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Class 12 Economics Chapter 3 Money And Banking
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Money And Banking
|PART – (A) INTRODUCTORY MACROECONOMICS|
(A) Very Short Types Question & Answers:
1. What is barter system?
Ans: Barter system of exchange refers to the system where goods are exchange for goods.
2. What is cash reserve ratio?
Ans: Cash reserve ratio refers to the minimum percentage of time and demand deposits, required to be kept by commercial banks with the central bank.
3. In the equation of transaction demand for money MdT = K.T what does the T at the right hand side stand for?
Ans: T = Transaction.
4. What us borrowing rate of a commercial bank?
Ans: It is the rate of interest at which commercial banks accepts deposits.
5. What is velocity of circulation of money?
Ans: The number of times the rupees has been circulated is known as velocity of circulation.
6. Define high-powered money.
Ans: The currency created by the central bank is known as high powered money. It includes currency held by public and cash reserves with banks.
7. A person earns ₹ 700 per month. Calculate his average cash holding.
Ans: Average Cash Holding = 700 ÷ 2 = 350
8. What is a person’s average transaction demand for money?
Ans: It is his half of his monthly transaction.
9. Write true or false:
The transaction demand for money is positively related to the real income of an economy and also to its average price level.
10. At liquidity trap, what is the elasticity of speculative demand for money?
11. “The speculative demand for money is — (directly, inversely) related to the market rate of interest.” — Fill in the blank by choosing the correct word.
12. In a modern economy, people hold money broadly for two motives. One is transaction motive, what is the other?
Ans: Speculative motive.
13. Name the monetary authority that issues currency notes in India.
Ans: Reserve Bank of India (RBI).
14. Why is reserve keeping with the RBI costly for commercial banks?
Ans: In reduces the borrowing capacity of the Commercial Banks.
15. Why is necessary for the RBI to keep reserve from commercial banks?
Ans: For credit Creation.
16. What is statutory liquidity ratio?
Ans: Statutory liquidity ratio refers to the minimum percentage of time and demand deposits, required to be kept by commercial banks with themselves.
17. How is the credit worthiness of a person judged by commercial banks?
Ans: By investigating current assets of the person concerned.
18. What is Money?
Ans: Money is defined as anything that is widely accepted for the exchange of goods and services.
19. Write true or false: Money is convenient unit of account.
20. What is deterioration of money?
Ans: Money deterioration means deterioration in the value of money comparing with other currencies.
21. What is liquid money?
Ans: Liquid money means money can be converted into other assets. We can spend money to buy anything we require. So it can be said that money is most liquid of other assets.
22. What is demonetization?
Ans: Demonetization is the act of stripping a currency unit of its status as legal tender by the government, typically replacing it with a new currency or withdrawing it from circulation altogether.
23. Explain the concept of deficit financing.
Ans: The process of creation of new money i.e., currency, coins or money is known as deficit financing. The central bank of a country issues new currency under the system of deficit financing and give it to the government.
24. What are some examples of significant demonetization efforts?
Ans: Notable examples of demonetization include India’s demonetization in 2016, when the government invalidated high-value currency notes, and Zimbabwe’s demonetization in 2019, where the country phased out its local currency and adopted foreign currencies.
25. What factors can influence the changes in money supply?
Ans: Several factors can influence changes in money supply, including central bank actions (such as open market operations and changes in reserve requirements), commercial bank lending practices, public demand for money, government fiscal policies, and external factors such as international capital flows.
26. What is flat money? Can coins be termed as flat money?
Ans: Fat money is any money that is under the fat or order from the government to act as money.
Yes coins can be termed as flat money.
27. What is currency deposit ratio? Why does it increase during the festive reason?
Ans: It is the amount of money kept by public in cash and demand deposits with the commercial banks.
During festive seasons public wants their money in liquid forms, it increases during such seasons.
28. Explain the reserve deposit ratio.
Ans: The amount of money that the commercial bank deposited in cash as well as also invest in different schemes is known as reserve deposit ratio. For example: Cash Reserve Ratio (CRR) Statutory Liquidity Ratio (SLR) etc.
29. What is M₁ money supply?
Ans: M₁ money supply refers to the narrowest measure of money supply that includes the most liquid forms of money. It includes physical currency (coins and notes) held by the public, demand deposits (checking accounts), and other checkable deposits.
30. What is M2 money supply?
Ans: M2 money supply is a broader measure of money supply that includes all components of M₁ plus certain less liquid forms of money. In addition to the components of M₁, M2 includes savings deposits, time deposits (such as fixed deposits), and money market mutual funds.
31. What is M3 money supply?
Ans: Mn money supply is an even broader measure of money supply that includes all components of M2 plus certain additional categories. It includes large time deposits, institutional money market funds, and other less liquid forms of money held by institutional investors.
32. How does an increase in money supply impact the economy?
Ans: An increase in money supply can stimulate economic activity by providing more funds for lending and investment. It can lead to lower interest rates, increased consumer spending, and investment in businesses. However, if the increase in money supply is excessive, it can also contribute to inflationary pressures in the economy.
33. What is a central bank?
Ans: A central bank is a financial institution that is responsible for overseeing and managing a country’s monetary system, controlling the money supply, and regulating the banking industry. It acts as the banker to the government and plays a vital role in ensuring the stability and smooth functioning of the economy.
34. What is the lender of last resort function of a central bank?
Ans: The lender of last resort function means that the central bank provides emergency liquidity assistance to banks and financial institutions facing financial difficulties. In times of crisis or liquidity shortages, the central bank acts as a lender to ensure the stability of the financial system and prevent systemic risks.
35. How does a central bank issue currency?
Ans: A central bank has the authority to issue and manage the currency of a country. It determines the amount of currency to be circulated and ensures an adequate supply of cash to meet the demands of the public and the banking system. The central bank also plays a role in designing and maintaining the security features of currency to prevent counterfeiting.
36. What are the limits to credit creation by commercial banks?
Ans: The limits to credit creation by commercial banks include statutory reserve requirements, capital adequacy ratios, liquidity constraints, borrower creditworthiness assessments, and market demand for credit.
37. What is a commercial bank?
Ans: A commercial bank is a financial institution that provides a range of banking services to individuals, businesses, and organisations. It accepts deposits from customers and offers various types of loans, credit facilities, and other financial services.
38. What are the investment and wealth management services provided by commercial banks?
Ans: Commercial banks offer investment and wealth management services to customers, including investment advisory, portfolio management, mutual funds, insurance products, and retirement planning. They assist individuals and businesses in managing and growing their wealth.
39. What is the statutory reserve requirement?
Ans: The statutory reserve requirement is a regulation that mandates commercial banks to maintain a certain percentage of their deposits as reserves with the central bank. This requirement limits the amount of money that banks can create through lending, as they must hold a portion of their deposits as reserves.
40. What is the capital adequacy ratio?
Ans: The capital adequacy ratio is a regulatory requirement that mandates banks to maintain a minimum level of capital in relation to their risk-weighted assets. This ratio ensures that banks have a sufficient capital buffer to absorb potential losses and reduces the risk of insolvency. It limits the extent to which banks can leverage their capital for lending and credit creation.
41. What is the money multiplier?
Ans: The money multiplier refers to the relationship between the increase in the money supply and the initial deposit made in the banking system. It represents the potential multiple expansion of the money supply through the process of credit creation by commercial banks.
42. In order to encourage investment in the economy, the central bank will adopt which of the following measures?
(a) Increase cash reserve ratio.
(b) Reduce cash reserve ratio.
(c) Increase bank rate.
(d) None of the above. (Choose the correct option)
Ans: (b) Reduce cash reserve ratio
(B) Short Type Questions & Answers:
1. What are the limitations of relying solely on money supply measures?
Ans: While money supply measures are important indicators, they have limitations. They do not capture all forms of wealth or assets that can serve as a store of value. Additionally, changes in money velocity (the speed at which money circulates in the economy) and other factors can affect the relationship between money supply and economic activity. Therefore, other economic indicators and measures need to be considered alongside money supply when analysing the overall state of the economy.
2. Are there any limitations or challenges in using these policy tools in the money supply?
Ans: Yes, there are limitations and challenges in using these policy tools. The effectiveness of open market operations can be influenced by market conditions and the availability of government securities. Changing reserve requirements may impact banks’ lending capacity and can have unintended consequences. Adjusting the discount rate may not always result in the desired changes in borrowing and lending behaviour, as banks may rely on other funding sources. Additionally, the transmission mechanism of these policy tools to the overall economy can be complex and may take time to have an impact.
3. What is demonetisation? Mention one positive effect of demonetisation in the Indian economy.
Ans: Demonetization is the act of stripping a currency unit of its status as legal tender. It occurs whenever there is a change in national currency. The current form or forms of money is pulled from circulation and retired, often to be replaced with new notes or coins.
One positive effect of demonetization is Black Money Reduced Significantly.
