• UGI USER
  • May 09, 2024
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MONEY AND CURRENCY SYSTEM

What is money?

  • Money is a medium of exchange, a unit of account, and a store of value. It is a universally accepted means for people to trade goods and services. Historically, money has taken various forms, including coins, paper notes, and digital currencies. In modern economies, money is primarily created and regulated by central banks and governments.

Functions of Money
Primary Functions

  • Medium of Exchange: Money facilitates transactions by providing a common medium that is widely accepted in exchange for goods and services. This eliminates the inefficiencies of barter systems, where a direct exchange of goods is required.
  • Unit of Account: Money provides a standard measure of value, making it easier to compare the worth of different goods and services. This helps in setting prices and making economic decisions.

Secondary Functions

  • Store of Value: Money can be saved and retrieved in the future, maintaining its value over time. This allows individuals and businesses to plan for future expenditures.
  • Standard of Deferred Payment: Money is used as a standard for future payments, enabling credit transactions and the borrowing of funds.
  • Transfer of Values: The value of money remains consistent throughout the country and is transferable (e.g., ₹500 cash can be deposited and transferred to any corner of the country, while its value remains the same).

Evolution of Money

  • Barter System: In the earliest economies, there was no concept of money. People exchanged goods and services directly through barter. However, this system had limitations, such as the double coincidence of wants, where both parties had to want what the other offered.
  • Commodity Money: To overcome the limitations of barter, societies began using commodities as a medium of exchange. Commonly used commodities included cattle, grains, shells, and precious metals like gold and silver. These commodities had intrinsic value and were widely accepted.
  • Metallic Money: As trade expanded, the use of metal coins became widespread. Coins were durable, divisible, and had intrinsic value. They were stamped with symbols to indicate their authenticity and value.
  • Paper Money: The inconvenience of carrying large quantities of metal coins led to the development of paper money. Initially, paper money was a promise to pay the bearer a specific amount of gold or silver from the issuer’s reserves. Over time, it evolved into fiat money, which is not backed by physical commodities but by the trust and authority of the issuing government.
  • Banking and Credit: With the growth of commerce and the emergence of banking, credit money became prevalent. Banks issued notes and checks that could be redeemed for money or used directly for transactions.
  • Electronic Money: The advent of electronic banking and payment systems in the 20th century led to the rise of electronic money. This includes digital transfers, credit and debit card transactions, and online payments.
  • Cryptocurrencies: The latest development in the evolution of money is the emergence of cryptocurrencies like Bitcoin. These digital currencies use blockchain technology for secure, decentralized transactions and are not controlled by any central authority.
Advantages of Money Disadvantages of Money
Facilitates Trade: Money simplifies transactions by serving as a common medium of exchange, eliminating the complexities of barter. Inflation: Excessive printing of money or an increase in money supply can lead to inflation, reducing the purchasing power of money.
Measure of Value: Money provides a standard unit of account, making it easier to compare the value of goods and services. Income Inequality: Accumulation of wealth can lead to disparities in income and wealth distribution, contributing to social and economic inequality.
Store of Value: Money can be saved and used in the future, preserving its value over time. Counterfeiting: The risk of counterfeit money can undermine trust in the currency and lead to financial losses.
Liquidity: Money is easily convertible into other forms of assets or used for transactions, providing liquidity to individuals and businesses. Dependency: Overreliance on money can lead to materialism and a loss of traditional values and skills.
Standard of Deferred Payment: Money allows for credit and deferred payments, facilitating long-term financing and investment. Economic Crises: Mismanagement of the money supply and financial systems can lead to economic crises, such as recessions or depressions.
Global Trade: Money enables international trade by providing a common platform for exchange rates and transactions. Currency Fluctuations: Exchange rate volatility can affect international trade and investment, leading to economic instability in countries with weak currencies.

Types of Money

  • Legal Tender: This is money that is officially recognized by a government as a valid medium of exchange and must be accepted as payment for debts. Legal tender typically includes coins and banknotes issued by the central bank.
  • Fiduciary Money: This type of money is based on trust and is not backed by a physical commodity or guaranteed by the government as legal tender. Examples include cheques, promissory notes, and certain types of bank deposits. People accept fiduciary money based on the belief that it can be exchanged for goods or services or converted into legal tender.
  • Commercial Bank Money: This refers to money created by commercial banks through the process of lending. It exists in the form of bank deposits and is widely used for transactions through cheques, debit cards, and electronic transfers. Commercial bank money is a significant part of the money supply in modern economies.
    • Fractional Reserve Banking: This is a banking system in which banks hold only a fraction of their deposits in reserve as cash and lend out the remainder. This process creates new money in the form of bank deposits and is a primary way in which commercial bank money is created.
  • Credit Money: This type of money includes instruments that represent a promise to pay in the future, such as bonds, bills of exchange, and other forms of debt. The monetary value of credit money is based on the credibility of the issuer and the expected future value rather than the current commodity value.

Creation of Money

  • The money supply is a crucial concept in economics, referring to the total amount of currency and various types of deposits held by the public and banks in an economy at a given time. It’s influenced by various factors and managed through several monetary policy tools:
  • Money Supply (M1): This is a narrow measure of the money supply that includes currency held by the public (CU) and demand deposits (DD) in banks.
  • Influences on Money Supply:
    • Consumer Unit (CU): Refers to the amount of currency held by the public.
    • Demand Draft (DD): Refers to demand deposits, which are bank deposits that can be withdrawn on demand.
    • Time Deposits: Fixed-term deposits that affect the broader measures of money supply.
  • Key Ratios Affecting Money Supply
    • Currency Deposit Ratio (CDR): The ratio of currency held by the public to their bank deposits. It reflects public preference for liquidity.
    • Reserve Deposit Ratio (RDR): The percentage of deposits that commercial banks hold as reserves.
  • Reserve Money:
    • Banks keep a portion of deposits as reserves, either as vault cash or deposited with the Reserve Bank of India (RBI).
    • This reserve is used to meet cash demands from account holders.
  • Instruments Used by RBI to Manage Money Supply:
    • Cash Reserve Ratio (CRR): A fraction of deposits that banks must maintain with the RBI as reserves.
    • Statutory Liquidity Ratio (SLR): A fraction of deposits that banks must hold in specified liquid assets (cash, gold, etc.).
    • Bank Rate: An interest rate at which the RBI lends money to commercial banks. It influences the Reserve Deposit Ratio (RDR).
  • Commercial Banks:
    • Accept deposits from the public and lend money to borrowers at a profit.
    • Borrowing Rate: The interest rate offered by banks to depositors.
    • Lending Rate: The interest rate charged by banks to borrowers for a loan.
    • Spread: The difference between the borrowing rate and lending rate, which represents the bank’s profit.
  • Types of Deposits:
    • Demand Deposit: Payable by banks on demand from the account holder (e.g., savings and current accounts).
    • Time Deposit: Deposits with a fixed maturity period (e.g., fixed deposits).
Order of liquidity: Money / Currency > Demand deposits > Saving Deposits > Time Deposit.

