Money and BankingClass 12 Introductory Macroeconomics NCERT Solutions
11 Solutions
Generated by KedovoAI
Solution 1 of 11
Q1Questions
What is a barter system? What are its drawbacks?
Solution
A barter system is a system of economic exchange where goods and services are directly exchanged for other goods and services without the use of money.
The primary drawbacks of the barter system are:
- Lack of Double Coincidence of Wants: This is the most significant drawback. For an exchange to occur, both parties must have what the other wants and be willing to trade. For example, a person with a surplus of rice who wants clothing must find another person who has a surplus of clothing and wants rice. This is highly improbable and makes transactions difficult.
- High Search Costs: Individuals have to spend a considerable amount of time and resources searching for suitable persons to exchange their surplus goods with. As the number of individuals in an economy increases, these search costs become prohibitively high.
- Difficulty in Storing Wealth: It is difficult to store wealth in a barter system. Many goods, like agricultural products, are perishable and cannot be stored for long periods. Storing large quantities of goods also requires a lot of space and can be costly.
Q2Questions
What are the main functions of money? How does money overcome the shortcomings of a barter system?
Solution
The main functions of money in a modern economy are:
- Medium of Exchange: Money acts as an intermediate good that is commonly accepted by all parties in a transaction. This eliminates the need for a double coincidence of wants.
- Unit of Account: Money provides a common measure of value. The value of all goods and services can be expressed in monetary units (e.g., rupees), which allows for easy comparison of their relative values.
- Store of Value: Money can be used to store wealth for future use. Unlike many goods in a barter system, money is not perishable, and its storage costs are very low.
Money overcomes the shortcomings of a barter system in the following ways:
- By acting as a medium of exchange, money solves the problem of the double coincidence of wants. An individual can sell their surplus goods for money and use that money to buy the goods they need, without having to find someone with the exact opposite needs.
- By serving as a unit of account, money provides a standardized way to measure and compare the value of different goods and services, which is difficult in a barter system where the value of one good is expressed in terms of numerous other goods.
- By being a store of value, money allows individuals to save their wealth conveniently. It overcomes the problem of storing perishable goods and the high costs associated with storage that exist in a barter economy.
Q3Questions
What is transaction demand for money? How is it related to the value of transactions over a specified period of time?
Solution
The transaction demand for money refers to the money that people desire to hold in order to carry out their day-to-day transactions. People hold cash balances because their income is typically received at discrete points in time (e.g., monthly salary), while their expenditure occurs continuously throughout that period. This mismatch between the timing of receipts and payments necessitates holding some money for transaction purposes.
The transaction demand for money is directly and positively related to the total value of transactions over a specified period. The relationship can be expressed as:
M_T^d = k * TWhere:
M_T^dis the transaction demand for money.Tis the total value of (nominal) transactions in the economy over a unit period.kis a positive fraction.
This equation means that as the total value of transactions (
T) in an economy increases, the demand for money to facilitate these transactions (M_T^d) also increases. Since the value of transactions is closely related to the nominal GDP, the transaction demand for money is positively related to both the real income (GDP) and the general price level.Q4Questions
What are the alternative definitions of money supply in India?
Solution
The Reserve Bank of India (RBI) publishes figures for four alternative measures of money supply, which are categorized based on their liquidity. These measures are:
-
M1 = CU + DD
- Where CU is currency (notes and coins) held by the public, and DD is net demand deposits held by commercial banks. M1 is the most liquid measure.
-
M2 = M1 + Savings deposits with Post Office savings banks
- This measure includes the highly liquid components of M1 plus savings deposits with the post office, which are slightly less liquid.
-
M3 = M1 + Net time deposits of commercial banks
- This includes M1 plus the net time deposits (like fixed deposits) of commercial banks. It is the most commonly used measure of money supply and is also known as aggregate monetary resources.
-
M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates)
- This is the broadest measure of money supply and is the least liquid of all.
M1 and M2 are referred to as narrow money, while M3 and M4 are known as broad money. The measures are in decreasing order of liquidity, from M1 (most liquid) to M4 (least liquid).
Q5Questions
What is a 'legal tender'? What is 'fiat money'?
Solution
Fiat Money: Fiat money refers to currency (notes and coins) that does not have intrinsic value, unlike a gold or silver coin. Its value is derived from the guarantee provided by the issuing authority, which is the government or the central bank (the RBI in India). People accept it as a medium of exchange because the government has decreed it to be so.
Legal Tender: Legal tender is any form of money that cannot be refused by any citizen of the country for the settlement of any kind of transaction. In India, currency notes and coins are legal tenders. For example, if you offer to pay a debt in rupees, the creditor is legally obligated to accept it. However, other forms of payment like cheques drawn on savings or current accounts are not legal tenders, as they can be refused as a mode of payment.
Q6Questions
What is High Powered Money?
Solution
High Powered Money, also known as 'reserve money' or 'monetary base', is the total currency issued by the central bank of a country (the Reserve Bank of India). This money can be held either by the public (as currency in circulation) or by the commercial banks (as reserves).
