ECOVISIONNAIRE

MONEY AND BANKING UNIT 2

Q1. (i) Define money and money supply

(ii) State components of money supply.
Ans.(i) Money is anything that serves as medium of exchange. It is usable for undertaking
transactions i.e. receipts and payment.
Money supply is stock of money in the country on a specific day.

(ii) Money supply = Currency (Coins + Notes) + Net Demand deposits held by commercial
banks.

Q2. Explain the process of money creation/ credit creation/ credit multiplier. (V. IMPT.)
Ans. Money multiplier refers to the process of creation of credit by the commercial banks, with
the help of initial deposits made by the public and legal reserve ratio (LRR). Banks do not keep
all their deposits with themselves. Rather they keep only a certain % as Legal reserve ratio (LRR)
and give balance to others in the form of loans.

For example the initial deposits in banks is Rs. 100 and the LRR is 20 percent. Further suppose
that banks keep only the minimum required Rs. 20 as reserve, no more no less.
Banks are now free to lend the remainder Rs. 80. Suppose they lend Rs. 80. Now, since all the
transactions are routed through the banks, the money spent by the borrowers comes back
into thebanks in the deposit accounts of those who have received this payment. This increases
demand deposits in banks by Rs. 80. When banks receive new deposits of Rs. 80, the banks keep
20 percent of it as reserves and use the remaining Rs. 64 for giving loans.

The borrowers use these loans for making payments. The money comes back into the accounts
of those who have received the payments. Bank deposits again rise, but by a smaller amount of
Rs. 64. In this way in every round 80 percent of loans are converted into deposit. In this way total
deposits ofRs.500 are created. The rule for deposit creation is:
Total deposit creation = Initial deposits x 1/ Legal reserve ratio = 100 x 1/0.2 = 500

Deposit creation by commercial banks

Increase in reserves (LRR
Round Increase in bank deposits Increase in loans =20%)
1st 100 80 20
2nd 80 64 16
3rd 64 51.20 12.8
. . . .
. . . .
. . . .
Total 500 400 100
Credit multiplier
= 1 / LRR= 1 / 0.2 = 5
The total deposit creation is initial deposit xcredit multiplier = 100 x 5 = 500. Since bank
deposits are a part of money supply, it is also called money creation.

Q3. Give components of M1 as a measure of money supply.

Ans.M1 = C + DD + OD
C = currency held by the public. It includes both paper currency and coins.
DD = demand deposits in the banks. Here we will not include the demand deposits of bank made
in another bank i.e. interbank deposits are to be excluded. OD = other deposits held by the RBI.
These deposits held by RBI are of all economic units except the Govt. and Banks.

OD includes deposits of Foreign banks, Foreign Govt. , IMF, World Bank etc.

Q4. Explain the main functions of RBI. (V. IMPT)

Ans. 1. Bank of Issue (Currency Authority)
(a)The Central Bank is the sole authority for the issue of the currency in the country. It brings
uniformityin note circulation and also gives direct control to central bank over money supply.

(b) The Central bank has to back the currency with assets of equal value. These assets
usually consist of gold coin, gold bullion, foreign securities, and the domestic government's
local securities.

(c) Putting and withdrawing currency into and from circulation is also the job of its banking
department.

(d)RBI issues the currency notes of various denominations (such as Rs. 100, 500 etc) On the
other hand, Ministry of finance (Government of India) issues currency coins and note of Rs 1.
Though the Govt. issues one rupee note and coins but the responsibility of making them
circulate in the economy lies with RBI.

2. Banker to the Government

The Reserve Bank of India acts as a banker, agent and a financial advisor to both Central and
State Governments.
(a) As a banker, it carries out all banking business of the government.
• Government keeps its cash balances on current account with the Central Bank.
• The Central Bank accepts receipts and makes payments for the government.
• The Central Bank also provides short-term credit to the government, so that the
government can meet any shortfalls in receipts over expenditures. The government borrows
money by selling treasury bills to the Central Bank.
(b) As an agent, the central bank has the responsibility of managing the public debt.
(c) As a financial advisor, the Central Bank advises the government on banking and financial
matters.

3. Bankers' Bank and

Supervisor Bankers
Bank-

(a)As the banker to banks, the Central Bank holds a part of the cash reserves of banks (Cash
reserve ratio)
(b) Central bank provides centralised Clearing and remittance facilities to commercial banks.
(c)The Central Bank can give advances to banks temporarily in need of funds. However, the
banks, in temporarily need of funds are supposed to approach other sources first like the call
money market and then only approach the Central Bank. That is central bank acts as lender of
last resort.( This system of guarantee assures individual account-holders that their banks will be
able to pay their money back in case of a crisis and there is no need to panic thus avoiding bank
runs)
Supervisor –
(a)The Central Bank supervise, regulate and control the commercial banks. It may be related to
their licensing, branch expansion, management, amalgamation (merging of banks) and
liquidation (the winding up of banks).
(b) RBI does periodic inspection of banks and checks the returns filed by them.

