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15_MONEY AND BANKING

 

 

 

 

ECONOMICS (CLASS-XII)

 

Chapter-15

MONEY AND BANKING

 

 

 

MEANING OF MONEY                     

“Anything that is generally acceptable by the people in exchange of goods & services or in repayments of debts.”

 

BARTER SYSTEM

Barter system refers to the exchange of goods without the use of money. The economy based on barter exchange is called C.C.Economy.   [Commodity for commodity exchange economy. In such an economy, a person gives his surplus goods and gets in return the goods they need.

 

LIMITATIONS

 

(1) Lack of Double Coincidence of Wants

 

Double coincidence of wants occurs., when the buyer has exact commodity which the seller wants in return for his commodity. There must be a simultaneous fulfillment of wants of the buyers and the seller in the form of commodities exchanged. However this may not be possible. The inability of buyer to find such a seller is known as lack of double incidence of wants.

 

(2) Lack of Common Unit of Value

 

A common unit of value would be when one single good is used to express the exchange  rate of all other commodities that are being offered for sale. There is no common measure of value in the barter system. All commodities do not possess equal values. The problem arises in what proportions the two goods must be exchanged.

(3) Lack of store of Value

Another difficulty under the barter system is related to the storing of wealth.For future store of value means the ability to store the purchasing power for the future use. For a commodity to be a store of value, it must have following characteristics :

  • It should not be perishable.
  • It should be easy to store and carry from one place to another.

 

(4) Lack of Standard Deferred Payment

Another drawback of barter system is that it lacks the standard of future payments, so credit transaction cannot take place smoothly. Trade is often hampered because of the problems regarding the type, quality and the value of the goods to be exchanged in the  future.

EVOLUTION OF MONEY

The money has evolved through many stages.

(1)   Commodities like sea shells, stones, arrows, grains were used as money. These commodities had various disadvantages. They were not standardized in terms of quality.

(2)   Metallic money : Metals like Gold, Silver, Bronze, and Copper were used as money in the form of coins. These metals had the advantage of being durable and portable.

(3)   Paper money : Paper money was started by merchants to safeguard the gold to be used as money. Instead of carrying bags of gold coins to transect. Merchant started using paper receipt with a promise to pay gold coins in future. Soon people started exchanging paper receipt. It is also known as convertible money.

 

FUNCTIONS OF MONEY

 

(1) Medium of Exchange

Medium of exchange is the primary function of money. People exchange goods and services through the medium of money. Money has the quality of general acceptability; therefore all the exchange in the economy takes place in terms of money. Seller acceptsmoney in exchange of their goods. By having medium of exchange, people do not have to waste the time and efforts. This function provides the following benefits.

(i)   It overcomes the difficulty of barter system of lack of double coincidence of wants, (ii)  It allows freedom of choice as people can purchase goods of their own choice, (iii)  It widens the area of trade.

 

(2) Measure of Value

Money acts AS A UNIT OF ACCOUNT or Common measure of value. It serves as a unit of measurement in terms of which the value of all the goods and services are measured and expressed. When value of commodity is expressed in money is known as price. A consumer compares the value of alternative purchases in terms of money. Producers compare the value of alternative purchase in terms of money. It is therefore very important that value of money should be stable.

Benefits : It provides the basis for keeping accounts, estimating national income, calculating profits and loss etc.

Consumers compares the value of alternative purchases in terms of money. It is therefore very important that value of money should be stable.

 

  1. Store of Value

Money also acts as a store of value. People can keep their wealth in terms of money. Money help us to store the purchasing power which can be used at any time in the future to purchase. However, it suffers from the drawback that money’s value changes over time. People wish to keep a part of their wealth in the form of money because savings in terms of goods is very difficult.

It has following advantages:

(1)        Money comes in convinient denominations.

(2)        It is easily portable.

(3)        It is easily exchanged for goods at all times.

