Money and Banking Notes | Class 12 Economics Notes

Table of Contents

Chapter – 3: Money and Banking (6 to 10 Marks)

Short and Long Answer Type Questions

1. What is Barter System? What are the features of Barter System? Explain its advantages and drawbacks.

Ans: The system in which goods are exchanged for goods is known as Barter System. It is a system in which goods and services are exchanged without the use of money.

The features of Barter System are:

Barter involves direct exchange of goods and services.
It is non-monetised system.
There is absence of market mechanism in barter economy.
In the barter economy, economic activities are at a low level and there is economic backwardness.

The advantages of Barter System are:

Simple System: The barter system is very easy and simple. Goods and services are exchanged without the use of money.
Balanced production: The Barter economy is a simple economy where people produce goods either for self consumption or for exchange with other goods which they want.
Proper utilization: In this system, natural and personal resources are properly utilized to meet the needs of the society.
Reduction of Economic inequalities: Under this system, there is no possibility of storing goods over a long period. As a result there is no problem of concentration of economic power into the hands of rich people.
Free from problems of foreign trade: Foreign trade problems such as foreign exchange crises does not exist under barter system.

The basic difficulties of Barter System are:

Lack of Double coincidence of wants: In barter system, goods are exchanged between two people to satisfy their demands and wants if the wants of two people does not coincide, then barter exchange cannot takes place. This is known as lack of Double coincidence of wants.
Absence of common measure of value: In this system, there is absence of common unit in which the value of goods and services should be measured.
Difficulty of Divisibility: It is difficult to fix a rate of exchange for certain goods which are indivisible.
Difficulty in storing of goods: Barter system does not allow any convenient method of storage
of value.
Difficulty in making deferred payments: In a barter economy, it is not easy to make payments in the future

Difficulty of Transportation: The major problem of barter system is to transport goods and services from one place to another conveniently.

2. What is Money? What are its various types?

Ans: Anything which is generally accepted as a medium of exchange in payment of debts and as payment of goods and services is called money.

Different types of Money: On the basis of money material, money can be classified into the following two categories:

Full Bodied Money: Full bodied money is that money whose value as a commodity is equal to its value as money.
Representative Money: This type of money is usually made of paper. The paper money itself has no market value but it represents full bodied coins or their equivalent to bullion.
Credit Money: Credit money refers to that money whose value as money is greater than its commodity value (i.e. value of material from which it is made). It includes token coins, circulating promissory note, deposits at banks, fiat money and high powered money.
High Powered Money: High powered money (or monetary base) refers to the money produced by RBI and Government of India. Alternatively, total liability of monetary authority of the country and RBI is called high powered money which is denoted by H.

3. Explain the primary, secondary and contingent functions of Money.

Ans: Money performs four important functions each of which overcomes one of the difficulties of barter. Functions of money can be divided into three categories:

Primary Functions

a) Medium of Exchange (Primary): The first and foremost function of money is that it acts as a medium of exchange. Barter exchanges become extremely difficult in an economy. It is because of reason that people looking for suitable persons to exchange their goods would have to spend for of time and labour.

b) Measure of Value (Primary): Measuring value of a commodity we take money as a unit of amount. Money serves as a unit of measurement in terms of which the value of all goods and services are measured and expressed.

Secondary Functions

a) Standard of Deferred Payments (Secondary): Money serves as a standard of deferred payment. Deferred payments refer to those payments which are to be made in future.

b) Store of Value (Secondary): Store of value means store of wealth for future use. Money is not perishable and its storage costs are also considerably lower. It is also acceptable to anyone of any point of time.

c) Transfer of value: Money also serves as transfer of value. It facilitates movement of capital from one individual to another and from one place to another.

Contingent functions:

Contingent functions refers to those functions of money which help various economic entities such as consumers, producers etc. in taking their economic decisions. These include the following:

a) Measurement of National Income: Money helps in measurement of national income by expressing the value of goods and services produced in a country in money terms.

b) Distribution of National Income: Money also helps in distribution of national income through the system of wage, rent, interest and profit.

c) Maximization of Satisfaction: Money helps in maximization of satisfaction of consumers and producers.

d) Basis of Credit: Money is the prime basis of credit. Credit instruments like cheques, bills of exchange etc. cannot be used without the existence of money.

e) Productivity of Capital: Productivity of capital is increased by money because capital in the form of money can be easily transferred from unproductive area to productive areas.

