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| Chapter | 3. Money and Banking |
| Subject | Economics |
| Textbook | Macro Economics |
| Class | Twelve |
| Category | NCERT Solutions for Class 12 |
The NCERT Solutions for Class 12 Macro Economics cover all the questions pertaining to the subject in a very clear and lucid manner. Apart from being highly accurate, these solutions are also very easy to memorize. These solutions are written as per the latest CBSE syllabus and are helpful in clearing doubts. On this solution page, we have provided you with complete overview of the concepts and methods covered in the Chapter 3 of Macro Economics – Money and Banking.
NCERT Solutions for Class 12 Macro Economics Chapter 3
Money and Banking Solutions
Q1) What is a barter system? What are its drawbacks?
Answer) In ancient times, the barter system was used to exchange things. It was a method of exchanging one commodity, product, or set of goods for another. For example, if a person has 1 kg of sugar and wants 1 kg of jaggery in trade, he can do so if someone else is prepared to exchange sugar for jaggery. A commodity for commodity exchange was the name given to this activity. It was also supplanted by the monetary system.
The drawbacks of the barter system are:
- It suffered from the double coincidence of wants that means two individuals should be complementing each other in their requirement in order for the exchange to happen. For e.g wheat for rice.
- There was lack of common measurement i.e. value of good of one item was not always equal to the other item being exchanged for. For e.g exchange of rice for cow.
- It was difficult to store the items that were obtained from exchange for future exchanges, as many items perished.
- It was difficult to make future payments and contractual payments.
Q2) What are the main functions of money? How does money overcome the shortcomings of a barter system?
Answer) Money had the following functions:
- Primary Function.
- Secondary Function.
Primary functions are as follows:
- 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.
- Money served as a common source of value for the goods. In barter system it was not possible to determine value of an item. But money made it possible to value goods. So it served as a measure of value.
Secondary functions are as follows:
- 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.
- Deferred payments have become much easier with introduction of money. Loans can be repaid in a much better way as compared to barter system.
It overcame the following shortcomings of barter system:
- It eliminated the double coincidence of wants which was the most important shortcoming in barter system.
- It overcame the problem of valuation of goods. In barter system goods exchanged were not proper in value with each other.
- It facilitated contractual payments and future payments that were not possible in barter system.
- It was easy to store money than perishable goods as was provided in barter system.
Q3) What is transaction demand for money? How is it related to the value of transactions over a specified period of time?
Answer) It is the amount of money that is essential for performing every day transactions. It is also called that amount that everyone save 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 expenditures of household and business motive for businessman needing money for running business.
Relation between transaction demand and value of transactions is as follows:
Where,
V = 1/K which represents 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
Q4) 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?
Answer) Let the price of bond be Rs. P
A = P(1 + r/100)n
According to the question
A = Rs. 500
r = 5%
n = 2 years
Putting the values in the formula,
500 = P (1 + 5/100)2
or, 500 = P (1 + 1/20)2
or, 500 = P (21/20)2
or, 500 = P (441/400)
or, P = 200000/441
So, P = Rs. 453.51.
Therefore, it is calculated that the price of the bond is Rs. 453.51.
Q5) Why is speculative demand for money inversely related to the rate of interest?
Answer) The inverse relationship between speculative demand for money and the rate of interest is that when interest rates rise, speculative demand for money falls, and vice versa. As a result, the speculative demand for the money curve slopes downward to the right. There are two possibilities:
- People will convert their money into bonds if the market rate of interest is very high and predicted to diminish in the future, i.e. the price of a bond rises, anticipating capital gain from bond-holding. As a result, there is little speculative demand for money.
- People change their bonds into money in order to avoid future capital loss if interest rates are low and people anticipate that they will rise in the future, i.e. decreasing bond prices anticipating capital loss from bond ownership. They keep cash on hand because they believe that non-monetary assets such as bonds will generate little income, lowering the cost of money keeping.
Q6) What is a ‘liquidity trap’?
Answer) 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 that leads to decrease in 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.
Q7) What are the alternative definitions of money supply in India?
Answer) 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 is having the highest liquidity and M4 having the least.
Now,
M1 = C + DD + OD
Where,
C is the currency held by public of the nation
DD is the demand deposit present in banks
OD is the other types of deposits present in 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)
Q8) What is a ‘legal tender’? What is ‘fiat money’?
Answer) Legal tender is a medium of payment which is accepted by a legal system for making payments in order to meet financial obligation. It is a form of payment that is recognised by the government in order to pay for any kind of debt or financial obligation. For e.g. the notes and coins that are in use in India is legal tender money.
Fiat money is a currency that lacks value in itself unless otherwise declared legal tender by the government. It acts as money which is backed by the government. It can be used for paying for purchase of goods and services.
Q9) What is High Powered Money?