4. Controller of Money Supply and Credit

The Central Bank controls the money supply in the best interests of the economy. The bank
does this through various instruments.

The instruments of monetary policy of central bank are broadly classified into 2
categories
(A) Quantitative (These influence the quantum of credit in the economy)
(B) Qualitative (These influence the direction of credit in the economy)

DETAIL OF QUANTITATIVE INSTRUMENTS.

1. Bank Rate/repo rate:-The interest rate at which commercial banks borrow money from
central bank to meet their long term needs us known as bank rate and the interest rate at which
commercial banks borrow money from central bank increase the bank rate/repo rate. This in
turn leads to rise in rate of interest charged by the commercial banks. Rise in the interest rates
rate reduces demand for loans. Less loans will decrease money supply in economy. But when
RBI wants to increase money flow in economy then bank rate / repo rate is reduced. Decrease
in interest rates, increases demand for loans. More loans will increase money flow in economy.

2. Open market operation.(OMO) OMO is the buying and selling of government securities by
theCentral Bank (RBI) from / to the public and banks. To decrease money supply RBI sells
securities and receives cheque from buyers. So the money flows out from the commercial banks
into the central bank. This reduces the banks ability to give credit and so money supply in
economy decrease.
To increase money supply in economy the Central Bank buys securities and gives cheque to the
seller. When the cheque clears, the cash reserves of commercial bank increases. This directly
increases the bank’s ability to give credit and so money supply in economy increase.

3. Legal Reserve Requirements -Commercial Banks are required to maintain reserves on two
accounts:
(a) Cash reserve ratio(CRR) - Every commercial bank is required to keep percentage of its
deposits withthe central bank, this is known as cash reserve ratio. To decrease money supply in
economy, central bank raise this ratio. This will reduce the cash reserves of the commercial
banks and they can now give less credit. Thus money flow in economy will reduce. But to
increase money flow, this ratio is decreased so that more loans can be granted, which will
increase money supply in economy.

(b) Liquidity ratio or Statutory Liquidity ratio. (SLR) Every bank is required to maintain a
percentage ofits deposits in the form of cash or other liquid assets. This ratio is called liquidity
ratio. To decrease money supply in economy, central bank raise this ratio. This will reduce the
cash reserves of the commercial banks and they can now give less credit. Thus money flow in
economy will reduce. But to increase money flow, this ratio is decreased so that more loans can
be granted, which will increase money supply in economy.
4. Reverse REPO -When the commercial banks have surplus funds they can deposit these funds
with thecentral bank (RBI) and earn interest. The rate of interest paid by the Central Bank on
such deposits is called Reverse Repo Rate. To decrease money supply in economy, central bank
increase reverse repo rate, so that banks deposit more funds with the central bank. This will
reduce the cash reserves of the commercial banks and they can now give less credit. Thus money
flow in economy will reduce.
To increase money flow, central bank will decrease Reverse Repo Rate so that banks deposit less
funds with central bank. So now banks will use more funds to give loan to public which will
increase money supply in economy.

DETAIL OF QUALITATIVE INSTRUMENTS.

1. Margin requirements - It means difference between value of security offered for Loan and
actualamount of loan granted. (For example if we give security of 100 to bank and bank will give
loan of 70, then margin is 30.) To decrease money supply in economy, central bank raise this
margin. So banks can now give less credit. Thus money flow in economy will reduce. But to
increase money supply, this margin is decreased so that more loans can be granted, which will
increase money supply in economy.
2. Moral suasion -Moral Suasion implies persuasion and pressure done by the central banks
on theother banks so that they follow the policy given by the Central Bank. This is done by
discussions, letters, speeches and hints to the banks. The Central Bank frequently announces its
policies and advices the banks to follow its policies. For example to reduce money supply RBI
makes policies for reducing credit while to increase money supply makes policies for increasing
credit.
3. Selective credit control. They can be applied in both positive as well as negative ways. In
positive waythe central bank uses different measures to increase credit flow into particular
sectors. In negative way different methods are used to reduce the flow of credit into particular
sectors. For example to reduce money supply central bank may issue instructions directly to the
commercial banks not to give credit for certain purposes.

TIP 1 - Shortcut to remember instruments of Monetary policy = BLOC MMS BLOC

means B= Bank rate (Also connect it with Repo and reverse repo rate), L= Liquidity
ratio, O = Open market operations, C = Cash reserve ratio MMS means M = Margin
requirements, M = Moral suasion, S = Selective credit control
TIP 2 - Shortcut to remember that to decrease loans how should monetary policy
instruments be changed. MIILD = M= Monetary, I = Instruments, I = Increase, L =
Loans, D = Decrease
(Monetary instruments – bank rate, repo rate, reverse repo rate, liquidity ratio, cash
reserve ratio, margin requirement – When all these increase, then loans given by
bank decrease which will decrease money supply in economy)

Q5. Explain how RBI acts as a lender of last resort.

