We have given these Economics Class 12 Important Questions Macroeconomics Chapter 3 Money and Banking to solve different types of questions in the exam. Go through these Money and Banking Class 12 Important Questions and Answers Solutions & Previous Year Questions to score good marks in the board examination.
Important Questions of Money and Banking Class 12 Macroeconomics Chapter 3
Question 1.
State the two components of M1 measure of money supply. (April re-exam 2018)
Answer:
M1 includes, (any 2)
- currency held by public in form of notes and coins.
- net demand deposit held by commercial banks.
- other deposits held by RBI.
Question 2.
Define money supply. (Delhi 2018,2011(C). 2010)
Answer:
The total stock of money in circulation among the public at a particular point of time is called money supply.
Question 3.
State the components of money supply. (Delhi (C) 2015, 2013, 2010: All India 2013)
Or
What is included in money supply? (Delhi (C) 2012,2011)
Or
Name the two components of money supply. All India 2010
Answer:
The following are included in money supply
- Currency notes held by public.
- Demand deposits of Commercial Banks.
Question 4.
What is barter? (Delhi (C) 2013)
Answer:
Barter is a system of exchange, where goods are exchanged for goods.
Question 5.
Define money. (All India (C) 2012.2011)
Or
Give the meaning of money. (All India 2010)
Answer:
Money is defined as an object that is commonly accepted as a medium of exchange. It is an intermediate good which is acceptable to both the parties i.e. buyers and sellers.
Question 6.
Explain the store of value function of money. (Delhi 2017: All India (C) 2014)
Or
Explain the store of value as function of money. (Foreign 2014)
Answer:
Money is an asset that retains its value over time. People store their wealth in the form of money, without fearing for loss in its value. Money overcomes the problem of storing perishable item under barter system of exchange. With money, people hold liquidity and value in a much more convenient manner.
Question 7.
State the meaning and components of money supply. (Delhi 2017)
Or
Explain the concept of money supply. (Delhi (C) 2013)
Or
Define money supply and explain its components. (Delhi 2014, Foreign 2014)
Answer:
The total stock of money in circulation among the public at a particular point of time is called money supply.
Money supply comprises of the following components:
- Currency (notes and coins) held by the public.
- Net demand deposits and time deposits held by the commercial banks.
- Other deposits held by the Central Bank.
- Total deposits with post office (excluding National Saving Certificates).
Question 8.
Explain ‘difficulty in storing wealth problem faced in barter system of exchange. (All India 2017)
Answer:
In barter system of exchange, goods were exchanged for goods. Due to absence of money in barter system, wealth was stored in terms of goods. Storing of goods carried some problems like cost of storage, loss in value of goods due to passage of time, difficulty to transfer from one place to other, etc. So, it was difficult for people to store their purchasing power under barter system of exchange.
Question 9.
Explain the medium of exchange function of money. (All India 2017,2013)
Or
Explain the significance of medium of exchange function of money. (Delhi 2014)
Answer:
The primary function of money is, acting as a medium of exchange between two parties involved in a transaction. It avoids the practical problems of wastage of time and resources, involved in the barter system of an exchange and it improves the transactional efficiency. It also promotes allocational efficiency in the trade and production of goods and services. Hence, it can be said that money has separated the acts of sales and purchases.
Question 10.
Explain the significance of the unit of account function of money. (All India 2014)
Or
Explain the ‘unit of account’ function of money. (All India (C) 2014, 2013)
Answer:
Money serves as a unit of value or common measure of value in terms of which the value of all goods and services are measured. This helps in measuring the exchange values of commodities. The prices of all the goods and services can be fixed in terms of money and the problem of expressing the value of each commodity in terms of quantities of other goods can be avoided.
This function of money makes it possible to measure the value of different goods and services in a common value and facilitates the keeping of business accounts. It would not be possible to keep business account unless all business transaction are expressed in terms of money.
Question 11.
Explain the significance of standard of deferred payment function of money. (All India 2014, 2012)
Answer:
Money simplifies the mechanism of deferred payments significantly. Deferred payments means future payment. When we take a loan from somebody, we not only pay the principal amount but also the interest amount. Under barter system of exchange, it was very difficult to make such transactions. As money maintains a standard value over a period of time, provided price remains constant, deferred payments can be easily made.
Question 12.
Explain the problem of double coincidence of wants faced under barter system. How has money solved it? (Delhi 2013)
Or
Explain how money has solved the problem of double coincidence of wants. (Delhi (C) 2013)
Answer:
Barter system can only work, when both the persons are ready to exchange each other’s goods i.e. person A should have the good person B wants and vice-versa. But usually this type of double coincidence is rare, especially in modem times.
