Money and Banking (Questions)

Read this article to learn about the seven frequently asked questions on money and banking.

Q.1. Distinguish between Central Bank and Commercial Bank.

Ans. Distinction between Central Bank and Commercial Bank is as follows:

 

Q.2. Explain briefly the agency functions performed by commercial banks

Ans. Commercial banks perform the following agency functions for their customers:

(i) Transfer of funds:

Banks provide cheap and easy remittance of funds from one place to another via demand drafts, mail transfers and telegraphic transfers. Banks have now started providing its account holders with the facility of deposit and withdrawal from any of its branches in the country.

(ii) Collection of Funds:

Banks also collect cheques, demand drafts, bills, bonds etc. on behalf of their customers.

(iii) Sale/Purchase of Securities:

Banks also purchase and sell shares and securities on behalf of their customers.

(iv) Collection of Dividend/Interest:

Banks collect dividend and interest on behalf of their customers.

(v) Payment of Bills:

Banks can also make payments of various bills like telephone, electricity etc. and help in booking of railway/air tickets, payment of insurance premium etc. for their customers.

(vi) Acting as Executor/Trustee:

Banks can also act as executors and trustees of wills of their customers.

(vii) Payment of tax and consultancy:

Banks accept payment of all types of taxes and also provide consultancy for income tax.

(viii) Act as correspondent, agent, and representative:

Banks also act as correspondent, agent or representative of customers and help in securing documentation for air and sea passage.

Q.3. Explain the following functions of the central bank:

Ans. (i) Bank of issue

(ii) Bankers bank

(i) Bank of issue refers to the legal right to issue currency:

The central bank enjoys complete monopoly of note issue. This brings about uniformity in note circulation. At the same time it gives the central bank power to influence money supply because currency with public is a part of money supply.

(ii) Bankers’ bank:

Commercial banks have to keep a certain percentage of its deposits as cash reserves with the central bank. The central bank uses these reserves to meet the emergency cash needs of the commercial banks. The central banks in this way gives loans to these banks .It makes the central bank the banker’s bank.

Q.4. What is a barter system? What are its drawbacks?

Ans. Direct exchange of goods for goods without the use of money as a medium, is called barter system.

Main drawbacks of this system are:

(i) Lack of double coincidence of wants:

a. This is the major drawback of barter system. Exchange in barter system is possible only when a person finds another person who not only requires the goods possessed by him but also has the goods which are required by the first person.

b. For example, if a person wants to exchange wheat for cloth, he has to search for a person who is willing to sell cloth and wants wheat in return. Exchange is not possible unless there is a double coincidence of wants.

(ii) Lack of common measure of value:

a. There is no common measure of value in barter system and therefore, proper accounting is not possible.

b. There is no way in which various goods and services can be measured in a common unit; hence this drawback.

(iii) Lack of standard for deferred payment:

a. Barter system also lacks any satisfactory unit to make the future contracts possible.

b. All future payments under barter system have to be stated in terms of specified goods or services and disagreement over their quality and quantity is one of the main problems.

(iv) Lack of store of value:

a. In barter system, storage of future purchasing power is very difficult.

b. It can be stored in the form of commodities only which involves storage cost.

c. Further there are chances of loss in the value of commodities due to insects, spoilage etc. as every commodity cannot be stored for a long time. For example if wheat is stored, it is bound to be spoiled by rats, insects etc.

Q.5. What are the main functions of money? How does money overcome the shortcomings of a barter system?

Ans. Main functions performed by money are:

(i) Medium of Exchange:

a. Money acts as a medium of exchange. It helps in purchasing and selling of goods.

b. All goods are exchanged for money which is used in buying the goods which are needed. Money has thus helped trade grow at national and international level.

c. Earlier because of difficulties of barter system trade was restricted to local areas only. The difficulty of double coincidence of wants is removed by money.

d. Now a person can easily sell his goods to anyone for money and with the help of that money he can purchase the goods which he wants from the person having that good in exchange for money.

(ii) Unit of Value:

a. Money acts as a unit of value. It is a common measure of value and value of all goods and services is measured in terms of money.

b. Measuring the values of commodities at the time of exchange has now become much easier.

c. The prices of all goods and services are expressed in terms of money. Money has made accounting possible, since accounts cannot be maintained unless there is a common unit of measurement.

(iii) Standard of Deferred Payments:

a. Deferred payments are the payments which are required to be made in future.

b. Money serves as a standard for deferred payments too.

c. When money is borrowed by someone, he can easily return the principal along with interest amount on a future date. Making future payments in terms of money is much easier as problems regarding quality of good and commodity to be used do not arise.

d. Further, value of money remains more stable as compared to the prices of other commodities.

(iv) Store of Value:

a. Money can be easily stored as an asset for future as compared to storing the value in terms of goods because it does not involve much storage costs and there is also no loss of value.

b. Goods are perishable whereas money is not.

c. Money is the best form of store of value as against any other commodity. Value of goods frequently changes whereas value of money is more stable. Money has thus also solved the problem of store of value faced in the barter system earlier.

Q.6. Explain the functions of a commercial bank.

Ans. Commercial bank is a financial institution that accepts deposits from general public for the purpose of lending to various individuals/organizations.

The main functions of a commercial bank are:

(i) Accepting Deposits:

Commercial bank accepts money from general public in the form of deposits.

The public can deposit its money in the following types of accounts:

(a) Savings Bank Deposit Accounts

(b) Current Deposit Accounts

(c) Fixed/Term Deposit Accounts

(d) Recurring Deposit Accounts

(ii) Advancing of Loans and Advances:

Loans and advances are given by commercial banks in the form of (a) Cash Credit Limits (b) Term Loans (c) Demand Loans (d) Overdraft Facility of and (e) Discounting Bills of Exchange.

(iii) Investment of Funds:

A Commercial bank also invests its surplus funds in government and other approved securities.

(iv) Agency Functions:

Commercial banks perform a large number of agency functions too for their customers.

A few of them are as follows:

(a) Transfer of funds from one place to another by demand drafts, mail transfers and telegraphic transfers.

(b) Collection as well as payment against cheques, demand drafts and bills of exchange.

(c) Payment of bills on behalf of their customers.

(d) Collection of dividends and interest.

(e) Acting as executors and trustees of wills of customers.

(v) General Utility Services:

Banks also provide general utility services like Locker facility. Travellers cheques. Gift cheques. Underwriting securities. Sale and purchase of foreign exchange etc.

Q.7. Explain the process of money creation by the commercial banks with the help of a numerical example.

Ans. The money (or deposit or credit) creation by the commercial banks is determined by the amount of initial deposit and the legal reserve ratio(LRR). Suppose the amount of initial deposit is Rs 10,000 and LRR 18.20%. The banks will keep 20% i.e. Rs 2000 as reserve and lend the remaining Rs 8000. Those who borrow spend this money.

It is assumed that Rs 8000 comes back to the banks. This raises total deposits to Rs 18000. Banks again keep 20% of Rs 8000 i.e. Rs 1600 as reserve and lend Rs 6400. This further raises the amount of deposits with the banks. In this way deposits go on increasing @ 80% of the last deposit.

How many times will these deposits be determined by the deposit multiplier:

The total deposits will be:

Total money creation = Initial deposit x Money multiplier

= 10,000 X 5 = Rs 50000