It is called 'high-powered' because it acts as a basis for the creation of credit and the expansion of the money supply in the economy. The total amount of deposits that commercial banks can create is a multiple of the reserves they hold, and these reserves are a component of the high-powered money.
Q7Questions
Explain the functions of a commercial bank.
Solution
Commercial banks are institutions that are part of the money-creating system of an economy. Their primary functions are:
- Accepting Deposits: Commercial banks accept deposits from the public, providing a safe place for individuals and firms to keep their excess funds. They offer interest on these deposits, encouraging people to save.
- Providing Loans: Banks lend out a portion of the deposited funds to individuals and firms who need to borrow for various purposes, such as home loans, crop loans, or business expansion. They charge a higher interest rate on loans than they pay on deposits.
- Credit Creation: Banks create credit, which is a significant part of the money supply. When a bank provides a loan, it opens a new deposit in the borrower's name, thereby increasing the total amount of deposits in the economy. This process is limited by the reserve requirements set by the central bank.
- Financial Intermediation: Commercial banks act as intermediaries between those who have surplus funds (savers) and those who need funds (borrowers). They channel savings into productive investments.
- Facilitating Transactions: By offering services like cheques and debit cards, banks make transactions more convenient and safer than using large amounts of cash.
Q8Questions
What is money multiplier? What determines the value of this multiplier?
Solution
The money multiplier is the mechanism by which the banking system can create a total amount of money (in the form of deposits) that is a multiple of the initial reserves. It represents the maximum amount of money that can be created for every unit of reserves in the banking system.
The value of the money multiplier is determined by the 'Required Reserve Ratio' or 'Cash Reserve Ratio' (CRR). The CRR is the percentage of total deposits that every commercial bank is legally required to keep as reserves with the central bank (RBI).
The value of the multiplier is calculated as the reciprocal of the CRR. The formula is:
Money Multiplier = 1 / Cash Reserve Ratio (CRR)
For example, if the CRR is 20% (or 0.2), the money multiplier will be 1 / 0.2 = 5. This means that an initial reserve of Rs 100 can support a total deposit creation of up to Rs 500 (100 x 5). Therefore, the value of the multiplier is inversely related to the CRR; a lower CRR leads to a higher money multiplier and greater money creation, while a higher CRR reduces the multiplier and limits money creation.
Q9Questions
What are the instruments of monetary policy of RBI?
Solution
The tools used by the Reserve Bank of India (RBI) to control the money supply are known as instruments of monetary policy. They can be classified as quantitative and qualitative tools.
Quantitative Tools: These tools control the total volume of money supply in the economy.
- Reserve Ratios: The RBI can change the Cash Reserve Ratio (CRR) or the Statutory Liquidity Ratio (SLR). An increase in these ratios reduces the funds available for lending with commercial banks, thus decreasing the money supply. A decrease has the opposite effect.
- Open Market Operations (OMO): This refers to the buying and selling of government bonds by the RBI in the open market. When the RBI buys bonds, it injects money into the system, increasing the money supply. When it sells bonds, it withdraws money, reducing the money supply. This includes 'repo' (repurchase agreement) and 'reverse repo' operations, which have become the main tools of monetary policy.
- Bank Rate: This is the rate at which the RBI lends to commercial banks. By increasing the bank rate, the RBI makes borrowing more expensive for commercial banks, which reduces their reserves and lending capacity, thereby decreasing the money supply. A decrease in the bank rate increases the money supply.
Qualitative Tools: These tools regulate the direction of credit.
- Moral Suasion: This involves persuasion and pressure by the RBI on commercial banks to encourage or discourage lending for specific purposes, in line with the overall economic policy.
Q10Questions
Do you consider a commercial bank 'creator of money' in the economy?
Solution
Yes, a commercial bank is considered a 'creator of money' in the economy. While the central bank is the sole authority to issue currency (high-powered money), commercial banks create credit, which constitutes a major part of the money supply (specifically, the deposit component).
The process of money creation is as follows:
- Banks are legally required to keep only a fraction of their total deposits as reserves (as per the CRR).
- They can lend out the remaining portion of the deposits.
- When a bank lends money to a person or a firm, it does not give out cash. Instead, it opens a new deposit account in the borrower's name and credits the loan amount to it.
- This new deposit is a part of the total money supply. The borrower can then use this deposit to make payments.
This process continues as the loaned money gets deposited in other banks, which in turn keep a fraction as reserves and lend out the rest. Through this process, the banking system as a whole can create total deposits that are a multiple of the initial reserves, as determined by the money multiplier. Therefore, by creating credit, commercial banks effectively create money.
Q11Questions
What role of RBI is known as 'lender of last resort'?
Solution
The role of the RBI as the 'lender of last resort' means that it stands ready to provide funds to commercial banks when they face a financial crisis and are unable to secure funds from other sources.
Commercial banks may face situations where they need immediate funds to meet their obligations, such as a sudden surge in withdrawals by depositors. If a bank cannot borrow from the market or other banks, it can approach the RBI as a last resort. The RBI provides loans to such banks against approved securities. This function is crucial for maintaining the stability of the banking system and public confidence in it. By ensuring that a solvent bank does not fail due to temporary liquidity problems, the RBI prevents potential financial panics and protects the interests of the depositors.