Money eliminates the problem of double coincidence of wants. In modern times, the buyer and the seller exchange goods for money, due to common measure of value function of money. It facilitates exchanges of goods and services and helps in carrying on trade smoothly.
Question 13.
Explain the ‘medium of exchange function of money. How has it solved the related problem created by barter? (All India 2016)
Answer:
Medium of exchange function of money: Money serves as a unit of value or common measure of value in terms of which the value of all goods and services are measured. This helps in measuring the exchange values of commodities. The prices of all the goods and services can be fixed in terms of money and the problem of expressing the value of each commodity in terms of quantities of other goods can be avoided.
This function of money has solved the problem of ‘double co-incidence of wants’ created by the barter system of exchange. Under the barter system, it was very rare when the owner of some goods or services could find someone who wanted his goods or services and at the same time, he possessed that goods or services that the first person wanted, e.g. a man wanting rice in exchange of wheat had to find a man wanting wheat in exchange of rice.
This made the exchange of goods and services difficult. But the evolution of money has solved this problem. A person can sell his wheat in the market for money and from that money he can purchase rice. So, the ‘medium of exchange’ function of money has solved the problem of ‘double co-incidence of wants’ related with the barter system of exchange.
Question 14.
Explain the ‘standard of deferred payment’ function of money. How has it solved the related problem created by barter? (All India 2016)
Answer:
Money simplifies the mechanism of deferred payments significantly. Deferred payments means future payment. When we take a loan from somebody, we not only pay the principal amount but also the interest amount. Under barter system of exchange, it was very difficult to make such transactions. As money maintains a standard value over a period of time, provided price remains constant, deferred payments can be easily made.
The related problem created by the barter system of exchange was ‘lack of standard of deferred payments’. In barter system, it was difficult to return value in future in terms of goods of same quantity and quality. Therefore, future payments regarding interest and loans became difficult. But money has solved this problem. Loans can be re-paid back in money and interest payments can also be made in money.
Question 15.
Explain the ‘store of value’ function of money. How has it solved the related problem created by barter? (Delhi 2016)
Answer:
Money is an asset that retains its value over time. People store their wealth in the form of money, without fearing for loss in its value. Money overcomes the problem of storing perishable item under barter system of exchange. With money, people hold liquidity and value in a much more convenient manner.
The related problem of barter which this function of money has solved is the problem of ‘lack of store of value’. Due to absence of money in barter system, wealth was stored in terms of goods. Storing of goods carried sortie problems like cost of storage, loss of value, difficult to transfer from one place to other etc. So, it was difficult for people to store their purchasing power, under the barter system of exchange. But this problem was solved with the emergence of money as a medium of exchange.
Question 16.
Explain the ‘unit of account’ function of money. How has it solved the related problem created by barter? Delhi 2016
Answer:
Money serves as a unit of value or common measure of value in terms of which the value of all goods and services are measured. This helps in measuring the exchange values of commodities. The prices of all the goods and services can be fixed in terms of money and the problem of expressing the value of each commodity in terms of quantities of other goods can be avoided.
The related problem of barter which this function of money has solved is the problem of Tack of common measure of value’.In barter system, there was absence of a common unit of measurement in which the value of goods and services can be measured. In the absence of common unit, proper valuation was not possible.
e.g. cloth is measured in metre (i.e. length) while milk is measured in litre (i.e. capacity), hence both cannot be measured in a single unit, thereby complicating the process of exchange. But the evolution of money has solved this problem, and now every good or service can be measured in terms of money.
Question 17.
How does money overcome the problems of barter system? Explain briefly. (All India 2011)
Answer:
Money overcomes the problem of barter system by replacing the C-C economy with monetary economy, as is explained below.
- In barter system, there was a problem of double coincidence of wants. It was very difficult to match the expectations of two different individuals. Thus, money was evolved to overcome the problem of coincidence of wants, as it was very difficult to find two persons having goods needed by each other in the barter system of exchange.
- When there was no money, it was difficult to give common unit of value to measure goods or services but when money evolved it gave a common unit of account to every goods and services.
- Money facilitates the contractual and future payments i.e. deferred payments which, were very difficult to pay under the barter system.
- Money is also a legal tender which has a general acceptance which was not the case under the barter system.
Question 18.
Define ‘money multiplier’. (All India 2019)
Answer:
Money multiplier refer to the fraction by which money get multiplied in the process by the commerical banks.
Question 19.
Define demand deposits. (All India 2019, 2015 (C). 2014, 2012, 2011, 2010; Delhi 2014, 2013, 2012)
Answer:
Demand deposits are current and savings account deposits with banks or other financial institutions, which are payable on demand.
Question 20.
