NCERT Solutions for Class 12 Economics Part A Chapter 3 Money and Banking

1. What is a barter system? What are its drawbacks?

Ans. Barter system is a system of exchange commodity for commodity. It was used during the ancient times. In other words, this system was often used to exchange one commodity against another before the existence of monetary system. For example, if a person is having rice and he wants tea, then he can exchange rice with a person who already has tea and wants rice. The economy having the barter system was termed as ‘C-C economy’, i.e., commodity is exchanged for commodity.

The various drawbacks of the barter system are mentioned below:

(i) Problem of double coincidence of wants: Double coincidence of wants refers to a situation, wherein needs of two individuals should complement each other in order to let the exchange take place. For example, in the aforesaid case, the second person must be in need of rice in exchange of tea.

(ii) Lack of common unit of value: Under barter system, there wasn’t any common unit for measuring the value of one good in terms of another good for the purpose of exchange. For example, a horse cannot be measured in terms of rice, in the case of exchange between rice and horse.

(iii) Difficulty in wealth storage: It was extremely difficult to store the commodities for future exchange purposes. The perishable goods like grains, milk and meat could not be stored to exchange the goods in future.
Therefore, wealth storage was an unvoidable difficulty of barter system.

(iv) Lack of standard of deferred payments: The future payments were impossible to be met in a C-C economy (barter system) as wealth could not be stored. Likewise, it was equally difficult to pay back the loans.

2. What are the main functions of money? How does money overcome the shortcomings of a barter system?

Ans. The main functions of money are as follows:

(i) Medium of exchange: Money acts as a medium of exchange because it facilitates the exchange through a common medium, which is termed as currency. In other words, money facilitates buying and selling of goods. For example, a person can sell his goods to another in exchange of money and that person can utilise money to purchase goods of his own choice. Hence, Money solves the problem of double coincidence of wants.

(ii) Unit of value: The value of goods can be easily measured in terms of money. It is a common medium on the basis of which we can calculate the value of each and every good. The value of a good in terms of money is known as the price. In barter system, there was no common denomination for measuring values of goods and hence became a drawback.

(iii) Store of value: This function elaborates the importance of money as value storage. This means that wealth in the form of money can be easily stored as a medium of exchange for future use. For example, money can be stored in banks for meeting emergency and future needs and contingencies.

(iv) Standard of deferred payments: Payments can be easily made through the money as a common medium. In other words, it is very difficult to repay the loan in terms of goods and services. However, with the help of money the payments of loans or interests can be made with ease.

Money overcomes the shortcomings of barter system in the following manner:

(i) Money has resolved the problem of double coincidence of wants. For example, if a person is in need of wheat in exchange of tea, then he/she must look for a person who is ready to trade wheat for tea. Money made the need for such searches redundant.

(ii) In barter system, it was almost impossible to measure the value of one good in terms of another. For example, it is difficult to calculate the value of a horse in terms of rice.

(iii) It was not at all easy to store goods, especially perishable goods (fruits, meat, etc.) for the purpose of value storage. Money has resolved this purpose.

(iv) The contractual or future payments were very difficult to be made in barter system. For example, a worker working on contractual basis could not be paid in terms of rice or chairs.

3. What is transaction demand for money? How is it related to the value of transactions over a specified period of time?

Ans. Transaction demand for money refers to the need of money for meeting day to day transactional needs. As money is a liquid asset (easily acceptable or exchangeable), that’s why everyone has the tendency to hold money. People earn incomes at different points of time but usually consume throughout the entire period. So, people tend to hold the money for transaction purposes.
The relationship between the value of transactions and transaction demand for money can be explained as follows:
The transaction demand for money in an economy $$(M\frac{d}{t})\space\text{can be written as:}\\(M\frac{d}{t})=K.T\\\space or\frac{1}{k}.(M\frac{d}{t})=T\\Or\space v.M\frac{d}{t}=T$$

Where, v =1/k, represents velocity of circulation of money
T = Total value of transactions in the economy over a period of time
k is a positive fraction
MTd = Stock of money people are willing to hold at a particular point of time.
The transaction demand for money is said to be positively related to the total value of transactions and negatively related to the velocity with which money is circulated.

4. What are the alternative definitions of money supply in India?

Ans. The various definitions of money supply in India as prescribed by RBI are M₁, M₂, M₃ and M₄.
M₁, M₂, M₃ and M₄ are arranged in the descending order of liquidity. In other words, in these components of money supply, M₁ is considered to be the most important measure as it is regarded as most liquid assets.
So,
M₁ = C + DD + OD
Where,
C = Currency held by public
DD = Net demand deposits of the bank
OD = Other deposits held by RBI
M₂ = M₁ + Savings of the people with Post offices (M₂ consists of the components of M1 as well as the savings of people with Post office.)
M₃ = M₁ + Net time deposits with commercial banks (M₃ is the most widely used measure of money supply. It includes the components of M₁ and net time deposits of commercial banks.)
M₄ = M₃ + Total deposits with post offices (excluding National Saving certificate)
All these definitions of money supply in India are represented in the flow chart given below.

