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Class 12 Economics Chapter 3 Money and Banking
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Money and Banking
PART – A
VERY SHORT TYPE QUESTIONS ANSWERS
- What is barter system?
Ans : Barter system of exchange refers to the system where goods are exchange for goods.
- In the equation of transaction demand for money MdT = K.T what does the T at th right hand side stand for?
Ans : T = Transaction.
- What is velocity of circulation of money?
Ans : The number of times the rupees has been circulated is known as velocity of circulation.
- A person earns Rs. 700 per month. Calculate his average cash holding.
Ans : Average Cash Holding = 700 ÷ 2 = 350
- What is a person’s average transaction demand for money?
Ans : It is his half of his monthly transaction.
- 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.
An s : True.
- At liquidity trap, what is the elasticity of speculative demand for money?
Ans : Infinity
- “The speculative demand for money is — (directly, inversely) related to the market rate of interest.”
— Fill in the blank by choosing the correct word.
Ans : Inversely
- Ina modern economy, people hold money broadly for two motives. One is transaction motive, what is the other?
Ans : Speculative motive
- Name the monetary authority that issues currency notes in India.
Ans : Reserve Bank of India (RBI)
11. Why is reserve keeping with the RBI costly for commercial banks?
Ans : In reduces the borrowing capacity of the commercial Banks.
12. Why is necessary for the RBI to keep reserve from commercial banks?
Ans : For credit Creation
13. What is cash reserve ratio?
Ans : Cash reserve ratio refers to the maximum percentage of time and demand deposits, required to be kept by commercial banks with the central bank.
14. What is statutory liquidity ratio?
Ans : Statutory liquidity ratio refers to the maximum percentage of time and demand deposits, required to be kept by commercial banks with themselves.
15. What us borrowing rate of a commercial bank?
Ans : It is the rate of interest at which commercial banks accepts deposits.
16. How is the credit worthiness of a person judged by commercial banks?
Ans : By investigating current assets of the person concerned.
17. 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.
18. Choose the correct one:
The fraction of the commercial banks deposits that is kept with the Reserve Bank of India is called (Reserve deposit ratio/Cash reserve ratio/statutory liquidity ratio).
Ans : Cash Reserve Ratio (CRR)
19. Write true or false:
Fixed deposits which is also called time deposit does not have a fixed period of maturity.
Ans : False
20. Fill in the blanks:
Is the most liquid of all assets which is generally accepted by all.
Ans : Money.
21. What is Money?
Ans : Money is defined as anything that is widely accepted for the exchange of goods and services.
22. Write true or false: Money is convenient unit of account.
Ans : True.
23. What is deterioration of money?
Ans : Money deterioration means deterioration in the value of money comparing with other currencies.
24. What is liquid money?
Ans : Liquid money means money can be converted into other assets. We can spend money to buy anything we required. So it can be said that money is most liquid of other assets.
25. Write true or false:
Demand deposits are not legal tenders.
Ans : True
26. Give one factor on which currency deposit ration (cdr) depends.
Ans : Demand deposits
- SHORT ANSWER QUESTION II TYPE – MARKS : 3
- Suppose a bond promises Rs. 600 at the end of the three years with no intermediate return. If the rate of interest is 10% per annum. What is the price of the bond?
Ans : For 1st year
Interest = 600 x 10% = 60
∴ Bond Price = ( 600 – 60 ) = Rs. 540
For 2nd year
Interest = 540 x 10% = 60
∴ Bond Price = ( 540 – 54 ) = Rs. 486
For 3rd year
Interest = 486 x 10% = 48.6
∴ Bond Price = ( 486 – 48.6 ) = Rs. 437.40
∴ The price of bonds are, Rs 540, Rs 486, Rs 437.40 respectively.
- Suppose the price of a bond is Rs 400 and the rate of return per annum is 5%. It there is no intermediate return, what will be the total return after two years?
Ans : Given, Bond price = Rs 400
Interest Rate = 5% ( per year )
∴ Total return after 1st year = 400=400x 5/100 = Rs 420
Again, Total return in the 2nd year = 420+420x 5/100 = Rs 441
- 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 cheque able deposits whereas time deposits do not enjoy cheque facility.
Iv) Demand deposit are treated as part of money supply whereas time deposits are not treated as part of money supply.
- What is flat money? Can coins termed as flat money?2016
Ans : Flat money is any money that i under the flat or order from the government to act as money.
- 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.
- 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.
- What is the significance of bank rate as a tool of RBI? 2014
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.
- Exhibit a sample balance sheet of commercial banks.