Answer) High Powered Money is the money that the RBI and the government create, with the public holding the currency and banks holding the cash reserves. It is distinct from money in that money is made up of demand deposits, whereas cash reserves are used to create demand deposits.
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.
Q10) Explain the functions of a commercial bank.
Answer) A commercial bank is a type of financial organisation that handles all transactions involving the deposit and withdrawal of money for the public, as well as the provision of loans for investment purposes and other similar activities.
- Accept Deposits: Deposits are accepted at the bank in the form of savings, current, and fixed deposits. Surplus funds received from businesses and people are lent to meet the short-term needs of commercial operations.
- Credit Cash: When a customer receives credit or a loan, they do not receive liquid cash. The customer’s bank account is opened first, and then the funds are sent to the account. The bank is able to manufacture money through this technique.
- Provides Loan and Advances: Another important duty of this bank is to provide loans and advances to entrepreneurs and business persons, as well as collect interest. It is the most important source of earnings for any bank.
- Overdraft Facility: This is a loan offered to a customer in exchange for keeping their current account open and allowing them to overdraw up to a certain limit.
- Discounting Bills of Exchange: A discount bill of exchange is a written agreement that acknowledges the sum of money to be paid for products acquired at a future date. A commercial bank’s discounting strategy can also be used to clear the payment before the quoted period.
- Locker Facilities: Customers can use a bank’s locker facilities to store their valuables or papers discreetly. This service is charged at least once a year by the banks.
- Purchasing and Selling Securities: The bank provides you with the option of buying and selling securities.
Q11) 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?
Answer) Money multiplier is that amount of money that banks create as deposits with each a unit of money it is keeping as reserve. It is determined as the ratio of total money supply by the stock of high powered money in the economy.
MM = M/H
Where, MM is the money multiplier
M represents stock of money
H represents high powered money
Now,
M/H = [(1 + cdr)/(cdr + rdr)] > 1
Therefore, the current deposit ratio (cdr) and reserve deposit ratio (rdr) play an important role in the determination of money multiplier.
Q12) What are the instruments of monetary policy of RBI? How does RBI stabilize money supply against exogenous shocks?
Answer) The central bank’s policy on the use of monetary tools within its authority to fulfil the Act’s goals is referred to as monetary policy. The Reserve Bank of India (RBI) is charged for implementing monetary policy in India. The Reserve Bank of India Act, 1934, expressly mandates this obligation.
The instruments of monetary policy of the RBI are as follows:
1. Quantitative Measures
- Varying Reserve Ratios:
- Cash Reserve Ratio (CRR): It is a portion of a bank’s total deposits that the Reserve Bank of India requires to be kept with the latter as liquid cash reserves.
- Statutory Liquidity Ratio (SLS): It is essentially the reserve requirement that banks must maintain before extending credit to customers. It is essentially the reserve requirement that banks must maintain before extending credit to customers.
- Bank Rate: The interest rate charged by a nation’s central bank to its domestic banks in order for them to borrow money is referred to as its bank rate. The interest rates charged by central banks are meant to stabilise the economy.
- High Powered Money: It is the money created by the RBI and the government, in which the public holds the currency, and the banks hold the cash reserves. It differs from money for that money consists of demand deposits, whereas cash reserves serve as a foundation for creating demand deposits.
2. Qualitative Measures
- Open Market Operation: It refers to the central bank’s selling and purchase of securities on the open market to and from commercial banks or the general public.
- Bank Rate Policy: It refers to the central bank’s manipulation of the discount rate in order to influence the economy’s credit condition.
- Sterilisation by RBI: The RBI’s market-based strategy in neutralising a portion or the whole monetary impact of foreign inflows is known as sterilising.
- Moral Suasion: The RBI uses this strategy to persuade commercial banks to assist in regulating the money supply in the economy.
The Reserve Bank of India (RBI) is a key player in the management of external shocks. Assume a foreigner decides to put money into Indian bonds. The foreign currency is then exchanged into Indian rupees by the bond seller at a commercial bank. The same commercial bank deposits money in the RBI, increasing assets and liabilities on the balance sheet; but, the overall reserves of the commercial bank remain unaltered.
Q13) Do you consider a commercial bank ‘creator of money’ in the economy?
Answer) Commercial banks primary role is money creation or credit creation in an economy. This is based on the assumption that not all the depositors will withdraw all their deposits at once from the bank. By this way the money can be used to provide credit to others and hence generate credit through demand deposits.
Q14) What role of RBI is known as ‘lender of last resort’?
Answer) When a commercial bank is faced with a financial crisis and is unable to secure funds from other sources, the central bank steps in as a “lender of last resort,” providing financial assistance in the form of credit. The central bank’s role saves the commercial bank from failure. As a result, the central bank acts as a guarantor for commercial banks, ensuring that the financial system in the economy is sound and healthy.
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