GS Notes

6. Economics Notes 40

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Elaborate Notes

Fiat Money and Legal Tender

  • Fiat Money: The term ‘fiat’ is a Latin word meaning “let it be done” or “it shall be,” signifying a decree or order. Fiat money is a type of currency that is declared by a government to be legal tender, but it is not backed by a physical commodity like gold or silver.

    • Historical Context: The transition to fiat money was gradual. Historically, money was often ‘commodity money’ (e.g., gold coins, salt, shells) which had intrinsic value. This evolved into ‘representative money,’ where banknotes or certificates were backed by and could be exchanged for a fixed amount of a commodity. The modern system of fiat money became globally dominant after the collapse of the Bretton Woods system in 1971. The US President Richard Nixon unilaterally cancelled the direct international convertibility of the US dollar to gold, an event often termed the “Nixon Shock” (1971). Prior to this, under the Bretton Woods Agreement (1944), the US dollar was pegged to gold at a rate of $35 per troy ounce, and other currencies were pegged to the US dollar.
    • Value Proposition: The value of fiat money is derived from the trust the public has in the issuing authority (the government and its central bank) and its stability, which is maintained through prudent fiscal and monetary policy. Economist John Maynard Keynes was a prominent advocate for managed fiat currencies, arguing they give governments greater flexibility to manage economic downturns.
    • Clarification on Acceptance: The statement “There is no obligation on any person to accept this money” refers to its nature without the legal tender status. Unlike gold, which is accepted due to its intrinsic value, a piece of paper (fiat currency) has no inherent value. It is the government’s “fiat” or order, making it a “legal tender,” that legally compels its acceptance for settling debts.

  • Legal Tender: This is a legal status conferred upon a form of money, stipulating that it must be accepted if offered in payment of a debt.

    • Statutory Backing in India:
      • Banknotes: The Reserve Bank of India Act, 1934, in Section 26(2), states that every banknote issued by the RBI shall be legal tender at any place in India for the payment of the amount expressed therein. This grants the RBI the sole right to issue banknotes (except the one-rupee note).
      • Coins: Coins are issued by the Government of India under the Coinage Act, 2011 (which replaced the 1906 Act). Section 6 of this Act specifies the denominations of coins that shall be legal tender in payment or on account.
      • One Rupee Note: Historically, this was issued by the Government of India under the Currency Ordinance, 1940. It is signed by the Finance Secretary and constitutes a liability of the Government of India, not the RBI.

  • Types of Legal Tender:

    • Unlimited Legal Tender: This can be used to settle debts of any amount. In India, all banknotes (₹2 and above) are unlimited legal tender.
    • Limited Legal Tender: This can be used to settle debts only up to a certain maximum limit. As per the Coinage Act, 2011:
      • Coins of denomination of one rupee and above are legal tender for sums not exceeding one thousand rupees.
      • The 50 paise coin is legal tender for any sum not exceeding ten rupees. Coins below 50 paise (which are no longer minted) ceased to be legal tender.

Alternative Forms of Money

  • Non-Legal Tender / Optional Money: These are forms of payment that are not legally mandated for acceptance in debt settlement. Their acceptance depends on the consent and trust between the parties involved.

    • Fiduciary Money: This derives its value from the trust (‘fiducia’ is Latin for trust) between the payer and the payee. Cheques, drafts, and bills of exchange are classic examples. A person is not legally obligated to accept a cheque as payment; they do so based on their trust in the drawer and the banking system.

  • Near Money / Quasi-Money: These are financial assets that are not cash but are highly liquid and can be converted into cash with minimal delay or loss of value. They fulfill the store-of-value function of money but not directly the medium-of-exchange function.

    • Examples: Fixed deposits, recurring deposits, treasury bills, commercial papers, and bonds. One cannot use a fixed deposit certificate to buy groceries, but it can be quickly liquidated into cash.

