Money and Banking (Frequently asked Questions)

Read this article to learn about the most frequently asked questions on the Money and Banking.

Q.1. Mention any three defects of barter system.

Ans. Three defects of barter system are as under:

(i) Lack of coincidence of wants:

In barter system, an exchange is possible only when both the parties require goods of each other. This double coincidence of wants is the main drawback of barter system and this is time consuming too.

(ii) Lack of Divisibility:

Lack of divisibility also creates problem in barter system. For example if a person wants to sell a cow and buy a number of articles, it is not possible as cow cannot be divided into small parts.

(iii) Absence of Common Measure of Value:

Since there is no common limit of value, the value of each commodity has to be expressed in terms of all other commodities which is not feasible at all.

Q.2. Explain the components of Legal Reserve Ratio.

Ans. It has two components. Statutory Liquidity Ratio and Cash Reserve Ratio SLR is the ratio of deposits which banks keep with themselves.

CRR is the ratio of deposits which bank keep with the central bank.

Q.3. What are the contingent functions of money?

Ans. Money performs many contingent functions as follows:

(i) Basis of Credit:

Modem economies are based on credit. Cheques, bills of exchange etc. are the credit distribution having claims over money and they provide easier ways of transferring value.

(ii) Basis of Distribution of Income:

Money has facilitated the task of factor payment and distribution of national income.

(iii) Equalisation of Marginal utilities and productivities:

Maximising satisfaction by equalizing marginal utilities is possible for a consumer since prices of all goods are expressed in terms of money. Similarly money has facilitated the producers to maximize their production by equalizing marginal productivities.

(iv) Guarantor of Solvency:

Maintaining sufficient liquidity in their assets serves as a guarantor of solvency for the firms.

(v) Best utilization of Resources:

Money provides the opportunity for making best utilization of resources as people with ready purchasing power can take advantage of an investment opportunity.

(vi) Liquidity:

Money is the most liquid asset. It has increased the mobility and productivity of capital

Q.4. State any three main functions of Central Bank. Describe any one of them.

Ans. The three main functions of Central Bank are:

(i) Issue of Currency

(ii) Bankers’ Bank

(iii) Controller of credit and money supply

Controller of Credit and Money Supply:

Central Bank controls credit and money supply in the country through its monetary policy. Central Bank has the main authority to issue the currency in the country. It controls credit and money supply by various quantitative and qualitative measures. Bank rate policy, open market operations, varying Cash Reserve Ratio and Statutory Liquidity Ratio affect the amount of availability of credit provided by the banks.

The qualitative measures affect the allocation of credit among various sectors. Margin requirements, moral suasion and selective credit control are the qualitative measures available to Central Bank through which it can influence the availability of credit in the economy.

Q.5. Explain “Banker to the Government” function of the Central Bank.

OR

Explain ‘Government’s Banker’ function of the Central Bank.

Ans. Banker to the government means that central bank gives the same banking facilities to the government which commercial banks give to the general public. The central banks does not give such facilities to the general public. The central bank keep accounts of governments, gives them loans, works as agent in matters of collection of taxes, etc.

Q.6. Explain banker’s bank, function of Central Bank.

Ans. Commercial banks are required to keep a certain minimum percentage of deposits as cash reserves with the central bank. Central banks uses these reserves to give loans to the commercial banks to meet their emergent needs. It is called the bankers’ bank function of the central bank.

Q.7. Explain the ‘lender of last resort’ function of the Central Bank.

Ans. Central bank lends money to the commercial banks in time of need. Dependence of commercial banks on central banks in times of emergent need is referred to as the ‘lender of last resort’ function of the central bank.

Q.8. Explain how do ‘open market operations’ by the Central Bank affect money creation by commercial banks.

Ans. Open market operations refers to the buying and selling of securities by the Central Bank from and to the general Public. Sale of securities by the Central Bank leads to flow of money out of commercial banks and into the Central Bank. This reduces effective deposits with commercial banks and checks money creation reducing aggregate demand and investment.

Q.9. Explain Central Bank’s function as currency authority.

Ans. It has the sole authority to issue currency. It does so in accordance with the requirements of the economy.

Q.10. Briefly explain any four functions of a commercial bank.

Ans. The functions performed by a commercial bank are:

(i) Acceptance of Deposits:

i. The banks accept deposits from the general public.

ii. The various types of deposit accounts are (a) Savings Bank Deposit (b) Current deposits and (c) Term deposits.

iii. Banks pay interest on the deposits but no interest is paid in case of current account.

iv. Rate of interest is higher in case of term deposit accounts.

v. Money kept in savings and current accounts is repayable on demand but term deposits are repayable only after the expiry of fixed time period.