State the role played by the Central Bank as the “lender of last resort”. (All India 2019)
Answer:
Central Bank functions as a lender of last resort which means, when commercial banks fails to get credit from any other source, Central Bank help commercial banks by lending money.
Question 21.
What is reverse repo rate? (All India (C) 2016)
Answer:
It is the rate at which the Central Bank accepts deposits of commercial banks.
Question 22.
Give the meaning of cash reserve ratio. (Delhi (C) 2016)
Or
What is meant by cash reserve ratio? (All India (C) 2015; All India (C) 2014)
Or
Define cash reserve ratio. (Delhi 2011)
Answer:
The percentage of total deposits, which a Commercial Bank needs to keep as reserve with the Central Bank, is termed as Cash Reserve Ratio.
Question 23.
What are time deposits? (All India 2014, All India (C) 2013,2012; Delhi (C) 2014, 2010)
Or
What are time deposits in banks? (All India (C) 2013)
Answer:
Time deposits are fixed term and recurring deposits having a fixed period of maturity, where the term of deposit may vary. Cheques cannot be issued against them and they are not payable on demand but these deposits yield interests for the depositor.
Question 24.
What is a Central Bank? (Foreign 2014)
Answer:
The Central Bank is an apex banking institution which controls the entire banking system and money supply of a country. Reserve Bank of India is the Central Bank of India.
Question 25.
What is statutory liquidity ratio? (All India (C) 2014)
Or
Define statutory liquidity ratio. (All India 2011)
Answer:
Commercial Bank is required to maintain a fixed percentage of its assets in the form of cash or other liquid assets. This is termed as Statutory Liquidity Ratio.
Question 26.
What is meant by bank rate? (All India (C) 2014)
Or
What is bank rate? (Delhi (C) 2012)
Answer:
The rate at which Commercial Banks can borrow funds from Central Bank without any collateral security.
Question 27.
Explain the bankers’ bank function of the Central Bank. All India 2017
Or
Explain the role of Central Bank as banker’s bank. (All India (C) 2014)
Or
Explain the banker’s bank function of Central Bank. (Foreign 2016: All India 2015,2014: Delhi (C) 2013, Delhi 2012, All India (C) 2013)
Answer:
Central Bank keeps the cash balances of Commercial Banks and issues loans to them on requirements in the same manner as the Commercial Bank does for its customers. A Central Bank has almost the same relation with the other Commercial Banks of the country that the Commercial Banks have with the common public. That is why the Central Bank is also called as banker’s bank.
Question 28.
Explain the process of credit creation by commercial banks. (All India 2017)
Or
Explain the process of money creation by bank. (Delhi 2010)
Or
Explain the process of money creation by Commercial Banks with the help of a numerical example. (Delhi 2011; All India (C) 2010,2010)
Answer:
Commercial banks create credit out of their total deposits which are many more times greater than their initial level of deposits. Money created by commercial banks can be ascertrained by using the given formula
Money Creation = Initial Deposits × \(\frac { 1 }{ LRR }\)
For example, let the LRR be 20% and Initial deposits = Rs 10,000
As required, the banks keep 20%, i.e. Rs 2,000 as cash and lend the remaining amount of Rs 8,000. Further, it is also assumed that, persons receiving the debt will deposit the amount in the bank. This will result in banks receiving fresh deposits of Rs 8,000. The banks again keep ? 1,600 as cash and lend Rs 6,400, which is also 80% of the last deposit, this money also comes back to the banks leading to a fresh deposit of Rs 6,400. In this way, the money goes on multiplying and ultimately, total money creation according to the formula, will be
Money Creation = 10,000 × \(\frac { 1 }{ 20% }\)
= Rs 50,000
Question 29.
Explain the currency authority function of Central Bank. (Foreign 2014)
Or
Explain the ‘bank of issue’ function of the Central Bank. (All India 2016; Delhi 2016)
Answer:
Central Bank of the country has the sole authority of currency issue in the country, which gives it a monopoly in issuing currency. As in India RBI issues the currency, while currency notes are printed by the subsidiaries of RBI and coins are minted by the Central Government of the country. However both currency notes and coins are circulated by RBI, which gives RBI the power to control, supervise and enhance the money supply in the economy.
Question 30.
Explain lender of the last resort function of the Central Bank. (Delhi 2014,2010: All India 2013, 2010)
Or
Explain the role of Reserve Bank of India as lender of last resort. (March 2018: Delhi 2014; All India 2012)
Answer:
When a Commercial Bank fails to accommodate its financial requirements then it can approach the Central Bank and the Central Bank acts as the lender of last resort. The Central Bank issues loans to a Commercial Bank against specified and approved securities of the bank. In this way, the Central Bank ensures the smooth functioning of Commercial Banks and appropriate flow of credit in the economy.