4. What is supply of Money? What are its components? Mention various determinants of money supply.

Ans: Supply of money is defined as the total stock of all the forms money (paper money, coins and demand deposits of banks) which is held by the public at any particular point of time. The stock of money with the government, RBI and Banks is not included in supply of money.

Components of Supply of Money: Money supply composed of currency with the public and demand deposits in the banks. Currency with the public includes notes in circulation and coins but excludes cash with banks.

Determinants of Supply of Money

The amounts of high powered money and
The size of money multiplier

5. What are various measures of money supply?

Ans: The reserve bank of India has given the four measures of money supply viz, M1, M2, M3 and M4.

M1 = C + DD + OD.
M2 = M1 + Savings deposits with post office saving banks.
M3 = M1 + Net time deposits of commercial banks
M4 = M3 + Total deposits with post office savings organizations (Excluding National Savings Certificates).

6. What is Demand for money? Explain transaction and speculative demand for money. 2012, 2014

Ans: Money is the most liquid of all assets because a person having money (cash) can convert it into anything he likes. Therefore, demand for money is in fact the demand for its liquidity (liquidity preference), i.e. demand for cash. According to Keynes, demand for money for liquidity preference as he called it meant demand for money to hold cash balance. In a modern economy, people hold money mainly for two motives – transaction motive and speculative motive.

Transaction demand for Money

Transaction demand for money is the amount of money required for current transaction of individuals and firms. The main reasons to hold money in cash for meeting day to day transactions is to bridge the interval between receipt of income and expenditure. For example, a worker who gets his wages of Rs. 700 on the first day of the month has to spend it continuously throughout the month. His cash balance at the beginning and end of the month are Rs. 700 and 0 respectively. So, the average cash holding of the man will be (Rs. 700 + Rs. 0) / 2 = Rs. 350. With the help of Rs. 700, so, the average transaction demand for money of the person is equal to half of his monthly income.

Let us now consider a two person economy consisting of a firm (owned by a person) and a worker. At the beginning of every month, the firm owner, pays the worker a salary of Rs. 500. The worker spends this income of the output produced by the firm. So, at the beginning of every month the worker has a money balance of Rs. 500 and the firm has a balance of Rs. 0. And on the last day of the month, the firm has a balance of Rs. 500 through its output sales. The average money holding of the firm as well as the worker is Rs. 250 each. So the total transaction demand for money in the economy is Rs. 500 (250 + 250)

The total volume of monthly transactions in the economy is Rs. 1000 because the firm has sold its output worth Rs. 500 to the worker and the worker has sold his services worth Rs. 500 to the firm. The transaction demand for money in the economy is a fraction of the total volume of transactions in the economy over the unit period of time. So the transaction demand for money in the economy can written as:

M^D_T = K.T………….(i)

Where,

T = Total volume of transactions in the economy over unit period of time.

K = A positive fraction.

Speculative Demand for Money

Speculative demand for money refers to the demand for holding certain amount of wealth in reserve to make speculative gains out of the purchases and sale of bonds and securities through future changes in the rate of interest. Wealth can be held (stored) 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. Thus, according to Keynes, there are two types of assets, i.e. money and bonds. People compare rate of return on bond with rate of interest on bank deposits. It is speculation about future changes (rise/fall) in interest rate and bond prices that the resulting demand for money is called ‘speculative demand for money.”

7. What are Commercial Banks? Explain the primary and secondary functions of a commercial bank. 2015

Ans: Commercial Banks are the financial institution which accepts deposits from different institutions and advances loans to some other institutions. According to Banking Companies Act, 1949,”A banking company is one which transacts the business of banking which means the accepting for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, drafts or otherwise.”

A commercial bank has the following features:

A Bank is a profit seeking commercial enterprises.
It deals in money, i.e., it accepts deposits from the public and advances loans to the needy borrowers.
It deals with credit. It creates credit for the purposes of lending money.
The deposits made with the bank are repayable on demand and can be withdrawn by the depositor by means of any instruments whether a cheque or otherwise.

Functions of Commercial banks

The functions of commercial banks are divided into two parts: Primary functions and Secondary functions. Secondary functions are further divided into Agency functions and general utility functions.

A) Primary functions:

Acceptance of deposits: It is the most important function of a bank. Under this function, bank accepts deposits from individuals and organizations and finances the temporary needs of firms.
Making loans and advances: The second important function of banks is advancing loan. The commercial bank earns interest by lending money.
Investments of Funds: Besides loans and advances, banks also invest a part of its funds in securities to earn extra income.
Credit Creations: The Bank creates credit by opening an account in the name of the borrower while making advances. The borrower is allowed to withdraw money by cheque whenever he needs.

