CHAPTER – 3

MONEY AND BANKING

I Choose the correct answer

1. The main function of money is

a) Saving c) Expenditure
b) Medium of exchange d) Investment

2. The bank which acts as monetary authority of India

a) RBI c) RRB
b) NABARD d) IDBI

3. The banks which are a part of the money creating system of the
economy are
a) Bankers c) RBI
b) Commercial banks d) None of the above.

4. The rate at which the RBI lends money to commercial banks against
securities
a) Bank rate c) Reverse Repo rate
b) Repo rate d) None of the above

5. The important tool by which RBI influences money supply is

a) Open market operations c) Closed market operation
b) Money operation d) None of the above

II Fill in the blanks

1. Economic exchanges without the use of money are referred to as

………. Barter system
2. …………….is the only institution which can issue currency in India-RBI
3. …………issues coins in India - Government of India
4. The principal motive for holding money is to carry out ……Transactions
5. M1 and M2 are known as …………… Narrow money.
III Match the following:

A B

1. SLR a) Government of India

2. Circulation of coin b) Statutory Liquidity
3. Money Ratio
4. M3 and M4 c) Broad Money
5. Repurchase d) Repo
agreement e) Medium of
Exchange
1 – b; 2 – a; 3 – e; 4 – c; 5 – d.

IV Answer the following questions in a sentence/word.

1. What do you mean by barter system?

The economic exchanges without the mediation of money (use of
money), is called Barter system. (It is a system of exchange for goods for
goods).
2. Give the meaning of money.
Money is the commonly accepted medium of exchange.
According to F. A. Walker ‘Money is what money does.’
According to Crowther, Money is anything that is generally acceptable
as a medium of exchange and at the same time acts as a measure and
store of value.
3. What is time deposit?
The deposits that have a fixed period for maturity are called time
deposit. These are the deposits in which money is deposited for a fixed
period and cannot be withdrawn before stipulated time. deposited.
4. What is Fiat money?
The currency and coins are called Fiat Money. It is a highly liquid legal
money in circulation as they cannot be refused by any citizen of India for
any kind of transactions. It is the money which does not have any intrinsic
 value. Intrinsic value is the value of metal or paper which is
equal to face value of coin or currency note.
5. Write the meaning of high-powered money.
The currency issued by the Central Bank can be held by the public or by
the Commercial Banks.
6. Expand CRR.
Cash Reserve Ratio.
7. What is bank rate?
Bank Rate is the rate at which the RBI gives loans to the commercial
banks.

V Answer the following questions in 4 sentences.

1. Mention any two functions of money
The two functions of Money are
• Medium of exchange
• Measure of value
2. Give the meaning of CRR and SLR.
The Cash Reserve Ratio (CRR) is a certain percentage of bank deposits
which a commercial bank is required to keep as cash reserves with RBI
in the form of reserve.
The Statutory Liquidity Ratio (SLR) refers a certain percentage of total
deposits and time deposits which the commercial banks must maintain
with themselves in the form of liquid assets, as per the directions of RBI.
3. State the credit control instruments of RBI.
There are two instruments of RBI to control credit viz., Quantitative
techniques and Qualitative techniques.
The Quantitative Credit Control Techniques includes
1. Bank rate
2. Open market operations
3. CRR – Cash Reserve Ratio
 4. SLR- Statutory Liquidity Ratio.

The Qualitative Credit Control Techniques are

1.Credit rationing
2.Margin Requirements
3.Moral Suasion
4.Publicity
5.Direct Action.
4. Mention the two motives of demand for money.
The two motives of demand for money are as follows:
• The transaction Motive
• The Speculative Motive.
5. How does bank rate influence money supply?
In India, RBI can influence money supply by changing the rate at which
it gives loans to the commercial banks. This rate is called as Bank Rate.
By increasing the bank rate, loans taken by commercial banks become
more expensive which reduces the reserves held by the commercial
bank and hence decreases money supply.
A fall in the bank rate can increase the money supply.
6. What role of RBI is known as ‘Lender of Last Resort’?
RBI is the only institution which can issue currency. RBI helps the
commercial banks in times of their financial crisis. When commercial
banks need more funds to create more credit, they may go to the market
for raising such funds or go to the RBI. The RBI provides them funds through
various instruments. So, RBI saves the commercial bank from being
bankrupt. This role of RBI, that of being ready to lend to banks at all times
is another important function of RBI.
VI Answer the following questions in 12 sentences.

