Understanding the Financial System | Key Components and Importance

A financial system is an institutional framework that facilitates the mobilization of funds from savers to investors. It comprises financial institutions like commercial banks, financial markets (such as the money market for short-term funds and the capital market for long-term funds), instruments, and regulatory bodies. The system plays a crucial role in ensuring liquidity, enabling efficient capital allocation, and implementing government monetary policies. It helps business firms secure investments necessary for growth, which in turn contributes to the overall development of the economy.

Table of contents

1. Introduction
2. Difficulties of the Barter System
3. Evolution of Money
4. Definition of Money
5. Four Types of Money
6. Components of Money Supply
7. Monetary Aggregates
8. Value of Money
9. Gresham’s Law
10. Quantity Theory of Money
11. Inflation
12. Functions of Money
13. Introduction to Banking
14. Introduction to Commercial Bank and Central Banking

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1. Introduction

In any economy, households save money from their income after consumption and put their savings in financial institutions like commercial banks. On the other hand, the businessmen are the investors who borrow those funds from the commercial banks.

So the financial system is defined as an institutional arrangement through which funds are mobilized from the savers and transferred to the investors.

The money market is an institutional arrangement for the transaction of short-term funds or short-term financial assets which mature within one year, vis-à-vis, the capital market where long-term funds and assets are transacted.

Government of the country enforces monetary policy through this financial system. For instance, when there is recession in the market, the government (monetary authority) brings down the rate of interest and allow credit to be given liberally to the producers. Similarly at the time of inflation, the interest rates are increased and credits are controlled.

During high unemployment, government may try to help those sectors with high employment potential by directing credit flows in these sectors.

So, business firms depend heavily on the financial system for investment which is essential for their own development and this in turn develops the entire economy.

2. Difficulties of the Barter System

• Lack of coincidence of wants
• Lack of store of value
• Lack of divisibility of commodities
• Lack of common measure of value
• Difficulty in making deferred payments
• Lack of coincidence of wants
• Lack of store of value
• Lack of divisibility of commodities
• Lack of common measure of value
• Difficulty in making deferred payments

3. Evolution of Money

The term ‘Money’ was derived from the name of Goddess “Juno Moneta” of Rome.

4. Definition of Money

Robertson: Robertson defined money as “anything which is widely accepted in payments for goods or in discharge of other kinds of business obligations”.

Seligman: According to Seligman’s definition, “Money is one that possesses general acceptability”.

Walker: According to Walker, “Money is what money does”.

5. Four Types of Money

5.1 Commodity Money

It is the simplest and the oldest type of money. It is built on scarce/valuable 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. Examples of commodity money include gold coins, beads, shells, spices, etc.

5.2 Fiat Money

The term ‘fiat’ means a formal authorization or proposition or a decree. This means fiat money gets its value from a government order. Here the gov- ernment 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.

Some of the examples of fiat money are coins and bills.

5.3 Fiduciary Money

By the term ‘fiduciary’ it is meant the involvement of trust, especially with regard to the relationship between a trustee and a beneficiary. That is why 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.

Some examples of fiduciary money include cheques, banknotes, or drafts.

5.4 Commercial Bank Money

It is described as claims against financial institutions that can be used to pur- chase 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 which is a process where commercial banks give out loans worth more than the value of the actual currency they hold.

Example for this is any type of loan by the commercial banks may be termed as commercial bank money.

6. Components of Money Supply

Money supply includes all money in the economy. The components of money supply may vary from country to country.

Broadly speaking, money supply composes of the following:

6.1 Currency issued by the Central Bank

In any country, the Central Bank issues currency. Currency consists of paper notes and coins. The one rupee note and coins are issued by the Finance De- partment of the Government of India.

6.2 Demand deposits created by commercial banks

Bank deposits are a prominent component of money supply. Commercial banks create credit from the primary deposits of money received from the public. Credit is created in the form of deposits called derived or secondary deposits.