 

  1. Standard of Deferred Payment

Deferred payment refers to the payment that needs to be made on a future date. eg. Wages, interest payment etc. It performs this function successfully because: (i)  Its value is relatively more stable than other commodities.

(ii)  The element of durability is higher than other commodities, (hi)  It possesses the quality of general acceptability. This functions fascillitates the borrowing and trading activities and helps in the creation of financial institution.

MONEY SUPPLY

“Money supply is defined as the total amount of money that is available with the public of an economy at any given point of time.” It reflects two features:

(i)       Money supply is a stock variable.

(ii)      It reflects to the availability of money held with the public not with government or banks.

The R.B.I, has four ways of measuring the money supply in the Indian economy

(1)      M1: It is the first and the basic measure of money supply in the Indian economy. It is the most liquid measure of money supply.

Ml = C + DD + OD

where    C : is the currency that is held with the public.

DD : These are the net demand deposits that are held by the public in

banks. OD : These are the other deposits that are held with the RBI. It includes

deposits held by the RBI on behalf of foreign bank and govt, it is an

insignificant component of Mj.

(2)      M2 : It is the second measure of money supply. It is defined as the sum of Mx and saving deposit with post office saving banks. Therefore,

M2 = Mx + Saving deposits with post office.

(3)   M3 : It is the third measure of money supply. It includes all the          components of Ml as well as all the net time deposits of all the banks        other the post office banks.

M3 = Mi + net time deposit held with the banks.

(4)      M4 : It is the widest way in which the RBI can measure the money   supply.It includes all the components of M3 as well as all the deposits of        post offices.

M4 = M3 + net deposits with the post office

Two Main Components of Money Supply

(1)      Currency:

It includes coins and currency notes. The currency notes are called paper money. It is also called fiat money (It is defined as money which under law must be accepted for all debts).

(2)      Chequable Deposits:

It is any deposit account on which cheque can be written. It is called demand deposits because amount in such deposits is payable on demand. It is considered equally to the currency held. It is also the part of measure of money supply.

 

BANKING

COMMERCIAL BANKS

Commercial bank is defined as an organization that accepts chequable demand deposits and uses the deposit money to lend or invest it to the general public.

1 FEATURES OR CHARACTERISTICS

  1. It accepts deposits from the public.
  2. It uses the deposits money for investment or for lending.
  3. It can create money through their lending operations.

FUCTIONS OF COMMERCIAL BANKS

There are 3 types of functions:

  1. Accepts Deposits

The primary function of commercial bank is to accept deposits from the public. They accept the deposits from households and firms.

The banks accept mainly 3 types of deposits:

(a)  Demand Deposits : These are the deposits which can be withdrawn by the depositor at any time by means of cheque. These deposits are made by businessman and industrialists who use these deposits for making business payment. The account in which the money is deposited is known as Current Account. No interest is paid by the bank.

(b)  Saving Account: Saving account or deposit is usually held by households. It provides chequable facility to the customers. There are restrictions on the number of

withdrawal and interest is paid by the bank.

(c) Fixed Deposits/Time Deposits: These are the deposits which can be withdrawn only after the expiry of certain time period. These deposits carry the highest rate of interest. These are not payable on demand and doesn’t carry cheque facility.

  1. Lendin

The money received as deposits by bank is lend to firms and households that is used to undertake investment. The bank offers the following type of loan:

(a)  Term Loans : Term loans are extended for pre-determined period of time. In this case the entire sum of money is given to the borrower in a loan account. Interest is charged on the entire amount of loan that has been given by the bank.

(b)  Cash Credit: Under this, the bank credits the borrower’s account with certain sum of money, which is determined by the security kept. The borrower is allowed to withdraw the money as and when required. However the interest is charged on the amount of money withdrawn.

(c)  Overdraft: This facility is available only to those who maintains current account with the bank. In this facility, the bank allows the customer to overdraw his current account. The negative balance is the level of overdraft extended to a customer. The interest is paid on the amount of money overdrawn.