Demand of Money

  • Money is recognized as the most liquid asset due to its universal acceptance and ability to be easily exchanged for commodities. However, holding cash has an opportunity cost, as placing money in a bank’s fixed deposit can yield interest.
  • The demand for money, also known as liquidity preference, consists of two components: transaction demand and speculative demand. The amount of money demanded is influenced by the volume of transactions, which is dependent on an individual’s income. Consequently, an increase in income leads to a higher demand for money. Conversely, a rise in interest rates results in a decreased demand for money.
  • Individuals hold money for various reasons, including:
    • Transaction Motive: The primary reason for holding money is to facilitate everyday transactions, such as purchasing groceries, utensils, and tickets for transportation.
    • Transaction Demand: This is the amount of money needed for the ongoing transactions of businesses and individuals. According to economist John Maynard Keynes, the level of income determines the transaction demand for money. A higher income level results in a larger amount of money held for transactions.
    • Interest Rate Influence: The demand for money for transactions is inversely related to the interest rate. An increase in the interest rate raises the cost of holding money, leading to a decrease in money holdings. Conversely, a decrease in the interest rate lowers the cost of holding money, resulting in an increase in money holdings.
    • Price Level Influence: There is a direct relationship between the price level and the demand for money. An increase in prices requires more money to be held for transactions, while a decrease in prices reduces the amount of money needed.
  • The total annual value of transactions in an economy, encompassing all intermediate goods and services, exceeds its nominal Gross Domestic Product (GDP). An increase in nominal GDP suggests a corresponding rise in the total transaction value.
  • Another motive for holding money is the speculative motive. This occurs when individuals prefer to keep their money as cash rather than investing it in potentially risky assets like stocks or bonds. The speculative demand for money is influenced by various factors:
  • Market Movements: People speculate on future returns based on their interpretations of market trends.
  • Interest Rates: According to economist John Maynard Keynes, speculative demand for money is inversely related to the interest rate. When interest rates are high, individuals anticipate a future decrease in rates, leading to an increase in bond prices. Therefore, investors may prefer to hold bonds until the expected rise in prices materializes.
  • Future Expectations: Conversely, when interest rates are low, people expect them to increase in the near future. As interest rates rise, bond prices tend to fall. In this scenario, investors may choose to hold onto their money until the anticipated decrease in bond prices occurs.
Speculative Demand and Liquidity Trap
·   Liquidity Trap: This occurs when interest rates are extremely low, and people anticipate future interest rate increases and a consequent decline in bond prices. However, instead of rising, interest rates remain low, leading to potential capital losses. As a result, individuals choose to hold onto their money rather than invest it.

·   Bonds: These are financial instruments that represent a promise for future monetary returns over a specified period.

Factors Affecting Money Demand

  • Prevalent Price Level: A high price level or interest rate reduces the demand for money, and vice versa.
  • Inflation Level: A high inflation level leads to a reduced demand for money, as people prefer to save rather than spend.
  • Disposable Income: Higher disposable income results in a higher tendency to spend, leading to a higher demand for money.
  • Innovation Level in an Economy: The level of innovation in an economy can also affect the demand for money, although the specific relationship may vary.

Money Supply and Monetary Aggregates

  • Money Supply: Also known as the monetary aggregate, money supply refers to the total amount of money in circulation at a given time. It is sometimes referred to as “money stock,” “stock of money,” or “quantity of money.”
  • Classification by RBI: The Reserve Bank of India (RBI) classifies the money supply into various categories: M0, M1, M2, M3, and M4.
  • Reserve Money (M0): Also known as the monetary base, M0 consists of currency in circulation, bankers’ deposits with the RBI, and other deposits with the RBI. It is the foundation of the economy’s money supply.
  • Narrow Money (M1 & M2):
    • M1: Includes currency with the public, demand deposits with the banking system, and other deposits with the RBI. M1 is highly liquid and is not typically used by banks for lending.
    • M2: Adds savings deposits of post-office savings banks to M1.
  • Broad Money (M3 & M4):
    • M3: Consists of M1 plus net time deposits with the banking system. M3 is a common measure of the money supply and is known as the aggregate monetary resource. “Net” indicates that only public deposits are included, excluding interbank deposits.
    • M4: Includes M3 plus all deposits with post-office savings banks (excluding national savings certificates).
  • Liquidity Order: In terms of liquidity, the order is M1 > M2 > M3 > M4.

High-Powered Money

  • Definition: High-powered money, also known as the monetary base or reserve money, is the total liability of the central monetary authority of a country, such as the Reserve Bank of India (RBI).
  • Components: The liabilities of the RBI include:
    • Currency and coins in circulation with the public.
    • Vault cash held by commercial banks at the RBI.
    • Deposits of the Government of India and commercial banks with the RBI.
  • Obligations: The RBI is obligated to provide an equivalent value of currency when demanded by a note holder. Similarly, deposits are refundable by the RBI upon demand from deposit holders.
  • Backing: These liabilities must be supported by assets such as gold and foreign reserves.
  • Money Supply Equation: Money supply (M) is the sum of currency (CU) and net demand deposits (DD). The equation can be expressed as M = CU + DD = (1 + cdr) * DD, where cdr is the currency-deposit ratio (CU/DD).
  • High Power Money: Currency issued by the central bank is known as high-powered money because it is backed by reserves and its value is guaranteed by the government.
  • Sources in India: The RBI issues currency notes in various denominations, while the Government of India mints coins and issues one-rupee notes.

