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Money and Banking

Money and Banking

Action PlanNotesQuestionsMock-Test
Study Action Plan (Sorted by Difficulty)
Liquidity Preference Theory
Accuracy: 33%
Total Attempted12
Total Correct4
Total Incorrect8
Difficulty Level:
High
Supply of Money
Accuracy: 58%
Total Attempted26
Total Correct15
Total Incorrect11
Difficulty Level:
Medium
Demand for Money
Accuracy: 61%
Total Attempted23
Total Correct14
Total Incorrect9
Difficulty Level:
Medium
Open Market Operations
Accuracy: 61%
Total Attempted18
Total Correct11
Total Incorrect7
Difficulty Level:
Medium
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
Accuracy: 73%
Total Attempted11
Total Correct8
Total Incorrect3
Difficulty Level:
Medium
Functions of Money
Accuracy: 74%
Total Attempted19
Total Correct14
Total Incorrect5
Difficulty Level:
Medium
Money Multiplier
Accuracy: 75%
Total Attempted12
Total Correct9
Total Incorrect3
Difficulty Level:
Low
Money Creation by Banking System
Accuracy: 80%
Total Attempted15
Total Correct12
Total Incorrect3
Difficulty Level:
Low
Monetary Policy Tools
Accuracy: 86%
Total Attempted21
Total Correct18
Total Incorrect3
Difficulty Level:
Low
Repo and Reverse Repo Rates
Accuracy: 100%
Total Attempted11
Total Correct11
Total Incorrect0
Difficulty Level:
Low

Learning Objectives

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Learning Objectives

  • Define the concept of money and its role in an economy.
  • Explain the functions of money, including medium of exchange and unit of account.
  • Describe the process of money creation by commercial banks.
  • Identify the various measures of money supply, such as narrow and broad money.
  • Discuss the role of the Reserve Bank of India in regulating money supply.
  • Analyze the impact of monetary policy tools like bank rate and reserve ratios on the economy.
  • Explain the concept of liquidity trap and its implications for monetary policy.
  • Discuss the significance of legal tender and fiat money in the economy.
  • Evaluate the effects of demonetization on the economy and banking system.

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Revision Notes & Summary

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Chapter 3: Money and Banking

Key Concepts

  • Barter exchange: Economic exchanges without money.
  • Money: Commonly accepted medium of exchange.
  • Unit of account: Money provides a standard measure of value.
  • Bonds: Financial instruments representing a loan made by an investor to a borrower.
  • Liquidity trap: A situation where monetary policy becomes ineffective.
  • Legal tender: Currency that must be accepted if offered in payment of a debt.
  • Broad money: Includes all money in circulation plus deposits in banks.
  • Reserve deposit ratio: The fraction of deposits that a bank must hold as reserves.
  • Money multiplier: The ratio of the amount of deposits created by banks to the amount of reserves.
  • Open market operation: Buying and selling government securities to influence the money supply.
  • Medium of exchange: Money facilitates transactions.
  • Store of value: Money can be saved and retrieved in the future.
  • Rate of interest: The amount charged for borrowing money.
  • Fiat money: Currency without intrinsic value, established as money by government regulation.
  • Narrow money: Includes only the most liquid forms of money.
  • Currency deposit ratio: The ratio of currency held by the public to deposits in banks.
  • High powered money: The monetary base, which includes currency in circulation and reserves held by banks.
  • Lender of last resort: The role of the central bank to provide liquidity to banks in distress.
  • Bank Rate: The rate at which the central bank lends to commercial banks.
  • Cash Reserve Ratio (CRR): The percentage of deposits that banks must hold as reserves.
  • Repo Rate: The rate at which the central bank lends money to commercial banks.
  • Reverse Repo Rate: The rate at which the central bank borrows money from commercial banks.

Functions of Money

  1. Medium of Exchange: Facilitates transactions and eliminates the need for barter.
  2. Unit of Account: Provides a standard measure of value for goods and services.
  3. Store of Value: Allows individuals to save and retrieve value over time.

Money Supply in India

  • M1 (Narrow Money): Currency held by the public + Demand Deposits.
  • M2: M1 + Savings deposits with Post Office savings banks.
  • M3 (Broad Money): M1 + Net time deposits of commercial banks.
  • M4: M3 + Total deposits with Post Office savings organizations (excluding National Savings Certificates).

Important Events

  • Demonetisation (November 2016): Initiative to tackle corruption and black money by invalidating old currency notes of Rs 500 and Rs 1000.

Monetary Policy Instruments of RBI

  • Bank Rate: Influences the cost of borrowing for banks.
  • Open Market Operations: Buying/selling government securities to control money supply.
  • Reserve Requirements: CRR and SLR to control the amount of money banks can lend.

Common Questions

  1. What is a barter system? What are its drawbacks?
  2. What are the main functions of money? How does money overcome the shortcomings of a barter system?
  3. What is transaction demand for money? How is it related to the value of transactions over a specified period of time?
  4. What are the alternative definitions of money supply in India?
  5. What is a 'legal tender'? What is ‘fiat money'?
  6. What is High Powered Money?
  7. Explain the functions of a commercial bank.
  8. What is money multiplier? What determines the value of this multiplier?
  9. What are the instruments of monetary policy of RBI?
  10. Do you consider a commercial bank ‘creator of money' in the economy?
  11. What role of RBI is known as 'lender of last resort'?
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Practice Test – MCQs, True/False

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Multiple Choice Questions

A.

Speculative demand for money becomes zero

B.

Speculative demand for money becomes infinite

C.

Transaction demand for money becomes zero

D.