(ii) Giving Loans and Advances:

i. Banks accept deposit from the public for the purpose of lending.

ii. Banks keep certain portion of the deposits as reserve and the balance is given to borrowers in the form of loans and advances.

iii. Rate of interest charged by banks on loans and advances is more than what is paid by the banks on deposits.

iv. Demand loans, term loans, cash credit, overdrafts and discounting bills are the various types of loans and advances given by banks.

(iii) Agency Functions:

i. Banks perform a number of functions on behalf of their customers such as transfer of funds from one place to another, collection of cheques, hills etc, payment of insurance premium, bills, taxes etc.

ii. Banks also buy and sell shares and securities for their customers.

iii. They also collect interest and dividend on behalf of their customers. Banks can also act as trustees and executors of property of their customers.

iv. They also provide information about economic position of its customers to others and also collect the same information for their customers.

(iv) General Utility Services:

i. Banks also provide some general utility services like locker facility to keep important documents and valuables like ornaments.

ii. Underwriting of securities for government, public and private companies, providing merchant banking services, sale and purchase of foreign currencies etc. are some of the other general utility services provided by banks.

Q.11. What is meant by open market operations? Briefly describe their effect on credit creation by commercial banks?

Ans. i. Buying and selling of securities by central bank from/to banks and public is known as open market operations.

ii. These are carried out by Central Bank to influence the money supply.

iii. When central bank sells securities to commercial banks, the cash reserves of banks get reduced and thus ability of banks to give credit gets reduced to consumers and the money supply in the country is decreased.

iv. Similarly if central bank wants to increase the money supply in the country, it repurchases the securities from commercial banks. The banks get more cash from the central bank and then they are able to give more credit to consumer with their increased cash. The money supply in the country will increase when securities are repurchased by central bank.

v. Hence, sale of securities by the central bank will reduce the credit creation by banks and repurchase of securities by central bank will increase the credit creation by banks.

Q.12. Explain the problem of double coincidence of wants faced under barter system. How has money solved it?

Ans. The problem of double coincidence of wants arises when there is no medium of exchange. In such a case the buyer has to make a search for the seller who also wants to buy the same good which the buyer itself offers for exchange.

Money has solved the problem by working as a medium of exchange. The seller can sell ^e goods in the market in return for money and buy the goods he wants to buy in return for the money.

Q.13. State four functions of money. Describe any one of them:

Ans. The four functions of money are:

(i) Medium of exchange

(ii) Measure of Value

(iii) Store of value

(iv) Standard of deferred payment

(i) Medium of exchange:

i. Money is a medium of exchange. All exchange transaction are carried out with the help of money.

ii. For performing this function money should have general acceptability. People exchange goods and services using money.

iii. Money has removed the main difficulty of double coincidence of wants experienced in the barter system.

iv. Sale and purchase transactions can now be carried out independently.

v. Money has facilitated exchange, which in turn has increased productivity and efficiency.

vi. Monetary system is of great use to the human society.

vii. Money provides freedom of choice in buying things from those who offer the best value for money.

Q.14. Explain any two functions of money.

Ans. Functions of money are:

(i) Medium of exchange:

Buying & selling is done with money. It has facilitated trade.

(ii) Store of value:

Money acts as a store of value. It is acceptable at any point of time. It is not perishable so it can be stored for future use.

(iii) Unit of account:

The value of all goods and services can be expressed in monetary units. This facilitates exchange.

(iv) Standard of deferred payment:

It also serves as a standard of payment contracted to be made at some future date.

Q.15. Explain the ‘standard of deferred payment’ function of money.

Ans. Money serves as a standard of payments contracted to be made in future. It makes borrowing and lending convenient.

Q.16. What are the items which are not included in money supply?

Ans. The items not included in money supply are:

(i) The amount of notes and coins held by commercial banks.

(ii) The stock of gold with the central bank

(iii) Cash held by government in treasury and the central bank

Q.17. What are the alternative definitions of money supply in India?

Ans. Measures of money supply:

Reserve Bank of India has presented following four measures of money supply as M₁, M₂, M₃ and M₄. These definitions have come into play from April 1977 and are in the decreasing order of liquidity.

1. M₁ = C + DD + OD

Where C = Currency held by the general Public

DD = Net demand deposits of Banks

OD = Other deposits held with the RBI

M₁ is a narrow concept of money. It is most liquid and easiest for transactions.