Factors Affecting Money Supply

  • Monetary Base: The amount of currency in circulation and commercial bank deposits held at the central bank. A larger reserve money leads to a higher money supply.
  • Monetary Policy: An expansionary monetary policy increases the money supply, while a contractionary policy reduces it.
  • Individual Preferences: The higher the proportion of income that individuals deposit in banks, the lower the money supply.
  • Fiscal Policy: Changes in taxation and government spending can impact the money supply. Higher taxes reduce it, while deficit financing and an increase in government securities sales can decrease the money supply.
  • Business Cycle: The money supply tends to increase during economic booms and decrease during recessions.
  • Money Multiplier: The process of creating money in the economy through the creation of credit, based on the fractional reserve banking system.
  • Interest Rates: Higher interest rates reduce the money supply by discouraging borrowing.

Money Multiplier

  • The money multiplier is a concept that illustrates the maximum amount of broad money (M) that commercial banks can create from a given amount of base money (H) and a specific reserve ratio (rdr). It is also known as the monetary multiplier and reflects the extent to which changes in deposits can affect the money supply. The formula for the money multiplier is:
  • Money Multiplier = 1/ Required Reserve Ratio (R)

where:

  • M is the stock of money.
  • H is the stock of high-powered money.
  • cdr is the Currency Deposit Ratio (C/DD), the ratio of currency held by the public to their deposits in commercial banks.
  • rdr is the Reserve Deposit Ratio, the fraction of deposits that banks are required to hold as reserves.
  • The money multiplier is greater than 1, indicating that the money supply can expand more than the initial increase in base money. The key determinants of the money multiplier are the currency deposit ratio (cdr) and the reserve deposit ratio (rdr).
  • The process of credit creation, which leads to the money multiplier effect, works as follows:
    • When a bank receives a deposit (A), its total reserves increase.
    • The bank must keep a portion (r × A) as required reserves to meet withdrawal demands, where r is the required reserve ratio.
    • The bank can lend out the excess reserves (A – r × A).
    • If the borrower deposits the loan amount back into the banking system, the total reserves of the bank increase by the amount of the loan minus required reserves.
    • The bank can then lend out a portion of these new deposits, and the cycle continues, leading to an increase in the total money supply.
  • A higher required reserve ratio (R) means that banks have less excess reserves to lend out, resulting in a lower money multiplier. Conversely, a lower required reserve ratio allows banks to lend out more of their deposits, leading to a higher money multiplier.

Velocity of Money Circulation

  • Definition: The velocity of money circulation is a measure of how often a unit of currency is used to purchase goods and services within a certain period. It reflects the average number of times money changes hands.
  • Example: If you use a ₹10 note to buy a pen, and the shopkeeper uses the same note to buy chocolate, the currency has facilitated transactions worth ₹20.
  • Factors Affecting Velocity:
  • Income Distribution: Money circulates faster in the hands of lower-income individuals who tend to spend it quickly.
  • Business Cycle: During economic booms, higher demand and supply lead to more transactions, increasing the velocity of money.
  • EMI Preference: The use of installment loans for purchases can result in a higher velocity of money.
  • Developed Countries: Higher spending patterns and trust in government social security can lead to a higher velocity of money circulation.
  • Credit Creation in India
  • Mechanism: Banks create credit by advancing loans or purchasing securities. They maintain a portion of deposits as liquid cash (cash reserve) as required by the RBI and lend out the excess.
  • Secondary or Derivative Deposit: When banks authorize a loan, they open a deposit account in the borrower’s name. This deposit is known as a secondary or derivative deposit.
  • Credit Multiplier: The remaining deposit after lending is known as the credit multiplier. Credit is created from secondary deposits, and the credit multiplier is the inverse of the Cash Reserve Ratio (CRR), indicating how many times primary deposits multiply.
  • Need for Credit:
    • Demand Side: Consumers require credit for acquiring assets like consumer durables.
    • Supply Side: Corporates need credit for long-term investments.
  • Types of Loans:
    • Commercial Loan: Given to businesses for acquiring fixed assets and maintaining operations.
    • Individual Loan: Given to consumers for consumption and acquiring durables.
    • Installment Credit: The credit amount is predetermined and paid out in stages or all at once, but repaid in installments.
    • Operating Credit: Given to meet daily operational needs with a set credit limit, providing a current account for withdrawals.
    • Receivable Finance: Given in the form of bills of finance.

Variants of Currency

Currency Type/ Concept Description
Hard Currency Required in international trade. World’s strongest currency with high liquidity. Always scarce. Examples: USD, Euro, GBP.
Soft Currency Widely available in a country’s forex market. Example: Indian Rupee in India’s forex market.
Hot Currency Temporary term for a hard currency exiting an economy rapidly. Example: USD during the South East Asian crisis.
Heated Currency Domestic currency under pressure due to high exit of hard currency. Also known as ‘currency under heat’ or ‘under hammering’.
Cheap Currency Money flowing into the economy when a government repurchases bonds before maturity. Indicates a period of lower interest rates in the banking industry.
Dear Currency Money flowing from the public to the government or economy when bonds are issued. Indicates a period of higher interest rates in the banking industry.
Helicopter Money Concept by economist Milton Friedman. Involves central bank printing currency and distributing it freely during recessions.

Currency in India

  • Early History: The first paper currency in India was issued during the British East India Company rule, with the 1 Rupee note being the earliest denomination.
  • Private Banks: In the late 18th century, private banks like the Bank of Hindustan and presidency banks were among the first to issue paper notes.

Currency Circle:

  • 1861 Act: Following this act, the Government of India had a monopoly on issuing paper notes. However, due to limited mobility, development, and education, these notes were only legal tender in major cities and their surrounding areas, known as “Currency Circles.”

Currency Controller in India:

  • RBI Act 1934: Section 22 of this act grants the Reserve Bank of India (RBI) the exclusive right to issue banknotes of all denominations.
  • Transfer of Function: The currency function was transferred from the Controller of Currency to the RBI on April 1, 1935.
  • Current Role: The RBI is responsible for designing, producing, and managing the nation’s currency, ensuring an adequate supply of clean and genuine notes.