9. What is inflation?
Ans : When the prices of goods and service rises continuously for a longer period of time, it is called inflation. Inflation are mainly demand pull and cost push. Demand pull inflation arises due to excess demand of the goods and services and cost push inflation occurs due to the increase cost of production.
10. Mention any three shortcomings of a barter system.
Ans : The shortcomings
(i) Lack of coincidence of wants.
(ii) Lack of storage facilities.
(iii) Lack of measurement of value.
11. Match the following:
12. 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. Expect producers of money.
C. SHORT ANSWER QUESTION TYPE – I : (MARKS : 4)
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 basis 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 a beater 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 meters, milk in liters 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 trough 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 remains 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) Standards 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 term 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 term of money. Pensions, principal and interest on debt, salaries etc. Are some examples of deferred payments.
2. What is liquidity trap?—Explain.
Ans : ‘Liquidity trap’ is a situation of very low rate of interest where people are ready to hold whatever stock of money is supplied expecting interest rate to rise in future and bond prices to fall.
3. 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.
4. Explain the significance of M1, M 2, M3 and M4 in regard 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 organizations (including national saving certificates)
5. What is sterilisation operation of RBI?
Ans : RBI stabilize money supply against exogenous shock by sterilization.RBI after uses its instruments of money creation for stabilizing the stock of money in the economy from external shocks. Suppose due to future growth prospects in India investor 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 s sterilizations.
6. Explain a sample balance sheet of the RBI.
|Liabilities (in Rs)||Assets (in Rs)|
|1||Gold – 10||1||Circulating money – 8|
|2||Foreign Currency – 20||2||Money Deposited (public)-200|
|3||Loan to Gout – 230||3||Reserve Deposits|
|(commercial Banks) – 40|
|4||Loan to Commercial Banks – 5||4||Deposited Money of Go I – 15|
|Total = Rs 265||Total = Rs 263|
7. Explain the functions of money in a modern economy.
Ans : See Q. No. 1 (Short Type I ).
8. Write a note on barter system.
Ans : Barter system of exchange refers to the system where goods are exchanged for goods. However, the barter system have been abolished due to the various problem in it. The most important problem of barter system was that it can’t work as a medium of common exchange due to lack of coincidence of wants among the people. Moreover, measure of value and store of value of the goods are another problems associated with the barter system, for which this system could not run long.
9. What is open market operation? Explain in brief.
Ans : See Q. No. 8(ii),(Long Type).
10. What is the significance of bank rate policy exercised by the RBI?
Ans : See Q. No. 8(i),(Long Type).
11. What are the functions of commercial Bank?
Ans : The functions of commercial banks may be divided into 3 main groups-
(a) Primary functions
(b) Agency functions
(c) General utility functions
The primary functions may be divided into advancing loans, and accepting deposits.
The agency functions include (a) collection and making payments on behalf of their customers, such as pensions, (b) Sale and purchase of securities (c) Trustee and executor.
The general utility functions include locker facility, travellers cheque, Underwriting of securities etc.
12. 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 ro, 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 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 future. It can only rise.
13. Explain the determinants of money supply..
Ans : The determinant of money supply.
(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 apart 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,
14. If National Income in an economy increases by R 1,000 crore as a result of a new investment (∆ I) of Rs 200 crore, find out the value of (i) MOC, and (ii) Multiplier (K)
Ans : Marginal propensity to consumer
D. LONG ANSWER QUESTIONS TYPE : (MARKS : 5)
1. The aggregate demand for money in the economy can be shown with the following equation:
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, refers to the speculative demand for money and here the term ‘max’ indicates relationship with the rate of interest.
2. Describe the speculative demand for money.
Ans : Different people have different expectations regarding the future movement 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 expect 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.
3. Explain the transaction demand for money.
Ans : Transaction demand for money refers to demand for money for conducting day-to-day transaction. 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. 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.
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 (∴ LLR = Legal Reserve Ratio
5. 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/CFR+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,
And rdr = reserve deposit ratio of banks.
Currency deposit ratio is the proportion of currency (c) held by public to other holding 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.
6. Explain the functions of RBI.
Ans : The main functions are:
(a) Issue of notes
(b) Banker to Government.
(c) Banker’s Bank
(d) Controller of money supply and credit
(e) Maintenance of foreign exchange
(f) Lender of Last Resort.
7. Can commercial bank create money?
Ans : A commercial bank is creator of money in the economy because it create 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 transaction. 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. “RBI is responsible for changes in the supply of money in the economy” – Elaborate this statement.