4. Define money multiplier.
Ans: ‘Money Multiplier’ or deposits multiplier measures the amount of money that the banks are able to create in the form of deposits with every unit of money it keeps as reserves. It is calculated as—
Money Multiplier = 1/LRR (∵ LRR = Legal Reserve Ratio)
5. Explain the concept of aggregate monetary resources.
Ans: Supply of money is defined as the total stock of all the forms money which are held by the public at any particular point of time two points need to be noted in this connections. First supply of money is a stock variable because it is related to a point of time. Second, stock of money always refers to the stock of money held by the public. The stock of money with government, Reserve Bank of India and banking system is not included in supply of money. Here the term public includes all economic units like households, firms, local authorities, non banking financial institutions etc. except producers of money.
6. What is the role of a central bank in managing foreign exchange reserves?
Ans: A central bank manages a country’s foreign exchange reserves, which are held in various currencies. It intervenes in the foreign exchange market to manage the exchange rate of the domestic currency, maintain stability, and meet the requirements of international trade and payments. These questions and answers provide an overview of the role and functions of a central bank in overseeing the monetary system, regulating the banking sector, and promoting financial stability and economic growth in a country.
7. Can commercial bank create money?
Ans: A commercial bank is creator of money in the economy because it creates demand deposits in the economy. Demand deposits are those deposits which can be withdrawn by the depositor at any time by means of cheque or otherwise. These deposits are payable on demand. No interest is paid on such deposits, rather, the depositors have to pay something to the bank for the services rendered by it. These deposits are made by business men to carry out their day to day transactions. The accounts in which they are deposited are called current accounts. There are no restrictions on the quantity of money to be kept in these accounts. Further, any number of cheques can be issued in a month.
8. How does the central bank use its quantitative credit control measures to control inflationary situation of an economy?
Ans: During the period of inflation, the central bank tightens its policies to restrict the money supply. Thus, the central bank adopt the quantitative measures. It includes measures like bank rate policy, open market operations and the manipulation of the reserve ratio. This method regulate the lending ability of the financial sector of the whole economy and do not discriminate among the various sectors of the economy. A contraction in demand for credit consequent on an increase in the cost of credit restricts the total equability of money in the economy, and hence may prone an anti-inflationary measure of control. Similarly, a sale of securities by the central bank serves as an anti-inflationary measure of control. A fall in the value of deposit multiplier amounts to a contradiction in the availability of credit and thus it may serve as an anti-inflationary measure.
9. Write a note on ‘demonetization’.
Ans: Demonetization is the act of stripping a currency unit of its status as legal tender. It occurs whenever there is a change of national currency. It can cause chaos by a serious downturn in an economy if it goes wrong. Demonetization has been used as a total to stabilise a currency and fight inflation, to facilitate trade and access to markets, and to push informal economic activity into more transparency and away from black and grey market. On 9 November 2016, the Government of India announced the demonetization of all Rs. 500 and Rs. 1000 banknotes of the Mahatma Gandhi series. It also announced the issuance of new Rs. 500 and Rs. 2000 banknotes in exchange for the demonetised banknotes.
10. What are the potential benefits of demonetization?
Ans: The potential benefits of demonetization can include reducing the circulation of illicit funds, unaccounted wealth, and counterfeit currency. It can promote transparency, formalise the economy, enhance the effectiveness of monetary policy, encourage digital transactions, and contribute to the overall financial and economic stability of a country.
11. What is the discount rate and how does it impact the money supply?
Ans: The discount rate is the interest rate at which commercial banks can borrow funds from the central bank. By adjusting the discount rate, the central bank can influence the cost of borrowing for banks. A decrease in the discount rate encourages banks to borrow more, increasing the money supply. Conversely, an increase in the discount rate makes borrowing more expensive, leading to a decrease in the money supply.
12. What is the significance of bank rate as a tool of RBI?
Ans: The bank rate is the rate at which, the central bank leads funds as a lender of last resort to bank against approved securities or eligible bills of exchange. The effect of a change in the bank rate is to change the cost of securing funds from the central bank. A low bank rate encourages the banks to keep small proportion of their deposits as reserves, since borrowing from central bank is now less costly than before. As a result, banks use a greater proportion of their resources for giving out loans to borrowers or investors. The central bank raises the bank rate in a situation of inflation.
13. Distinguish between demand deposits and time deposits. Are demand deposits legal tenders?
Ans: (i) Demand deposits are payable on demand and either through cheque or otherwise. Fixed deposits are payable only after the expiry of the specified period.
(ii) Demand deposits do not carry interest, whereas time deposits carry a fixed rate of interest.
(iii) Demand deposits are checkable deposits whereas time deposits do not enjoy cheque facility.
(iv) Demand deposits are treated as part of money supply whereas time deposits are not treated as part of money supply.
14. Exhibit a sample balance sheet of commercial banks.
|(i) Primary Deposits Rs. 1000||(i) Cash Rs. 1000|
|(ii) Demand Deposits (Say CRR is 10%) (Rs. 900 is now also Secondary Deposit). Rs. 900||(ii) Loans Rs. 900|
|Total Rs 1,900||Total Rs 1,900|
15. Mention any three shortcomings of a barter system.
Ans: The shortcomings of a barter system was:
(i) Lack of coincidence of wants.
(ii) Lack of storage facilities.
(iii) Lack of measurement of value.
16. Match the following:
|(a) Money supply||(i) lender of last resort.|
|(b) Fiat money||(ii) currency notes and coins.|
|(c) RBI||(iii) Stock concept.|
|(a) Money supply||(iii) Stock concept.|
|(b) Fiat money||(ii) currency notes and coins.|
|(c) RBI||(i) lender of last resort.|
17. How is speculative demand for money related to the rate of interest?
Ans: Different people have different expectations regarding the future movements in the market rate of interest based on their private information regarding the economy. Speculative demand is the demand for money for storing of wealth. Wealth can be held in the form of landed property, bonds, money bullion etc. For the sake of simplicity, all forms of assets except money may be clubbed in a single category called bonds. Speculative demand for money is determined by the rate of interest. There is a negative relationship between the interest rate and the market price of a bond.
When the interest rate is very high, everyone expects it to fall in future and hence anticipates capital gains from bond holding. Hence people convert their money into bonds. Thus speculative demand for money is low. When interest rate comes down more and more people expect it to rise in the future and anticipates capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money. Hence speculative demand for money is inversely related to the rate of interest.
18. Explain the significance of M₁, M₂, M3 and M4 in regards to supply of money.
Ans: The alternative definition of money supply in India are, M = C + DD + OD Where,
C is currency held by the public
DD is the demand deposits in banks.
OD is the other deposits with RBI
M2 = M₁ + savings deposits with post office saving banks.
N3 = M₁ + net time deposits of commercial banks.
N4 = M3 + total deposits with post office savings organisations (including national saving certificates).
19. Explain the role of the RBI as the lender of the last resort.
Ans: When commercial banks have exhausted all resources to supplement their funds all times of financial crisis, they approach the central bank as a last resort.
As lender of last resort, central Bank provides financial accommodation to commercial banks:
(i) by rediscounting their eligible securities and bills of exchange. and
(ii) by providing loans against their securities. This saves banks from possible failure and banking system from a possible breakdown.
20. Exhibit a sample balance sheet of the RBI.
|Liabilities (in Rs)||Assets (in Rs)|
|(a) Gold-10||(a) Circulating money – 8|
|(b) Foreign Currency – 20||(b) Money Deposited (public)-200|
|(c) Loan to Gout-230||(c) Reserve Deposits (commercial Banks) – 40|
|(d) Loan to Commercial Banks-5||(d) Deposited Money of Go I -15|
|Total = Rs 265||Total = Rs 263|
21. If National Income in an economy increases by Rs 1,000 crore as a result of a new investment (Δ I) of Rs 200 crore, find out the values of (i) MPC, and (ii) Multiplier (K).
Ans: Marginal propensity to consumer
Multiplier = 1/(1-MPC)
∴ MPC = Δc/Δy = 200/1000 = 0.2
∴ Multiplier = 1/(1-MPC) = 1/(1- 0.2) = 1/0.8 = 1.25
22. Explain the relationship between speculative demand for money with the rate of interest with the help of diagram.
Ans: It is speculation about future changes in interest rate and bond prices that the resulting demand for money is called speculative demand for money. There is a negative relationship between speculative demand for money with the rate of interest. The inverse relationship is explain with a diagram below.
In the figure speculative demand for money is measured on the horizontal axis and the rate of interest on the vertical axis. When rate of interest is r0, speculative demand for money is zero. The rate of interest is very high and everyone expects it to fall in future people, therefore, are sure to get capital gain in future. So every one converts the speculative money holding into bonds. On the other hand, when rate of interest is r1, people believe it too low that it cannot fall future. It can only rise.
