CH-3 MONEY AND BANKING NOTES

1. What is a barter system? What are its drawbacks?

The barter system was used in ancient times for exchanging goods. It was a
system where one commodity was exchanged for another. Like, we can say that
a person has 1 kg of wheat and he wants to have 1 kg of rice in exchange for
that, then he can exchange the same if there is someone who is willing to
exchange rice for wheat. It was called commodity for commodity exchange.
Later, it was replaced by the monetary system. The drawbacks of the barter
system are listed below:
1. It suffered from the double coincidence of wants, which means two
individuals should complement each other in their requirements in order for
the exchange to happen. For example, wheat for rice.
2. There was a lack of common measurement, i.e. value of the good of one
item was not always equal to the other item being exchanged for. For example,
the exchange of rice for the cow.
3. It was difficult to store the items that were obtained from exchange for
future exchanges, as many items perished.
4. It was difficult to make future payments and contractual payments.
2. What are the main functions of money? How does money overcome the
shortcomings of a barter system?
Money had the following functions:
1. Primary
2. Secondary
The primary functions of money are as follows:
a. Money served as the medium of exchange and facilitated buying and selling
of goods and services. The exchange was simple and could be scaled
accordingly.
b. Money served as a common source of value for goods. In the barter system,
it was not possible to determine the value of an item. But money made it
possible to value goods. So it served as a measure of value.
The secondary functions of money are as follows:
a. Money could be easily stored as compared to the goods that were received
in exchange in a barter system. So it acted as a store of value.
b. Deferred payments have become much easier with the introduction of
money. Loans can be repaid in a much better way as compared to the barter
system.
It overcame the following shortcomings of the barter system:
1. It eliminated the double coincidence of wants which was the most important
shortcoming of the barter system.
2. It overcame the problem of the valuation of goods. In the barter system,
goods exchanged were not proper in value with each other.
3. It facilitated contractual payments and future payments that were not
possible in the barter system.
4. It was easy to store money than perishable goods as was provided in the
barter system.
3. What is transaction demand for money? How is it related to the value of
transactions over a specified period of time?
It is the amount of money that is essential for performing everyday
transactions. It is also called the amount that everyone saves in order to
finance the expenditures in future. There are two motives for holding
transaction money. The income motive is for those who want to meet the
expenditures of the household, and the business motive is for businessmen
needing money to run the business.
The relation between transaction demand and the value of transactions is as
follows:

Where
V = 1/K, which represents the velocity of circulation of money
T = Total transaction value over time in an economy
K = A positive fraction
MTD = Money stock that people were willing to hold at a time
4. Suppose a bond promises Rs. 500 at the end of two years with no
intermediate return. If the rate of interest is 5 per cent per annum, what is
the price of the bond?
Let the price of the bond be Rs. P
We know formulae of interest is

According to the question,

A = Rs. 500
r = 5%
n = 2 years
Putting the values in the formula

Putting the values in the formula

P = Rs. 453.51
Therefore, it is calculated that the price of the bond is Rs.453.51.
5. Why is speculative demand for money inversely related to the rate of
interest?
Speculative demand for money is the need to have money for transactions
other than those necessary for living. It is the money that is essential for
investment. The rate of interest is inversely related to speculative demand, as
when the rate of interest is high, the speculative demand will be less and vice
versa. If in a market, the rate of interest is high, everyone will start expecting it
to become low in future so that they can gain from holding investments in the
form of bonds and, as a result, will convert money into bonds which makes
speculative demand for money low. In contrast, when the rate of interest is
low, people will try the bond rates to rise in future, which will be capital loss
and leads to converting bonds into money to avoid loss in future. It makes
speculative demand for money high.
6. What is `liquidity trap’?
This is referred to as the situation when bond interest rates are low, and
savings rates are high. It is believed that rates of interest will rise in future,
which leads to a decrease in the value of bonds, so consumers do not like to
keep an asset whose price is going to decline in future. Therefore, people
convert bonds to money in order to avoid loss.
7. What are the alternative definitions of money supply in India?
There are four definitions of money supply in India which are: M1, M2, M3, and
M4. These are arranged in descending order of liquidity. Therefore, M1 has the
highest liquidity, and M4 has the least.
Now,
M1 = C + DD + OD
Where,
C is the currency held by the public of the nation
DD is the demand deposit present in banks
OD is the other type of deposit present in the RBI
Also
M2 = M1 + Savings done by people in post offices
M3 = M1 + Net time deposits of the banks
M4 = M3 + Total deposit held in post offices excluding NSC (National Savings
Certificate).
8. What is a ‘legal tender’? What is ‘fiat money’?
A legal tender is a medium of payment which is accepted by a legal system for
making payments in order to meet the financial obligation. It is a form of
payment that is recognised by the government in order to pay for any kind of
debt or the financial obligation. For example, the notes and coins that are in
use in India are legal tender money.
Fiat money is a currency that lacks value in itself unless declared legal tender
by the government. It acts as money which is backed by the government. It can
be used to pay for the purchase of goods and services.
9. What is ‘high powered money’?
High powered money is referred to as the currency which has been issued by
the Government or the Reserve Bank of India. A major portion of this currency
is stored as reserves in Reserve Bank, while some part of it is kept with the
public.
It can be represented by the equation
H = C+R
Where,
H stands for High Powered Money
C stands for Currency that is with the public (includes cash and coins)
R stands for Deposits in RBI with bank and government.
10. Explain the functions of a commercial bank.
Commercial banks have the following functions:
1. The primary function of banks is to accept deposits. There are different types
of deposits, as detailed below:
a. Savings Account: It is a basic account in which an individual saves money and
earns interest. At times of need, money can be withdrawn with cheques,
withdrawal forms, ATMs etc.
b. Current Account: These are business accounts and no restrictions on
withdrawal and deposit. No interest is earned, but an overdraft facility is
available.
c. Fixed Deposit: These are deposits for a fixed time period, and money cannot
be withdrawn in between. They have higher interest rates. The rate of interest
is reduced if liquidated before maturity.
2. Banks provide loans and loan advances for various purposes. Loans can be of
short or long-term and have a higher rate of interest.
3. Banks also perform the following agency functions:
a. Banks provide fund transfer facilities through the internet or other banking
instruments.
b. Banks collect money for customers in the form of cheques or bills.
c. Banks provide the facility of periodic payments by using standing
instructions.
d. Banks also collect periodic payments in the form of salary, pension, premium
or dividend.
4. Provides financial assistance to businesses by discounting the bills of
exchange. This is done by purchasing of bills produced by customers and
deducting interest from the face value of the bill.
5. Banks create credit in the economy in the form of demand deposits. It helps
in the growth of an economy.
6. Some other functions served by the bank include: providing locker facility,
forex buying and selling, gold loans, share and debenture underwriting, gift
cheques etc.
11. What is ‘money multiplier’? How will you determine its value? What
ratios play an important role in the determination of the value of the money
multiplier?
The money multiplier is the amount of money that banks create as deposits,
with each unit of money it is kept as a reserve. It is determined as the ratio of
the total money supply to the stock of high powered money in the economy.

