and particularly, the competition is much in the countryside. Even the commercial banks are competing among themselves. Again, the monetary policy of the RBI is also not effective to maintain adequate integration among various constituents of Indian money market.

(ii) Shortage of Funds:

Another important feature of Indian money market is the shortage of funds. Therefore, the demand for loanable funds in the money market is much higher than that of its supply.

This shortage of fund is mostly resulted from:

(i) Small capacity to save arising out of low per capita income;

(ii) Inadequate banking network and poor banking habit of the people, in general;

(iii) Absence of adequate and diversified investment opportunities and finally, the emergence of strong parallel economy having a huge magnitude of black money.

In recent years, the development of rural banking structure, with the opening rural branches of commercial banks and with the expansion of Co-operative banks, has improved the fund position of the Indian money market, to some extent.

(iii) Lack of Adequate Banking Facilities:

Indian money market is also characterised by lack of adequate banking facilities. Rural banking network in the country is still inadequate. Population per bank office in India was 12,000 persons in 1993 as compared to that of only 1,400 persons in USA. In the rural areas, a substantial number of population, having small saving potential, have no access to facilities.

Under such a system, a huge amount of small savings are not mobilised which needs to be mobilised for its productive uses through the expansion of banking network.

(iv) Lack of Rational Interest Rate Structure:

There is lack of rational interest structure which is mostly resulted from lack of co-ordination among different banking institutions. Recently, there is some improvement in this regard, particularly after the introduction of standardisation of interest rates by the RBI for its rationalisation.

However, the present system of administered interest rates is suffering from the defects like:

(i) Too many concessional rates of interest;

(ii) Comparatively low yield on government securities, and

(iii) Improper lending and deposit rates fixed by the commercial banks.

(v) Absence of Organised Bill Market:

There is absence of organised bill market in India although the commercial banks purchase and discount both inland and foreign bills to a limited extent. Although, the RBI has introduced its limited bill market under its scheme of 1952 and 1970, but the same scheme has failed to popularize the bill finance in India.

The popularity of the cash credit system and lack of uniformity in commercial bills are mostly responsible for the poor development of bill market in the country. Even after the introduction of Bill Market Scheme, 1970, the bill finance has declined and its extent been declined from 20.3 per cent in 1971 to a mere 11.0 per cent in 1995-96.

(vi) Existence of Unorganised Money Market:

Another important feature of Indian money market is the existence of its unorganised character, where one of its segments is constituted by the indigenous bankers and moneylenders. This unorganised segment in completely separated from the organised segment of the money market.

Although the RBI has tried to bring the indigenous bankers under its direct control yet all the attempts have failed. Thus, as the indigenous bankers remained outside the organised money market, therefore, RBI’s control over the money market is quite limited.

(vii) Seasonal Stringency of Money and Fluctuations in Interest Rates:

Another important feature of Indian money market is seasonal stringency of money and the volatile fluctuation of interest rates. India, being an agricultural country has to face huge demand for funds during the period of October to June every year so as to meet its requirement for farm operations and also for trading in agricultural produce.

But the money market is not having sufficient elasticity thus it creates seasonal stringency of funds leading to a rise in the rate of interest. But in the rainy and slack season the demand for fund slumps down leading to a automatic fall in the rate of interest. Such regular fluctuations in interest rates are not at all conducive to developmental activities of the country.

3. Essay on the Under-Development of Indian Money Market:

Considering various defects of Indian money market it can be observed that the money market in India is relatively underdeveloped. Moreover, in respect of resources, organisation stability and elasticity, the said market cannot be compared with the developed money markets of London and New York. But among the third world countries India has been maintaining the most developed banking system. Even then the organisation of the money market is still underdeveloped.

The underdevelopment nature of Indian money market is mostly determined by the following shortcomings:

Firstly, Indian money market fails to possess an adequate and continuous supply of short term assets such as treasury bills, bills of exchange, short term Government bonds etc.

Secondly, this market is lacking the highly organised banking system, so important for the successful working of a money market.

Thirdly, the sub-markets like acceptance market and the commercial bill market are non-existent in Indian money market.