23. Explain the transaction demand for money.
Ans: Transaction demand for money refers to demand for money for conducting day-to-day transactions. People earn incomes at some point of time but spend it continuously throughout the interval. Demand for money for transaction purpose is mainly determined by the level of income. Higher the level of income, the larger will be the transaction demand.
The transaction demand for money is related to the volume of transactions over a specified period of time. It can be shown with the help of an example. Suppose there are only two persons- a producer and a worker in an economy. The producer pays the worker a salary of Rs. 1000 at the beginning of every month, the worker in turn spends this income on the good produced by the producer. Thus at the beginning of each month the worker has a money balance of Rs. 1000 and the producer a balance of Rs. 0 and on the last day of the month the situation is reversed. The producer has a balance of Rs. 1000 and the worker has a zero balance. Thus the total demand for money in this two persons economy is Rs. 1000. But the total volume of transactions are worth Rs. 1000 to the worker and the worker has sold his services to the producer for Rs. 1000. Thus, transaction demand for money is related to the value of transaction over a specified period of time.
24. Describe the speculative demand for money.
Ans: Different people have different expectations regarding the future movements in the market rate of interest based on their private information regarding the economy. Speculative demand is the demand for money for storing of wealth. Wealth can be held in the form of landed property, bonds, money bullion etc. For the sake of simplicity, all forms of assets except money may be clubbed in a single category called bonds. Speculative demand for money is determined by the rate of interest. There is a negative relationship between the interest rate and the market price of a bond.
When the interest rate is very high, everyone expects it to fall in future and hence anticipated capital gains from bond holding. Hence people convert their money into bonds. Thus speculative demand for money is low. When interest rate comes down more and more people expect it to rise in the future and anticipates capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money. Hence speculative demand for money is inversely related to the rate of interest.
25. The aggregate demand for money in the economy can be shown with the following equation:
Md = KPY + r max– r/r – r min ______ Explain the equation.
Ans: Given, the equation ______
Md = KPY + r max– r/r – r min
Here, in the above equation,
Md stands for demand for money. KPY means the demand for money for transaction and precautionary motive respectively and both are the functions of income, i.e. Y.
Again, r max– r/r–rmin refers to the speculative demand for money and here the term ‘max’ and ‘min’ indicates inverse relationship with the rate of interest.
(C) Long Type Questions & Answers:
1. What are the functions of money? Explain how the difficulties of barter system were overcome by money.
Ans: Main functions of Money are:
(i) Medium of exchange.
(ii) Measure of value.
(iii) Store of value.
(iv) Standard of deferred payments.
(i) Medium of exchange: Medium of exchange is the basic or primary function of money. People exchange goods and services through.the medium of money. Money acts as a medium of exchange or as a medium of payments. Money is also called a bearer of options or generalised purchasing power because it provides freedom of choice to buy things people want most from those who offer them best bargain.
(ii) Measure of value: Money serves as a unit of account or a measure of value. Money is a measuring rod, i.e. in terms of money, the values of other commodities and services are measured, compared and expressed. Different goods produced in the country are measured in different units like cloth in metres, milk in litres and sugar in kilograms. Without a common unit, exchange of goods becomes very difficult. Values of goods and services can be expressed easily in a single unit through money. Again, without a measure of value, there can be no pricing system.
(iii) Store of value: Money acts as a store of value for individuals. Wealth can be stared in the form of money for future use. It is convenient to store value in terms of money because–
(a) money has the advantage of general acceptability.
(b) value of money remain relatively stable compared to other commodities.
(c) storage of money does not need much space. Store of values in also called assert function of money.
(iv) Standard of deferred payment: Money serves as a standard of differed payment. Deferred payments refer to those payments which are to be made in future. Thus soon as money is used as a medium of exchange and as a unit of value, it is almost essentially used at the unit in terms of which all future payments are expressed. In a modern economy, a large number of transactions involve future payments which can easily be stated in terms of money. Pensions, principal and interest on debt, salaries etc. are some examples of deferred payments.
2. What is sterilisation operation of RBI?
Ans: RBI stabilize money supply against exogenous shock by sterilisation. RBI after uses its instruments of money creation for stabilising the stock of money in the economy from external shocks. Suppose due to future growth prospects in India investors from across the world increase their investments in India. Bonds which under such, circumstances, are likely to yield a high rate of return. They will buy these bonds with foreign currency. Since one can not purchase goods in the domestic market with foreign currency, a person who sells these bonds to foreign investors will exchange her foreign currency holding into rupee at a commercial bank. The bank in turn, will submit this foreign currency to RBI and it deposits with RBI will be credited with equivalent sum of money. By doing this the commercial bank’s total reserves and deposits remain unchanged, there will be increments in the assets and liabilities on the RBI balance sheet. RBI’s foreign exchange holding goes up. On the other hand, the deposits of commercial banks with RBI also increase by an equal amount, but that means an increase in the stock of high powered money.
This increase money supply will lead to increase in prices of all commodities and now people have more money in this hands with which they compete each other in the commodities market for buying the some old stock of goods at high prices. The process ends up in bidding up in the general price level. In this type of securities RBI will undertake an open market sale of government sacristies of an amount equal to the amount of foreign exchange inflow in the economy thereby keeping the stock of high powered money and total money supply unchanged. Thus it sterilize the economy against adverse external shocks. This operation of RBI is known as sterilisations.
3. What is the significance of measuring money supply?
Ans: The measurement of money supply holds great significance for several reasons:
(a) Monetary Policy: Money supply measurement is essential for central banks in formulating and implementing monetary policy. By monitoring changes in the money supply, central banks can assess the level of liquidity in the economy and make adjustments to interest rates, reserve requirements, and other policy tools to influence economic activity, inflation, and financial stability.
(b) Economic Analysis: Money supply data provides valuable insights into the overall health and performance of an economy. Changes in the money supply can indicate shifts in spending patterns, investment levels, and inflationary pressures. Economists and policymakers analyse money supply data to understand the current state of the economy, predict future trends, and make informed decisions.
(c) Inflation Monitoring: Monitoring money supply growth is crucial for gauging inflationary pressures in an economy. When the money supply expands rapidly, it can lead to excessive liquidity and increase the risk of inflation. Central banks closely track money supply growth to ensure that it aligns with their inflation targets and take appropriate actions to maintain price stability.
(d) Financial Stability: Monitoring money supply helps assess the stability and soundness of the financial system. Uncontrolled growth in the money supply can lead to asset price bubbles, speculative behaviour, and financial imbalances. By keeping track of money supply growth, policymakers can identify potential risks and take preventive measures to maintain financial stability.
(e) Policy Evaluation: Measuring money supply allows policymakers to evaluate the effectiveness of past monetary policy decisions. By analysing the relationship between money supply changes and their impact on economic variables such as GDP growth, inflation, and interest rates, policymakers can assess the outcomes of their policy actions and make necessary adjustments for future policy decisions.
(f) International Comparisons: Measuring money supply provides a basis for comparing the monetary systems and policies of different countries. It allows policymakers and economists to understand the differences in monetary conditions, inflation rates, and economic performance among nations and provides insights into the effectiveness of various monetary policy approaches.
4. What are the main functions of a Central bank?
Ans: The main functions of a central bank can be summarised as follows:
(a) Monetary Policy: One of the primary functions of a central bank is to formulate and implement monetary policy. Central banks control the money supply, manage interest rates, and use various tools to influence economic conditions such as inflation, employment, and economic growth. They adjust policy parameters to maintain price stability and promote sustainable economic development.
(b) Issuing Currency: Central banks have the authority to issue and regulate the national currency. They ensure an adequate supply of currency notes and coins in circulation, maintain their integrity, and manage the distribution and withdrawal of currency to meet the needs of the economy.
(c) Banker to the Government: Central banks act as bankers to the government, providing services such as managing government accounts, processing payments, and issuing government securities. They also advise the government on financial and economic matters, including fiscal policy coordination and debt management.
(d) Banker’s Bank and Lender of Last Resort: Central banks serve as the bank for commercial banks and provide them with essential services. They maintain accounts for commercial banks, facilitate interbank transactions, and provide liquidity support in times of financial stress. Central banks act as lenders of last resort, extending emergency funding to banks to prevent systemic disruptions and maintain stability in the financial system.
(e) Supervision and Regulation: Central banks play a crucial role in ensuring the stability and soundness of the banking and financial system. They establish and enforce prudential regulations, conduct bank examinations, and oversee the operations of financial institutions. Central banks aim to maintain a safe and efficient banking system, protect depositors, and mitigate systemic risks.
(f) Foreign Exchange Management: Central banks manage foreign exchange reserves and conduct foreign exchange operations. They intervene in currency markets to stabilise exchange rates, maintain competitiveness, and manage external imbalances. Central banks also participate in international monetary cooperation and manage relationships with other central banks and international organisations.