(d)  Money at call: Such loans are very short period loans &can be called back by the banks at a very short period say one to fourteen days.

  1. Credit Creation

This is the most important function of commercial Bank. In the process of accepting deposits and advancing of loans, commercial bank creates credit. They are able to lend more money then they had as a cash deposits. This is known as Credit Creation.

People deposit money with the commercial bank.Bank use this money in the deposit to gives loans. When bank gives loan to someone, it simply creates a bank deposits equal j to the loan amount in the name of the borrower. This new deposit created by the bank becomes a part of the money supply. This is known as bank credit money.

LRR : It is the part or fraction of the demand deposits by the commercial bank which bank has to keep in this form of cash.

Credit creation = Initial deposits

Suppose deposits of Rs. 100 are made in banks. The minimum reserve requirement is being put at 10% of the total deposits. Bank will keep a cash reserve equal to Rs. 10 only and lend the remaining amount of Rs. 90. For this bank has not to part with its cash reserves, instead borrowers are credited with chequable deposits. This is the first round creation and equal 90% of the initial deposits. Borrowers will use the deposits(which are raised through banks) to meet their obligation to their creditors, by paying them, most probably in the form of cheques drawn on bank. He will deposits the same in their respective bank account. The bank get the new deposits. They keep 10% of the deposits i.e., Rs. 9 as cash and lend the remaining Rs. 81. Thus, the second round creation. It is 10% of the previous round increase. In the same manner, the third round creation of deposits will be 90% of Rs. 81, i.e., Rs. 72.90 and in the fouth round it will be 90% of Rs.72.90, i.e. Rs. 65.61 and so on. Like these creations in each of the further round will be 90% of the previous round. In each round, the increase becomes smaller and smaller and ultimately, it becomes zero. The sum total of all deposits will ultimately be Rs. 1000, i.e., ten times the initial deposit.

  Deposit Loan Cash Reserve
Initial Rs. 100 90 10
1st Round Rs. 90 81 9
2nd Round Rs. 81 72.90 8.10
 
 
  1000 900 100

 

CENTRAL BANK

Central bank is the apex or head of the financial & monetary system of a country which controls, supervise, regulate, and organize the financial & monetary system of a country.

The apex or central bank of India is reserve bank of India (RBI). It was established on 1st April 1935.

FUNCTIONS OF CENTRAL BANK

(1) Issues The Currency Note

The central bank has the sole monopoly to issue currency notes. Currency notes and coins issued by the central bank are the legal tender money. Legal tender money is one which every individual is bound to accept by law in exchange of goods and services.

Following are the reasons for giving the monopoly right to central bank.

(a)      It gives uniformity in money distribution.

(b)      It enables the government to have supervision and control over the supply of money in the country.

(c)      It enables the central bank to exercise the control over the creation of credit by the commercial bank.

(2)   Banker, Fiscal Agent and Advisor To The Government

As a banker : As banker to the government, it performs the following function.

(a)      It receives deposits from the government and collect cheques and draft deposited in the government account.

(b)      It makes payment on behalf of the government to meet its budget deficit.

(c)      It also advances short tern loan to the government in exchange of securities.

(d)      It provides foreign exchange to the government.

As a fiscal agent: As a fiscal agent,it performs the following function:

(a)      It manages the public debt.

(b)      It collects taxes and other payment on behalf of the government.

(c)      It represents the government in the international financial institution (e.g. World Bank, IMF).

As an advisor: The central bank also acts as a financial advisor to the government. It gives advice to the government on all financial & economic matters. Such as deficit financing, foreign exchange policy.

  1. 3. Banker to the Bank and Supervisor

Central bank act as a banker to the bank in the following ways.

(a)  Custodian of the cash reserves of the commercial bank: Every commercialbank has to keep a certain percentage of its cash reserves with the central bank. It helpsto control credit in the country.

The percentage is fixed by the central bank. The central bank use these reserves to meet the emergency cash needs of the bank. The central bank gives loans to these banks.