Question 31.
Explain the role of Central Bank as a ‘Banker to the government’. (Delhi (C) 2014)
Or
Explain the banker to the government function of the Central Bank. (Delhi 2013,2010: All India 2010)
Or
Explain ‘banker to the government’ function of the Central Bank. (Delhi 2017)
Answer:
Central Bank acts as a banker, advisor and agent to the Central and State Governments. As the common public keep their cash balance, demand deposits and time deposits with Commercial Banks, in the same way the Central Bank manages the cash reserves and demand deposits of governments in current accounts. It carries out the exchange, remittance and other banking operations on behalf of the government, i.e. the Central Bank maintains same relation with the government as Commerical Banks has with the general public.
Question 32.
Explain the meaning of cash reserve ratio and statutory liquidity ratio. (All India 2010)
Answer:
Cash reserve ratio: The percentage of total deposits, which a Commercial Bank needs to keep as reserve with the Central Bank, is termed as Cash Reserve Ratio.
Statutory liquidity ratio: Commercial Bank is required to maintain a fixed percentage of its assets in the form of cash or other liquid assets. This is termed as Statutory Liquidity Ratio.
Question 33.
Distinguish between ‘Qualitative and Quantitative tools’ of credit control as may be used by a Central Bank. (All India 2019)
Answer:
Central Bank uses different instrument to control money supply. These tools can be broadly classified as
(i) Quantitative tools These are those which directly impacts the quantity of money supply in the economy. These tools are very effective to either increase or decrease money supply. These tools includes
- Bank rate
- Legal reserve ratio
- Open market operations
- Repo and reverse repo rate
(ii) Qualitative tools These on the other hand, are those which impacts the quality of money supply not volume. These are not much effective tool to control money supply. It includes
- Margin requirement
- Moral suasion
- Selective credit control.
Question 34.
Discuss briefly the following functions of a Central Bank. (All India 2019)
(i) Banker’s bank
(ii) Lender of last resort
Answer:
(i) Central Bank keeps the cash balances of Commercial Banks and issues loans to them on requirements in the same manner as the Commercial Bank does for its customers. A Central Bank has almost the same relation with the other Commercial Banks of the country that the Commercial Banks have with the common public. That is why the Central Bank is also called as banker’s bank.
(ii) When a Commercial Bank fails to accommodate its financial requirements then it can approach the Central Bank and the Central Bank acts as the lender of last resort. The Central Bank issues loans to a Commercial Bank against specified and approved securities of the bank. In this way, the Central Bank ensures the smooth functioning of Commercial Banks and appropriate flow of credit in the economy.
Question 35.
Discuss briefly the ‘credit controller’ function of a Central Bank. (All India 2019)
Answer:
By credit control, it is meant that flow of credit can be regulated in such a way that it may rise or fall according to the needs of the economy. This is done by the Central Bank by using two types of tools which are stated below
(i) Quantitative tools These are those which directly impacts the quantity of money supply in the economy. These tools are very effective to either increase or decrease money supply. These tools includes
- Bank rate
- Legal reserve ratio
- Open market operations
- Repo and reverse repo rate
(ii) Qualitative tools These on the other hand, are those which impacts the quality of money supply not volume. These are not much effective tool to control money supply. It includes
- Margin requirement
- Moral suasion
- Selective credit control.
Question 36.
Explain, using a numerical example, how a reduction in reserve deposit ratio, affects the credit creation power of the banking svstem. (All India 2019)
Answer:
An increase in bank lending due to decrease in legal reserves should translate to an expansion of a country’s money supply. The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is the money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.
To calculate this, start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20% for every Rs 100, a customer deposits into a bank (from say earlier 25%), Rs 20 must be kept in reserve out of each Rs 100 deposited. However, the remaining Rs 80 can be loaned out to other bank customers. This Rs 80 is then deposited by the customers into another bank account, which in turn must also keep 20% or Rs 16 in reserve, but can lend out the remaining Rs 64.
This cycle continues as more people deposit money and more banks continue lending it until finally the Rs 100 initially deposited creates a total of Rs 500 (Rs 100/0.2) in deposits. As money multiplier is inversely associated with legal reserves ratio, i.e. money multiplier = \(\frac { 1 }{ LRR }\) and money created = Initial Bank Deposits × Money Multiplier.
So, if LRR is 25%, banks will create 4 time more money while if LRR falls to 20%, banks will create 5 times more money and so on.
Question 37.