5. How does a central bank conduct monetary policy?
Ans: A central bank conducts monetary policy through various tools and strategies to influence the money supply, interest rates, and overall economic conditions. The exact methods used may vary depending on the central bank’s objectives, the prevailing economic conditions, and the institutional framework. Here are the general steps involved in the process:
(a) Set Policy Objectives: The central bank establishes its monetary policy objectives, which typically include maintaining price stability, promoting economic growth, and ensuring financial stability. These objectives may be explicitly stated or inferred from the central bank’s mandate.
(b) Collect and Analyze Data: The central bank collects a wide range of economic data, including inflation, employment, GDP growth, money supply, and financial market indicators. This data is analysed to assess the current state of the economy and identify any emerging trends or risks.
(c) Assess Economic Conditions: Based on the data analysis, the central bank evaluates the current and projected economic conditions, including inflationary pressures, output gaps, employment levels, and other relevant factors. This assessment helps determine the appropriate stance of monetary policy.
(d) Formulate Policy Strategy: The central bank formulates a policy strategy based on its assessment of economic conditions and policy objectives. This strategy defines the actions and tools the central bank will use to achieve its objectives. It may include specific targets for inflation, interest rates, or other key variables.
(e) Implement Policy Tools: The central bank deploys various policy tools to influence the money supply, interest rates and financial conditions.
The main policy tools used include:
(a) Open Market Operations: The central bank buys or sells government securities in the open market to inject or withdraw liquidity from the banking system. Purchases increase the money supply, while sales decrease it.
(b) Reserve Requirements: The central bank sets the minimum reserve requirements that commercial banks must hold. Adjusting these requirements affects the amount of money banks can lend and influences the money supply.
(c) Policy Interest Rates: The central bank sets a benchmark interest rate, often called the policy rate or the key policy rate. By adjusting this rate, the central bank influences borrowing costs, which affects spending, investment, and overall economic activity.
(d) Forward Guidance: Central banks provide guidance and communicate their intentions regarding future policy actions, interest rate expectations, or economic conditions. This helps shape market expectations and influence borrowing and investment decisions.
(e) Monitor and Evaluate: The central bank continuously monitors economic and financial developments, assesses the impact of its policy actions, and makes adjustments as necessary. It uses a range of indicators to evaluate the effectiveness of its policy measures and their alignment with the policy objectives.
(f) Communication and Transparency: Central banks communicate their policy decisions, rationale, and assessments to the public, financial markets, and other stakeholders. This transparency helps manage expectations, enhance credibility, and foster public understanding of the central bank’s actions.
(g) Review and Adapt: Central banks periodically review their policy framework, tools, and strategies to ensure they remain effective and relevant. They assess the impact of past policy actions, evaluate changing economic conditions, and make adjustments to their approach as needed.
By employing these steps and using a combination of policy tools, central banks aim to achieve their objectives, promote stability, and contribute to sustainable economic growth. The specific approach and techniques employed by a central bank may vary depending on the country, its monetary framework, and the unique characteristics of the economy.
6. What is the role of a central bank in regulating the banking system?
Ans: The role of a central bank in regulating the banking system is critical for ensuring the stability, integrity, and soundness of the financial system.
Here are the main aspects of a central bank’s role in banking regulation:
(a) Licensing and Supervision: Central banks.are typically responsible for issuing licences to banks, granting them the authority to operate and engage in banking activities. They also undertake ongoing supervision to ensure that banks comply with regulatory requirements, maintain sound business practices, and manage risks effectively. Regular examinations, inspections, and assessments are conducted to assess the financial health and compliance of banks.
(b) Monitoring Systemic Risks: Central banks monitor the financial system as a whole to identify and address systemic risks. They assess the interconnectedness of banks, monitor concentrations of risk, and analyse potential vulnerabilities that could impact the stability of the banking system. This includes monitoring risks associated with credit, liquidity, market conditions, and other factors that could pose systemic threats.
(c) Crisis Management: Central banks play a key role in crisis management and resolution when banks face financial distress or insolvency. They develop contingency plans and frameworks for dealing with bank failures, including mechanisms for orderly resolution, deposit insurance, and financial assistance. Central banks may provide emergency liquidity support to solvent but illiquid banks to prevent systemic disruptions.
(d) Consumer Protection: Central banks often have a role in protecting consumers and promoting fair and transparent banking practices. They establish regulations and guidelines to ensure that banks treat customers fairly, disclose information accurately, and address customer complaints. Central banks may have specific departments or units dedicated to consumer protection and financial education.
(e) Anti-Money Laundering and Combating Financing of Terrorism (AML/CFT): Central banks contribute to efforts aimed at combating money laundering and the financing of terrorism. They establish and enforce regulations that require banks to have robust AML/CFT measures, conduct customer due diligence, report suspicious transactions, and maintain effective controls to prevent illicit activities.
(f) International Cooperation: Central banks collaborate with other regulatory and supervisory authorities at the national and international, levels. They participate in international forums, exchange information, and contribute to the development of global regulatory standards and best practices. Central banks also engage in bilateral and multilateral cooperation to address cross-border banking issues and promote financial stability globally.
7. How does a central bank promote financial stability and economic growth?
Ans: A central bank plays a crucial role in promoting financial stability and economic growth through various actions and policies. Here are some ways in which a central bank contributes to these objectives:
(a) Monetary Policy: The primary tool used by central banks to promote financial stability and economic growth is monetary policy. By adjusting interest rates, managing the money supply, and using other policy instruments, central banks aim to maintain price stability, control inflation, and support sustainable economic growth. By influencing borrowing costs and credit availability, central banks stimulate investment, consumption, and economic activity.
(b) Financial System Regulation: Central banks regulate and supervise financial institutions to ensure the stability and soundness of the financial system. They establish prudential regulations, capital adequacy requirements, and risk management standards for banks and other financial institutions. By monitoring and supervising financial entities, central banks mitigate systemic risks, promote the safety of deposits, and prevent excessive risk-taking that could jeopardise financial stability.
(c) Crisis Management and Resolution: Central banks play a critical role in managing and resolving financial crises. They act as lenders of last resort, providing liquidity support to solvent but illiquid banks to prevent systemic disruptions. In times of financial distress, central banks collaborate with other regulatory authorities and government agencies to develop comprehensive strategies for resolving troubled financial institutions and maintaining financial stability.
(d) Payment Systems Oversight: Central banks oversee and regulate payment and settlement systems to ensure their safety, efficiency, and integrity. By promoting secure and efficient payment mechanisms, central banks facilitate smooth transactions, reduce settlement risks, and enhance confidence in the financial system. This contributes to economic growth by facilitating the smooth functioning of commercial transactions.
(e) Financial Market Stability: Central banks monitor and address risks in financial markets to promote stability. They monitor market conditions, assess potential vulnerabilities, and take appropriate actions to prevent excessive volatility, speculative bubbles, and market disruptions. Central banks may intervene in financial markets, if necessary, to maintain stability and confidence.
8. What are the main functions of a commercial bank?
Ans: The main functions of a commercial bank are as follows:
(a) Accepting Deposits: Commercial banks accept various types of deposits from individuals, businesses, and other entities. These include current accounts, savings accounts, fixed deposit accounts, and recurring deposit accounts. By accepting deposits, banks provide a safe place for customers to store their money and earn interest.
(b) Providing Loans and Advances: Commercial banks lend money to individuals, businesses, and other borrowers. They offer various types of loans and advances, such as personal loans, home loans, business loans, working capital loans, and project finance. Banks assess the creditworthiness of borrowers and provide funds to meet their financing needs.
(c) Credit Creation: One of the unique functions of commercial banks is the creation of credit. When a bank lends money, it does not need to have the exact amount in deposits. Banks can create credit by extending loans and advances, thereby increasing the money supply in the economy.
(d) Payment Services: Commercial banks facilitate payments and transfers on behalf of their customers. They provide services such as issuing checks, facilitating electronic fund transfers, processing credit and debit card transactions, and offering online and mobile banking platforms. Banks play a crucial role in the smooth functioning of the payment system, enabling individuals and businesses to make transactions conveniently and securely.
(e) Foreign Exchange Services: Commercial banks offer foreign exchange services, including currency exchange, international fund transfers, trade finance, and foreign currency accounts. They assist individuals and businesses in conducting cross-border transactions, managing foreign currency risks, and facilitating international trade and investments.
(f) Trade Finance: Commercial banks provide trade finance services to facilitate domestic and international trade. They issue letters of credit, provide export financing, offer trade-related guarantees, and assist in documentary collections. These services help mitigate risks, provide financing options, and support the smooth flow of goods and services in the trading process.
(g) Investment Banking: Many commercial banks have investment banking divisions that offer services such as underwriting securities, facilitating mergers and acquisitions, providing advisory services, managing initial public offerings (IPOS), and conducting capital market activities. Investment banking activities help businesses raise capital, execute financial transactions, and access the capital markets.