Decimalization of Coinage:

  • Pre-Independence: Before independence, 1 Rupee was divided into 16 Annas or 64 Pice.
  • Post-Independence: In 1957, the coinage was decimalized, changing the structure to 1 Rupee being divided into 100 Paise. The term “Naya Paisa” (new paise) was introduced, which was later dropped in 1964.

Currency Chests:

  • Definition: Currency Chests are storage facilities where banknotes and Rupee coins are stored on behalf of the Reserve Bank.
  • Operators: Various banks, including the State Bank of India, nationalized banks, private sector banks, a foreign bank, a state cooperative bank, and a regional rural bank, operate currency chests.
  • Significance: Deposits in currency chests are considered as reserves of the RBI and are included in the Cash Reserve Ratio (CRR).

Currency Notes and Coins in India

  • Languages on Currency Notes:
    • The value of a currency note is displayed in 17 languages: 15 on the back panel and Hindi and English on the front panel.
    • The 15 languages on the back panel include Assamese, Bengali, Gujarati, Kannada, Kashmiri, Konkani, Malayalam, Marathi, Nepali, Oriya, Punjabi, Sanskrit, Tamil, Telugu, and Urdu.
  • Signature on Currency Notes:
    • All currency notes, except the one-rupee note, bear the signature of the incumbent RBI Governor.
    • The one-rupee note, issued by the Ministry of Finance, carries the signature of the Finance Secretary.
  • Role of RBI with Respect to Coins:
    • The Government of India mints coins, and the Reserve Bank of India distributes them on behalf of the government.
    • The RBI is the sole source of legal tender in India, distributing one-rupee notes, coins, and small coins across the country as an agent of the government.
  • Paper Currency in Circulation:
    • Paper currency notes are issued in denominations of ₹5, ₹10, ₹20, ₹50, ₹100, ₹200 and ₹500.
    • Printing of ₹1 and ₹2 notes has been discontinued as per the Coinage Act of 2011.
    • The RBI may issue notes of any denomination up to ₹10,000 as per the RBI Act.
  • Issue and Currency Departments of the RBI:
    • The Issue Department is a separate entity with assets and liabilities distinct from the Banking Department.
    • The Department of Currency Management, responsible for currency management, is located at the Central Office in Mumbai.
    • There are 19 issue offices in India.
    • The RBI authorizes selected bank branches to open Currency Chests and Coin Deposits.
  • Proportional Reserve System:
    • Initially, the assets of the Issue Department were required to include at least 2/5ths of gold or sterling securities, with the remaining 3/5ths in rupee coins.
    • This system was changed in 1956 to the Minimum Reserve System.
  • Minimum Reserve:
    • The RBI is required to maintain a reserve equivalent to ₹200 crores in gold and foreign currency, of which ₹115 crores should be in gold.
    • This system has been in place since 1957, and the RBI is empowered to issue currency to any extent against this minimum reserve.

Plastic Money

  • Definition: Plastic money refers to the use of hard plastic cards, such as debit cards, credit cards, charge cards, and ATM cards, for day-to-day transactions instead of physical banknotes.

Card Types Based on Payment Modality:

Credit Card:

  • Allows purchases on credit, even if the holder may not have sufficient balance in their bank account.
  • The bank pays the merchant and later recovers the amount from the customer.
  • Customers can pay the full amount due or convert it into Equated Monthly Installments (EMI).
  • Interest rates are charged based on the billing cycle, grace period, and other terms.
  • Can be used for ATM withdrawals, which is considered borrowing and incurs interest.

Debit Card:

  • Allows purchases up to the amount in the holder’s bank account.
  • The bank transfers the amount from the customer’s account during a transaction.
  • Purchases cannot be made if there is an insufficient balance.
  • Some e-commerce sites allow EMI transactions with debit cards.
  • ATM withdrawals are not considered borrowing, as the money comes from the user’s own account.

Hybrid/Duo Card:

  • A single card with two chips for both credit and debit functions.
  • Example: Indus Bank Hybrid card.

Prepaid Card:

  • A subtype of a debit card that can be purchased even without a bank account.
  • The card is preloaded with a certain amount of money and can be used for specific purposes.
  • Example: IRCTC’s UBI prepaid card for purchasing rail tickets and meals.

Legal Tender Money

  • Definition: Legal tender money is the currency that is legally recognized by the law of a country for the settlement of transactions and debts.
  • Characteristics: It is also known as lawful money and must be accepted as a medium of exchange and payment for debts. Refusal to accept legal tender for debt repayment is not legally permissible.
  • Variability: While paper money denominations are usually considered legal tender, the acceptance of coin denominations as legal tender varies from country to country.
  • RBI Act, 1934: According to this act, the Reserve Bank of India has the exclusive right to issue banknotes, and every banknote issued is legal tender for the amount expressed therein.
  • Government Recognition: The value of paper money is determined by the government’s recognition, which can grant or revoke legal tender status.

Types of Legal Tender Money:

  • Limited Legal Tender Money:
    • Can be used for the payment of debts up to a certain limit.
    • Beyond this limit, a creditor can refuse payment without facing legal consequences.
    • Example: In India, coins are considered limited legal tender.
  • Unlimited Legal Tender Money:
    • Can be used for the payment of debts of any amount.
    • Legal action can be taken against a person who refuses to accept this form of money.
    • Example: Paper notes are considered unlimited legal tender in India.

Blockchain and Distributed Ledger Technology (DLT)

  • Definition: Blockchain, also known as Distributed Ledger Technology (DLT), is a decentralized technology that uses cryptographic hashing to make the history of any digital asset unalterable and transparent.
  • Invention: It was invented by Satoshi Nakamoto in 2008 as a public transaction ledger for Bitcoin, the first cryptocurrency.
  • Decentralization: Blockchain technology allows users to control their own assets without the intervention of third parties, including the government.

Key Concepts:

  • Blocks: Files where data related to the blockchain network is permanently recorded.
  • Nodes: Electronic devices that maintain copies of the blockchain and help operate the network.
  • Miners: Individuals or entities that create new blocks on the blockchain through a process called mining.