Cryptocurrency

  • A cryptocurrency is a digital or virtual currency secured by cryptography, making it nearly impossible to counterfeit. Many are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers.
    • Decentralization: A defining feature is their organic nature; they are not issued by any central authority, rendering them theoretically immune to government interference or manipulation. The first and most well-known cryptocurrency, Bitcoin, was created in 2009 by an anonymous entity known as Satoshi Nakamoto.
    • Legal Tender Status: Due to their price volatility, security concerns, and decentralized nature, most nations have not granted cryptocurrencies legal tender status. They are often treated as assets or commodities for taxation purposes.
    • International Example: In a landmark move, El Salvador adopted Bitcoin as a legal tender in September 2021, becoming the first country to do so. The move was promoted as a way to facilitate remittances and promote financial inclusion but has been met with criticism from international bodies like the IMF due to economic stability risks.

RBI’s Balance Sheet: Assets and Liabilities

The RBI, like any bank, maintains a balance sheet where its total assets must equal its total liabilities. This reflects the sources and uses of its funds.

  • Assets of RBI (Sources of Money Creation):

    • Government Securities: These are debt instruments (like Treasury Bills and government bonds) issued by the government to borrow money. When the RBI purchases these through Open Market Operations (OMOs), it injects money into the system. These are an asset for RBI as the government is liable to pay back the principal with interest.
    • Gold Coins and Bullion: The RBI holds a significant amount of gold as part of its foreign exchange reserves, a legacy of the gold-standard era. Its value provides confidence in the currency.
    • Foreign Currency Assets (Foreign Securities): These include securities and bonds issued by foreign governments and deposits with other central banks.
    • Loans and Advances: The RBI extends short-term loans to the central and state governments, as well as to scheduled commercial banks (e.g., through the repo window).
    • Coins and One Rupee Notes: While a liability of the GoI, when the RBI holds them for circulation, they are treated as an asset on its books, acquired from the government.

  • Liabilities of RBI (Components of Money):

    • Currency in Circulation: This is the primary liability. All currency notes (except ₹1 note) issued by the RBI represent its promise to pay the bearer the sum denoted on the note. This includes:
      • Currency held by the public.
      • Vault cash held by commercial banks.
    • Deposits held by Banks (Banker’s Deposits): Commercial banks are required to maintain a certain percentage of their deposits as reserves with the RBI (as part of CRR). These deposits are a liability for the RBI.
    • Other Deposits with RBI: A minor component that includes deposits of quasi-governmental bodies, foreign central banks, and international financial institutions (like the IMF and World Bank).

Money Supply and its Concepts

  • Money Supply: It refers to the total stock of money in circulation among the public at a specific point in time. The ‘public’ here refers to money-using sectors (individuals, firms) and excludes money-creating sectors (RBI, Government, and the banking system).

  • Stock vs. Flow Variable:

    • Stock Variable: It is measured at a particular point in time and has no time dimension. Examples include a person’s wealth, capital stock of a country, or the money supply on a specific date (e.g., as of March 31, 2024). It is a static concept.
    • Flow Variable: It is measured over a period of time and has a time dimension (e.g., per day, per month, per year). Examples include national income (GDP), consumption, investment, and a person’s monthly salary. It is a dynamic concept.

  • Bill Discounting: A trade finance mechanism where a seller gets an early payment on their invoice. The seller sells the bill of exchange (a promise of future payment from the buyer) to a financial institution (like a bank) at a discount. The bank pays the seller immediately and collects the full amount from the buyer on the due date. Rediscounting occurs when the initial discounting bank sells the bill to another entity, often the central bank, to obtain funds before the bill’s maturity.

Fractional Reserve System and Money Creation

  • Concept: This is the cornerstone of modern banking. It is a system where commercial banks are required to keep only a fraction of their total deposits as reserves (in the form of cash with themselves or as deposits with the central bank) and are allowed to lend out the rest.
  • Money Multiplier Effect: The system allows the banking system to create credit, and thus money, far in excess of the initial primary deposits. The process works as follows:
    1. An initial deposit is made in a bank (e.g., ₹1000).
    2. The bank keeps a fraction as reserve (e.g., LRR is 20%, so ₹200 is kept as reserve).
    3. The remaining amount (₹800) is lent out.
    4. The borrower spends this money, and the recipient deposits it back into the banking system (based on the assumption that all transactions are routed through banks).
    5. This ₹800 becomes a new deposit, of which 20% (₹160) is kept as reserve, and the rest (₹640) is lent out.
    6. This cycle continues, with each round creating smaller amounts of new loans and deposits, until the initial deposit is fully absorbed into reserves across the system.
  • Formula: The potential for money creation is determined by the Money Multiplier, calculated as: Money Multiplier = 1 / LRR (Legal Reserve Ratio). In the example, Money Multiplier = 1 / 0.20 = 5. This means an initial deposit of ₹1000 can potentially lead to a total deposit creation of ₹5000 (₹1000 x 5). A lower LRR leads to a higher money multiplier, and vice-versa, making LRR a potent tool of monetary policy.