2. M₂= M₁ + Savings of the people with Post Offices

3. M₃ = M₁ + Net time deposits of the Commercial Banks.

4. M₄ = M₃ + Savings with the Post Offices excluding those in the form of National Savings Certificates.

Q.18. What is a ‘legal tender’? What is ‘fiat money’?

Ans. Fiat Money: Fiat means “order”. Hence money by order (or authority) of the government is called Fiat money.

Money can be classified into limited legal tender money and unlimited legal tender money

Limited Legal Tender Money:

It is the money which no individual can be forced to accept beyond the legal limit fixed by government. In our country coins of the denomination of one paisa to twenty five paisa are considered as limited legal tender money upto Rs 25. No one can be forced to accept them beyond Rs 25.

Unlimited Legal Tender Money:

It is that money which is accepted without any limit. In India 50 paisa coin, one rupee coin, two rupee coin, five rupee coin and paper notes of all denominations are considered as Unlimited legal tender money.

Q.19. Do you consider a commercial bank as ‘creator of money’ in the economy?

Ans. Credit Creation:

Credit creation is one of the most important functions performed by commercial banks, at a specified rate of interest as per RBI’s guidelines. Credit plays vital role in the monetary and business system of any country.

The process of credit creation:

Banks advance loans to their customers out of their primary deposits keeping a small amount of cash reserve with them. When an advance is given by a bank, the amount of loan advanced is credited to borrower’s account by the bank. Thus every loan creates a deposit for the bank and thus enables it to give more loans. This process of credit creation enables a bank to give multiple number of loans and advances to general public.

Q.20. Explain the process of money creation by commercial Banks.

OR

How does a commercial bank create money.

Ans. Money creation by banks is determined by (1) Fresh deposits and (2) Legal Reserve Ratio. Suppose fresh deposit is Rs 10,000 and LRR is 20%. Initially banks keep Rs 2,000 as cash and lend Rs 8,000. Those who borrow spend this Rs 8,000. It is assumed that this Rs 8,000 comes into banks as a fresh deposit. Banks again keep 20% of it as cash reserve and lend the rest. In this way money creation goes on. Total money creation is Rs 50,000.

Money creation = Initial deposit =1/LRP

Q.21. How do changes in bank rate affect money creation by Commercial Banks? Explain

Ans. Goods which are purchased by a production unit from other production units and meant for resale or for using up completely during the same year are called intermediate goods.

Example:

Raw materials or any other example.

Goods which are purchased for consumption and investment are called final goods.

Examples:

Purchased of machinery for installation in factory or any other example.

Q.22. Explain the meaning of cash reserve ratio and statutory liquidity ratio.

Ans. CRR is the ratio of deposits of commercial bank which is to be kept with the central bank.

SLR is the ratio of deposits of commercial bank that bank has keep with itself.

Q.23. What role of RBI is known as ‘lender of last resort’? Explain.

Ans. i. Whenever commercial banks face problem in meeting obligations of their depositors, the central bank helps them by advancing necessary credit against eligible securities on certain terms and conditions. This facility from central bank saves the banks from failure.

ii. Central Bank never refuses to accommodate the eligible banks and helps them in difficult circumstances.

iii. That is why central bank is known as ‘lender of last resort’.

iv. This function of central bank is its most important function.

v. In Central Banking System, when all other options seem to be closed for a bank in distress, it sends SOS to the central bank as “the lender of last resort”; hence this name given to RBI’s role as saviour.

Q.24. Explain the significance of the ‘store of value’ function of money.

Ans. i. Wealth can easily be stored in the form of money and it can easily be converted into other forms, when required.

ii. People prefer to keep a part of their wealth in form of money.

iii. Money can be stored without any loss in its value whereas other commodities like wheat etc. cannot be stored for a long period.

iv. Money is the most liquid of all assets as it can be easily converted into any other asset at any time without the loss of time or value.

v. Money is thus the most desired form of storing the value.

Q.25. Explain the meaning of the managed flexible foreign exchange rate.

Ans. Under the managed float regime, market determine foreign exchange rate is allowed to fluctuate within certain limits. When the exchange rate crosses these limits then central bank. Intervenes in the market as buyer/seller (as the case may be) of foreign exchange. In this way foreign exchange rate is managed to float only within limits (these limits are decided by the central bank).

Q.26. State any three points of distinction between Central Bank and Commercial Banks.

Ans. 1. Central bank acts in public interest while commercial banks work with profit motive.

2. Central bank does not do the ordinary banking business of accepting deposits and giving loans while commercial banks do.

3. Central banks has the power of printing notes while commercial banks do not have such power or, any other relevant distinction.