Discuss briefly the credit creation process of the banking system using a hypothetical numerical example. (All India 2019)
Or
Explain the credit creation role of Commercial Banks with the help of a numerical example. (All India (C) 2014,2013: Delhi (C) 2014)
Or
How do Commercial Banks create deposits? Explain. Delhi 2013
Or
How does a Commercial Bank create money? All India 2010
Answer:
Commercial banks create credit out of their total deposits which are many more times greater than their initial level of deposits. Money created by commercial banks can be ascertrained by using the given formula
Money Creation = Initial Deposits × \(\frac { 1 }{ LRR }\)
For example, let the LRR be 20% and Initial deposits = Rs 10,000
As required, the banks keep 20%, i.e. Rs 2,000 as cash and lend the remaining amount of Rs 8,000. Further, it is also assumed that, persons receiving the debt will deposit the amount in the bank. This will result in banks receiving fresh deposits of Rs 8,000. The banks again keep ? 1,600 as cash and lend Rs 6,400, which is also 80% of the last deposit, this money also comes back to the banks leading to a fresh deposit of Rs 6,400. In this way, the money goes on multiplying and ultimately, total money creation according to the formula, will be
Money Creation = 10,000 × \(\frac { 1 }{ 20% }\)
= Rs 50,000
Question 38.
Explain, using a numerical example, how an increase in reserve deposit ratio affects the credit creation power of the banking system. (All India 2019)
Answer:
Reverse deposit ratio is the rate of interest at which commercial banks can park their surplus funds with the Central Banks for a short period of time. Increase in reverse deposit rate will reduce the credit supply and vice-versa. The following numerical example will make this clear Suppose the reverse deposit ratio is 3%. At this rate, commercial banks are willing to deposit Rs 10 crore with the Central Bank out of total deposits of Rs 50 crore. Assuming legal reserve ratio to be 10%, then
Money creation = 40 × \(\frac { 1 }{ 0.1 }\) = Rs 400 crore
Now, reverse deposit ratio rises to 5% and at this rate commercial banks are willing to deposit Rs 20 crore with the Central Bank out of total deposits of Rs 50 crore. Now, money creation = 30 × \(\frac { 1 }{ 0.1 }\) = Rs 300 crore.
So, we see that as reverse deposit ratio rises, then credit creation falls.
Question 39.
Explain the role of reverse repo rate in controlling money supply. (Delhi 2017)
Answer:
Reverse repo is the rate of interest at which commercial banks can deposit their surplus funds with the Central Bank for a short period of time.
It is an important quantitative tool for controlling money supply in the economy. If the Central Bank wants to increase money supply in the economy, then it reduces the reverse repo rate. With fall in reverse repo rate, the commercial banks reduce the deposits of surplus funds with the Central Bank, thereby increasing the money supply. On the other hand, if the Central Bank wants to decrease money supply, then it increases the reverse repo rate. With rise in reverse repo rate, the commercial banks increase the deposits of surplus funds with the Central Bank, thereby decreasing the money supply.
Thus, reverse repo rate plays an important role in controlling money supply.
Question 40.
Explain how repo rate can be helpful in controlling credit creation? (All India 2016)
Answer:
Repo rate is the rate at which Reserve Bank of India (RBI) lends funds to commercial banks for a period ranging from 1 day to 14 days. It is quite an effective quantitative tool in controlling credit creation. If the RBI wants to decrease the level of credit creation in the country, then it increases the Repo Rate which makes the credit dearer. As the cost of borrowings increase, the people’s demand for credit goes down. This also leads to a fall in liquidity. All this leads to fall in the rate of credit creation.
On the other hand, if the RBI wants to increase the level of credit creation in the economy then it decreases the repo rate which makes the credit cheaper. As the cost of borrowings fall, people’s demand for credit goes up. This leads to increase in the rate of credit creation.
Question 41.
Explain the role of cash reserve ratio in controlling credit creation. (All India 2016)
Answer:
Cash Reserve Ratio (CRR) is the fraction of total deposits that each commercial bank must keep with the Central Bank of the country, as a part of fractional reserve system.
CRR is an important quantitative tool in controlling the credit creation in the country. When the Central Bank wants to decrease the level of credit creation in the economy, it increases the CRR. As the CRR increases, the loanable deposits left with the commercial bank decreases. This reduces the lending powers of the bank and as a result, the process of credit creation falls.
If on the other hand, the Central Bank wants to increase the level of credit creation in the country, it lowers the CRR. As the CRR decreases, the loanable deposits left with the commercial banks increases. This increases the lending powers of the banks and as a result, the level of credit creation in the country rises.
Question 42.
Explain how ‘margin requirements’ are helpful in controlling credit creation? (Delhi 2016)
Answer:
‘Margin requirements’ refer to the difference between the amount of loan granted and the current value of security offered for loans. It is an important qualitative instrument for controlling credit creation. If the Central Bank of the country wants to expand the process of credit creation, then it lowers the margin requirements. Lowering of margin requirements enables the borrower to borrow more against the security offered. This increases the money supply in the economy and credit creation expands.