5. What is a ‘legal tender’? What is ‘fiat money’?

Ans. Legal tender represents the currency notes and coins which are issued by the monetary authorities of India (RBI and Government of India) as a legal medium of payment. These legal tenders cannot be refused by any citizen of the country for settlment of any kind of transaction. Fiat money derives its value only on the basis of government order (fiat). The currency becomes fiat money when the government declares it to be the legal tender. This money is not backed up by any physical commodities, like gold. This money does not have any intrinsic value, i.e. the real value is not equivalent to the face value printed on the notes and coins.

6. What is High Powered Money?

Ans. High powered money refers to the total liability of the monetary authority of a particular country. This is also known as the monetary base and is created by the RBI. High powered money comprises of currency (notes and coins), deposits with the government and reserves of commercial banks with RBI. So
summarising it, high powered money is:
H = C + R
Where
H – High powered money
C – Currency
R – Cash Reserves of commercial banks

7. Explain the functions of a commercial bank.

Ans. Commercial banks perform various functions. Some of them that are mentioned below:

(i) Accepting deposits: The most basic function of commercial banks is to accept the deposits from the customers. These deposits could be of the following types:

(a) Saving Accounts: Saving account serves the needs of those individuals who want to save a part of their income and earn an interest on the amount saved. The Account holder of saving account can deposit cheques, drafts, etc. but, there is a prescribed limit on the number of withdrawals.

(b) Fixed Deposit Accounts: Going by the name itself, fixed deposit accounts imply that deposits are kept for fixed period of time; for example, `500 per month for 6 years. The period is required to be decided in advance, while opening the account. Holders of such accounts do not enjoy the cheque facility. Higher the time period, higher will be the interest rate, which is decided by the RBI.

(c) Current Deposits Accounts: Current deposit accounts are also known as 'Demand Deposits' as it allows the depositor to withdraw money at any time through cheques. Businessmen usually use this account to make numerous transactions in a single day. However, no interest is provided on the deposits. Banks provide account statements to the current account holders at regular intervals.

(ii) Granting loans and advances: Another most important function of the commercial banks is to grant loans and advances. The rate of interest which is charged by the banks on loans granted to the general public is higher than the rate of interest paid by the banks on demand deposits and saving deposits. Loans granted by commercial banks are generally for long term and are given against some securities. Advances are given by a bank only for a shorter period of time.

(iii) Agency functions: The commercial banks also perform various agency functions with the main purpose of acceptance of deposits and granting of loans to the general public. Their functions include:

(a) Transfer of funds: The banks facilitiate easy flow of funds from place to place via mail transfers, demand drafts, etc.

(b) Collection of funds: The banks also collect funds on behalf of its customers through bills, cheques, etc.

(c) Banks also collect insurance premiums, dividends, interest on debentures, etc.

(d) Banks also perform the function of assisting in the process of tax payment by the account holders.

(e) Banks also play the role of trustees or executors.

(iv) Discounting Bills of Exchange: Commercial Banks provide financial help to the business community by discounting of bills of exchange. The banks purchase these bills, produced by customers, by deducting a sum of money as interest, from the face value of the bill. Thus, it provide easy finances to the business community when required.

(v) Credit creation: Commercial Banks are also responsible for creating credit in the economy through demand deposits. Credit creation works as a catalyst in the growth of the economy.

(vi) Other functions:

(a) Provide locker facility

(b) Purchase and sale of foreign exchange

(d) Underwriting of shares and debentures

(e) Providing information and statistical data useful to customers

8. What is money multiplier? What determines the value of this multiplier?

Ans. Money multiplier is the ratio of the stock of money to the stock of high powered money in an economy
$$\text{Symbolicaly , MM}=\frac{M}{H}$$

M indicates stock of money
H indicates high pow
ered money
The value of money multiplier is always greater than 1.
The value of money multiplier can be derived as follows:
We know that M = C + DD = (1 + cdr) DD

Where,
M = Money supply
C = Currency held by people
cdr = Currency deposit ratio
DD = Demand deposits
Let treasury deposits of gov
ernment be D.
We know, High Powered Money = Currency + Reserve money
Or
H = C + R
= cdr D + rdr D
= D (cdr + rdr) (Taking D common)
$$\text{Money multiplier }=\frac{M}{H}$$
So, the ratio of money supply to high powered
$$\text{money}=\frac{M}{H}\text{becomes}$$
$$\frac{M}{H}=\frac{1+cdr}{cdr+rdr}$$
$$\text{But}\space rdr < 1$$
$$\text{SO,}\frac{M}{H}=\frac{1+cdr}{cdr+rdr}>1$$
The currency deposit ratio (cdr) and the reserve deposit ratio (rdr) play a crucial role in determining the money multiplier.
The currency deposit ratio (cdr) is the ratio of the money (currency) held by public to that they hold in bank deposits.
$$\text{That is, cdr =}\frac{C}{DD}$$
The reserve deposit ratio (rdr) is the proportion of the total deposits kept by the commercial banks as reserve.