(b)  As a lender of the last resort : In case the commercial bank, fails to meet their financial requirement from other sources they can approach to the central bank as a last resort for loans and advances. Central bank helps these banks by discounting approved securities and bills of exchange or providing loans against their securities. By providing temporary financial help, central bank helps the financial structure of the country from collapse. The direct lending to the commercial bank is refered to as ‘lender to the last resort function of central bank.

(c)  As a clearing agent: Central bank acts as a clearing house for the bankers. Central bank can easily settle the claims of various banks against each other simply by book entries of transfer form and to the accounts. This method of setting the account is

called clearing house function of central bank.

The representatives of different banks meet daily in the clearing hour to settle their bank payments. The differences between the various banks at the end of the day of each clearing are settled.

This function economies the use of money in the banking operations. This strengthens the banking system of the country.

(4) Custodian of Foreign Exchange Reserves

Central bank acts as a custodian of the foreign exchange reserves -US dollars, British pounds. etc. This right of the central bank helps to overcome the balance of payment difficulty and to maintain.

Stability in the exchange rate. All the foreign currency received has to be deposited with the central banks.

5) Controller of Credit

It is the most important function of central bank. By controlling the credit effectively, central bank established stability not only in the internal price level but also in the foreign exchange rate and full employment.

CREDIT CONTROL

It refers to the regulation of credit by the central bank for achieving some definite objectives such as price stability, economic growth and exchange rate stability etc. These objectives are achieved by regulating money supply.

(1) Quantitative Methods : It refers to those methods of credit control which are used by the central bank to influence the total volume of credit without regard for the purpose for which credit is put.

(a)  Bank Rate Policy : It is the rate at which central bank lends money to the commercial bank. There is a direct relationship between bank rate and interest rate. When the bank rate increases, interest rate also increases. This affects the lending capacity of the commercial banks and this reduces the money supply.

(b)      Cash Reserve Ratio : The fixed % of cash which is to be kept with RBI by commercial banks as a cash is known as CRR. When credit is to be decreased, central bank can increases this ratio so as to reduce the lending power of banks & when it intends to expand the credit, it reduces the ratio.

(c)  Statutory Liquidity Ratio (SLR) : A certain % of the deposits must be in the form of liquid assets means cash. It is known as SLR. In order to expand credit, this ratio is required to be reduced but to reduce the credit, SLR must be increased.

(d)  Open Market Operation : Under open market operations, central bank buys and sells the Govt, securities in the open market. As RBI purchases the securities, it increases the money supply with the bank. This increases the credit availability. As the RBI sells the securities, it reduces the money supply and credit in the economy.

(e)  RapoRate :It is the rate at which the central bank of a country lends money to the commercial bank in the case of any shortfall of funds. It is a short term funding.

(f)   Reserve Repo Rate :It is the rate at which central bank borrows money from commercial bank.Higher reverse repo rate always induces the commercial books to lend more money to central bank due to attractive lending interest rates.

(2) Qualitative Methods : These are the selective methods which are used by the central bank to regulate the credit into the particular direction of the economy.

(a)  Margin Requirement : It refers to the difference between the extant of loan

granted and the amount of security that bank ask for the loan. Increase in the

margin requirement, reduces the money supply in the economy and decrease in

margin requirement increases it.

(b)  Moral suasion : It refers to oral or written appeal made by the RBI to the banks to increase or decrease money supply in the economy.

(c)  Rationings of credit : Under this method, reserve bank fixes credit quota for another bank. If the member bank seek more loans then their fixed quota, they will have to pay higher interest.

  1. Difference between Central Bank and Commercial Bank.
  Central Bank   Commercial Bank
(i)

 

 

 

(ii)

 

(iii)

 

(iv)

 

 

 

(v)

It is an apex institute which regulates the entire monetary system of the country.

Its objective is to promote social welfare.

It is a government owned institution.

It has the monopoly right to issue note.