B) Secondary functions of a bank: This function is divided into two parts – Agency functions and General utility functions.

1) Agency functions: These functions are performed by the banker for its own customer. For these bank changes certain commission from its customers. These functions are:

Remittance of Funds: Banks help their customers in transferring funds from one place to another through cheques, drafts etc.
Collection and payment of Credit Instruments: Banks collects and pays various credit instruments like cheques, bill of exchange, promissory notes etc.
Purchasing and Sale of securities: Banks undertake purchase and sale of various securities like shares, stocks, bonds, debentures etc. on behalf of their customers.
Income Tax Consultancy: Sometimes bankers also employ income tax experts not only to prepare income tax returns for their customer but to help them to get refund of income tax in appropriate cases.
Dealings in Gold/Silver: The buying and selling of gold and silver.

2) General Utility functions: These are certain utility functions performed by the modern commercial bank which are:

Locker facility: Banks provides locker facility to their customers where they can their valuables.
Traveler’s cheques: Bank issue travelers cheques to help their customers to travel without the fear of theft or loss of money.
Gift cheque: Some banks issue gift cheques of various denominations to be used on auspicious occasions.
Letter of Credit: Letter of credit is issued by the banks to their customers certifying their credit worthiness. Letter of credit is very useful in foreign trade.
Foreign Exchange Business: Banks also deal in the business of foreign currencies.

8. What do you mean by a Central Bank? Explain the nature of central bank.

Ans: Central Bank: The central bank is the supreme monetary institution of any country. It is a national bank which provides banking services to the government and commercial banks. It also helps in implementing monetary policy of the government and issuing currency. It is established, owned, controlled and financed by the govt. of the country.

In the words of R.S. Sayers, “It is a bank which controls the commercial banks in such a way as to promote the general monetary policy of the country.”

India’s central bank is called the Reserve Bank of India. It is the apex monetary institution of India (2017). Reserve Bank of India was established on April 1, 1935 under schedule II of the Reserve Bank of India Act, 1934. Originally it was constituted as private banks with a share capital of Rs. 5 Crores. Entire share capital was owned by the private individuals. After independence, it was decided to nationalize the Reserve Bank of India and it was nationalized under the Reserve Bank (Transfer to public ownership) Act 1948, on January 1, 1949. From January 1, 1949 the RBI started functioning as a state owned and state controlled central bank. The nature of Central Bank is as follows:

It is the head of all the banks of India. It is the supreme monetary institution of the country.
They always work for national welfare of a country. They do not aim at earning profits.
It is established, owned, controlled and financed by the govt. of the country.
It does not compete with other financial institutions in the market.
The RBI acts as the banker, agent and advisor to the Government of India and State governments.

9. Distinguish between a Central Bank and Commercial Banks.

Ans: There are some fundamental differences between them:

Profit making is not the objective of central banks, although, they do earn profits. But, the principle aim of a commercial bank is to make large amounts of profits.
The central bank is owned and controlled by the Government. But A commercial bank is generally owned, managed and controlled by private citizens.
There is only one central bank in a country. But, there are commercial banks operating in a country on a competitive basis.
The central bank is the only agency in a country entrusted with the power of issuance of notes. But, the commercial banks do not have the power of issuing notes.
The central bank s the lender of the money market. But, the commercial banks are just its sub-ordinates.

10. Explain central banking functions of RBI or traditional functions?

Ans: The functions of RBI are:

a) Note Issue: The reserves bank of India is the sole authority for the issue of currency in India other than one rupee coins/notes and subsidiary coins. The RBI has adopted the minimum reserves system of note issue to issue currency notes in the country. Under this system the RBI maintains a minimum reserve of Rs. 200 crore of which Rs. 115 crore is in gold and the rest in securities. The issue department of RBI has the responsibility to issue paper money. It is responsible for getting its periodical requirements of notes printed from the currency presses of the Government of India, distribution of currency among the public and withdrawal of unserviceable notes and coins from circulation. The Issue Department deals directly with the public in exchange of currency for coins and vice versa and exchange of notes of one denomination for another.

b) Bankers to Government: The RBI acts as banker to the Central and State Government as a bankers as a adviser as a agent into their capacities:

As a bankers.
As an agent.
As an advisor.

As a Government banker the RBI performs the following functions:-

It maintains and operates deposit account of the central and state governments.
It receives and collects payment on behalf of the Central and state governments.
It makes payments on behalf of the central and state governments.
It provides short term advances to government for which are called ways and means advances etc.

