CHAPTER 3: Money and Banking (Date : 04-10-2022)

Correct Answer : D

Explanation

Money is the commonly accepted medium of exchange.

• In an economy which consists of only one individual like Person camped in Antarctica, there cannot be any exchange of commodities and hence there is no role for money.
• Even if there is more than one individual and these individuals do not take part in market transactions, for example: a family living on an isolated island, money has no function for them.
• However, as soon as there is more than one economic agent who engages themselves in transactions through the market, money becomes an important instrument for facilitating these exchanges.
• Hence option D is correct.

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Correct Answer : A

Explanation

• Economic exchanges without the mediation of money are referred to as barter exchanges. However, they presume the rather improbable double coincidence of wants.
• Consider, for example, an individual who has a surplus of rice which she wishes to exchange for clothing. If she is not lucky enough, she may not be able to find another person who has the diametrically opposite demand for rice with a surplus of clothing to offer in exchange.
  • The search costs may become prohibitive as the number of individuals increases.
  • Thus, to smoothen the transaction, an intermediate good is necessary which is acceptable to both parties like money.
• The individuals can then sell their produces for money and use this money to purchase the commodities they need. Though facilitation of exchanges is considered to be the principal role of money, it serves other purposes as well. The following are the main functions of money in a modern economy.
• Hence option A is correct.

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Correct Answer : C

Explanation

• The Reserve Bank of India was set up on the basis of the recommendations of the Hilton Young Commission, under the Reserve Bank of India Act, 1934.
• RBI acts as the Manager of Foreign Exchange of GoI under the Foreign Exchange Management Act, 1999.
  • It facilitates external trade and payment and promote orderly development and maintenance of foreign exchange market in India. Hence statement 1 is correct.
• It issues the currency of the country. This currency issued by the central bank can be held by the public or by the commercial banks and is called the ‘high-powered money’ or ‘Reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.
• It controls the money supply of the country through various methods, like bank rates, open market operations and variations in reserve ratios.
• It acts as a banker to the government. It is the custodian of the foreign exchange reserves of the economy and also acts as a bank to the banking system. Hence statement 2 is correct.

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Correct Answer : D

Explanation

• The demand for money tells us what makes people desire a certain amount of money.
• Since money is required to conduct transactions, the value of transactions will determine the money people will want to keep: the larger is the quantum of transactions to be made, the larger is the quantity of money demanded.
• Since the quantum of transactions to be made depends on income, it should be clear that a rise in income will lead to a rise in demand for money (to make large transactions). Hence statement 1 is correct.
• People keep their savings in the form of money rather than putting it in a bank which gives them interest, how much money people keep also depends on the rate of interest.
• Specifically, when interest rates go up, people become less interested in holding money since holding money amounts to holding less interest-earning deposits, and thus less interest received. Hence statement 2 is correct.
  • Therefore, at higher interest rates, money demanded comes down.

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Correct Answer : C

Explanation

• Assets are things a firm owns or what a firm can claim from others. In the case of a bank, apart from buildings, furniture, etc., its assets are loans given to the public. Hence statements 2 and 4 are correct.
  • Another asset that a bank has is reserves. Reserves are deposits which commercial banks keep with the Central bank (RBI) and its cash like CRR and SLR. Reserves are similar to deposits we keep with banks. Hence statements 1 is correct.

• Liabilities for any firm are its debts or what it owes to others. For a bank, the main liability is the deposits which people keep with it.
  • Time and Demand deposits of the customers to the commercial banks are counted as liability for the commercial bank. Hence statement 3 is not correct.
• The RBI decides a certain percentage of deposits which every bank must keep as reserves. This is done to ensure that no bank is ‘over lending’. This is a legal requirement and is binding on the banks.
  • This is called the ‘Required Reserve Ratio’ or the ‘Reserve Ratio’ or ‘Cash Reserve Ratio’ (CRR)
  • Cash Reserve Ratio (CRR) = Percentage of deposits which a bank must keep as cash reserves with the bank.
  • Apart from the CRR, banks are also required to keep some reserves in liquid form in the short term. This ratio is called Statutory Liquidity Ratio or SLR.
  • The statutory requirement of the reserve ratio acts as a limit to the amount of credit that banks can create.

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Correct Answer : D

Explanation

POLICY TOOLS TO CONTROL MONEY SUPPLY:

• Reserve Bank is the only institution which can issue currency. This role of RBI, that of being ready to lend to banks at all times, is another important function of the central bank, and due to this the central bank is said to be the lender of last resort.
• The tools used by the Central bank to control money supply can be quantitative or qualitative.
  • Quantitative tools: control the extent of money supply by changing the CRR, or bank rate or open market operations. Hence statement 1 is not correct.
  • Qualitative tools include persuasion by the Central bank in order to make commercial banks discourage or encourage lending which is done through moral suasion, margin requirement, etc. Hence statement 2 is not correct.

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Correct Answer : C

Explanation

People desire to hold a money balance for two motives:

• Transaction Motive: holding money is to carry out transactions.
  • The number of times a unit of money changes hands during the unit period is called the velocity of circulation of money. The velocity of money has a time dimension.
• Relationship between the aggregate transaction demand for money of an economy and the (nominal) GDP in a given year:
• Normally, there exists a stable, positive relationship between the value of transactions and the nominal GDP. An increase in nominal GDP implies an increase in the total value of transactions and hence a greater transaction demand for money. Hence statement 1 is correct.
• The Speculative Motive: An individual may hold her wealth in the form of bonds.
  • A decrease in bond price means a loss to bond holder. Such a loss occurring from a falling bond price is called a capital loss to the bond holder.
  • Under such circumstances, Bond holder will try to sell her bond and hold money instead. Thus, speculations regarding future movements in interest rates and bond prices give rise to the speculative demand for money.
  • 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 anticipate 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. Hence statement 2 is correct.
• Total demand for money in an economy is, therefore, composed of transaction demand and speculative demand. The former is directly proportional to real GDP and price level, whereas the latter is inversely related to the market rate of interest.