Transaction demand for money becomes infinite
Correct Answer: B

Solution:

When the market rate of interest is at its minimum level, the speculative demand for money becomes infinite because everyone expects interest rates to rise, leading to capital losses on bonds.

Chapter Concept:

Liquidity Preference Theory

A.

The need to conduct transactions and the opportunity cost of holding money

B.

The supply of money in the economy

C.

The government's fiscal policy

D.

The level of exports and imports
Correct Answer: A

Solution:

The demand for money is influenced by the need to conduct transactions and the opportunity cost of holding money versus earning interest.

Chapter Concept:

Demand for Money

A.

It encourages banks to borrow more from the central bank.

B.

It discourages banks from depositing excess funds with the central bank.

C.

It encourages banks to deposit excess funds with the central bank.

D.

It has no effect on the banking system.
Correct Answer: C

Solution:

An increase in the reverse repo rate makes it more attractive for banks to deposit their excess funds with the central bank, thus reducing the money supply in the economy.

Chapter Concept:

Repo and Reverse Repo Rates

A.

A situation where interest rates are high and money demand is low.

B.

A situation where interest rates are low and money demand is infinite.

C.

A situation where interest rates are moderate and money demand is stable.

D.

A situation where interest rates and money demand are both unpredictable.
Correct Answer: B

Solution:

A liquidity trap occurs when interest rates are so low that everyone expects them to rise in the future, leading to potential capital losses on bonds. As a result, people prefer to hold onto money, making the speculative demand for money infinite.

Chapter Concept:

Liquidity Preference Theory

A.

The level of income and interest rates

B.

The availability of barter systems

C.

The supply of gold in the economy

D.

The government's fiscal policy
Correct Answer: A

Solution:

The demand for money is influenced by the need to conduct transactions and the opportunity cost of holding money versus earning interest, which are affected by income levels and interest rates.

Chapter Concept:

Demand for Money

A.

Lack of a common language

B.

Double coincidence of wants

C.

Scarcity of resources

D.

High transaction costs
Correct Answer: B

Solution:

Money overcomes the limitation of the double coincidence of wants, which is a major drawback of barter systems.

Chapter Concept:

Functions of Money

A.

Open Market Operations

B.

Cash Reserve Ratio (CRR)

C.

Fiscal Policy

D.

Statutory Liquidity Ratio (SLR)
Correct Answer: C

Solution:

Fiscal policy is not a tool used by the central bank to control money supply. It is a government policy related to taxation and spending.

Chapter Concept:

Supply of Money

A.

To regulate the money supply by buying and selling government securities.

B.

To issue currency notes and coins.

C.

To provide loans to commercial banks at a fixed interest rate.

D.

To manage foreign exchange reserves.
Correct Answer: A

Solution:

Open market operations involve the buying and selling of government securities by the central bank to regulate the money supply.

Chapter Concept:

Open Market Operations

A.

Decrease in money supply

B.

Increase in money supply

C.

No effect on money supply

D.

Increase in interest rates
Correct Answer: B

Solution:

When the central bank purchases government securities, it injects money into the economy, thereby increasing the money supply.

Chapter Concept:

Open Market Operations

A.

It decreases the money supply

B.

It increases the money supply

C.

It has no effect on the money supply

D.

It stabilizes the money supply
Correct Answer: B

Solution:

An open market purchase of government bonds by the central bank injects money into the economy, thereby increasing the money supply.

Chapter Concept:

Supply of Money

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Money and Banking

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True or False

Correct Answer: True

Solution:

Money serves multiple functions in an economy, including acting as a medium of exchange, unit of account, store of value, and sometimes as a standard of deferred payment.

Chapter Concept :

Functions of Money

Correct Answer: True

Solution:

Repo and reverse repo rates are indeed used in repurchase agreements to control liquidity in the banking system, influencing short-term interest rates and money supply.

Chapter Concept :

Repo and Reverse Repo Rates

Correct Answer: True

Solution:

Repo and Reverse Repo Rates are indeed mechanisms used in repurchase agreements to manage liquidity, thereby influencing short-term interest rates and money supply.

Chapter Concept :

Repo and Reverse Repo Rates

Correct Answer: True

Solution:

The demand for money is influenced by the opportunity cost of holding money versus earning interest. As interest rates increase, the opportunity cost of holding money increases, leading to a decrease in the demand for money.

Chapter Concept :

Demand for Money

Correct Answer: True

Solution:

The CRR is indeed a percentage of deposits which a bank must keep as cash reserves with the central bank, as a regulatory measure to control the money supply.

Chapter Concept :

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

Correct Answer: True

Solution:

Open Market Operations are a tool used by the central bank to control the money supply by buying and selling government securities.

Chapter Concept :

Open Market Operations

Correct Answer: False

Solution:

The supply of money in an economy is determined by both the central bank and the commercial banking system. The central bank issues currency and controls the money supply through various measures, while commercial banks create money through the process of accepting deposits and making loans.

Chapter Concept :

Supply of Money

Correct Answer: False

Solution:

Open Market Operations involve both buying and selling of government securities. Buying securities increases the money supply, while selling them decreases it.

Chapter Concept :

Open Market Operations

Correct Answer: False

Solution:

The Liquidity Preference Theory posits that the speculative demand for money is inversely related to the rate of interest. As interest rates decrease, people expect them to rise in the future, leading to capital losses on bonds, thus increasing the speculative demand for money.

Chapter Concept :

Liquidity Preference Theory

Correct Answer: True

Solution:

Money, unlike perishable goods, can be stored for future use, maintaining its value over time, provided that inflation is controlled.

Chapter Concept :

Functions of Money

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