9. How does a commercial bank contribute to economic development?
Ans: Commercial banks play a significant role in contributing to economic development through various functions and activities. Here are some ways in which commercial banks contribute to economic development:
(a) Financing Business Investments: Commercial banks provide funds to businesses for investments in machinery, equipment, infrastructure, and expansion projects. By offering loans and credit facilities, banks enable businesses to acquire the necessary capital for growth and development. This financing helps stimulate economic activity, create employment opportunities, and foster innovation.
(b) Facilitating Consumer Spending: Commercial banks offer personal loans and credit products that allow individuals to make major purchases, such as homes, vehicles, and consumer goods. By providing access to credit, banks empower consumers to make these purchases, thereby driving consumption and contributing to economic growth.
(c) Supporting Entrepreneurship and Small Businesses: Commercial banks play a crucial role in supporting entrepreneurship and the growth of small businesses. They provide startup capital, working capital, and business loans to aspiring entrepreneurs and small enterprises. By offering financial support and guidance, banks help create a conducive environment for the development of new businesses, job creation, and innovation.
(d) Payment Services and Financial Inclusion: Commercial banks facilitate payment services that enable individuals and businesses to conduct transactions efficiently and securely. They offer checking accounts, electronic fund transfers, and debit/credit cards that simplify the process of making payments. By promoting financial inclusion and ensuring access to banking services, commercial banks contribute to the participation of individuals and businesses in the formal economy.
(e) Mobilising Savings: Commercial banks encourage individuals and households to save their money by providing savings accounts, fixed deposit accounts, and other deposit products. By mobilising savings, banks pool funds that can be channelled towards productive investments. This helps in the accumulation of capital and the availability of funds for lending to businesses and individuals.
(f) Risk Management and Hedging: Commercial banks provide risk management services that help businesses and individuals mitigate various risks. They offer insurance products, foreign exchange services, hedging instruments, and risk advisory services. These services protect businesses from adverse events and help stabilise their operations, promoting stability and confidence in the economy.
10. What factors affect the size of the money multiplier?
Ans: Here are some key factors that can affect the size of the money multiplier:
(a) Reserve Requirement: The reserve requirement is the portion of deposits that banks are required to hold as reserves. A higher reserve requirement reduces the amount of excess reserves available to banks for lending, leading to a lower money multiplier. Conversely, a lower reserve requirement increases the potential for lending and results in a higher money multiplier.
(b) Currency Holding by the Public: The amount of currency held by the public impacts the money multiplier. When people hold a larger proportion of their money in the form of cash, it reduces the amount of deposits available for banks to lend and therefore decreases the money multiplier. On the other hand, if people prefer to hold less cash and keep more of their money in bank deposits, it increases the money multiplier.
(c) Bank Behavior and Lending Standards: The lending behaviour of banks and their willingness to extend credit also influence the money multiplier. If banks are cautious and have strict lending standards, they may lend a smaller portion of their deposits, resulting in a lower money multiplier. Conversely, if banks are more aggressive in lending and have lenient standards, they can increase the money multiplier.
(d) Central Bank Policy: The actions and policies of the central bank, such as open market operations, reserve requirements, and interest rate changes, can affect the money multiplier. For example, if the central bank conducts open market purchases of government securities, it injects reserves into the banking system, increasing the potential for lending and expanding the money multiplier. Conversely, if the central bank sells securities in open market operations, it reduces bank reserves and contracts the money multiplier.
(e) Public Confidence and Deposit Flows: Public confidence in the banking system plays a role in the size of the money multiplier. If there is a lack of confidence, depositors may withdraw funds from banks, reducing the available reserves for lending and decreasing the money multiplier. Conversely, if confidence is high, deposit flows into the banking system can increase reserves and expand the money multiplier.
11. How does the money multiplier relate to credit creation?
Ans: Here’s how the two concepts are connected:
(a) Initial Deposit: The process of credit creation starts with an initial deposit made by an individual or entity in a commercial bank. This initial deposit becomes the basis for the creation of credit and the subsequent expansion of the money supply.
(b) Reserve Requirement: Banks are required to hold a certain percentage of deposits as reserves, which is determined by the reserve requirement set by the central bank. The reserve requirement acts as a limit on the amount of credit that can be created from a given deposit.
Excess Reserves: The portion of the initial deposit that is not held as reserves is referred to as excess reserves. These excess reserves provide the basis for banks to extend loans and create new money through the process of credit creation.
(c) Lending and Creation of Deposits: Banks use their excess reserves to make loans to borrowers. When a bank extends a loan, it credits the borrower’s account with the loan amount, creating a new deposit. This new deposit adds to the overall money supply in the economy. Deposit Expansion and Re-lending: The borrower who receives the loan can now use the newly created deposit to make payments to other individuals or entities. These payments may be deposited in other banks, creating new deposits and expanding the money supply further. The process of lending, repayment, and re-lending continues, leading to multiple rounds of credit creation and deposit expansion.
(d) Money Multiplier Effect: The money multiplier captures the relationship between the initial deposit and the subsequent expansion of the money supply. It represents the ratio by which the money supply increases relative to the initial deposit. The money multiplier is calculated as the reciprocal of the reserve requirement ratio. For example, if the reserve requirement is 10%, the money multiplier would be 1/0.10 = 10. This means that for every initial deposit, the potential expansion of the money supply is ten times.
12. What are the policy tools used to control the money supply?
Ans: Central banks use various policy tools to control the money supply and influence economic conditions.
Here are some of the key policy tools used:
(a) Open Market Operations: Open market operations (OMO) involve the buying and selling of government securities (such as treasury bonds) by the central bank in the open market. When the central bank buys government securities, it injects money into the banking system, increasing the reserves of commercial banks and expanding the money supply. Conversely, when the central bank sells government securities, it absorbs money from the banking system, reducing reserves and contracting the money supply.
(b) Reserve Requirements: Reserve requirements refer to the percentage of deposits that commercial banks are required to hold as reserves. By adjusting the reserve requirement, the central bank can influence the amount of money that banks can lend and, therefore, the money supply. Decreasing the reserve requirement allows banks to hold fewer reserves, increasing their capacity to lend and expanding the money supply. Conversely, increasing the reserve requirement restricts banks’ ability to lend, leading to a contraction of the money supply.
(c) Discount Rate: The discount rate is the interest rate at which commercial banks can borrow funds directly from the central bank. By raising or lowering the discount rate, the central bank influences the cost of borrowing for commercial banks. When the discount rate is increased, borrowing becomes more expensive, leading to a decrease in bank lending and a contraction of the money supply. Conversely, when the discount rate is decreased, borrowing becomes cheaper, stimulating bank lending and expanding the money supply.
(d) Interest Rate Policy: Central banks also use interest rate policy to control the money supply indirectly. By adjusting the key policy interest rates, such as the overnight lending rate or the policy rate, the central bank can influence market interest rates. When the central bank raises interest rates, borrowing becomes more expensive, which can reduce borrowing and spending, leading to a contraction of the money supply. Conversely, when the central bank lowers interest rates, borrowing becomes cheaper, encouraging borrowing and spending, and expanding the money supply.
(e) Moral Suasion and Communication: Central banks also employ moral suasion and communication as policy tools. Through public statements, speeches, and communication with market participants, the central bank provides guidance on its monetary policy stance and future actions. Clear communication helps shape market expectations and influences borrowing and lending behaviour, thereby indirectly affecting the money supply.
13. How do policy tools affect the money supply?
Ans: Policy tools employed by central banks have the ability to influence the money supply in an economy.
Here’s how some of the key policy tools can impact the money supply:
(a) Open Market Operations (OMO): When the central bank conducts open market purchases of government securities, it injects money into the banking system. Banks receive payment for the securities, increasing their reserves. With higher reserves, banks have more capacity to extend loans and create new deposits, leading to an expansion of the money supply. Conversely, when the central bank sells government securities in open market operations, it absorbs money from the banking system. This reduces the reserves of commercial banks, limiting their ability to lend and thereby contracting the money supply.
(b) Reserve Requirements: By adjusting the reserve requirement ratio, the central bank can influence the amount of reserves that banks are required to hold. If the central bank lowers the reserve requirement, banks are required to hold a smaller portion of their deposits as reserves. This frees up more funds for lending, allowing banks to create new loans and deposits, which expands the money supply. Conversely, if the central bank increases the reserve requirement, banks must hold a higher portion of their deposits as reserves. This reduces the funds available for lending, limiting the creation of new loans and deposits, and thus contracting the money supply.
(c) Discount Rate: The central bank sets the discount rate, which is the interest rate at which commercial banks can borrow funds directly from the central bank. When the central bank raises the discount rate, it becomes more expensive for banks to borrow from the central bank. This discourages banks from borrowing and reduces their capacity to lend. As a result, the creation of new loans and deposits decreases, leading to a contraction of the money supply. Conversely, when the central bank lowers the discount rate, borrowing becomes cheaper for banks, stimulating their ability to lend and create new loans and deposits, thereby expanding the money supply.