Ans : The instruments by which the central bank controls the money supply and credit in the economy are categorised as quantitative and qualitative instruments. Quantitative instruments affect the volume of money supply and credit in the economy. The important quantitative instruments are-
(i) Bank Rate policy: The bank rate is the rate at which the central bank lends funds as a lender of last resort to banks 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. A a result banks use a greater proportion of their resources for giving out loans to borrower or investor. The bank rate is lowered during deflation. A high bank rate will have the opposite effect, During inflation bank rate is raised which reduces the flow of credit.
(ii) Open market operations: Open market operations refer to the buying and selling of government securities by the central bank from/to the public and banks. It lead to increase or decrease the stock of high powered money in the economy. The successful conduct of open market operations requires the existence of a will functioning securities. Market sale of securities reduces the reserves of commercial banks. It adversely affects the bank’s ability to create credit and therefore decrease the money supply in the economy.
(iii) Cash Reserve Ratio: Under the law a certain fixed percentage of the total deposits of banks need to be kept as cash with the central bank. The fixed percentage of cash is termed as the cash reserve ratio. Cash reserve ratio is a powerful instrument to control credit and lending power to the banks. A change in the cash reserve ratio alters the extent to which banks can create credit. For example if the CRR increases, the banks would be required to keep extra money in the form of cash. This reduces the amount of money that is available for lending. Similarly, when the CRR decreases, more amount of money becomes available for banks to lend. When the flow of credit is to be reduced cash reserve ratio is raised and when credit is to expanded, CRR is reduced.
(iv) By varying the statutory liquidity ratio (SLR): Every bank is required to maintain a fixed percentage of its assets in form of cash or other liquid assets called statutory liquidity ratio. These liquid assets take the form of
(a) Excess reserves: Which are kept with central bank over and above the CRR.
(b) Investments in government and other approved securities.
(c) Current accounts maintained with other banks.
RBI stabilize money supply against exogenous shock by sterilization.RBI after uses its instruments of money creation for stabilizing 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 investment in India. Bond which under such, circumstance, are likely to yield a high rate of return. They will buy these bonds with foreign currency. Since one cannot 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 hand with which they complete 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 sterilizations.
9. Explain the role of the RBI as the lender of the last resort.
Ans : When commercial banks have exhausted all resource to supplement their fund all time of financial crises, 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.
10. 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.
11. What are the instruments of monetary policy used by the RBI. Explain any two of them.
Ans : See Q. No. 8 (Long Type)
12. Explain the role of money in a modern economy.
Ans : Function of money: Money performs four important functions each of which overcomes one of the difficulties of barter. These are: (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.)
(iiii) Standard of deferred payments: Money serves as a standard of differed payment. Deferred payments 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 function 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.
Money also serves as transfer of value. Money facilitates movement of capital from one individual to another and from one place to another. Because of its general acceptability and the merit of liquidity, money can perform this function. It is because of this function of money, people can buy goods at far off place for the satisfaction of their wants. They can also purchase immovable property at any specific place for money. Further, people can loan out their surplus value and earn interest income. In this way, money facilitates the process of investment and growth in the country.
13. 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 ro 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 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
14. What is liquidity trap? How rate of interest is related to bond prices?
Ans : Liquidity trap is a situation of very low rate of interest where people are ready to hold whatever stock of money is supplied expecting interest rate to rise in future and bond prices to fall.
There is a negative relationship between the interest rate and the market price of a bond. If people think the present rate of interest as two high, they will expect the rate to fall as it returns to the normal rate. At the current high rate, people will therefore, hold bonds, instead of money. They will therefore not only currently enjoy the high rate of return provided by the bonds, but will also expect capital gains as the bond prices rise and the interest rate falls to normal in future. Conversely, if people think the present interest rate as low, then they will expect it to rise and bond prices to fall, as the interest rate return to the normal rate. They will therefore hold money rather than bonds.
15. 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 any shortfalls in its receipts over its disbursements. It also provides 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 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 required 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 credit: Control the total supply of money and the 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.
16. Explain the concept of deficit financing.
Ans : Deficit financing is one where the estimated revenue is less then the estimated expenditure. This means that tax is less then expenditure. The reduction in increase in aggregate demand is by an amount equal to the expenditure. The net effect of this will be to increase aggregate demand. Deficit financing is therefore a good policy to combat recession. Where the economy is in an under employment equilibrium due to deficit demand.
(i) It accelerates growth
(ii) It would be needed for the monetization of the economy
(i) It is not desirable during inflation as it adds to supply of money.
(ii) It would lead to unnecessary expenditure on the govt.
17. 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 sectors 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.
18. 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 stabilize 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 gray market. On 9 November 2016, the Government of India announced the demonetization of all Rs. 500 and R. 1000 banknote of the Mahatma Gandhi series. It also announced the issuance of new Rs. 500 and Rs. 2000 banknotes in exchange for the demonetised banknotes.
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