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Questions and Answers
What is the present value of Rs 10 discounted at a 5% market rate of interest?
What is the present value of Rs 10 discounted at a 5% market rate of interest?
Rs 9.52
What are some qualitative tools used by the Central bank to influence commercial banks?
What are some qualitative tools used by the Central bank to influence commercial banks?
Moral suasion, margin requirement
What is the amount of money, denoted as Y, required to generate Rs 110 at the end of two years when kept in a savings bank account?
What is the amount of money, denoted as Y, required to generate Rs 110 at the end of two years when kept in a savings bank account?
Rs 99.76
What is the main purpose of Open Market Operations conducted by the Central Bank?
What is the main purpose of Open Market Operations conducted by the Central Bank?
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What happens to the price of a bond in relation to the market rate of interest?
What happens to the price of a bond in relation to the market rate of interest?
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When the Central bank buys a Government bond in the open market, it increases the total amount of reserves and thus __________ the money supply.
When the Central bank buys a Government bond in the open market, it increases the total amount of reserves and thus __________ the money supply.
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Speculative demand for money is directly related to the rate of interest.
Speculative demand for money is directly related to the rate of interest.
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Outright open market operations are permanent in nature.
Outright open market operations are permanent in nature.
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Which component of the monetary base increased the most from 1981-82 to 2019-20?
Which component of the monetary base increased the most from 1981-82 to 2019-20?
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In which year was the total monetary base the highest?
In which year was the total monetary base the highest?
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Cash with Banks + Currency with the Public = __________
Cash with Banks + Currency with the Public = __________
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What are M1 and M2 known as in terms of money supply?
What are M1 and M2 known as in terms of money supply?
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What are M3 and M4 known as in terms of money supply?
What are M3 and M4 known as in terms of money supply?
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What is the most commonly used measure of money supply?
What is the most commonly used measure of money supply?
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What was the main objective of demonetisation in India in November 2016?
What was the main objective of demonetisation in India in November 2016?
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Money supply in India is regulated by the Reserve Bank of India (RBI).
Money supply in India is regulated by the Reserve Bank of India (RBI).
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What is the main function of money in facilitating economic exchanges?
What is the main function of money in facilitating economic exchanges?
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In a barter system, the exchange of goods occurs without the use of money.
In a barter system, the exchange of goods occurs without the use of money.
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What is the term used to describe economic exchanges without the mediation of money?
What is the term used to describe economic exchanges without the mediation of money?
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The value of all goods and services can be expressed in monetary units as money acts as a convenient ________.
The value of all goods and services can be expressed in monetary units as money acts as a convenient ________.
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Match the following terms with their definitions:
Match the following terms with their definitions:
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What do people prefer to do with their excess funds in the context of the passage?
What do people prefer to do with their excess funds in the context of the passage?
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Why do banks need to retain a portion of funds?
Why do banks need to retain a portion of funds?
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What assets do commercial banks own according to the passage?
What assets do commercial banks own according to the passage?
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Liabilities for a bank mainly consist of __________.
Liabilities for a bank mainly consist of __________.
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The Required Reserve Ratio (CRR) limits the amount of credit banks can create.
The Required Reserve Ratio (CRR) limits the amount of credit banks can create.
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Study Notes
Money and Banking
- Money is a commonly accepted medium of exchange, essential for facilitating transactions in an economy with multiple individuals and market transactions.
Functions of Money
- Medium of Exchange: enables exchange of goods and services between individuals
- Unit of Account: allows expression of value of goods and services in monetary units
- Store of Value: enables storage of wealth for future use
Limitations of Barter System
- Difficulty in finding suitable persons to exchange surpluses (double coincidence of wants)
- High search costs
- Perishable and bulky goods make storage and transportation difficult
Demand for Money
- Determined by the value of transactions to be made
- Influenced by income and interest rates
- Higher interest rates lead to lower demand for money
Supply of Money
- Comprises cash and bank deposits
- Created by central banks and commercial banking systems
- Central bank (e.g. Reserve Bank of India) issues currency, controls money supply, and acts as a banker to the government and banking system
- Commercial banks accept deposits, lend, and create money through credit creation
Money Creation by Banking System
- Banks can create money by lending, as not all depositors withdraw funds at the same time
- Lending increases deposits, which in turn increase money supply
Balance Sheet of a Bank
- Assets: reserves, loans, and other claims
- Liabilities: deposits
- Assets = Liabilities + Net Worth
Credit Creation and Money Multiplier
- Limited by Central Bank's reserve ratio (e.g. Cash Reserve Ratio)
- Reserve ratio determines the percentage of deposits banks must keep as cash reserves
- Money multiplier effect: banks create multiple amounts of credit with initial deposits
Role of Reserve Bank of India (RBI)
- Issues currency
- Controls money supply
- Acts as a banker to the government and banking system
- Sets reserve ratio and statutory liquidity ratio to regulate banking system### Money Multiplier Process
- The money multiplier process is illustrated in Table 3.2, where deposits are made and loans are given, and the required reserves are calculated.
- In the example, the total deposits are Rs 500, and the required reserves are Rs 100, which is 20% of the deposits.
- The bank lends Rs 400, and the deposits are increased by Rs 400, and the process continues until the total deposits reach Rs 500.
Balance Sheet of the Bank
- The balance sheet of the bank is shown in Table 3.3, where the assets are reserves and loans, and the liabilities are deposits.