On the other hand, if the Central Bank wants to contract the process of credit creation, then it increases the margin requirements. Increasing margin requirements ensures that the borrower is able to borrow less against the security offered. This reduces the money supply in the economy and consequently credit creation contracts.
Question 43.
Explain how bank rate is helpful in contrplling credit creation? (Delhi 2016)
Or
How does the Central Bank control credit creation in the economy through bank rate? Explain. (All India (C) 2014)
Or
How do changes in bank rate affect money creation by Commercial Banks? (Delhi 2010)
Or
How do changes in bank rate affect the money supply in an economy? Explain. (Delhi (C) 2015)
Answer:
The rate at which Commercial Banks can borrow money from RBI, when they run short of reserves, is called bank rate.
When the Central Bank increase the bank rate, it increases the cost of borrowing and hence, discourages the borrowers from taking a loan.
Due to this, the process of credit creation and flow of money also reduces. On the other hand, when the Centred Bank decreases the bank rate, it encourages the borrower to take more and more loan. A high demand of loan increases the credit multiplier and credit creation process of the Commercial Banks.
Question 44.
Explain how open market operations are helpful in controlling credit creation? (Delhi 2016)
Or
How does Central Bank control credit creation by Commercial Banks through open market operations? Explain. (All India 2013)
Or
Explain, how do open market operations by the Central Bank affect money creation by Commercial Banks? (All India 2010)
Or
Explain the meaning of open market operations. How is it used to reduce money supply in the economy? (All India (C) 2016)
Answer:
Under open market operations, RBI purchases or sells government securities to general public for the purpose of increasing or decreasing the stock of money in an economy. The purchase or sale of securities controls the money in the hands of public as they deposit or withdraw the money from Commercial Banks. Thus, money creation by Commercial Banks get affected.
Suppose, the Central Bank purchases securities of Rs 1,000 from a bond holder with issuing a cheque. The seller of the bond produces this cheque of Rs 1,000 to his Commercial Bank. The Commercial Bank credits the account of the seller by Rs 1,000 and the deposits of the bank goes up by Rs 1,000, which increase the credit creation capacity of the banks.
Thus, purchase of security increases the money creation of Commercial Banks and similarly, sale of securities decreases the credit creation of Commercial Banks. Thus, the Central Bank controls the process of money creation by Commercial Banks by open market operations.
Question 45.
What is Legal Reserve Ratio? Explain its components. (All India (C) 2013)
Or
Explain the components of Legal Reserve Ratio. (Delhi 2012)
Answer:
The minimum percentage of a bank’s total demand and time deposits, that is required to be maintained in the form of cash or specified liquid assets by the Commercial Banks with the Central Bank is termed as Legal Reserve Ratio.
The components of Legal Reserve Ratio are as follows
- Cash reserve ratio: The percentage of total deposits, which a Commercial Bank needs to keep as reserve with the Central Bank, is termed as Cash Reserve Ratio.
- Statutory liquidity ratio: Commercial Bank is required to maintain a fixed percentage of its assets in the form of cash or other liquid assets. This is termed as Statutory Liquidity Ratio.
Question 46.
Explain any two methods of credit control used by Central Bank. (All India 2013)
Answer:
The Central Bank acts as a controller of money supply and credit, using the following methods
(i) Margin requirement It is a qualitative method of credit control. A margin refers to the difference between market value of the security offered for loan and the amount loan offered by the Commercial Banks. During inflation, supply of credit is reduced by raising the requirement of margin. During deflation supply of credit is increased by lowering the requirement of ‘margin’. This measure is often used to discourage the flow of credit into speculative business activities.
(ii) Under open market operations, RBI purchases or sells government securities to general public for the purpose of increasing or decreasing the stock of money in an economy. The purchase or sale of securities controls the money in the hands of public as they deposit or withdraw the money from Commercial Banks. Thus, money creation by Commercial Banks get affected.
Question 47.
(a) State any two components of M1 measure of money supply.
(b) Elaborate any two instruments of credit control, as exercised by the Reserve Bank of India. Delhi 2019
Answer:
(a) Components of Money Supply:
The total stock of money in circulation among the public at a particular point of time is called money supply.
Money supply comprises of the following components:
- Currency (notes and coins) held by the public.
- Net demand deposits and time deposits held by the commercial banks.
- Other deposits held by the Central Bank.
- Total deposits with post office (excluding National Saving Certificates).