7. Monetary Aggregates

In India money supply is measured in terms of the following monetary aggregates:

M1  = Currency + Demand deposits + Other deposits.

M2 = M1 + Time liability portion of savings deposits with banks + Certificates of Deposits issued by banks + term deposits maturing within one year.

M3  = M2 + term deposits over one year maturity + call/term borrowings of banks. In India, mostly M3 money is used as broad money.

8. Value of Money

The purchasing power of money is called value of money. It is nothing but exchange value. How much of goods and services can be obtained in exchange of a unit of money is called value of money. The value of money mainly depends upon price level. The inverse value of Price (P) is called value of money 1/P.

8.1 Types of Value of Money

• Internal exchange value: How much goods and services can be obtained in exchange of a unit or money domestically is called internal exchange value.
• External Exchange value: How much foreign currency can be obtained in the exchange of a unit of domestic currency is called external exchange value.

8.2 Forms of Money

• Cash money and credit money
• Other financial assets (NBFI) g.:- Units of UTI, insurance policy etc.
• Paper money and coins
• Near money (or) money substitutes (bank cheque)

9. Gresham’s Law

The Law states that bad money drives good money out of circulation. This is true is case of bimetallism where two metal standard (gold and silver) operated side by side. In such a case one metal currency drives the other out of circulation. It also means cheap money drives out dear money. If a country uses both money as well as metal money the people will use the paper and hold the metal money.

10. Quantity Theory of Money

Quantity Theory of money deals with the relationship between quantity of money and price level of economy. Here we discuss three versions of the quantity theory of money.

10.1 Quantity theory by Irving Fisher

The quantity theory of money explains about the value of money. Irving Fisher gave an equation to determine the value of money.

Irving Fisher used an equation [MV = PT] MV = money supply. PT = money demand.

Where, M = Money supply issued by the legal authority V = Velocity of money

P = Price level T = Total output

Fisher used the equation to show the relationship between money supply and price level as direct and proportional.

The rate of change in money supply (dM/M) is equal to rate of change in P (dP/P).

(V) Velocity of money is constant.

Gross National Product (T) is also constant

This theory assumes money demand for transactional purpose only.

10.2 Criticisms

Fisher’s equation is abstract and mathematical truism. It does not explain the pro- cess by which M affects P.

It is presumed that entire M is used up in buying T instantly. It is unreal. No one spends all money the moment he earns it.

The concept of full employment is myth. There is natural rate of unemployment in every country.

Even with full employment, a country can increase national output by bringing those factors which are not available within economy from abroad.

It is presumed that money is used for transactions only. Hence the theory is often referred to as cash transaction theory. This ignores the other roles of money.

10.3 Quantity theory of money – cash balance approach (or) Cambridge equation

Cambridge University professors give another equation which explains the value of money i.e. M = PKT

M = money supply for a specific period of time P = Price level

K = cash balance, it is the part of total income T = Total output

However, Fisher’s version and the Cambridge version of the quantity theory are not exactly the same. There is a small difference. The total transactions in the market in a year, T, may not be exactly the same as total output of the year, Y (one reason for this is that all of the output of a year may not come to the market in that year. On the other hand, a good sold in a given year may not have been produced in that year. It may be an unsold good of the previous year.)

If we ignore this small difference between T and Y, if T = Y then a comparison of the two equations MV = PT and M = KPY shows that:

K = 1/V or V = 1/K. This is because of the fact that as greater proportion of income is kept as cash balance with the public, velocity of money will fall and vice versa.

Therefore, M = KPY = 1/V. PT or, MV = PT

Thus, the Cambridge K and Fisher’s V are the reciprocal of each other. Hence, 1/K can be taken to be the velocity of circulation of money. Strictly speaking of course, we should distinguish between T and Y. Therefore, V is called the ‘transactions velocity’ and 1/K is called the ‘income velocity’ of money.