- The bank's reserves are Rs 100, and the loans are Rs 400, making the total assets Rs 500.
- The deposits are Rs 500, which is equal to the total assets.
Money Supply and Reserve Requirements
- The money supply increases from Rs 100 to Rs 500, given a CRR of 20%.
- The requirement of reserves acts as a limit to money creation, and the bank cannot give a loan beyond Rs 400.
- The money multiplier is 5, meaning that reserves of Rs 100 create deposits of Rs 500.
Policy Tools to Control Money Supply
- The Reserve Bank of India (RBI) uses various policy tools to control money supply, including quantitative and qualitative tools.
- Quantitative tools include changing the CRR, bank rate, or open market operations.
- Qualitative tools include persuasion, moral suasion, and margin requirements.
- The RBI also uses open market operations, such as buying and selling government bonds, to influence money supply.
Open Market Operations
- Open market operations refer to the buying and selling of government bonds by the RBI.
- When the RBI buys a government bond, it increases the reserves and money supply.
- When the RBI sells a government bond, it decreases the reserves and money supply.
- There are two types of open market operations: outright and repo.
- Outright operations are permanent, while repo operations are temporary.
Bank Rate and Money Supply
- The bank rate is the rate at which the RBI lends to commercial banks.
- An increase in the bank rate makes loans more expensive, reducing the reserves held by commercial banks and decreasing money supply.
- A decrease in the bank rate can increase money supply.
Demand and Supply for Money
- The demand for money is driven by the transaction motive and the speculative motive.
- The transaction motive is the need to hold money for transactions, and the speculative motive is the need to hold money for speculative purposes.
- The demand for money is positively related to the nominal GDP and the average price level.
Velocity of Circulation of Money
- The velocity of circulation of money is the number of times a unit of money changes hands during a unit period of time.
- The velocity of circulation of money is equal to the total value of transactions divided by the stock of money.
- The velocity of circulation of money is a flow variable, while the demand for money is a stock concept.### The Concept of Money
- Money is a commonly accepted medium of exchange that facilitates exchange of goods and services.
- Barter system is a exchange of commodities without the mediation of money, which suffers from lack of double coincidence of wants.
- Money overcomes the shortcomings of barter system by acting as a unit of account, store of value, and medium of exchange.
Motives for Holding Money
- People hold money for two main motives:
- Transaction motive: to finance daily transactions.
- Speculative motive: to take advantage of expected changes in interest rates or bond prices.
Speculative Demand for Money
- Speculative demand for money is inversely related to the rate of interest.
- When interest rate falls, people expect it to rise in the future, leading to a high speculative demand for money.
- Speculative demand for money can be represented by the equation: MdS = rmax - r / r - rmin.
Liquidity Trap
- A liquidity trap occurs when the market rate of interest is already low, and people expect it to rise in the future, leading to a high speculative demand for money.
- In a liquidity trap, the economy is characterized by an infinite elastic speculative demand for money.
Money Supply
- Money supply consists of currency notes and coins, demand deposits, and time deposits held by commercial banks.
- Money supply can be classified into narrow money (M1) and broad money (M2, M3, M4) based on the decreasing order of liquidity.
- M1 includes currency notes and coins, and demand deposits held by commercial banks.
- M2 includes M1, plus savings deposits with post office savings banks.
- M3 includes M1, plus net time deposits of commercial banks.
- M4 includes M3, plus total deposits with post office savings organizations.
Fiat Money
- Fiat money is a type of money that has no intrinsic value, but derives its value from the guarantee provided by the issuing authority.
- Currency notes and coins are examples of fiat money.
Legal Tender
- A legal tender is a type of money that must be accepted as a means of payment by law.
- Currency notes and coins are legal tenders.
Demonetization
- Demonetization is the process of removing currency notes from circulation, and replacing them with new ones.
- The purpose of demonetization is to tackle corruption, black money, and terrorism.
- The demonetization process in India in 2016 led to a shortage of currency in circulation, but had a positive impact on tax compliance and the formal financial system.
Reserve Bank of India (RBI)
- The RBI is the monetary authority of India that regulates the supply of money in the economy.
- The RBI publishes figures for different measures of money supply, including M1, M2, M3, and M4.
Functions of Commercial Banks
- Commercial banks provide loans to individuals and firms.
- Commercial banks accept deposits from the public.
- Commercial banks act as a creator of money in the economy.
Money Multiplier
- The money multiplier is a measure of the extent to which commercial banks can create new money in the economy.
- The money multiplier is calculated as the ratio of the change in the money supply to the change in high-powered money.
Instruments of Monetary Policy
- Open market operations: the RBI buys or sells government securities to increase or decrease the money supply.
- Bank Rate: the rate at which the RBI lends to commercial banks.
- Cash Reserve Ratio (CRR): the percentage of deposits that commercial banks must hold in reserve.
- Repo Rate: the rate at which commercial banks borrow from the RBI.
- Reverse Repo Rate: the rate at which the RBI borrows from commercial banks.
Key Concepts
- High-powered money: the money created by the RBI through its monetary policy.
- Lender of last resort: the RBI's role of providing emergency loans to commercial banks.
- Currency deposit ratio: the ratio of currency deposits to total deposits.
- Reserve deposit ratio: the ratio of reserve deposits to total deposits.
- Money multiplier: the ratio of the change in the money supply to the change in high-powered money.
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Description
This quiz covers the fundamental concepts of money and banking, including the role of money in an economy and the conditions for its existence.