(b) Two instrument of credit control are as follows
(i) Repo rate: Repo rate is the rate at which Reserve Bank of India (RBI) lends funds to commercial banks for a period ranging from 1 day to 14 days. It is quite an effective quantitative tool in controlling credit creation. If the RBI wants to decrease the level of credit creation in the country, then it increases the Repo Rate which makes the credit dearer. As the cost of borrowings increase, the people’s demand for credit goes down. This also leads to a fall in liquidity. All this leads to fall in the rate of credit creation.
On the other hand, if the RBI wants to increase the level of credit creation in the economy then it decreases the repo rate which makes the credit cheaper. As the cost of borrowings fall, people’s demand for credit goes up. This leads to increase in the rate of credit creation.
(ii) Cash reserve ratio: The percentage of total deposits, which a Commercial Bank needs to keep as reserve with the Central Bank, is termed as Cash Reserve Ratio.
Question 48.
Define credit multiplier. What role does it play in determining the credit creation power of the banking system? Use a numerical illustration to explain. (Delhi 2019)
Answer:
Credit or money multiplier refers to the fraction by which commercial banks would be able to multiply money from their initial level of deposits. It is obtained by the following formula Credit/Money
Multiplier = \(\frac { 1 }{ Legal Reserve Rato (LRR) }\)
Commercial banks create credit out of their total deposits which are many more times greater than their initial level of deposits. Money created by commercial banks can be ascertrained by using the given formula
Money Creation = Initial Deposits × \(\frac { 1 }{ LRR }\)
For example, let the LRR be 20% and Initial deposits = Rs 10,000
As required, the banks keep 20%, i.e. Rs 2,000 as cash and lend the remaining amount of Rs 8,000. Further, it is also assumed that, persons receiving the debt will deposit the amount in the bank. This will result in banks receiving fresh deposits of Rs 8,000. The banks again keep ? 1,600 as cash and lend Rs 6,400, which is also 80% of the last deposit, this money also comes back to the banks leading to a fresh deposit of Rs 6,400. In this way, the money goes on multiplying and ultimately, total money creation according to the formula, will be
Money Creation = 10,000 × \(\frac { 1 }{ 20% }\)
= Rs 50,000
Question 49.
Describe any two methods by which Reserve Bank of India can regulate money supply. (Delhi (C) 2016)
Answer:
(i) Reverse repo rate: It is the rate at which the Central Bank accepts deposits of commercial banks.
(ii) Repo rate: Repo rate is the rate at which Reserve Bank of India (RBI) lends funds to commercial banks for a period ranging from 1 day to 14 days. It is quite an effective quantitative tool in controlling credit creation. If the RBI wants to decrease the level of credit creation in the country, then it increases the Repo Rate which makes the credit dearer. As the cost of borrowings increase, the people’s demand for credit goes down. This also leads to a fall in liquidity. All this leads to fall in the rate of credit creation.
On the other hand, if the RBI wants to increase the level of credit creation in the economy then it decreases the repo rate which makes the credit cheaper. As the cost of borrowings fall, people’s demand for credit goes up. This leads to increase in the rate of credit creation.
Question 50.
Describe any two functions of Central Bank. (Delhi (C) 2016)
Or
Explain any two main functions of a Central Bank. (All India (C) 2015: Delhi (C) 2015, Delhi (C) 2012)
Or
Explain any two functions of Central Bank. (All India (C) 2012)
Or
Explain the following functions of the Central Bank. (All India 2011)
(i) Bank of issue
(ii) Banker’s bank
Answer:
(i) Central Bank of the country has the sole authority of currency issue in the country, which gives it a monopoly in issuing currency. As in India RBI issues the currency, while currency notes are printed by the subsidiaries of RBI and coins are minted by the Central Government of the country. However both currency notes and coins are circulated by RBI, which gives RBI the power to control, supervise and enhance the money supply in the economy.
(ii) Central Bank keeps the cash balances of Commercial Banks and issues loans to them on requirements in the same manner as the Commercial Bank does for its customers. A Central Bank has almost the same relation with the other Commercial Banks of the country that the Commercial Banks have with the common public. That is why the Central Bank is also called as banker’s bank.
Multiple Choice Questions
Question 1.
Money supply includes (Choose the correct alternative) (All India (C) 2016)
(a) all deposits in banks
(b) only demand deposits in banks
(c) only time deposits in banks
(d) currency with the banks
Answer:
(b) Only demand deposits in banks
Question 2.
Who regulates money supply? (Choose the correct alternative) (All India (C) 2016)
(a) Government of India
(b) Reserve Bank of India
(c) Commercial Banks
(d) Planning Commission
Answer:
(b) Reserve Bank of India
Question 3.