1. Briefly explain the functions of RBI.

The main functions of RBI are as follows:

a) Printing and issuing currency notes- RBI has complete authority of printing
and issuing currency notes in the country. RBI issue all denominations of
currency notes except one rupee note, which is issued by finance ministry,
Government of India. RBI follows Minimum Reserve System of note issue while
printing currency since 1956.
b) Lender of last resort: RBI provides financial assistance to commercial banks
like giving credit, discounting bills, giving advances, etc during their financial
crisis and helps the banks as a lender of last resort.( When commercial banks
need more funds to create more credit, they may go to the market for raising
such funds or go to the RBI. The RBI provides them funds through various
instruments.)
c)Control of credit -The credit provided by all commercial banks is controlled
by RBI. It implies increase or decrease in the supply of money by regulating
the creation of credit. RBI implements both Quantitative and qualitative
techniques to control the credit generated by commercial banks. The
quantitative measures to control credit are Bank rate policy, Open market
operations, Repo and Reverse Repo rates, Cash reserve ratio and Statutory
liquidity ratio. The qualitative methods are Margin Requirement, Credit
Rationing, Moral Suasion, Direct Action etc.
d)Banker, agent, and advisor: RBI act as a banker, agent, and the financial
advisor of the government. As a banker to the government, it manages
accounts of the government. As an agent to the government, it buys and sells
securities on behalf of the government. As an advisor to the government, it
helps the government in framing policies to regulate the money market.
e) Bankers Bank: The activities of all commercial banks are controlled and
managed by the RBI.
f) Controls money market- RBI is the leader of money market. All
the activities and components of money market like commercial banks
and financial institutions are controlled and directed by RBI.

2. Write a note on legal definitions of money.

The total stock of money in circulation among the public at a particular point
of time is called money supply. Money supply is a stock concept. Money
supply has 2 components:

1.Currency Component

2.Deposit Component.

The legal definitions of money supply defined by RBI are defined as follows:

• M1 = CU + DD+OD

(C – currency notes/coins held by the public; DD is net demand of the public

held by the banks)

• 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 organizations.

M1 and M2 are narrow money. M3 and M4 are broad money.

M1is the most liquid, easiest for transaction whereas M4 is least liquid. M3 is
the most commonly used measure of money supply.

3.Write the meaning of transaction motive and speculative motive of demand

for money.

The demand for money refers to the total money demanded by the people for
various purposes. The motives are demand for money are,
1.Transaction Motive: Transaction motive demand for money refers to holding
money to carry out day to day transactions. The need for holding cash arises
because there is time gap between receipt of income and the consumption
expenditure. Our expenditure pattern does not normally match our income.
People receive income at certain intervals of time (week, month) which is to
be consumed throughout the period till the next receipt. Thus, people tend to
hold money in cash for various transaction purposes.

The Transaction demand for money is represented as follows:

MdT = k. T

Where, MdT is the demand for money for transaction motive, T is the total value

of transactions in the economy and k is a position fraction.

The transaction motive for money is a positive fraction of income.

2.Speculative Motive: Some people hold cash to invest on shares, bonds

debentures, gold, immovable properties etc. The speculative demand for
money refers to the demand for money that people hold as idle cash to
speculate with the aim of earning capital gains and profits. The speculative
demand for money is inversely related to rate of interest.

Price of the bond is inversely related to the market rate of interest. When the
interest rate is very high everyone expects it to fall in future and hence
anticipates capital gain from bond holding (preference to hold bond
increases and desire to hold lesser idle cash balances). 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 expects a capital loss. Thus, they convert their bonds into money
giving rise to a high speculative demand for money (the preference for
holding bonds falls and desire to hold idle cash balances
rises). Hence speculative demand for money is inversely related to the rate
of interest.