Where, MM is the money multiplier

M represents the stock of money
H represents high powered money
Now

Therefore, the current deposit ratio (cdr) and reserve deposit ratio (rdr) play an
important role in the determination of the money multiplier.
12. What are the instruments of monetary policy of RBI? How does RBI
stabilise the money supply against exogenous shocks?
Instruments of monetary policy are as follows:
1. Qualitative
2. Quantitative
The qualitative measures include the following components:
a. Marginal Requirements: The grant of a loan by commercial banks is on the
basis of the value of a security that is kept as a mortgage. Banks always
maintain a margin of difference between the market value of a security that is
mortgaged and the loan value. When the central bank restricts the money flow,
it results in the rise of the marginal requirement of loans and vice versa in the
case of credit policy.
b. Selective Credit Control (SCC): It is a monetary policy instrument that is
essential for affecting the credit flow of a sector both negatively as well as
positively. The positive aspect deals with the enhanced flow of credit to sectors
that need priority, while the negative aspect deals with restricting credit flow
to a particular sector.
c. Moral Suasion: It refers to a type of persuasion technique which is applied by
central banks to keep pressure on commercial banks in order to abide by the
monetary policies that are defined. It is carried out by conducting speeches,
seminars and meetings.
The quantitative measures are as follows:
a. Bank Rate: The rate at which a central bank, for example, RBI, provides loans
to a commercial bank is called as bank rate. If there is an increase in bank rates,
it will make the loans dearer for commercial banks, which will increase the rate
of lending, thereby reducing the capacity of the public to take credit. The
opposite happens in case of a decrease in bank rates leading to easy access to
credit.
b. Open Market Operations: In open market operations, securities are bought
and sold in an open market, which will affect the money supply in the
economy. Buying of securities by the central bank will boost the economy,
while selling of securities by RBI will clear out the extra cash balance of the
economy, which leads to a limited money supply.
c. Variable Reserve Ratios: There are two types of ratios that are used by RBI in
order to regulate the supply of money. These are the Statutory Liquid Ratio
(SLR) and Cash Reserve Ratio (CRR). SLR deals with the minimum percentage of
asset that needs to be maintained with RBI in the form of fixed or liquid assets.
When SLR increases, the flow of liquidity decreases and vice-versa. CRR deals
with the minimum amount of funds that need to be maintained with the RBI.
Change in the value of CRR has an impact on the economy. If CRR is increased,
it will result in less money available for lending, while the opposite happens if
CRR decreases.
At times, when foreign currency enters India in the form of bond purchases by
foreigners by exchanging foreign currency for rupees, the currency thus
collected will be deposited by a commercial bank to RBI, which experiences a
rise in liabilities and assets. To counter such a situation, RBI sells securities in an
open market in order to protect the enemy against shocks.
13. Do you consider a commercial bank a ‘creator of money’ in the economy?
Commercial banks’ primary role is money creation or credit creation in an
economy. This is based on the assumption that not all depositors will withdraw
all their deposits at once from the bank. In this way, the money can be used to
provide credit to others and hence generate credit through demand deposits.
14. What role of RBI is known as ‘lender of last resort’?
Any commercial bank which is facing a financial crisis and needs to obtain
funds for functioning seeks the help of the central bank of the country. In India,
RBI (Reserve Bank of India) is the central bank, and it provides assistance to
those banks in the form of credit, thereby saving them from getting bankrupt.
Therefore, by acting as a guarantor for commercial banks, the central bank
(RBI) maintains a sound and healthy system of banking in the economy.