10.4 Quantity theory by Keynes

According to J.M. Keynes, the money supply affects the rate of interest. When the money supply increases rate of interest will be decreased. It leads to the increase of investments level of employment, income, demand, price level etc., when the price level increases there is a decrease in the value of money.

According to Keynes, the rate of interest plays a dominant role in determination of value of money.

The Keynesian version of the Quantity Theory integrates monetary theory with the general theory of value.

In a broader sense, the term inflation refers to the persistent rise in general price level over a long period of time.

11. Inflation

Crowther: Crowther defined inflation as a state in which the value of money is falling, that is the prices are rising.

Samuelson: According to Samuelson, “Inflation denotes a rise in the general level of prices”.

11.1 Causes of Inflation

Primary Causes

When demand for a commodity in the market exceeds its supply, the excess demand will push up the price (‘Demand-pull inflation’).

When factor prices rise, costs of production rise (‘Cost –push inflation’).

• Increase in public spending
• Deficit financing of government spending
• Increased velocity of circulation Total use of money = money supply by the government x velocity of circulation of money.
• Population growth
• Hoarding
• Genuine shortage
• Exports
• Trade unions
• Tax reduction
• Imposition of indirect taxes
• Price-rise in international market
• Non-economic reasons

12. Functions of Money

• Primary Functions
  1. Medium of Exchange
  2. Measure of Value
• Secondary functions
  1. Store of value
  2. Standard of deferred payments
  3. Transfer of money
• Contingent functions
  1. Measurement and distribution of national income
  2. Money equalizes marginal utilities/productivities
  3. Basis of credit
  4. Liquidity

13. Introduction to Banking

Sayers define bank as, “an institution whose debts (bank deposits) are widely ac- cepted in settlement of other people’s debts”.

According to Crowther, “a bank collects money from those who have it to spare or who are saving it out of their incomes and lends this money to those who require it”.

Essentials of a Sound Banking System

• Adequate Liquidity
• Expansion of banking
• Investment and loan policies
• Human factor

13.1 Functions of a Commercial Bank

They are regarded as departmental – L store banks because they provide a wide variety of services to their customers.

• Acceptance of deposits
  1. Current deposits
  2. Savings deposits
  3. Term deposits
  4. Recurring or cumulative deposits
• Payment of loans and advances
  1. Demand loans/call loans
  2. Short term loans
  3. Cash credits
  4. Overdraft
  5. Discounting of bills of exchange
  6. Credit cards
• Creation of Credit
• Agency Functions
• General utility functions
  1. Locker facility
  2. Transfer of money
  3. Online transfer facilities
  4. Issuance of letters of credit
  5. Under writing facility
  6. Travelers cheque
  7. Foreign exchange
  8. Collection of information
  9. Automated Teller Machines

13.2 Principles of Commercial Banks

• Principle of liquidity
• Principle of profitability
• Principle of Solvency
• Principle of safety
• Principle of collection of savings
• Principle of loan and investment policy
• Principle of economy
• Principle of providing services
• Principle of secrecy
• Principle of modernization
• Principle of specialization
• Principle of location
• Principle of relation
• Principle of publicity

14. Introduction to Commercial Bank and Central Banking

A commercial bank is a financial intermediary. It accepts the deposits from the surplus units and lends these financial resources to the deficit units.

Central Bank is the apex of the banking system in a country. It controls, regulates and supervises the activities of the banks and the country’s banking system.

In our country, the Central Bank was established in 1935 under private management. It was nationalized by the Government in 1949 and named as RBI.

14.1 Objectives of the Central Bank

• To maintain the internal value of
• To preserve the external value of
• To ensure price
• To promote financial
• To promote economic

14.2 Functions of a Central Bank

• Note Issue
• Banker to Government
• Banker’s Bank
• Lender of last resort
• Controller of credit
• Custodian of foreign exchange reserves:

Distinction Between the Central Bank and the Commercial Bank

Financial Institutions