 

It is a banker of government and commercial bank.

(i)

 

 

 

(ii)

 

(iii)

 

(iv)

 

 

 

(v)

It is an organization that accepts chequable deposits & uses it to level and invest to the general public.

 

Its objective is earning profit.

 

It is owned both by private owners and government.

 

It does not have such right.

 

 

 

It is a banker of general public.

 

 

 

 

 

 

 

MONEY AND BANKING

MCQ

  1. Which feature of money is reflected in the statement “It separated the act of sale and purchase”.

(a)      Standard of deferred Payment    (b)      Store of Value

(c)      Measure of Value                      (d)      Medium of exchange.

  1. M1 includes:

(a)      Currency with Public                (b)      Saving deposits with post office

(c)      Time deposit of post office          (d)      All of the above.

  1. Money Supply is a ­­­­___________ concept.

(a)      Stock                                        (b)      Flow

(c)      Both (a) and (b)                         (d)      Neither (a) nor (b).

  1. Bank creates credit

(a)      On the basis of Profits               (b)      On the basis of Securities

(c)      On the basis of total Assets       (d)      On the basis of deposits.

  1. This bank operates in public Interest instead of profit motive

(a)      Reserve Bank of India               (b)      State Bank of India

(c)      Canara Bank                            (d)      Allahabad Bank.

  1. What will be the effect of increase in repo rate on money supply ___________.

(a)      Money supply will increase

(b)      Money supply will decrease

(c)      Money supply will remain same

(d)      Money supply will initially increase then it will decrease.

  1. means.

(a)      Credit creation                          (b)      Investment multiplier

(c)      Money multiplier                       (d)      None of these.

  1. If the total deposit created by the commercial bank is Rs. 10,000 crores and legal reserve requirement is 40%, what is the amount of initial deposits?

(a)      Rs. 2,200 crores                        (b)      Rs. 2,000 crores

(c)      Rs. 4,000 crores                        (d)      Rs. 14,000 crores.

  1. What happens when margin requirement increases?

(a)      Discourages the borrowing capacity of banks and money supply

(b)      Encourages people to borrow more money and money supply rises

(c)      Money supply remains constant

(d)      None of these.

  1. Which of the following is not an instrument of monetary policy?

(a)      Bank rate                                 (b)      Open market operations

(c)      Repo rate                                  (d)      Tax rate.

  1. On which deposits of the bank, overdraft facility is available.

(a)      Saving Account                         (b)      Demand Deposits

(c)      Time Deposits                           (d)      Other deposits with R.B.I.

  1. Which of the following functions is not performed by commercial bank.

(a)      Banker to the general public     (b)      Overdraft facility

(c)      Banker to the Government        (d)      Issue of letter of credit.

  1. Other name of legal reserve ratio is?

(a)      CRR                                         (b)      SLR

(c)      Variable reserve requirement    (d)      Bank rate.

  1. Which of the following will decreased the money supply?

(a)      Increase in the reverse repo rate         (b)      Selling of securities by R.B.I.

(c)      Decrease in margin requirement         (d)      Increase in Bank rate.

  1. Deposit multiplier means

(a)      The no. of times asset is created         (b)      The no. of times income is created

(c)      The no. of times credit is created         (d)      All of the same.

  1. Which function of money has overcome the limitation of lack of double coincidence of wants?

(a)      Store of Value                           (b)      Unit of account

(c)      Medium of Exchange                 (d)      Standard of deferred Payment.

  1. Derivative functions of money means

(a)      Which is same perspective of time, place etc.

(b)      Which are derived from basic functions

(c)      Both (a) and (b)

(d)      Neither (a) nor (b)

  1. Money means anything

(a)      Which has general acceptability

(b)      Used for the repayment of debt

(c)      Both (a) and (b)                         (d)      Only (a)

  1. Legal tender money is

(a)      Fiat Money                               (b)      Fiduciary money

(c)      High powered money                 (d)      All of the above.

 

 

 

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