Advantages:

  • Digital Records: Blockchain records transactions of digitally stored assets, with the information distributed across multiple locations simultaneously.
  • Decentralization: There is no central data store or administrative function, enhancing security and reducing the risk of data manipulation.
  • Reduction of Duplication: Blockchain technology can streamline processes like KYC (Know Your Customer), reducing the need for duplicate records and increasing efficiency.
  • Increased Transparency in Finance: DLT-based systems can enhance transparency and security in banking and finance, aiding in loan tracking, collateral management, fraud detection, and insurance claims management.
  • Land Records Maintenance: Blockchain can help in maintaining accurate and tamper-proof land records, reducing errors and fraud in land markets.

Crypto Currencies

  • Cryptocurrency is a digital or virtual form of currency that uses cryptography for security and operates on a decentralized network, typically a blockchain. It is not controlled by any central authority, making it immune to government interference or manipulation. Cryptocurrencies are designed to facilitate secure online transactions and are used as a medium of exchange, a store of value, and a unit of account.

Crypto-Currencies Vs Digital Currencies

Feature Cryptocurrencies Digital Currencies
Definition Digital or virtual currencies that use cryptography for security. Electronic form of currency that can be used for digital transactions.
Decentralization Typically decentralized, operating on a blockchain network. Can be centralized or decentralized, depending on the issuing authority.
Control Not controlled by any central authority or government. May be issued and regulated by a central authority, such as a central bank.
Anonymity Transactions can be pseudonymous, providing a level of privacy. Transactions may be traceable, depending on the system’s design.
Examples Bitcoin (BTC), Ethereum (ETH), Ripple (XRP), Litecoin (LTC). Central Bank Digital Currencies (CBDCs), e-money, digital fiat currencies.
Technology Primarily use blockchain technology for security and transparency. May use various technologies, including blockchain.
Legal Tender Status Generally not considered legal tender. Can be recognized as legal tender if issued by a central bank.
Regulation Subject to varying degrees of regulation across different countries. Typically subject to financial regulations and oversight.
Use Cases Used for investments, peer-to-peer transactions, and as a store of value. Used for digital transactions, payments, and as a store of value.
Volatility Often subject to high volatility in value. Generally more stable, especially if pegged to a fiat currency.

Concerns with Cryptocurrency

  • Highly Speculative: Cryptocurrencies are often subject to rapid price fluctuations, leading to speculative trading.
  • Illegal Online Marketing: Cryptocurrencies can be used for illicit activities such as drug dealing and child pornography.
  • Consumer Fraud: There have been instances of consumers being defrauded in cryptocurrency transactions.
  • Safe Havens for Black Money: Cryptocurrencies can be used to launder money or hide illicit funds due to their anonymity.

RBI and Stand of Supreme Court on Cryptocurrency

  • RBI Ban: In 2018, the Reserve Bank of India (RBI) banned cryptocurrency, citing concerns such as money laundering, terror financing, operational risks, and the potential disruption of commercial banks’ business models.
  • Supreme Court’s Verdict: The Supreme Court overturned the RBI’s ban, stating that dealing and trading in cryptocurrency is a legitimate business activity and that the RBI’s prohibition was excessive and unconstitutional.
Subhash Chandra Garg Committee Recommendations
·   The committee recommended that private cryptocurrencies be prohibited in India, except for state-issued cryptocurrencies.

·   It also suggested considering the introduction of an official government-backed cryptocurrency and proposed a law with penalties for cryptocurrency-related offences.

Way Forward

  • Awareness Campaigns: Instead of imposing bans, there should be efforts to educate investors about the risks associated with cryptocurrencies and to monitor trades for fraud and scams.
  • Regulatory Framework: The RBI should develop a detailed regulatory framework for licensing virtual currency intermediaries, with adherence to KYC standards similar to those of stock exchanges.
  • Blockchain Technology: Embracing blockchain technology could benefit India’s financial sector and governance. It is crucial to develop and strengthen regulatory frameworks that can adapt to technological innovations in the financial sector.

National Payments Corporation of India (NPCI)

  • Establishment: NPCI was established in December 2008 under the provisions of the Payment and Settlement Systems Act, 2007. It was founded by the Reserve Bank of India (RBI) and the Indian Banks’ Association (IBA) with the objective of creating a robust and inclusive payment and settlement infrastructure in India.
  • Ownership: NPCI is a not-for-profit organization registered under Section 8 of the Companies Act, 2013. It is owned by a consortium of major banks in India.
  • Mission: The mission of NPCI is to facilitate an affordable, accessible, and efficient payment system in India, thereby promoting financial inclusion and enhancing the efficiency of the banking system.
  • Governance: NPCI is governed by a board of directors, which includes representatives from its member banks as well as independent directors. The organization operates under the guidance and supervision of the RBI.
  • Impact: NPCI has played a crucial role in the digitalization of the Indian payment landscape, making digital payments more accessible and secure for the masses. Its initiatives have been instrumental in promoting cashless transactions and financial inclusion in the country.

Key Initiatives and Products

Payment System Description
Unified Payments Interface (UPI) Real-time payment system for inter-bank transactions via mobile phones.
Immediate Payment Service (IMPS) Allows instant inter-bank fund transfers, available 24/7.
Bharat Interface for Money (BHIM) App for UPI-based transactions, developed by NPCI.
National Financial Switch (NFS) Connects ATMs across India for seamless cash withdrawal and other services.
RuPay Domestic card payment network offering an alternative to international schemes.
Aadhaar Enabled Payment System (AePS) Enables financial transactions using Aadhaar authentication.
Bharat Bill Payment System (BBPS) Centralized platform for bill payment services for various utilities and services.
National Electronic Toll Collection (NETC) System for electronic toll collection on national highways, using FASTag.

Digital Payments

  • The Indian government and the Reserve Bank of India (RBI) are actively promoting digital payments to enhance the efficiency of the financial system and drive financial inclusion. Some of the key steps taken by the RBI:
  • NEFT and RTGS Fees: The RBI has eliminated fees for National Electronic Funds Transfer (NEFT) and Real Time Gross Settlement (RTGS) payments, encouraging banks to pass on the savings to customers.
  • Merchant Discount Rate (MDR): MDR charges for RuPay and Unified Payments Interface (UPI) transactions have been waived to incentivize digital payments.
  • Mandatory Acceptance: Businesses with an annual turnover of ₹50 crores or more are required to accept RuPay and UPI payments.