Speculative demand for money can be written as follows:

Mds = rmax - r
r - rmin
Where, r is the market rate of interest and rmax and rmin are the upper
and lower limits of r, both positive constants.
4. ‘Money act as a convenient unit of account’. Explain this sentence with
the example?
Measure of Value/Unit of account: The money acts as a common or
convenient unit of account. The values of all goods and services can be
expressed in terms of money (called price). As a measure of value, money
performs following functions:
• The value of all goods and services measured and expressed in
terms of the money.
• Rate of exchange of goods and services expressed in money.
• Facilitates the maintenance of accounts.
• It facilitates price mechanism.
• It makes goods and services comparable in terms of price.
For instance, when we say that the value of a book is Rs.500 we mean
that the book can be exchanged for 500 units of money, where a unit of money
is rupee in this case. If the price of a pencil is Rs.5 and that of a pen is Rs.10 we
can calculate the relative price of a pen with respect to a pencil i.e., a pen is
worth 10/5=2 pencils.
4.What is liquidity trap?

It is a situation in which speculative demand for money is perfectly elastic,

even if the rate of interest reaches to the lowest level. If the supply of money
in the economy increases then people purchases bonds with the extra
money ,demand for bonds will go up ,bond prices will rise and rate of interest
will decline(negative /inverse relation).But if the market rate of interest is
already very low then everyone expect it to rise in future .This creates capital
loss for bond holders and people try to sell bond and hold money instead (no
one wish to hold bond).In this situation 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 rmin.
Speculative demand for money can be written as follows:

Mds = rmax - r
r - rmin
Where, r is the market rate of interest and rmax and rmin are the upper and lower
limits of r, both positive constants.

Diagrammatically,
VII Answer the following questions in 20 sentences
1. Explain the functions of money. How does money overcome the short
comings of a barter system?
Walker – Money is what money does.
Crowther – Money is anything that is generally acceptable as a
medium of exchange and at the same time acts as a measure and as a
store of value.
The functions of Money are broadly classified as follows:
• Primary Functions
• Secondary Functions
• Contingent Functions
1) Primary Functions:
The primary functions of money are as follows:
a) Medium of Exchange: Money plays an important role as a medium of
exchange. It facilitates exchange of goods for money. It helps the
people to sell goods in one place and buy in another place. Money has
widened the scope of market transactions and made the exchange
easy and convenient. Money has become a circulating material
between buyers and sellers.
It has solved the problems of barter system. Barter exchanges become
extremely difficult in a large economy because of the high costs people
would have to incur looking for suitable persons to exchange their
surpluses.
b) Measure of Value/Unit of account: The money acts as a common or
convenient unit of account. The values of all goods and services can be
expressed in terms of money (called price). As a measure of value, money
performs following functions:
• The value of all goods and services measured and expressed in
terms of the money.
 • Rate of exchange of goods and services expressed
in money.
• Facilitates the maintenance of accounts.
• It facilitates price mechanism.
• It makes goods and services comparable in terms of price.
For instance, when we say that the value of a book is Rs.500 we mean
that the book can be exchanged for 500 units of money, where a unit of money
is rupee in this case. If the price of a pencil is Rs.5 and that of a pen is Rs.10 we
can calculate the relative price of a pen with respect to a pencil i.e., a pen is
worth 10/5=2 pencils.
But in barter system it is impossible to measure the value of goods and services.
(Eg- car would be valued in terms of horses etc.)

2) Secondary Functions: The secondary functions of money are as follows:

a) Store of value: People can save part of their present income and hold the
same for future. Money can be stored for precautionary motives needed
to overcome financial stringencies.
Money solves one of the deficiencies of barter system i.e., difficulty to
carry forward one’s wealth under the barter system. It is difficult to store
perishable items like vegetables, meat etc.
For instance, we have an endowment of wheat which we do not
wish to consume today entirely. We may regard this stock of surplus
wheat as an asset which we may wish to consume or even sell off, for
acquiring other commodities at some future date. But wheat is a
perishable item and cannot be stored beyond a certain period. Also,
holding the stock of rice required a lot of space. We may have to spend
considerable time and resources looking for people with a demand for
wheat when we wish to exchange our stock for buying other
commodities. This problem can be solved if we sell our wheat for money.
Money is not perishable land its storage costs are also less.
b) Standard of deferred payments: All the credit transactions are
expressed in terms of money. The payment can be delayed or
postponed. So, money can be used for delayed settlement of dues or
financial commitments. Delayed payments refer to those payments
which are made sometimes in the future.
Under barter system contractual or future payments would certainly be
very difficult. Eg: Imagine that you have taken a loan from somebody in
terms of wheat. How difficult it is to return this loan in terms of wheat of the
same quality?
c) Transfer of value: Money acts as a transfer of value from person to person
and from place to place. It implies that with the help of money
purchasing power can be transferred. Money helps us to buy goods,
properties, or anything from any part of the country or the world. Further,
money earned in different places can be brought or transferred to
anywhere in the world.
Under barter system transferring goods is a difficult task decides being
expensive.
Limitations of Barter system:
• 1.Double coincidence of wants
• 2.Lack of common unit of value
• 3.Lack of system for storage and transfer of value
• 4.Lack of a system for Future payments or contractual payments

3) Contingent Functions of Money: Other than Primary and Secondary

functions, money also performs other functions which are as follows:
a) Basis of Credit: Money serves as a basis of the credit. The modern
credit system exists only because of existence of money.
b) Distribution of National Income: Money helps in distribution of national
income. The reward paid to factors of production in the form of rent,
 wages, interest, and profit are nothing but the distribution of
National Income at factor prices.
c) Provides Liquidity and Uniformity: Money provides liquidity to all kinds
of assets both moveable and immovable. Money can be converted
into any type of asset and all assets can be converted into money.
d) Helps in consumers’ and producers’ equilibrium: All g o o d s a n d
services are expressed in terms of money. The consumer attains
equilibrium when the price of a product is equal to his marginal utility.
Similarly, the producers reach equilibrium if they get maximum
satisfaction. Both consumers and producers try to achieve equilibrium
with the help of money.

2. Write the story of gold smith Lala on the process of deposit and loan
(credit) creation by commercial banks.
A financial institution which performs all kinds of business and finance for
trade and commerce and agriculture etc. are called commercial bank.
It accepts deposits from public and advances loans.
The story of Gold Smith LALA: Once there was a goldsmith named Lala in
a village. In this village, people used gold and other precious metals to
buy goods and services. These metals were acting as money. People in
the village started keeping their gold with Lala for safe keeping. In return
for keeping their gold, Lala issued paper receipts to people of the village
and charged a small fee from them. Slowly, over time, the paper receipts
issued by Lala began to circulate as money. So to purchase rice, wheat,
shoes, clothes etc. people were giving paper receipts .Thus, the paper
receipts started acting as money since everyone in the village accepted
these as a medium of exchange.
Let us imagine that Lala had 100 kgs of gold, deposited by different
people and he had issued receipts corresponding to 100 kgs of gold. A
 person called Ramu comes to Lala and asks for a loan of 25
kgs of gold. Now Lala can decide that everyone with gold deposits will
not come to withdraw their deposits at the same time. So, he can give
loan to Mr. Ramu and charge him for it. If Lala gives the loan of 25 kgs of
gold, Ramu could also pay Mr.Ali and Mr.Ali could give 25kgs of gold
with Lala in return for a paper receipt. In effect, the paper receipts,
acting as money, would have increased to 125 kgs now. So, Lala has
created money only by accepting gold from the depositors and lending
gold as loan to the needy people.
The modern banking system precisely works the way Lala behaves in this
example.

3. Explain the open market operation.

The open market operation is one of the important tools of RBI to control
money supply. It refers to buying and selling of bonds issued by the
Government in the open market. This purchase and sale is entrusted to the
RBI on behalf of the Government.

When RBI buys a Government bond in the open market, it pays for it by giving
a cheque. This cheque increases the total amount of reserves in the economy
and thus increases the money supply.

Similarly, selling of a bond by RBI to private individuals or institutions leads to

reduction in quantity of reserves and money supply.

There are two types of open market operations. They are as follows:

a) Outright: Outright open market operations are permanent in nature.