Ans.As a lender of last resort, the central bank stands as a guarantor to the commercial banks
during financial emergencies. A commercial bank may lose confidence of the depositors
promoting them to withdraw their demand deposits at large. Since cash reserve ratio of the
commercial bank is only a fraction of its demand deposits, its reserves may run out, pushing the
bank into financial crises. It is the central bank during such times that stands by the commercial
bank as a guarantor and saves it from insolvency. However, the banks, in temporarily need of
funds are supposed to approach other sources first like the call money market and then only
approach the Central Bank. That is central bank acts as lender of last resort.

Q6. Explain Functions of money (V. Impt.)

Ans. Money performs following four functions.
(1) Money as a measure of value or unit of account
 The first function of money is that serves as a common measure for measuring the value
of goods and services.
 With the help of money we can measure each good or service in only one unit i.e. money.
 By reducing the value of all goods and services to a single unit (i.e. price), it becomes very
easy to find out the exchange ratios between them and comparing their prices
 For Ex. We can simply measure one pen as of ten Rs. i.e. it can be exchange for ten
monetary units i.e. 10 rupees. Now there is no need to measure a single commodity in
terms of different other items.
 The accounting process also gets simplified as now all the items will be recorded in terms
of monetary units and now these units can be easily subtracted or added.
(2) Money as a medium of exchange.
 Money is generally accepted by people in exchange of goods and services.
 Money reduces the time spent and energy spent in the barter exchange process.
 This function has removed the major difficulty of lack of double coincidence of wants' and
inconveniences associated with the barter system.
 Use of money allows purchase and sale to be conducted independently of one another.
 For example The person who now wants to sell his cow for buying wheat now need not
necessarily sell his cow to the person who is willing to give wheat. Our trader will simply sell
his cow to the person who gives maximum money for his cow.
 He will then use this money for buying wheat from that person which gives him the best deal
or lowest price for wheat of the best quality.
(All goods and services are ultimately exchanged by each other but still money acts as a mediator or
intermediary who increases the ease of trade.)
(3) Money as a standard for deferred or future payments.
 Money also perform the function of being the unit in terms of which future payments are
stated. that is money acts as a 'standard' for payments, which are to be made in future.
 Money makes the future payments relating to borrowing and lending much easier then
before. It has made possible the creation of banking system.
 It overcomes disagreements and risks that are there is Barter system regarding future
payments to be made as value of money remain constant
 Wages, salaries, interest, pensions , salaries etc are all future payments. Money can
overcome such problems which arise while making future payments.
 Money encourages future transactions which helps in capital formation and economic
development of the economy

(For ex. We have taken a loan from some one in the form of wheat. At the time of return of the loan
it may not be possible to return the wheat of same quality. Thus we need a medium like money
through which such transactions can be easily carried on and the principal and interest amounts can
be easily done. )

(4) Money as a store of value (Asset function).

  Money also performs the function of serving as a store of value.
 The person holding money has generalised purchasing power that can be spent through time.
 Money gives us the generalised purchasing power i.e. we can now buy freely whatever is
being offered for sale in the market and at whatever time we feel comfortable.
 We now know that money can be accepted at any time for any good or service and is thus a
store of value. There is no compulsion that we have to spend our money only on a particular
commodity only or within a particular time period only. We have the freedom to look for the
best bargain at the best possible time .
 It comes in convenient denominations.
 It is not perishable, easily portable, requires less place to store & there is no storage cost.
(Though value can also be stored buy purchasing some land, building etc. but in these assets there is
problem of storage cost, maintenance cost, and they are not completely liquid i.e. they can not be
quickly converted into cash and also there is a risk that there value may depreciate. But all these
problems are not there in money - No storage , maintenance cost etc. )

Q7. If total deposits created by commercial banks are Rs.12000, LRR is 25% calculate initial deposit.
Ans:Credit multiplier = 1/LRR = 1/.25 = 4
Initial deposit = Total deposit / credit multiplier = 12000/4 = 3000

Q8. Show numerical of credit creation where initial deposit is 100 and LRR is 20 %.
Ans.
Stage Increase in Increase in Increase in reserves (LRR =
bank deposits loans 20%)
1st 100 80 20
2nd 80 64 16
3rd 64 51.20 12.8
. . . .
. . . .
. . . .
Total 500 400 100

Credit multiplier = 1 . = 1 / 0.2 = 5

LRR

Q9. Calculate credit multiplier and total deposit created if initial deposit is of Rs. 500crores and LRR is
10%.
Ans: Credit multiplier = 1/LRR which is equal to 1/0.1=10
Initial deposit Rs.500crores
Total deposit = Initial deposit x credit multiplier = 500 x 10 = 5000crores.
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