(d) Interest Rate Policy: Central banks often use interest rate policy as a tool to influence the money supply indirectly. By adjusting key policy interest rates, such as the overnight lending rate or the policy rate, the central bank influences market interest rates. When the central bank raises interest rates, borrowing becomes more expensive for businesses and individuals. This can reduce borrowing and spending, leading to a contraction of the money supply. Conversely, when the central bank lowers interest rates, borrowing becomes cheaper, encouraging borrowing and spending, which can expand the money supply.
14. What are the reasons for implementing demonetization?
Ans: Demonetization is the process of discontinuing the use of a specific currency unit and replacing it with a new currency or digital payment systems. The reasons for implementing demonetization can vary depending on the goals and circumstances of a particular country. Here are some common reasons for implementing demonetization:
(a) Curbing Black Money and Corruption: One of the primary objectives of demonetization is to combat black money and corruption. By invalidating high-value currency notes, which are often used for illegal activities and tax evasion, governments aim to reduce the circulation of unaccounted wealth and promote a transparent economy. Demonetization provides an opportunity for individuals and businesses to declare their unreported income and assets or face penalties.
(b) Disrupting Terrorist Financing and Illegal Activities: Demonetization can disrupt the financing of illegal activities, including terrorism. By rendering existing currency notes obsolete, the government aims to make it more difficult for illegal entities to use cash for their operations. It forces them to either deposit their illicit funds in the banking system, making them traceable, or face severe difficulties in their financial transactions.
(c) Promoting Formalisation of the Economy: Demonetization can encourage a shift from an informal cash-based economy to a formal, digitised economy. It pushes people to adopt digital payment systems and encourages the use of formal banking channels, reducing the reliance on cash transactions. This can bring more economic activity into the formal sector, enhance financial inclusion, and enable better monitoring of financial transactions.
(d) Countering Counterfeit Currency: Demonetization provides an opportunity to introduce new currency notes with advanced security features, making it more difficult to counterfeit. By replacing old currency with new notes, governments aim to enhance the security and integrity of their currency, protecting it from counterfeiters and maintaining public trust in the monetary system.
(e) Promoting Digital Payments and Financial Inclusion: Demonetization can act as a catalyst for the adoption of digital payment systems and financial inclusion. By making cash less accessible, people are encouraged to use electronic payment methods, mobile wallets, and banking services. This transition to digital payments can lead to increased transparency, convenience, and efficiency in financial transactions.,
15. How does demonetization work?
Ans: Demonetization is a process by which the existing currency notes or coins of a specific denomination are declared invalid and are replaced with new currency or alternative payment methods. The exact procedure and implementation can vary depending on the country and the specific objectives of the demonetization exercise.
Here is a general overview of how demonetization typically works:
Announcement: The government or central bank announces the decision to demonetize certain currency notes or coins. The announcement includes details about which denominations will be demonetized and the timeline for the process.
(a) Withdrawal of Legal Tender Status: The specified currency notes or coins are declared to be no longer legal tender. This means that they can no longer be used for transactions, and their value is no longer guaranteed by the government. The objective is to render these notes or coins worthless for certain purposes.
(b) Public Notification and Awareness: The government initiates a public awareness campaign to inform people about the demonetization process. This includes educating the public about the deadlines for exchanging or depositing the old currency, the locations and procedures for doing so, and any additional requirements or limitations.
(c) Exchange or Deposit Period: A specified period is provided during which individuals can exchange their old currency notes for new ones or deposit them into their bank accounts. The exchange and deposit facilities are set up at banks, post offices, or other designated locations. Individuals are usually required to provide identification and provide a legitimate explanation for their possession of the old currency.
(d) Scrutiny and Verification: The exchanged or deposited currency undergoes scrutiny and verification by the banking authorities. This is done to detect counterfeit notes, illegal funds, or any other suspicious activities. Any discrepancies or irregularities may be investigated further.
(e) Replacement with New Currency: As the demonetization process progresses, new currency notes of the same or different denominations are introduced into circulation. These new notes may have enhanced security features to prevent counterfeiting and may be designed to be more user-friendly or convenient.
16. What are the challenges or drawbacks of demonetization?
Ans: While demonetization can be implemented with the intention of achieving certain objectives, it can also bring several challenges and drawbacks.
Here are some common challenges associated with demonetization:
(a) Disruption of Economic Activity: Demonetization can lead to a sudden shortage of cash in the economy, causing disruptions in day-to-day transactions and economic activities. Small businesses and individuals who heavily rely on cash transactions may face difficulties in conducting business, resulting in a temporary slowdown in economic growth.
(b) Inconvenience to the Public: Demonetization often involves long queues and delays at banks and ATMs as people rush to exchange their old currency or withdraw new currency. This can cause inconvenience and frustration among the public, particularly those who rely heavily on cash for their daily needs.
(c) Cash Shortages: The replacement of old currency with new currency may take time, leading to cash shortages in the economy. This can create liquidity issues, affecting sectors that rely heavily on cash transactions, such as agriculture and informal sectors. People may face challenges in meeting their immediate financial needs.
(d) Disruption of Informal Economy: Demonetization can have a significant impact on the informal economy, where cash transactions are prevalent. Small businesses and self-employed individuals who operate in the informal sector may face difficulties in transitioning to digital payments or formal banking channels, impacting their livelihoods.
(e) Counterfeit Currency Adaptation: Despite demonetization, counterfeit currency may still circulate in the economy. Criminal elements may find ways to adapt to the new currency or exploit loopholes, undermining the original intention of curbing illegal activities and counterfeit currency.
Administrative and Operational Challenges: Implementing demonetization requires careful planning, logistics, and coordination among various stakeholders, including banks, government agencies, and law enforcement. Inadequate preparation or inefficient execution can lead to administrative and operational challenges, delaying the process and causing confusion among the public.
17. How does demonetization impact the economy?
Ans: Demonetization can have various impacts on the economy, both positive and negative. The effects can vary depending on the specific context, the objectives of demonetization, and how it is implemented. Here are some potential impacts of demonetization:
(a) Impact on Cash-dependent Sectors: Demonetization can disrupt sectors that heavily rely on cash transactions, such as agriculture, small businesses, and the informal sector. Cash shortages and the transition to digital payments can temporarily slow down economic activity in these sectors, leading to a decline in production and employment.
(b) Formalization of the Economy: Demonetization can promote the formalisation of the economy by encouraging the use of digital payment methods and formal banking channels. It can reduce the size of the informal economy, increase financial inclusion, and enhance transparency in financial transactions.
(c) Curbing Black Money and Corruption: One of the primary objectives of demonetization is to combat black money and corruption. By invalidating high-value currency notes, demonetization aims to reduce the circulation of unaccounted wealth and promote a transparent economy. It provides an opportunity for individuals and businesses to declare their unreported income and assets or face penalties.
(d) Impact on Tax Revenue: Demonetization can have both short-term and long-term effects on tax revenue. In the short term, there may be a boost in tax collections as individuals and businesses deposit their unaccounted cash into the banking system. However, in the long run, the impact on tax revenue depends on the effectiveness of follow-up measures and the ability of the tax authorities to track and tax the previously unreported income.
(e) Reduction in Cash-based Transactions: Demonetization aims to reduce the reliance on cash transactions and promote digital payments. This can lead to a shift in consumer behaviour and a decrease in cash-based transactions. Increased adoption of digital payments can bring benefits such as enhanced convenience, reduced transaction costs, and improved transparency.
(f) Impact on Inflation: Demonetization can have short-term effects on inflation. As economic activity slows down due to cash shortages and disruptions, there may be a decline in demand, leading to a temporary easing of inflationary pressures. However, the impact on inflation depends on various factors such as the duration and severity of the cash shortage, the effectiveness of monetary policy measures, and the overall economic conditions.
18. Explain the functions of money in a modern economy.
Ans: Money serves several important functions in a modern economy.
These functions can be summarised as follows:
(a) Medium of Exchange: One of the primary functions of money is to act as a medium of exchange. Money serves as a widely accepted and recognized form of payment for goods, services, and debts. It eliminates the need for barter or direct exchange, where goods and services are traded for other goods and services. With money, individuals can easily exchange what they have (goods, labor, services) for what they want (other goods, services) in a more efficient and convenient manner.
(b) Unit of Account: Money also functions as a unit of account, providing a common standard for measuring and comparing the value of goods, services, assets, and debts. It allows for the pricing, valuation, and calculation of costs, profits, wages, and other economic variables. Money serves as a common denominator that simplifies economic transactions and facilitates economic decision-making.
(c) Store of Value: Money serves as a store of value, allowing individuals to accumulate wealth and transfer purchasing power over time. Unlike perishable or rapidly depreciating goods, money can be held and saved for future use. It preserves value over time and serves as a medium for storing wealth. Individuals can defer consumption by saving money, knowing that it will retain its value and can be used to purchase goods and services in the future.