As a Government agent the RBI perform the followings functions:-

Collect tax and other payments on behalf of the government.
Raise loan from the public and thus manages public debts.
Transfer funds and provide remittances facilities to the government etc.

As an adviser the RBI acts as an advising the Government on all financial matters such as loan separations investment, agricultural and industrial finance, banking planning etc. It also advices to promote the attainment of the national economic goals.

c) Bankers Bank: The Central Bank is a banker to all the other banks. It is the supreme bank of all the banks. As the supreme bank it performs various functions. Some of the functions are:

Custodian of cash reserve of the bank: The Central Bank acts as the custodian of cash reserve of the banks. Every Commercial bank has to keep a certain portion of their deposits and time and demand liabilities to the Central Bank in the form of cash reserves. The Central Bank maintains this cash reserve as the custodian and grants money to the commercial bank in times of emergency.
Lender of the last resort (2017): The Central Bank is the Lender of the last resort of the commercial banks. When the other banks shortage of funds, then they can approach to the Central Bank for financial assistance. The Central Bank lends money to them by discounting their bills. This enables the Central Bank to establish control over the banking system of the country. The RBI is ultimate source of money and credit provide fund to money market participate thus the RBI act as lender of last resort for the commercial banks.
Clearing agent (2018): In India the central clearing functions is managed by the RBI or the SBI is authorized to manage clearing house functions every day. Each commercial bank receives a number of cheques for collection from other banks on account of their customers. One bank may have to pay certain amount to another bank again the RBI will transfer fund from debtor to creditors account. Since all banks have their accounts with the RBI, the RBI can easily settle the claims of various banks each other with least use of cash. The clearing house functions of RBI are:

For settlement of banking transactions between two banks.
To helps in economizing the uses of cash by banks.
Look-over the liquidity position of the bank.

d) Control of credit: As a central bank, the RBI take the responsibility to control of credit in order to economic development and price stability in the country under credit control policy different method are used to control the volume of credit in the economy. Important of them are General Credit Control and Selective Credit Control.

e) Custodian of gold and foreign exchange reserves: – The RBI act as a custodian of gold and foreign exchange reserves for both on its own and on behalf of the Government.

11. Write a brief note on recent reforms in banking sector.

Ans: Recent Reforms in Banking Sector in India: In August 1991 committee on financial sector reforms under the chairmanship of M. Narsimhan was appointed by the Government of India. The committee submitted its report in November 1991. As a result several measures were undertaken to increase the efficiency and profits of the banking system. We explain below several reforms in the banking sector initiated since 1991.

a) Introduction of NPA Norms:

The Reserve Bank has fixed some NPA norms for scheduled commercial banks so that NPA (Non-Performing Assets) may be recovered.

b) Entry of Private Sector Banks:

After nationalization of 14 large banks in 1969, no bank had been allowed to be set up in the private sector. It was however realized that the competition in the money market would increase the efficiency of the banking. On January 22, 1993 the Reserve Bank issued guidelines for entry of new banks of private sector in banking business. According to this permission was given to private banks to enter the banking sector in order to foster competition in banking and to provide better services to customers provided they work in accordance with provisions of the Reserve Bank. Private Banks were allowed to collect capital upto 20% from institutional investors and upto 40% from NRIs. The Reserve Bank has also assured private sector banks to expand themselves without any fear of nationalization. UTI Bank Limited was the first private sector bank in the country which came into existence on April 2, 1994. In India 10 new banks of the private sector have so far been established.

c) Modernization of banks:

Banking system has also been modernized. With the help of information technology services delivery has been made convenient both for the customers and bankers.
Banking services have been computerized to perform daily functions very quickly and efficiently. Computerization will increase productivity and profitability of banks.
The use of computers and internet in banks has become very common. The use of computers and internet in the functions of banks is called e-banking. Under e-banking services like ATM facility, debit card facilities, banking on phone are being provided.