When the RBI buys the securities, it is without any promise to sell them
later. Similarly, when the RBI sells these securities, it is without any
 promise to buy them later. As a result, the
injection/absorption of the money is of permanent nature.
b) Repo or repurchase agreement: This is another type of operation in
which the RBI buys the security with agreement of purchase on
particular date and price. This is called repo. The interest rate at which
the money is lent in this way is called repo rate.
Similarly, instead of outright sale of securities the RBI may sell the
securities through an agreement which as a specification about the date
and price at which it will be repurchased. This type of agreement is called
reverse repo. The rate at which the money is withdrawn in this manner is
called the reverse repo rate.
The RBI conducts repo and reverse repo operations at various
maturities like overnight, 7 days, 14 days etc. These types of operations
have now become the main tool of monetary policy of the RBI.
4. Requirement of reserves acts as a limit to money (credit) creation.
Explain.
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 CRR
(Cash Reserve Ratio).
Apart from the CRR, banks are also required to keep some reserves
in liquid form in the short term. This ratio is called SLR (Statutory Liquidity
Ratio). The statutory requirement of the reserve ratio acts as a limit to the
amount of credit that banks can create.
For example, let us assume that a Bank starts with a deposit of Rs.100
made by Mr.X. The reserve ratio is 20%. Therefore the requirement of
reserve as per RBI rule is Rs.20 (100 – 20=80 .i.e.,20% of 100 is deducted)
The bank has Rs.80 to lend and the bank lends out Rs.80 to Mr.Y, which is
shown in the bank’s deposits in the next round as liabilities, making a total
of Rs.180 as deposits(100+80). Now bank is required to keep 20% of 180
i.e., 36 as cash reserves. The bank had started with Rs.100 as
cash. Since it is required to keep only Rs.36 as reserves it lends Rs.64
(100-36=64). The bank lends out Rs.64 to Mr.Z. This in turn shows up in the
bank, as deposits. The process keeps repeating itself till all the required
reserves become Rs.100. The required reserves will be Rs.100 only when
the total deposits become Rs.500. This is because, for deposits of Rs.500,
cash reserves would have to be Rs.100 (20% of 500 = 100)
The process is illustrated in the following table:
Round Deposit in Required Loan made by
Bank Reserve Bank

1 100 20 80

2 180 36 64

- - - -

- - - -

- - - -

- - - -

Last 500 100 400

In the above table, the first column lists each round. The second
column depicts the total deposits with the bank at the beginning of
each round. 20% of these deposits need to be deposited with the RBI
as required reserves (3rd column). What the bank lends in each round
gets added to the deposits with the bank in the 2nd round. 4th column
indicates the loans made by the banks.
VII Assignment and project-oriented questions

1.Write a note on Demonetization.

Demonetisation was a new step taken by the Government of India on 8th

November 2016 to tackle the problem of corruption, black money, terrorism
and circulation of fake currency in the economy. Old currency notes of Rs.500
and Rs.1000 were no longer legal tender. New currency notes in denomination
of Rs.500 and Rs.2000 were introduced. The public were advised to deposit old
currency notes in their bank account till 31st of March 2016 without any
declaration and up to 31st March 2017 with the RBI with declaration.

To avoid a complete breakdown and scarcity of cash, Government allowed

exchange of Rs.4000 old currency notes with new currency restricting to a
person per day. Further till 12th December 2016, old currency notes were
acceptable as legal tender at petrol pumps, Government hospitals and for
payment of Government dues like taxes, power bills etc.

This initiative had both appreciation and criticism.

1.There were long queues outside banks and ATM centres.

2.There was acute shortage of currency notes and had adverse effect on
economic activities. But now, normalcy has returned.

The demonetization also has positive effects.

1.It improved tax compliance as a large number of people were bought in

the tax ambit.

2.The savings of individual were channelized into the formal financial system.
As a result, banks have more resources at their disposal which can be used to
provide more loans at low rate of interest.

3.Demonetisation helps in curbing black money, reducing tax evasion and

corruption will decrease.
4.It also help in tax administration in another way, by shifting
transaction out of the cash economy into the formal payment system. To an
extent the Indian Economy transformed from cash payment to cashless
economic transactions (electronic payments).

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