RuPay and UPI:

  • Both RuPay and UPI are products of the National Payments Corporation of India (NPCI).
  • RuPay is India’s first domestic debit and credit card payment network.
  • RuPay cards are also accepted internationally in select countries, including Singapore, Bhutan, UAE, Bahrain, and Saudi Arabia.

Digital Payment Trends:

  • According to a survey, digital payment adoption in India increased from 38% in 2021 to 53% in 2022, driven by merchants expanding their digital payment options to meet rising consumer demand.
  • Buy Now Pay Later (BNPL) is considered a viable option by 31% of consumers, over traditional credit cards.
  • By 2025, the number of unique digital wallet users is expected to exceed 4.4 billion globally.
  • The digital payments sector has experienced significant growth, with a compound annual growth rate (CAGR) of 30%. By 2026, digital payments in India are projected to reach a value of $10 trillion, up from the current value of $3 trillion.

Committees on Digital Payment in India

Committee Name Year Chairperson Key Recommendations
Ratan Watal Committee 2016 Ratan P. Watal Promote digital payments, establish a Payments Regulatory Board, reduce cash transactions, improve cybersecurity.
Nandan Nilekani Committee 2019 Nandan Nilekani Increase digital payment penetration, enhance financial inclusion, reduce transaction costs, improve user experience.
Srikrishna Committee 2017 Justice B.N. Srikrishna Focus on data privacy and security, which are crucial for digital payments.
Nilekani Panel on Digital Payments 2019 Nandan Nilekani Enhance customer protection, regulate payment gateways, improve digital payment infrastructure.
Surendra Nath Sen Committee 2008 Surendra Nath Sen Modernize payment systems, promote electronic payments, establish a legal framework for digital transactions.

Digital Payments Platform

Platform Description
UPI & UPI 2.0 UPI is a payment system for money transfers between any two bank accounts using a smartphone. Launched in April 2016 by NPCI. Enables direct payments from bank accounts to merchants online and offline. Facilitates P2P collection requests. UPI 2.0 can be linked to overdraft accounts, allows pre-authorization of transactions, adds authentication of merchant QR codes through user notifications, and increases the transaction limit to 2 lakhs/day.
BHIM & BHIM 2.0 BHIM is a mobile payment app based on UPI, developed by NPCI and launched in 2016. BHIM 2.0, launched under the Ministry of Electronics and Information Technology, increases the transaction cap to ₹1,00,000 from verified merchants and provides easy and secure transactions.
BHARAT QR A mobile payment solution for Person to Merchant (P2M) transactions, derived mutually by payment networks NPCI, Visa, and Mastercard. Allows users to pay utility bills using BQR-enabled mobile banking apps without sharing user credentials with the merchant. Differs from POS transactions as it only requires a QR code, not a POS terminal.
Aadhar Enabled Payment System (AEPS) A bank-led model allowing interoperable transactions at the Point of Sale through any bank’s business correspondent using Aadhaar authentication, promoting financial inclusion.
EMV Cards EMV stands for Europay, Mastercard, and Visa. A debit card security standard with a microprocessor chip embedded in the card, preventing card skimming and cloning possible with magnetic stripe cards.
Mobile Money Identifier (MMID) A 7-digit number issued by banks against a bank account for fund transfers. Each bank account has one MMID. Different MMIDs can be linked to the same mobile number. The combination of mobile number and MMID uniquely links to an account number for beneficiary identification.

Issues and Challenges with Digital Payments

Issue/Challenge Description
Time-consuming Costs associated with RTGS and NEFT systems can be a hindrance and consume more time.
Structural Challenges Includes digital financial illiteracy, cybersecurity issues, etc.
Poor Digital Penetration Rural areas remain aloof from digital technology, making digital payment a distant dream in some regions.
Digital Inequality Marginalized sections such as women and the elderly often lack access to digital payment methods.
Fraud and Security Security breaches and data security risks are major concerns. Common fraud techniques include phishing, vishing, remote access, and account takeover.
Awareness and Adoption India’s cash-dominant society faces a lack of awareness regarding security and data privacy in digital payments.
Merchant Support Complexity of EMV standards and contactless payment leads to resistance among merchants.
Compatibility Mobile wallets need to be compatible with all mobile models and operating systems.
Rise of UPI UPI, developed by NPCI, competes with mobile wallets. In October 2020, BHIM-UPI transactions exceeded 2 billion in a month.

Solution and Way Forward

Solution/Approach Description
Improving Digital Literacy Increase digital transactions and enhance safety by reducing banking frauds.
Strengthening Cyber Infrastructure Strengthen cyber infrastructure and cybersecurity to reduce hacking and banking theft incidents.
Boosting Mobile Infrastructure Enhance compatibility of operating systems and android versions to increase confidence in digital payments.
Bridging the Digital Divide Incentivize digital payment adoption in urban and rural areas, especially among marginalized sections.
Easing Settlement Process Simplify the settlement process for merchants and enable end-of-day settlements.
Reducing Transaction Charges Lower charges on digital payments and discourage cash transactions by imposing cash handling costs.
Integrated Digital Payments System Establish an integrated system with stringent laws to reduce challenges and support quality outcomes.

Indices and Funds Related to Digital Payments

Index/ Fund Description Key Points
Digital Payment Index (DPI) Developed by the RBI to measure digitalization in India, with March 2018 as base year. DPI for March 2022: 349.30, compared to 304.06 in September 2021, indicating significant growth in digital payments.
Digital Competitiveness Index (DCI) Published by the IMD World Competitiveness Center, assesses the ability of 63 economies to adopt and leverage digital technologies. Evaluates based on knowledge, technology, and future readiness. US ranked most digitally competitive in 2021, India scored 55.13.
Acceptance Development Fund (ADF) Established by RBI to enhance digital payment infrastructure in rural areas and Tier III and Tier IV centers. ADF aims to improve digital payment acceptance infrastructure in specific regions.
Payment Infrastructure Development Fund (PIDF) Created by RBI following recommendations from Nandan Nilekani Committee, initial corpus of ₹500 crores. PIDF aims to encourage merchants to adopt PoS infrastructure for both physical and digital transactions.