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Correct Answer : A

Explanation

• Interest rate can be thought of as an opportunity cost or ‘price’ of holding money balance.
• If the supply of money in the economy increases and people purchase bonds with this extra money, demand for bonds will go up, bond prices will rise and the rate of interest will decline.
  • In other words, with an increased supply of money in the economy the price you have to pay for holding money balance, viz. the rate of interest, should come down.
• However, if the market rate of interest is already low enough so that everybody expects it to rise in future, causing capital losses, nobody will wish to hold bonds.
• Everyone in the economy will hold their wealth in money balance and if additional money is injected within the economy, it will be used up to satiate people’s craving for money balances without increasing the demand for bonds and without further lowering the rate of interest below the floor. Such a situation is called a liquidity trap. The speculative money demand function is infinitely elastic here.
• The rate of interest is so high that everyone expects it to fall in future and hence is sure about a future capital gain. Thus, everyone has converted the speculative money balance into bonds. Everyone is sure of a future rise in interest rates and a fall in bond prices. Everyone puts whatever wealth they acquire in the form of money and the speculative demand for money is infinite.
• Hence, option A is correct.

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Correct Answer : C

Explanation

• In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India.
  • However, coins are issued by the Government of India.
• Currency notes and coins are therefore called fiat money.
• They do not have intrinsic value like a gold or silver coin.
• They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction.
  • Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of payment. Hence, demand deposits are not legal tenders.
• Hence option C is correct.

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Correct Answer : C

Explanation

Legal Definitions: Narrow and Broad Money

• Money supply, like money demand, is a stock variable.
  • The total stock of money in circulation among the public at a particular point of time is called money supply.
• RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows:
  • M1 = CU + DD
  • M2 = M1 + Savings deposits with Post Office savings banks
  • M3 = M1 + Net time deposits of commercial banks
  • M4 = M3 + Total deposits with Post Office savings organisations (excluding
    National Savings Certificates)
    • where, CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks.
    • The word ‘net’ implies that only deposits of the public held by the banks are to be included in money supply.
    • The interbank deposits, which a commercial bank holds in
      other commercial banks, are not to be regarded as part of the money supply. Hence interbank transactions will not affect money supply in the economy.
• M1 and M2 are known as narrow money. M3 and M4 are known as broad money. These measures are in decreasing order of liquidity. M1 is the most liquid and easiest for transactions whereas M4 is the least liquid of all.
• M3 is the most commonly used measure of money supply. It is also known
  as aggregate monetary resources.
• Hence option C is correct.

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Correct Answer : B

Explanation

The key ratios which influence money supply in economy:

• The Currency Deposit Ratio: The Currency Deposit Ratio (CDR) is the ratio of money held by the public in the currency that they hold in bank deposits.
  • It reflects people’s preference for liquidity. It is a purely behavioural parameter which depends, among other things, on the seasonal pattern of expenditure.
    • For example, cdr increases during the festive season as people convert deposits to cash balance for meeting extra expenditure during such periods. Hence statement 1 is not correct.
• The Reserve Deposit Ratio: Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI.
  • Vault cash: Cash kept on hand in a depository institution's vault to meet day-to-day business needs, such as cashing checks for customers; can be counted as a portion of the institution's required reserves.
  • Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves. Hence statement 2 is correct.
• RBI uses various policy instruments to bring forth a healthy rdr in commercial banks, Like:
  • Cash Reserve Ratio (CRR): which specifies the fraction of their deposits that banks must keep with RBI, and
  • Statutory Liquidity Ratio (SLR) banks to maintain a given fraction of their total demand and time deposits in the form of specified liquid assets. Apart from these ratios RBI uses a certain interest rate called the Bank Rate to control the value of rdr.

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Correct Answer : A

Explanation

• High Powered Money: The total liability of the monetary authority of the country, RBI, is called the monetary base or high-powered money.
  • It consists of currency (notes and coins in circulation with the public and vault cash of commercial banks) and deposits held by the Government of India and commercial banks with RBI. Hence statement 1 is correct.
• These items are claims which the general public, government or banks have on RBI and hence are considered to be the liability of RBI. Hence statement 2 is not correct.
• The increment in total money supply exceeds the amount of HPM initially injected by RBI into the economy.
  • We define Money Multiplier as the ratio of the stock of money to the stock of HPM in an economy, viz. M/H. Clearly, its value is greater than 1. Money supply is equal to currency plus deposits: M = CU + DD = (1 + cdr)DD

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Correct Answer : D

Explanation

• Sterilization is a monetary action used by the central bank (RBI) in order to stem the negative effects emerging from capital inflows or outflows from a country's economy.
• It involves RBI conducting buy and sell operations in open markets by including fiscal policy measures in order to overcome problems like inflation.
• RBI will undertake an open market sale of government securities 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 sterilises the economy against adverse external shocks. This operation of RBI is known as sterilisation.
• This is a kind of open market operation (OPO), specific to the extract the forex normally infused by the international trades and Investments. In other OPO, normal buying or selling of bonds by the RBI on behalf of the govt to regulate the money supply in the economy.
• Open Market Operations. Open Market Operations refers to buying and selling of bonds issued by the Government in the open market. This purchase and sale are entrusted to the RBI on behalf of the Government. Buying/Selling of a bond by RBI (to private individuals or institutions) leads to a reduction/increase in the quantity of the money supply.
  • There are two types of open market operations: outright and repo.
• Hence option D is correct.

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