12. What are the principle methods or instruments of Credit Control used by the Central Bank?

Ans: The principle methods or instruments of Credit Control used by the Central Bank are: Quantitative or General Methods and Qualitative or Selective methods

Quantitative or General Methods: These are the traditional or general methods of credit control. These methods one used by Central Bank to have control over the total volume of credit in the economy neglecting the purpose for which it is used. These methods are:

Variation in the bank rate: Bank rate or discount rate is the rate at which the Central Bank of a country makes advances to the banks against approved securities or rediscounts the eligible bills. The purpose of change in the rate is to make the credit cheaper or expensive depending upon whether the purpose is to expand or control credit. An increase in bank rate result, in increase in lending rate of commercial banks lending to contraction of credit while a decrease in bank rate leads to decrease in lending rates of commercial banks lending to expansion of credit.
Open Market operations: Open market operations means deliberate and direct buying and selling of securities and bills in the market by the Central Bank. The open market operations of the RBI are mostly limited to government securities. In order to increase money supply in the market, the RBI purchases securities in the open market. On the other hand, in order to contract credit, the RBI starts selling the securities in the open market.
Cash reserve ratio: Every scheduled bank in India is required to maintain a minimum percentage of their deposits with the RBI. Larger the reserve, lesser is the power of the banks to create credit and smaller the reserves, greater is the power of the banks to create credit.
Statutory liquidity ratio: Statutory liquidity ratio is another reserve requirement used by the RBI to control money supply. In India, besides maintaining the cash reserve, every bank has to maintain a statutory reserve of liquid assets in terms of cash, gold or unencumbered securities. This is termed as statutory liquidity ratio. In increase in the liquidity ratio implies a transfer of banking funds to Government and corresponding reduction in credit available to the borrowers.
‘Repo’ Transactions: ‘Repo’ stands for repurchase. Repo or repurchase transactions are undertaken by the Central Bank in the money market to manipulate short term interest rates and to manage liquidity levels. Under repo, buying and selling of securities takes place with the condition that at the end of the specified fixed period the buyer shall sell the securities at the predetermined rate. The difference between the repurchase price and the original sale price will be earning for the lender. An increase in repo rate means the commercial banks will get more interest on their reserve with RBI which leads to shortage of funds in the economy. On the other hand, decrease in repo rate means the commercial banks will earn less return on their balance with RBI which increases withdrawal of funds by commercial banks from RBI and thus increases liquidity.

Qualitative or Selective Methods: These are basically the selective and general methods of credit control. These methods are used for controlling the use and direction of credit. They have nothing to do with the control of the total volume of credit in economy. These methods are :

Directions: Sec. 21 of the Banking Regulation Act gives powers to the RBI for controlling granting of advances by an individual bank or by banking as a whole. The RBI can give directions to any particular bank or all banks in general in regard to the purposes for which advances may or may not be made, the maximum amount of advance to any individual, firm or company etc.
Margin requirement: Margin means the difference between the market price of security and loan amount. Changing margin requirement is another credit control method followed by the RBI. This system was introduced in 1956. By requiring higher margin while accepting a commodity as a security, the RBI can decrease the flow of credit to particular sector or vice versa.
Consumer Credit Regulation: Under this method, consumer credit supply is regulated through hire-purchase and installment sale of consumer goods. Under this method the down payment, instalment amount, loan duration, etc is fixed in advance. This can help in checking the credit use and then inflation in a country.
Publicity: This is yet another method of selective credit control. Through it Central Bank (RBI) publishes various reports stating good sector and bad sectors in the system. This published information can help commercial banks to direct credit supply in the desired good sectors.
Credit Rationing: Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit exposure to unwanted sectors.
Moral suasion: It implies to pressure exerted by the RBI on the Indian banking system without any strict action for compliance of the rules. Under moral suasion central banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes. It helps in restraining credit during inflationary periods.
Direct action: Under this method the RBI can impose an action against a bank. If certain banks are not adhering to the RBI’s directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are in excess to their capital. Central bank can penalize a bank by changing some rates.

13. What is credit creation? What are the limitations of the credit creation process of commercial banks? Discuss.

Ans: The banks create secondary deposits or derivation from the primary deposits. This creation of derivative deposits is known as Credit Creation.

The limitations of the credit creation process of commercial banks are:

Availability of primary deposits: The commercial banks create credit only on the basis of primary deposits. They cannot create a large number of credits from a small primary deposit.
Requisite cash reserve ratio: The size of the credit multiplier is inversely related to the cash reserve ratio. The higher the ratio, the smaller will be volume of excess reserve available and smaller will be volume of credit creation and vice versa.
Banking habits of the people: The banking habit of the people also sets the limit for the capacity of banks to create credit. If the people don’t have banking habit and prefer to transact by cash and not by cheque, then multiple credit creation of the bank will not be possible.
Availability of good collateral security: The availability of collateral securities also places a limit on credit creation of banks. If securities are not available in sufficient number, the banks cannot expand their lending activities and thus, cannot create credit.
Credit policy of the Central Bank: The extent of credit creation also depends on the monetary policy of the Central bank. The Central bank provides a limit to the commercial banks to create credit and they are bound to follow it.