(d) Standard of Deferred Payment: Money acts as a standard of deferred payment, facilitating transactions that involve debts and obligations to be settled in the future. Contracts, loans, mortgages, and other financial arrangements are denominated in a monetary unit, allowing parties to agree on future payments and obligations. Money provides a reliable and stable measure of value for deferred payments over time.
(e) Measure of Value and Price: Money provides a measure of value and price, enabling individuals to compare and assess the relative worth of goods, services, and assets. It allows for the quantification and comparison of economic values, enabling efficient resource allocation, pricing decisions, and market interactions.
19. What is open market operations? Explain in brief.
Ans: Open market operations refer to the buying and selling of government securities, such as bonds, by the central bank in the open market. It is one of the primary tools used by central banks to implement monetary policy and influence the money supply and interest rates in an economy. Here’s a brief explanation of open market operations:
(a) Objective: The central bank conducts open market operations with the aim of achieving certain monetary policy objectives, such as controlling inflation, managing interest rates, stabilising the economy, or influencing economic growth.
(b) Buying and Selling of Securities: During open market operations, the central bank buys or sells government securities, typically bonds, from or to commercial banks, financial institutions, or the general public. These transactions take place in the open market, where buyers and sellers freely interact.
(c) Impact on Money Supply: When the central bank buys government securities from market participants, it pays for the securities by crediting the sellers’ accounts with the central bank. This increases the reserves of the sellers’ banks, effectively injecting new money into the banking system and increasing the money supply. Conversely, when the central bank sells government securities, it receives payment in the form of reserves, reducing the reserves of the buyers’ banks and decreasing the money supply.
(d) Influence on Interest Rates: Open market operations also have an impact on interest rates. When the central bank buys government securities and increases the money supply, it lowers short-term interest rates as banks have more reserves to lend. Conversely, when the central bank sells government securities and reduces the money supply, it puts upward pressure on short-term interest rates as banks have fewer reserves to lend.
(e) Fine-tuning Monetary Policy: Open market operations provide the central bank with flexibility in fine-tuning monetary policy. By adjusting the amount and frequency of buying or selling government securities, the central bank can influence the liquidity in the banking system, control the supply of money, and manage interest rates in line with its policy objectives.
(f) Communication Tool: Open market operations also serve as a communication tool for the central bank. The actions of the central bank in the open market can signal its stance on monetary policy, market conditions, and its expectations for the economy. Market participants closely analyse and interpret the central bank’s open market operations as an indication of its intentions and future policy moves.
20. What is the significance of bank rate policy exercised by the RBI?
Ans: The bank rate policy, also known as the policy repo rate or policy interest rate, is one of the key monetary policy tools used by the Reserve Bank of India (RBI) to influence the cost and availability of credit in the economy. The bank rate policy has several significant implications and impacts on various aspects of the economy. Here are the key significances of the bank rate policy:
(a) Controlling Inflation: One of the primary objectives of the bank rate policy is to control inflation. By adjusting the bank rate, the RBI influences the cost of borrowing for banks and, in turn, affects lending rates in the economy. A higher bank rate increases the cost of borrowing for banks, which can lead to higher lending rates for businesses and consumers. This helps in curbing excessive borrowing and spending, which can contribute to inflationary pressures. Conversely, a lower bank rate encourages borrowing and stimulates economic activity, promoting price stability.
(b) Managing Liquidity: The bank rate policy plays a crucial role in managing liquidity in the banking system. The bank rate determines the rate at which banks can borrow funds from the RBI through its liquidity adjustment facility (LAF). By raising or lowering the bank rate, the RBI can influence the cost of borrowing for banks and impact their liquidity position. A higher bank rate makes borrowing from the RBI more expensive, encouraging banks to reduce their borrowing and liquidity in the system. Conversely, a lower bank rate makes borrowing more affordable, leading to increased liquidity.
(c) Influencing Interest Rates: The bank rate policy has a significant impact on interest rates in the economy. Banks and financial institutions use the bank rate as a reference point for setting their lending and deposit rates. When the RBI raises the bank rate, it puts upward pressure on lending rates, making borrowing more expensive for businesses and consumers. This can help in cooling down the demand for credit and managing inflation. Conversely, when the RBI lowers the bank rate, it can lead to a reduction in lending rates, promoting borrowing and stimulating economic activity.
(d) Monetary Policy Transmission: The bank rate policy is a crucial element in the transmission mechanism of monetary policy. Changes in the bank rate by the RBI influence the cost and availability of credit, which, in turn, affects investment, consumption, and overall economic activity. Through the bank rate policy, the RBI aims to influence the behaviour of banks, financial institutions, businesses, and consumers, thereby impacting the broader economy.
(e) Signalling Effect: The bank rate policy also has a signalling effect on the market and economic participants. The RBI’s decision to raise or lower the bank rate sends a signal about its stance on monetary policy and its assessment of economic conditions. Market participants closely watch the bank rate decisions as an indication of the central bank’s policy direction and expectations regarding future interest rates and economic conditions.
21. Explain the determinants of money supply.
Ans: The determinants of money supply are:
(i) High powered money. and
(ii) The size of money multiplier.
(i) High powered money refers to the total monetary liability of the monetary authorities of the country. It consists of currency and deposits held by the government of India and commercial banks with RBI. These are the claims which general public, government or banks have on RBI and hence are considered to be the liability of RBI. A part of the currency issued is held by the public which is designate as C and A a part is held by the banks as reserves which is designate as R. A part of these currency reserves of the banks is held by them in their own cash vaults and a part is deposited in the Reserve Bank of India in the Reserve Accounts which banks hold with RBI. Thus, H = C+R
(ii) The size of money multiplier: Money multiplier in the degree to which money supply is expanded as a result of the increases in high powered money. The cash or reserve deposit ratio of the banks (rdr) and currency deposit ratio (cdr) of the public which determines the size of multiplier, i.e. M/F = 1 + cdr/cdr + rdr
22. Explain the multiplier process of money supply in an economy.
Ans: Money multiplier is the degree to which money supply is expanded as a result of the increase in high powered money i.e. m = M/H
m = Money multiplier
H = High powered money
Rearranging, we have M = H.m
The cash or reserve deposit ratio of the banks (rdr) and currency deposit ratio (cdr) of the public determines the value of the money multiplier.
To precise, M/H = 1+ cdr/cdr + rdr
This can be explained as under,
M = DD + C money supply………………(i)
H = C + R …………….. (ii) High powered money
By dividing equation (i) by (ii) we get
M/H = DD + C/C + R ……………………..(iii)
Again by dividing numerator and denominator on the right hand side of the equation (iii) by demand deposits (DD) we get,
M/H = 1 + cdr/cdr + rdr
Thus, 1 + cdr/cdr + rdr is the precise measure of money multiplier,
M = H. 1 + cdr/cdr + rdr where, cdr = currency deposit ratio of the public and rdr = reserve deposit ratio of banks.
Currency deposit ratio is the proportion of currency (c) held by public to other holdings of bank deposits (DD) i.e. cdr = C/DD. And reserve deposit ratio is the proportion of total deposits (DD) which commercial banks keep as resene (R) i.e. cdr = R/DD.
In the determination of the value of the money multiplier these ratios pay a very important rate.
23. Explain the functions of RBI.
Ans: The Reserve Bank of India (RBI) is the central bank of India and performs several important functions that are crucial for the functioning of the Indian economy. Here’s an explanation of the functions of the RBI: Monetary Policy Formulation and Implementation: One of the primary functions of the RBI is to formulate and implement monetary policy in India. It is responsible for maintaining price stability and controlling inflation by managing key monetary variables such as interest rates, money supply, and credit availability. The RBI sets the policy repo rate, which serves as a benchmark for other interest rates in the economy.
Currency Issuance and Management: The RBI has the authority to issue and manage the currency in circulation in India. It ensures an adequate supply of currency notes and coins to meet the demands of the public and the banking system. The RBI also plays a role in designing and maintaining the security features of currency to prevent counterfeiting.
Banker to the Government: The RBI acts as the banker and financial advisor to the central and state governments in India. It manages the government’s banking transactions, maintains accounts, and provides necessary banking services. The RBI also facilitates the government’s borrowing requirements and manages the issuance of government securities.
Banker to Banks and Supervisor of the Banking System: The RBI acts as a banker to banks and financial institutions in India. It holds their reserves, facilitates interbank transactions, and provides liquidity support when needed. The RBI also acts as a regulator and supervisor of the banking system, ensuring the stability, soundness, and integrity of banks through various regulations, inspections, and licensing requirements.
Regulation of Financial Institutions and Markets: The RBI plays a crucial role in regulating and supervising financial institutions and markets in India. It formulates and enforces prudential norms, guidelines, and regulations for banks, non-banking financial companies (NBFCs), payment systems, and other financial entities. The RBI’s objective is to maintain the stability and efficiency of the financial system and protect the interests of depositors and investors.