Digital Transactions Ombudsman (DTO)

  • Appointment: The RBI appoints senior officials as DTOs in 21 locations across India to address customer complaints.
  • Jurisdiction: DTOs can hear complaints up to ₹20 lakh related to prepaid payment instruments, mobile wallets, apps, NEFT/RTGS, and other digital transactions.
  • Authority: DTOs can order companies or banks to reverse/settle transactions and award up to an additional ₹1 lakh for mental agony suffered by the customer.
  • Appeal: Higher appeals can be made to the Deputy Governor of RBI.
  • Limitation: For amounts exceeding ₹20 lakh, victims must approach ordinary courts or consumer courts, depending on the case matter.

New Umbrella Entity (NUE) for the Payment System

  • The New Umbrella Entities (NUEs) are proposed organizations that will provide a variety of payment services, similar to those currently offered by the National Payments Corporation of India (NPCI).
  • Reasons for Establishing NUEs:
    • Promote Competition: Introducing NUEs aims to lower transaction costs and diversify product offerings in the payment system.
    • Manage New Payment Systems: NUEs will handle new payment methods, including wallet transactions, Aadhaar-based payments, remittance services, UPI transactions, ATMs, and white-label PoS.
    • Limit NPCI’s Monopoly: Currently, NPCI monopolizes retail payment systems in India. NUEs will encourage competition and improve service delivery in the retail digital payment sector.
    • Regulate Increasing Digital Transactions: With the surge in retail transfers, such as the transfer of ₹165 lakh crores in 27 billion transactions in 2020-21, there is a need for regulation to ensure efficient service delivery.
  • RBI Framework for NUEs:
    • Capital Requirements: NUEs must have a minimum paid-up capital of ₹500 crores and maintain a net worth of at least ₹300 crores at all times. No single promoter or group can hold more than 40% investment in an NUE.
    • Ownership: The promoter or promoter group of an NUE should be predominantly “owned and controlled by residents” with a minimum of three years of experience in the payment ecosystem.
    • Governance: NUEs must adhere to RBI’s corporate governance norms. The RBI reserves the right to approve director appointments and nominate a member to the NUE’s board.
    • Foreign Investment: Foreign investment in NUEs is permitted, provided they meet the additional criteria set by the RBI.

Initiatives to Promote a Cashless Or Less-Cash Economy

Initiative Description
Committee to strengthen the digital payment ecosystem Set up by the Finance Ministry under the chairmanship of Ratan Watal.
Chandrababu Naidu Chief Ministers’ Committee Committee to PM to promote and enhance the digital payment ecosystem in India.
Vittiya Saksharta Abhiyan Initiative by the Education Ministry, wherein college students explain digital transactions to people.
Joint initiative of NITI Aayog and NPCI Lottery/cashback schemes for customers (Lucky Grahak) and merchants (Digi Dhan Vyapar). The government launched referral bonuses and cashback schemes for using UPI-BHIM.
Digidhan Mission (2017) Launched by the Ministry of Electronics and Information Technology (MeitY) to create awareness about digital payments.
DIGIDHAN DASHBOARD Web portal launched by MeitY to monitor digital transactions in India.
Budget-2019 Imposed Tax Deduction at Source (TDS) on withdrawal of ₹1 crore or more from a single user account.
Digital Payment Abhiyan (2019- Sept) Launched by MEITY along with Google India and Data Security Council of India (DSCI) to promote digital payments.

Labels of ATM in India

ATM Label Features
Bank’s own ATM Owned and operated by the concerned bank and carries the bank’s logo. Costliest way for a bank to provide such services to its customers.
Brown Label ATM Owned and operated by a third party, a non-banking firm. Banks handle only part of the process, such as cash handling and backend server connectivity.
White Label ATM Does not bear the logo of the banks they serve. Interconnected with the entire ATM network in the country. The Tata Communications Payment Solutions – Indicash was the first to get permission from the RBI for setting up white-labeled ATMs.

Concept of Demonetization

  • Definition: Demonetization is the process of withdrawing the legal tender status of a currency.
  • Purpose: It is used to stabilize currency, combat inflation, increase transparency, and reduce black and grey market activities.
  • Historical Instances in India:
    • 1946: The RBI demonetized ₹1,000 and ₹10,000 notes.
    • 1978: The Morarji Desai government carried out demonetization.
    • 2016: The NDA government demonetized ₹500 and ₹1,000 notes.
  • Positive Impact of Demonetization:
    • Increased Tax Collection: There was a 24.7% increase in the number of registered Income Tax Returns (ITRs).
    • Tackled Black Money: The government identified over 37,000 shell companies engaged in black money and hawala transactions.
    • Reduced Organized Crimes: Financing for terrorist and Naxalite activities was significantly curtailed, and there was a decline in sex trafficking.
    • Curbed Fake Currency: No high-quality fake currency notes were found or seized post-demonetization.
    • Rise in Digital Transactions: Digital transactions increased by 50-55% points, reducing the government’s printing expenses.
  • Negative Impact of Demonetization:
    • Poor Planning: High-value notes constituted 87.5% of the currency value, causing disruptions for the common man.
    • Economic Slowdown: Shortage of money led to a slowdown in economic activities and affected the supply chain of the informal sector.
    • Decline in GDP: The growth rate dropped from 7.5% in September 2016 to 5.7% in June 2017.
    • Persistent Corruption: Corruption has not been fully eradicated post-demonetization.
    • Revival of Cash Holding: The cash-GDP ratio returned to levels similar to the pre-demonetization period.
    • Agricultural Sector Suffered: The reliance on cash transactions in agriculture led to stress in the sector.
    • Worsening Banking System: Banks’ inability to boost lending resulted in decreased interest income, worsening their capital situation and exacerbating the NPA issue.

Black Money

  • Definition: Black money refers to income that is not declared for tax purposes, acquired through illegitimate means, or unaccounted for, and is hidden from government authorities.
  • Contrast with White Money: White money is earned through legitimate means, is accounted for, and is taxed appropriately.

Generation of Black Money

  • Illegal Activities: Involves corruption, money laundering, smuggling, etc.
  • Tax Evasion: Corporations evading taxes.
  • Tax Avoidance: Exploiting loopholes in the tax system, though not illegal.
  • Investment in Jewellery and Real Estate: To hide actual income.
  • Tax Havens: Setting up companies in jurisdictions with low or no taxes.
  • Shell Companies: Creating entities to redirect profits and minimize tax liabilities.
  • Derivative Instruments: Investment through instruments like Participatory Notes (P-notes).