Measures of Money Supply in India

The RBI publishes four measures of money supply, denoted by M1, M2, M3, and M4. These are aggregates classified based on their liquidity.

  • M1 (Narrow Money): This is the most liquid measure.

    • M1 = CU + DD + OD
    • CU: Currency notes and coins held by the Public.
    • DD: Net Demand Deposits of the banking system (includes deposits in current and savings accounts, CASA). ‘Net’ implies that inter-bank deposits are excluded.
    • OD: ‘Other Deposits’ with the RBI (as defined in the RBI balance sheet liabilities section).

  • M2: A broader measure than M1.

    • M2 = M1 + Savings deposits with Post Office savings banks.

  • M3 (Broad Money): This is the most commonly used measure of money supply, often referred to as aggregate monetary resources.

    • M3 = M1 + Net Time Deposits of the banking system. (Net Time Deposits include Fixed and Recurring Deposits).
    • Alternatively, M3 = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net non-monetary liabilities of the banking sector.

  • M4: The broadest and least liquid measure.

    • M4 = M3 + All deposits with post office savings banks (excluding National Savings Certificates).

  • Liquidity Order: M1 > M2 > M3 > M4 (Most liquid to least liquid).

  • Reserve Money (M0) / High-Powered Money / Base Money: This represents the base on which the money supply is built.

    • M0 = Currency in circulation + Bankers’ Deposits with RBI + ‘Other’ Deposits with RBI.
    • It consists of all liabilities of the RBI that are monetary in nature.

  • Currency Deposit Ratio (CDR): It indicates the public’s preference for holding cash versus bank deposits.

    • CDR = Currency held by Public (CU) / Bank Deposits held by Public (DD + TD).
    • A higher CDR means the public prefers to hold more cash, which reduces the money multiplier effect.

Types of Bank Deposits

  • Demand Deposits: These can be withdrawn by the depositor on demand, without any prior notice. They are chequable deposits and are highly liquid.
    • Examples: Current Accounts (primarily for businesses, with no interest) and Savings Accounts (for individuals, with low interest). Collectively known as CASA deposits.
  • Time Deposits: These are held for a fixed term (maturity period) and cannot be withdrawn on demand. Premature withdrawal, if allowed, usually incurs a penalty. They offer higher interest rates than demand deposits.
    • Examples: Fixed Deposits (FD) where a lump sum is deposited for a fixed period, and Recurring Deposits (RD) where a fixed amount is deposited at regular intervals for a specified period.

Asset Classification and Banking Reforms

  • Stressed Assets Classification: To ensure asset quality, the RBI mandates banks to classify loans based on their payment history.

    • Special Mention Accounts (SMA): An early warning system for accounts showing signs of stress.
      • SMA-0: Principal or interest payment not overdue for more than 30 days but account showing signs of incipient stress.
      • SMA-1: Principal or interest overdue between 31-60 days.
      • SMA-2: Principal or interest overdue between 61-90 days.
    • Non-Performing Asset (NPA): A loan becomes an NPA if the principal or interest remains overdue for more than 90 days.

  • Banking Reforms in India:

    • Scheduled Banks: These are banks listed in the Second Schedule of the RBI Act, 1934. To qualify, a bank must have a paid-up capital and reserves of at least ₹5 lakh and satisfy the RBI that its affairs are not conducted in a manner detrimental to depositors’ interests. They are eligible for loans from the RBI at the bank rate and are granted membership in clearing houses.
    • Nationalization: A major policy shift driven by the goal of financial inclusion and directing credit to priority sectors (like agriculture). The government, under Prime Minister Indira Gandhi, nationalized 14 major commercial banks in 1969 and 6 more in 1980. The objective was to shift focus from class banking to mass banking and break the nexus between private banks and large industrial houses.
    • Regional Rural Banks (RRBs): Established under the RRB Act, 1976, based on the recommendations of the M. Narasimham Working Group (1975). The objective was to create a specialized rural financial institution to cater to the credit needs of small farmers, agricultural laborers, and artisans. The ownership is shared between the Central Government (50%), the concerned State Government (15%), and a Sponsor Bank (35%).
    • Differentiated Banks: A concept introduced to cater to the specific needs of different segments of the population, as opposed to ‘Universal Banks’ that offer a full range of services.
      • Small Finance Banks (SFBs): Recommended by the Usha Thorat Committee (2014). They provide basic banking services like accepting deposits and lending, with a focus on small business units, small and marginal farmers, and unorganized sector entities. A key mandate is that at least 75% of their Adjusted Net Bank Credit (ANBC) must go to the priority sector, and 50% of their loan portfolio must comprise loans up to ₹25 lakh.
      • Payment Banks: Recommended by the Nachiket Mor Committee (2014) on Comprehensive Financial Services for Small Businesses and Low-Income Households. Their primary objective is to enhance financial inclusion by providing small savings accounts and payments/remittance services. They can accept deposits (initially up to ₹1 lakh, now ₹2 lakh), issue debit cards, but cannot issue loans or credit cards.
    • On-Tap Licensing: This refers to a policy where the window for obtaining a bank license from the RBI is open throughout the year. This contrasts with the earlier stop-and-start policy where licenses were granted only during specific periods. It aims to encourage more players to enter the banking space.
    • MicroFinance Institutions (MFIs): These institutions provide small loans (microcredit) to low-income individuals who lack access to traditional banking services. The model was pioneered by Nobel Laureate Muhammad Yunus with the Grameen Bank in Bangladesh in the 1970s. In India, the MFI sector faced a crisis, notably in Andhra Pradesh (2010), due to allegations of exorbitant interest rates, coercive recovery practices, and multiple lending, which led to borrower distress. The Malegam Committee (2011) was subsequently formed to study the issues and recommend regulatory changes. The NCRB report (2015) highlighted a correlation between farmer suicides and indebtedness to non-institutional sources, including MFIs in some regions.

Economic Concepts

  • Opportunity Cost: This is a fundamental concept in economics, representing the value of the next-best alternative that must be forgone in order to pursue a certain action. It is the benefit lost from the option not chosen. For instance, the opportunity cost of an individual spending four years in university is the income they would have earned if they had worked during that period.

Prelims Pointers

  • Fiat money is currency that a government has declared to be legal tender, but it is not backed by a physical commodity.
  • The Gold Standard system, part of the Bretton Woods Agreement (1944), pegged the US dollar to gold at $35 per ounce and ended in 1971.
  • The RBI Act, 1934 gives the RBI the sole right to issue banknotes in India.
  • Coins are issued by the Government of India under the Coinage Act, 2011.
  • The one-rupee note is issued by the Ministry of Finance, Government of India.
  • Limited Legal Tender: A 50 paise coin is legal tender for payments up to ₹10. A one-rupee coin is legal tender for payments up to ₹1000.
  • Fiduciary money (e.g., Cheques) works on the basis of trust.
  • Near Money or Quasi-Money refers to highly liquid assets like Fixed Deposits (FDs) and Treasury Bills.
  • El Salvador was the first country to make Bitcoin a legal tender.
  • Money Supply is a stock concept, measured at a point in time. National Income is a flow concept.
  • Money Multiplier formula: 1 / Legal Reserve Ratio (LRR).
  • Measures of Money Supply:
    1. M1 = Currency with Public (CU) + Demand Deposits (DD) + Other Deposits with RBI.
    2. M2 = M1 + Savings deposits with Post Office savings banks.
    3. M3 = M1 + Net Time Deposits of the banking system.
    4. M4 = M3 + Total deposits with Post Offices.
  • Order of Liquidity: M1 > M2 > M3 > M4.
  • M1 and M2 are known as Narrow Money. M3 and M4 are known as Broad Money.
  • M3 is the most commonly used measure of money supply in India.
  • Reserve Money (M0) is also called High-Powered Money or Base Money.
  • Stressed Asset Classification:
    1. SMA-1: Overdue for 31-60 days.
    2. SMA-2: Overdue for 61-90 days.
    3. NPA: Overdue for more than 90 days.
  • Scheduled Banks are those included in the Second Schedule of the RBI Act, 1934.
  • Nationalization of Banks: 14 banks in 1969 and 6 banks in 1980.
  • Regional Rural Banks (RRBs) were established under the RRB Act, 1976.
  • Ownership of RRBs: Central Govt (50%), State Govt (15%), Sponsor Bank (35%).
  • Narasimham Committee (1975) recommended the establishment of RRBs.
  • Small Finance Banks were recommended by the Usha Thorat Committee.
  • Payment Banks were recommended by the Nachiket Mor Committee.
  • Deposit limit for Payment Banks is ₹2 lakh per individual customer. Payment Banks cannot issue loans or credit cards.
  • Microfinance concept was pioneered by Nobel Laureate Muhammad Yunus of Grameen Bank, Bangladesh.