Foreign Exchange Management: The RBI manages and regulates the foreign exchange market in India. It formulates and implements foreign exchange policies, manages the country’s foreign exchange reserves, and controls the exchange rate regime. The RBI intervenes in the foreign exchange market to maintain orderly conditions and manage fluctuations in the value of the Indian rupee.
Developmental Functions: The RBI also performs various developmental functions to promote a healthy and inclusive financial system. It supports initiatives to enhance financial inclusion, provides credit facilities to priority sectors, and promotes the development of specialised financial institutions and markets. The RBI also conducts research, collects data, and publishes reports on various aspects of the Indian economy.
These functions of the RBI are aimed at maintaining financial stability, promoting economic growth, ensuring the smooth functioning of the financial system, and safeguarding the interests of the public and stakeholders in the Indian economy. The RBI plays a crucial role in shaping and regulating the monetary and financial landscape of India.
24. What are the instruments of monetary policy used by the RBI. Explain any two of them.
Ans: The Reserve Bank of India (RBI) uses various instruments of monetary policy to manage and regulate the money supply, interest rates, and liquidity in the economy. These instruments are employed to achieve the objectives of price stability, economic growth, and financial stability. Here are two important instruments of monetary policy used by the RBI:
Repo Rate: The repo rate is a key instrument of monetary policy used by the RBI to regulate short-term borrowing and lending between the central bank and commercial banks. In a repo transaction, the RBI provides funds to banks against government securities as collateral. By adjusting the repo rate, the RBI influences the cost of borrowing for banks and affects short-term interest rates in the economy.
When the RBI raises the repo rate, it makes borrowing more expensive for banks, which leads to an increase in lending rates. This helps in curbing excessive borrowing and spending, managing inflation, and reducing liquidity in the system. Conversely, when the RBI lowers the repo rate, it reduces the cost of borrowing for banks, encouraging them to borrow more and lend at lower rates. This stimulates economic activity, promotes investment and consumption, and increases liquidity in the system.
Cash Reserve Ratio (CRR): The Cash Reserve Ratio is the percentage of total deposits that banks are required to maintain with the RBI in the form of cash reserves. It is a tool used by the RBI to regulate the liquidity in the banking system and control the money supply. By adjusting the CRR, the RBI can influence the amount of money that banks can lend and the liquidity available in the system.
When the RBI raises the CRR, it mandates banks to hold a higher proportion of their deposits as cash reserves, reducing the amount of money available for lending. This helps in reducing liquidity in the system and controlling inflationary pressures. Conversely, when the RBI lowers the CRR, it allows banks to hold a lower proportion of their deposits as cash reserves, increasing the amount of money available for lending. This boosts liquidity in the system, stimulates economic activity, and promotes credit creation.
These two instruments, the repo rate and the Cash Reserve Ratio, are important tools used by the RBI to manage monetary policy. By adjusting these instruments, the RBI influences interest rates, credit availability, and liquidity in the economy, thereby impacting investment, consumption, and overall economic activity. These measures play a crucial role in achieving the objectives of price stability, economic growth, and financial stability in the country.
25. What are the functions of money?
Ans: Functions of Money: Money performs four important functions each of which overcomes one of the difficulties of barter.
(i) Medium of Exchange.
(ii) Measure of Value.
(iii) Standard of Deferred Payments. and
(iv) Store of Value.
(i) Medium of Exchange: The first and foremost function of money is that it acts as a medium of exchange. Money eliminates the need for double coincidence of wants. It is no longer necessary for the person who possesses/produces wheat to look for a producer to cloth who will buy his wheat and at the same time sell him cloth. All he has to do is to find a buyer of his wheat in the market. Once he sells his wheat for money, he can purchase cloth – his desired commodity or any other commodity from the market. Since money acts as an intermediate in the exchange process, it is called as medium of exchange.
(ii) Measure of Value: The second fundamental function of money is that it acts as a common measure of value. Money serves as a unit of measurement in terms of which the value of all goods and services are measured and expressed. When we express the value of a commodity in terms of money, it is known as price. That is, the number of monetary units for which a unit of good or service can be had. For example, if the price of a pen in Rs. 10 then a pen can be had in exchange for ten monetary units (where the monetary unit in this case is the rupee.)
(iii) Standard of Deferred Payments: Money serves as a standard of deferred payment. Deferred payment refer to those payments which are to be made in future. Money is used as a medium of exchange, but this time the payment is spread over a period of time. Thus as soon as money is used as a medium of exchange and as a unit of value, it is almost essentially used as the unit in terms of which all future payments are expressed.
(iv) Store of Value: Money is not perishable and its storage costs are also considerably lower. It is also acceptable to anyone at any point of time. Thus money can act as a store of value for individuals. Wealth can be stored in the form of money for future use. Keynes places great emphasis on this functions of money. People normally keep a part of their wealth in the form of money because savings in terms of goods is very difficult. However, to perform this function well, the value of money must be sufficiently stable. A rising price level reduces the purchasing power of money. It may be noted that any asset other than money can also act as a store of value. e.g. land. houses or even bonds.
26. What is demand for money? How demand for money is related to the rate of interest.
Ans: The total demand for money broadly comes from two motives transaction motive and speculative motive.
People derive to hold money i.e demand for money to carry out their routine transactions. This is because our expenditure patterns normally do not match our receipts. Demand for money for transaction purpose is mainly determined by the level of income. Higher the level of income, the larger will be the transaction demand. Transaction demand is a fraction of total volume of transactions over the unit period of time and can be written as MdT = kT where T is the total value of transaction is the economy over unit period of time and k is a positive fraction.
Speculative demand is the demand for money for storing of wealth. Wealth can be held in the form of landed property, bonds, money, bullion etc. it is speculation about future changes in interest rate and bond prices that the resulting demand for money is called speculative demand for money.
Speculative demand can be expressed as, Mds = f(r) where Mds = Speculative demand for money.
r = rate of interest
Speculative demand for money and rate of interest has a inverse relationship.
In the figure speculative demand for money is measured on the horizontal axis and the rate of interest on the vertical axis when rate of interest is r0 speculative demand for money is zero. The rate of interest is very high and everyone expects it to fall in future. People therefore, are sure to get capital gains in future. So everyone converts the speculative money holding into bonds. On the other hand, when rate of interest is r1, people believe it too low that it cannot fall further. It can only rise. To hold bonds at this interest rate means almost a certain risk of capital loss as the interest rates rise and the bond prices fall. At this low interest rate the speculative demand for many is infinite. The curve thus becomes perfectly interest elastic and is called the liquidity reap.
Total demand for money is an economy can be written as. Md = Mdt + Mds
27. Explain the major role of RBI as a monetary authority of India.
Ans: The major role of RBI are as follows:
(i) Issues of currency: The RBI is the role authority for the issue of currency in India in order to secure control over volume of currency and credits. The issue of currency into circulation and its withdraw from circulation takes place through the banking department of the RBI and the one rupee notes and small coins are issued by the central Government, this distribution to the public is the sole responsibility of the RBI.
(ii) Bankers to the Government: The RBI acts as banker to the government the central as well as state governments. RBI provides short term credit to the government to meet any shortfalls in its receipts over its disbursements. It also provide short term credit to state governments as ways and means advances. The RBI also charged with the responsibility of managing the public debt, the RBI manager all new issues of government loans, services the public debt outstanding and nurses the market for government securities and mobilising resources for financing public sector projects.
RBI achieves central and state government on the quantum timing and terms of such loans and co-ordinates their borrowing programme. RBI also acts as advisor to the government on all banking and financial matters.
(iii) Bankers Bank and Supervisor: As bankers bank RBI hold a part of the cash reserves of banks, lends them funds for short periods, and provide them with centralised clearing and cheap and quick remittances facilities. The RBI as the country’s central bank is authorised statutorily to require scheduled commercial bank to deposit with it a stipulated ratio of their net total liabilities. This ratio is called Cash Reserve Ratio under the Reserve Bank of India Act, 1934 and the Banking Regulation Act, 1949 the RBI enjoys extensive power of supervision, regulation and control over commercial and co-operative banks.
(iv) Controller of Money supply and credit: Control the total supply of money and bank credit in the best interest of the national economy is a very important function of RBI. The RBI has to satisfy diverse and competing claims on it and the rest of the banking system for credit in a manner that promotes maximum output and employment with price stability, a high rate of economy growth with distributional justice and reasonable balance in the country’s balance of payments.
(v) Promotional Role: RBI also playing an active role in two main directions, (a) in building up and strengthening the country’s financial infrastructure, filling up major institutional gaps through the setting up of new financial institutions and reorganising the existing ones in the context of changing development and other policy needs of the economy and (b) in devising new measures for influencing the allocation of credit in socially desired directions.