Effects of Black Money

  • Financial Ecosystem: Adversely affects the country’s financial system.
  • Inflation: Leads to uncontrolled money supply and higher inflation.
  • Credibility: Erodes the country’s credibility.
  • Illegal Activities: Often used for illicit activities like drug dealing and terrorism.
  • Tax Loss: Results in significant tax revenue loss for the government.
  • Parallel Economy: Creates an underground economy parallel to the formal economy.

Government Initiatives to Curb Black Money

  • Tax Reforms: Incorporating tax deduction at the source.
  • Demonetization: Of ₹500 and ₹1000 notes.
  • Digital Transactions: Encouraging and promoting cashless and digital transactions.
  • Electoral Reforms: Implementation of electoral bonds.
  • Legislative Reforms:
    • Prevention of Corruption Act, 1988.
    • Benami Transactions (Prohibition) Act, 1988.
    • Prevention of Money Laundering Act, 2002.
    • The Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015.
    • Lokpal and Lokayuktas Act, 2013.

 

UPSC PREVIOUS YEAR QUESTIONS

 

1.  Which one of the following statements correctly describes the meaning of legal tender money? (2018)

1.  The money which is tendered in a court of law to defray the fee of legal cases.
2.  The money which a creditor is under compulsion to accept in settlement of his claim.
3.  The bank money in the forms of cheques, drafts, bills of exchange, etc.
4.  The metallic money in circulation in a country.

2.  Consider the following liquid assets: (2013)

1.  Demand deposits with the banks.
2.  Time deposits with the banks.
3.  Saving deposits with the banks.
4.  Currency

The current sequence of these assets in decreasing order of liquidity is:

(a) 1-4-3-2
(b) 4-3-2-1
(c) 2-3-1-4
(d) 4-1-3-2

3.  Supply of money remains the same when there is an increase in demand of money, there will be(2013)

1.  A fall in the levels of price.
2.  An increase in the rate of interest
3.  A decrease in the rate of interest
4.  An increase in the level of income and employment

4.  If a commodity is provided free to the public by the government, then: (2018)

1.  The opportunity cost is zero.
2.  The opportunity cost is ignored.
3.  The opportunity cost is transferred from the consumers of the product to the taxpaying public.
4.  The opportunity cost is transferred from the consumers of the product to the government.

5.  Consider the following: (2016)

1.  Currency with the public
2.  Demand deposits with banks
3.  Time deposits with banks

Which of these are included in Broad Money (M3)?

(a) 1 and 2
(b) 1 and 3
(c) 2 and 3
(d) 1, 2 and 3

6.  Following are some components of money supply in India:(2016)

1.  Currency with the public
2.  Aggregate demand deposits with banks
3.  Aggregate time deposits with banks
4.  ‘Other’ deposits with the Reserve Bank of India

Which of the aforesaid items are components of narrow money (M1) in India?

(a) 1, 2 and 3
(b) 2 and 4 only
(c) 1, 2 and 4
(d) 1 and 4 only

7.  Which of the following measures would result in an increase in the money supply in the economy? (2012)

1.  Purchase of G-Sec from the public by the Central Bank.
2.  Deposit of currency in commercial banks by the public.
3.  Borrowing by the government from the Central Bank.
4.  Sale of government securities to the public by the Central Bank.

Select the correct codes:

(a) 1 only
(b) 2 and 4 only
(c) 1 and 3
(d) 2, 3 and 4

8.  The money multiplier in an economy increases with which one of the following? (2019)

1.  Increase in the cash reserve ratio
2.  Increase in the banking habit of the population
3.  Increase in the statutory liquidity ratio
4.  Increase in the population of the country

9.  Which one of the following statements correctly describes the meaning of legal tender money? (2018)

1.  The money which is tendered in courts of law to defray the fee of legal cases.
2.  The money which a creditor is under compulsion to accept in settlement of his claims.
3.  The bank money in the forms of cheques, drafts, bills of exchange, etc.
4.  The metallic money in circulation in a country.

10.  With reference to ‘Bitcoins’ sometimes seen in the news, which of the following statements is/are correct? (2019)

1.  Bitcoins are tracked by the Central Banks of the countries.
2.  Anyone with a Bitcoin address can send and receive Bitcoins from anyone else with a Bitcoin address.
3.  Online payments can be sent without either side knowing the identity of the other.

Select the correct answer using the code given below.

(a) 1 and 2 only
(b) 3 only
(c) 2 and 3 only
(d) 1, 2 and 3

11.  Which one of the following links all the ATMs in India? (2018)

(a) Indian Banks’ Association
(b) National Securities Depository Limited
(c) National Payments Corporation of India
(d) Reserve Bank of India

12.  Consider the following statements: (2017)

1.  National Payments Corporation of India (NPCI) helps in promoting financial inclusion in the country.
2.  NPCI has launched RuPay, a card payment scheme.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

13.  Which of the following is the most likely consequence of implementing the ‘Unified Payments Interface (UPI)’? (2017)

1.  Mobile wallets will not be necessary for online payments.
2.  Digital currency will totally replace physical currency in about two decades.
3.  FDI inflows will drastically increase.
4.  Direct transfer of subsidies to poor people will become very effective.

14.  Which of the following best describes the term “Merchant Discount Rate” sometimes seen in the news? (2019)

1.  The incentive is given by a bank to a merchant for accepting payments through debit cards pertaining to that bank.
2.  The amount paid back by banks to their customers when they use debit cards for financial transactions for purchasing goods or services.
3.  The charge to a merchant by a bank for accepting payments from his customers through the bank’s debit cards.
4.  The incentive is given by the Government to merchants for promoting digital payments by their customers through Point of Sale (PoS) machines and debit cards.

15.  Which one of the following effects of the creation of black money in India has been the main cause of worry to the Government of India? (2021)

1.  Diversion of resources to the purchase of real estate and investment in luxury housing
2.  Investment in unproductive activities and purchase of precious stones, jewellery, gold, etc.
3.  Large donations to political parties and growth of regionalism
4.  Loss of revenue to the State Exchequer due to tax evasion

16.  What is Cryptocurrency? How does it affect global society? Has it been affecting Indian society also? (2022)