Mains Insights

Fiat Money and Monetary Sovereignty

  • Cause-Effect: The shift from the Gold Standard to a fiat currency system gave central banks and governments significant power over the economy. This ‘monetary sovereignty’ allows them to use monetary policy (like adjusting interest rates or money supply) to combat recessions, control inflation, and manage economic growth.
  • Debate: Proponents argue this flexibility is crucial for modern economic management. Critics, particularly from the Austrian school of economics, argue that it leads to fiscal irresponsibility, as governments can finance deficits by simply printing more money, leading to hyperinflation and currency debasement (e.g., Zimbabwe, Venezuela). This forms the core of the debate between Keynesian interventionism and free-market principles.

Cryptocurrency: Financial Innovation vs. Regulatory Challenge (GS-III)

  • Dichotomy: Cryptocurrencies represent a technological leap with potential benefits like lower transaction costs (especially for international remittances) and greater financial inclusion. However, their anonymity, volatility, and decentralized nature pose significant challenges for governments.
  • Analytical Perspective: The rise of cryptocurrencies forces a re-evaluation of the very concept of money and the role of the state. For India, the policy dilemma involves balancing the promotion of innovation in blockchain technology against the risks of money laundering, terror financing, macroeconomic instability, and threats to its own monetary sovereignty. The case of El Salvador serves as a real-world experiment whose outcomes (both positive and negative) are crucial for other nations to study.

Financial Inclusion: Evolution and Challenges (GS-II & GS-III)

  • Evolution of Policy: The approach to financial inclusion in India has evolved significantly.
    1. Phase 1 (State-led): Nationalization of banks (1969, 1980) and the establishment of RRBs (1976) were top-down approaches to force credit into rural and unserved areas. While they expanded reach, they were often plagued by inefficiency, political interference, and poor asset quality.
    2. Phase 2 (Technology-led & Market-driven): Post-liberalization, and especially in the last decade, the focus has shifted. The Pradhan Mantri Jan Dhan Yojana (PMJDY) represents a technology-driven, bottom-up approach, leveraging the JAM trinity (Jan Dhan, Aadhaar, Mobile). The introduction of differentiated banks (SFBs, Payment Banks) is a market-oriented solution to serve niche segments that universal banks found unprofitable.
  • Cause-Effect: Greater financial inclusion channels savings into the formal economy, increases the efficacy of monetary policy, and enables efficient delivery of welfare through Direct Benefit Transfer (DBT), reducing leakages. However, challenges remain in moving beyond mere account opening to ensuring meaningful access to credit, insurance, and investment products, thereby preventing accounts from becoming dormant.

Microfinance: Social Mission vs. Commercial Motive (GS-II)

  • The Core Conflict: The MFI model was conceived as a tool for social empowerment and poverty alleviation. However, when MFIs in India became for-profit entities and got listed on stock exchanges, the focus shifted from social impact to maximizing shareholder returns.
  • Analysis of Failure: This led to a ‘mission drift’. The pursuit of high profits resulted in high interest rates and aggressive recovery practices, pushing vulnerable borrowers into a debt trap, as highlighted by the Andhra Pradesh crisis. This demonstrates a classic market failure where the pursuit of private profit led to negative social outcomes.
  • Way Forward: The experience underscores the need for a robust regulatory framework that balances the financial sustainability of MFIs with the protection of borrower interests. Capping interest rates, promoting transparency, and enforcing a code of conduct (as recommended by the Malegam Committee) are crucial steps to ensure that microfinance serves its original social purpose.

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