9. What are the instruments of monetary policy of RBI?

Ans. The monetary policy (credit policy) of RBI involves the two instruments given in the flow chart below:

Quantitative Measures: Quantitative measures refer to such measures which affect the variables, and in turn the overall money supply in the economy is affected. These measures are designed to control of the bank credit.

Instruments of quantitative measures:

(i) Bank rate: The rate at which central bank extends loan to the commercial banks is termed as bank rate. This instrument is like a key at the hands of RBI to control the money supply.
Increase in the bank rate will make the loans to be more expensive for the commercial banks; thereby, creating a pressure on the banks to increase the rate of lending as a result of which, the public capacity to take credit will gradually fall leading to a fall in the volume of credit demanded. The reverse happens in case of a decrease in the bank rate. The increased lending capacity of banks resultant to which, an increased public demand for credit will automatically lead to a rise in the volume of credit.

(ii) Varying Reserve Ratio: The reserve ratio decides the reserve requirements, wherein banks are liable to maintain a certain amount of reserves with the Central Bank.
The three main ratios are:

(a) Cash Reserve Ratio (CRR): It refers to the minimum amount of funds that a commercial bank is supposed to maintain with the Reserve Bank of India, in the form of deposits. For example, suppose the total assets of a bank are worth `500 crores and the minimum cash reserve ratio is 10%. Then the amount that the commercial bank is required to maintain with RBI is `50 crores. If this ratio rises to 20%, then the reserve with RBI increases to `100 crores. Thus, less money will be left with the commercial bank for lending purpose. This will consequently lead to considerable decrease in the money supply. On the contrary, a fall in CRR will lead to an increase in the money supply.

(b) Statuary Liquidity Ratio (SLR): SLR is all about maintaining the minimum reserve of assets with RBI, unlike the cash reserve ratio which is concerned with maintaining a cash balance (reserve) with RBI. So, SLR is defined as the minimum percentage of assets which is required to be maintained in the form of either fixed or liquid assets with RBI. The flow of credit can be reduced by increasing this liquidity ratio and vice-versa. In the previous example, this can be understood as rise in SLR will refrain the banks from injecting money in the economy, thereby contributing towards decrease in money supply. The reverse will be the case if there is a fall in SLR, as it will increases the money supply in the economy.

(iii) Open Market Operations (OMO): Open Market operations are concerned with buying and selling of securities in an open market, to control the money supply in the economy. The selling of securities by RBI will take the extra cash balance out from the economy, thereby limiting the money supply, whereas if the RBI buys securities, then additional money is pumped into the economy stimulating the money supply.

Qualitative Measures: The measures that affect the credit qualitatively are:

(i) Marginal Requirements: The commercial banks' function of granting loans rests upon the value of the security being mortgaged. So, the banks usually keep a margin, which is said to be the difference between the market value of security and the loan value. For example, a commercial bank grants loan of `1,00,000 against a security of `1,20,000. So, the margin is calculated as 1,20,000 – 1,00,000 = 20,000. When the central bank decides to restrict the flow of money, then the margin requirement of loan is raised and vice-versa in the case of expansionary credit policy.

(ii) Selective Credit Control (SCC): Another instrument of the monetary policy that helps in controlling the flow of credit to particular sector positively and negatively is known as Selective Credit Control. The positive aspect is related to the increased flow of credit to the priority sectors. However, the negative aspect is related to the measures to restrict credit to a particular sector.

(iii) Moral Suasions: It is a technique followed by the Central Bank to pressurise the commercial banks to abide by the persuasion monetary policy. This includes meetings, seminars, speeches and discussions, which describe the present economic scenario and thereby persuading the commercial banks to make changes accordingly. In other words, this is an unofficial monetary policy that is exercised through the power of talk.

10. Do you consider a commercial bank ‘creator of money’ in the economy'?

Ans. Commercial banks often play an important role as a 'money creator' in the economy. They have the capacity to generate credit through demand deposits, which makes the credit more than the initial deposits.
The process of money creation is explained here by taking an example of a bank XYZ. A depositor deposits ₹10,000 in his savings account, which will be treated as the demand deposit of the bank. Based on the assumption that not all customers will turn up on the same day to withdraw their deposits, bank usually maintains a minimum cash reserve of 10 % of the total demand deposits, i.e., ₹1000. It lends the remaining amount of ₹9000 in the form of credit to other customers. This further creates deposits for the bank XYZ. With the cash reserve of `1000, the credit creation is worth ₹10,000. So, the credit multiplier is given by:
$$\text{Credit multiplier =}\frac{1}{CRR}=\frac{1}{10}\%=10$$
The money supply in the economy will increase by the amount (times) of credit multiplier.

11. What role of RBI is known as ‘lender of last resort’?

Ans. When a commercial bank faces some financial crisis and eventually fails to obtain funds from other sources, then the central bank comes in the picture and plays the vital role of ‘lender of last resort’ by providing them the financial assistance in the form of credit. This role of the Central Bank finally saves the commercial bank from bankruptcy. Thus, the Central Bank also plays the role of guarantor for the commercial banks by maintaining a sound and healthy banking system in the economy.