Fourthly, Indian money market has totally failed to develop market for short term assets and accordingly there are no dealers of short term assets who act as intermediaries between the Government and the entire banking system.

Fifthly, Indian money market in suffering from lack of co-ordination between its different constituents.

Sixthly, Indian money market again fails to attract any foreign funds.

Finally, Indian money market cannot be termed as a developed one considering its supply of fund and the liquidity position.

4. Essay on the Measures to Reform and Strengthen Indian Money Market:

In recent years, serious efforts have been made by the Government and the RBI to remove the shortcomings of Indian money market. RBI, in the mean time has reduced considerably the differences between the various constituents of money market. Differences in the interest rates have also been reduced by the RBI and the monetary stringency has also been reduced by the RBI through open market operations and bill market scheme.

Even then, Indian money market is still very much dependent on the call money market which is again characterised by high volatility. In the mean time, the RBI has introduced various measures to reform the money market as per recommendations of the Sukhamoy Chakraborty Committee on the “Review of the working of the Monetary system” and the Narasimham Committee report on the working of the Financial System in India.

Following are some of the important reform measures introduced to strengthen the Indian money market:

(i) Remission of Stamp Duty:

In order to remove the major administrative constraint in the use of bill system, the Government has remitted the stamp duty in August 1989. However, the experts feel that unless the cash credit system is discouraged this government decision to remit the stump duty is not going to favour the prevailing bill system.

(ii) Deregulation of Interest Rates:

Another important step to strengthen the money market was to deregulate the money market interest rates since May, 1989. This will bring interest rate flexibility and transparency in money market transactions.

Again in November, 1991.as per the recommendations of the Narasimham Committee, the interest rates have been further deregulated and the banks and other financial institutions have been advised to determine and adopt market related rates of interest as far as practicable.

(iii) Introduction of New Instruments:

The RBI has introduced certain money market instruments for strengthening the market conditions. These instruments are—182 days treasury bills, longer maturity treasury bills, Certificates of Deposits (CDs), Commercial Paper (CP) and dated Government securities.

Discount and Finance House of India (DFHI) promoted the 182-day treasury bills systematically and these bills were the first security sold by auction for financing the fiscal deficit of the Central Government. Again, the DFHI has also developed a secondary market in these bills and they become popular with the commercial banks.

Again in 1992-93, the Government decided to introduce 364 day treasury bills and discontinued the 164-day treasury bills. The 364 day treasury bills can be held by commercial banks for meeting its statutory liquidity ratio. CDs received a considerable market during 1995-96.

The volume of outstanding CDs gradually rose from Rs 6,385 crore in January 1995 to Rs 20,815 crore on July 5, 1996. CPs are another instrument which made considerable progress in 1992-93 and 1993-94. Outstanding amount of CPs increased from Rs 64.70 crore in June 1991 to Rs 3,264 crore in March 1994. Again the activity of CP market declined sharply in 1995-96 and thereby the outstanding CPs as on April 30. 1996 was only Rs 71.3 crore.

(iv) DFHI:

The Discount and Finance House of India (DFHI) was set up on April 25, 1988 as a part of the reform package for strengthening money market. The main function of DFHI is to bring the entire financial system consisting of the scheduled commercial banks, co-operative banks, foreign banks and all- India financial institutions, both in the public and private sector, within the fold of the Indian money market.

This House will normally buy bills and short term papers from different banks and financial institutions in order to invest all of their idle funds for short periods. DFHI has also started to buy and sell government securities from April 1992 in limited quantity with the necessary refinance support from the RBI.

(v) Money Market Mutual Funds (MMMFs):

The Government announced the establishment of Money Market Mutual Funds (MMMFs) in April 1992 with the sole objective to bring money market instruments within the reach of individuals. The MMMFs have been set up by different scheduled commercial banks and public financial institutions.

The shares or units of MMMFs have been issued only to individuals. Thus the aforesaid measures to reform Indian money market have helped it to become more advanced, solvent and vibrant. With the introduction of new instruments, the secondary market has also developed considerably.

Moreover, with the setting up of DFHI and MMMFs, the lot of Indian money market has achieved considerable progress in recent rimes and is also expected to achieve further progress in the years to come.