Which of the following is not a function of money? (Delhi (C) 2015) (Choose the correct alternative)
(a) Medium of exchange
(b) Price stability
(c) Store of value
(d) Unit of account
Answer:
(b) Price stability
Question 4.
Which of the following is not a problem of barter system of exchange? (Delhi (C) 2015)
(a) Store of value
(b) Double coincidence of wants
(c) Unit of account
(d) Unemployment
Answer:
(d) Unemployment
Question 5.
In order to encourage investment in the economy, the Central Bank may (Choose the correct alternative) (All India 2019)
(a) Reduce Cash Reserve Ratio
(b) Increase Cash Reserve Ratio
(c) Sell Government securities in open market
(d) Increase Bank Rate
Answer:
(a) Reduce Cash Reserve Ratio
Question 6.
Credit creation by commercial banks is determined by (April re-exam 2018) (Choose the correct alternative)
(a) Cash Reserve Ratio (CRR)
(b) Statutory Liquidity Ratio (SLR)
(c) Initial deposits
(d) All of the above
Answer:
(d) All of the above
Question 7.
The Central Bank can increase availability of credit by (Choose the correct alternative) (March 2018)
(a) Raising repo rate
(b) Raising reverse repo rate
(c) Buying government securities
(d) Selling government securities
Answer:
(c) Buying government securities
Question 8.
The ratio of total deposits that a commercial bank has to keep with Reserve Bank of India is called (Choose the correct alternative) (Delhi 2017)
(a) Statutory liquidity ratio
(b) Deposit ratio
(c) Cash reserve ratio
(d) Legal reserve ratio
Answer:
(c) Cash reserve ratio
Question 9.
Demand deposits include (Choose the correct alternative). (All India 2017)
(a) saving account deposits and fixed deposits
(b) saving account deposits and current account deposits
(c) current account deposits and fixed deposits
(d) All types of deposits
Answer:
(b) Saving account deposits and current account deposits
Question 10.
The definition of money includes
(a) currency and foreign exchanges
(b) currency demand deposit and other financial assets
(c) only currency and coins
(d) currency and demand deposits
Answer:
(b) currency demand deposit and other financial assets
Question 11.
Which of the following is an example of plastic money?
(a) Prepaid gift card
(b) Traveller’s cheque
(c) Currency note
(d) Demand draft
Answer:
(a) Prepaid gift card
Question 12.
Supply of money is concept.
(a) stock
(b) flow
(c) income
(d) All of these
Answer:
(a) stock
Question 13.
measures of money supply issued by RBI are known as broad money.
(a) M1 and M1
(b) M2 and M3
(c) M3 and M4
(d) High powered money
Answer:
(c) M3 and M4
Question 14.
The difference between lending rates and borrowing rates of a commercial bank, is called
(a) capital
(b) reserves
(c) profits
(d) All of the above
Answer:
(c) profits
Question 15.
LRR (Legal Reserve Ratio) includes
(a) CRR (Cash Reserve Ratio)
(b) Repo
(c) SLR (Statutory Liquidity Ratio)
(d) Both (a) and (c)
Answer:
(d) Both (a) and (c)
Question 16.
The process of credit/money creation in an economy is affected by
(a) initial deposits amount
(b) LRR
(c) bank rate
(d) Both (a) and (b)
Answer:
(d) Both (a) and (b)
Question 17.
If LRR is 20% and initial deposit is Rs 10,000 in a commercial bank, find total money creation amount.
(a) Rs 5,000
(b) Rs 5,00,000
(c) Rs 50,000
(d) Rs 2,000
Answer:
(c) Rs 50,000
Question 18.
Which is not a feature of fixed deposit accounts?
(a) Specific period of time
(b) Higher interest rate
(c) Payable on demand
(d) Tax benefit
Answer:
(c) Payable on demand
Question 19.
Central Bank is a banker to
(a) State Government
(b) Other banks
(c) Central Government
(d) All of the above
Answer:
(d) All of the above
Question 20.
Commercial banks maintain for liquidity and to honour the demand of cash withdrawals by their customers.
(a) SLR
(b) margin requirements
(c) CRR
(d) repo
Answer:
(a) SLR
Question 21.
What can RBI do, if it wants to increase credit in the economy?
(a) Decrease repo and CRR
(b) Increase repo and CRR
(c) Increase repo and decrease CRR
(d) Decrease repo and increase CRR
Answer:
(a) Decrease repo and CRR
Question 22.
Functions performed by Central Bank related to government does not include which of the following?
(a) RBI manages public debt
(b) RBI also sells treasury bills
(c) RBI make advances which are repayable within 90 days
(d) RBI comes to rescue the other banks in times of financial crises
Answer:
(d) RBI comes to rescue the other banks in times of financial crises