UNIT :7 MONEY AND BANKING
(8 MARKS)
Money :- It is anything which is generally acceptable as a medium of exchange and at the same time acts as a measure of value, store of value and means of deferred payments.
Functions of Money
(1) Medium of Exchange :-
- It is generally accepted means of payment for exchange of goods and services.
- Facilitates trade, widens area of market by separating act of sale and purchase.
- Reduces time and labour needed for trade in case of using goods for trade (Barter System).
( 2) Measure of Value or Unit of Value :-
- All goods and services can be given one unique value (Price) by expressing them in terms of money.
-It is common unit of measurement of all goods. Thus makes exchange easier.
-Helps developing efficient accounting system. Goods and services can be accounted for easily in terms of rupees. It would have been difficult to make account in many units like litres, quintals, meters etc. and adding up different units is not possible.
-Comparisons can be made.
-Its value remains constant.
3. Store of Value
-It is liquid store of value.
-It comes in convenient denominations.
-Value remains constant, its not perishable easily portable, requires less place to store & there is no storage cost.
4.Standard of deferred Payments -Or future payments like salaries, pension, interest etc.
-Facilitates borrowing and lending.
-It led to creation of financial institutions as it overcomes disagreements and risks that are there is barter system regarding future payments to be made as value of money reaming constant.
FUCNTIONS OF CENTRAL BANK
1) Currency Authority:- The central Bank is the sole authority for the issue of currency in the country. All the currency issued by the central bank is its monetary liability. This means that the central bank is obliged to back the currency with assets of equal value.
2) Banker to the government:- The central bank acts as a banker acts as a banker to the government both central as well as state governments. It carries out all the banking business of the government and the government keeps its cash balances on current account with the central bank.
3) Bankers bank and supervisor :- As the banker to banks, the central bank holds a part of the cash reserves of banks, lends them short term funds and provides them with centralized clearing and remittance facilities.

4) Controller of Money Supply and Credit:- The central bank controls the money supply and credit in the best interests of the economy by various instruments as quantitative and qualitative instruments.
Quantitative Instrument:-
A)Bank Rate Policy:- The bank rate is the rate at which the central Bank lends funds as a lender of last resort to banks against approved securities or eligible bills of exchange.
B) Open Market Operations: Open market operations is the buying and selling of government securities by the central bank from to the public and banks on its own account. The sale of government securities to banks have the effect of reducing their reserves.
C) Varying Reserve Requirements (Legal Reserve Ratio): Banks are obliged to maintain reserves with the central bank on two accounts. One is the cash
reserve ratio and the other is statutory liquidity Ratio. SLR is the fraction of legal reserves, the banks are required to keep as cash within the bank itself.
The CRR is the ratio the banks are required to keep with Central bank. Varying
CRR and SLR are tools of monetary and credit control.
II) Qualitative Credit Control. A) Imposing margin requirement on secured loans: A margin is the difference between the amount of the loan and market value of the security offered by the borrower against the loan. The advantages of this instrument are manifold.

B) Moral suasion: This is a combination of persuasion and pressure that the
Central Bank applies on the other banks in order to get them to fall in line with its policy.
C) Selective credit controls: These can be applied in both a positive as well as a negative manner.
Quantitative credit control measures used by RBI are :-
1. Cash Reserve Ratio (CRR ) :- It is of certain ratio of commercial banks net demand deposits & times liabilities which it has to keep with central bank RBI as cash.
If RBI increases CRR, Banks have to keep larger percentage of their deposits with RBI, their credit giving ability decreases and money supply decreases. Similarly if RBI decreases CRR
,money supply increases,
2, Statutory Liquidity Ratio (SLR ) :- It is the ratio or percentage of net total demand & time liabilities of commercial banks which they have to keep in form of liquid assets as excess reserves, they have to invest in government securities or in securities approved by RBI and current account balances with other banks.
If RBI increases SLR then credit giving ability of bank decreases and money supply decreases.
If RBI decreases SLR banks credit giving ability and thus money supply increases.
3. Open Market Operations (OMO ) :- It is the buying and selling of government security by the Central Bank from/to the public and banks on its own account.
Sale of government securities will reduce reserves.
* RBI sells securities Bank gives RBI a cheque for the securities.
* The RBI collects the amount by reducing the bank’s reserves by the particular amount.
* This directly reduces bank’s ability to give credit.
* Therefore this decreases money supply in the economy.
When RBI buys securities from banks
* RBI gives the bank a cheque drawn on itself in the payment for the securities.
* When cheque clears, RBI increases reserves of the bank by the particular amount.
* This direc tly increases the bank’s ability to give credit.
* Thus money supply increases.
4. Bank Rate Policy
Bank rate is the rate at which Central Bank lends funds to commercial banks.
If bank rate increases:
* Cost of borrowng from RBI increases.
* So banks borrow less
* Their credit giving ability decreases.
* Banks also increase lending rates i.e. rate at which they lend to public.
* This discourage businessmen from taking loans. This reduces volume of credit and money supply.
A decrease in bank rates on the other hand will increase credit and money supply.
Measure of Money Supply are :-
M1 is most liquid measure of money supply
M1 = C + DD + OD
C = Currency held by public (currency & coins ).
Demand Deposits (DD ) :- Only net demand deposits of banks are included in money supply, as other part of demand deposit that represents inter-bank deposits held by

one bank with another does not constitute demand deposit held by public.
Other Deposit (OD) with RBI :- These are the deposits held by the RBI of all economic units except the government and banks. OD includes demand deposits of public financial institution (like IDBI) foreign central banks, foreign government, the IMF, the
World Bank etc.
1 mark questions.
1.what is barter system?
Barter refers to goods were exchanged for goods.
2. what is money?
Money is anything that is generally accepted as medium of exchange.
3. What are primary functions of money?
Medium of exchange measure of value.
4. What are secondary functions of money?
Standard of deferred of payments and store of value.
5. Define money supply?
Money supply means the total stock of money held by public in spendable form.
6. Is money supply a stock or flow?
Money supply is a stock because it is measured at a point of time.
7. Define money creation?
Money creation is the process of credit creation by banks through derivative deposits.
8. Define central Bank?
Central bank is an apex institution that controls monetary and banking structure of the country.
9. Define Cash Reserve Ratio.
It is the ratio of bank deposits that commercial banks must keep with the central bank.
10. Define Bank Rate.
The bank rate is the rate at which the central bank lends funds to banks against approved securities or bills of exchange.
11. What is meant by statutory liquidity ratio?
It is the ratio of total demand and time deposits of commercial banks which it has to keep in the form of specified liquid assets.
12. What will be the effect of a rise in bank rate on money supply?
Money supply will fall
3 / 4 mark questions
1.
State two problems of barter system of exchange. How does money solve them? i) Lack of common measure of value: Absence of common measure of value in barter system creates great problem because a lot of time is wasted to bargain between buyer and seller of different commodities. Money provides a common denomination to all the ii) goods and services by which exchange become convenient.
Lack of double co-incidence of wants: Double coincidence wants means that two persons who want to exchange two goods between each other, must be in need of each other. But it difficult to find such person under barter system. Money solves this problems by medium of exchange act.
2.
Mention four functions of money. Explain any two.
1.
Medium of exchange
2.
Unit of value.
3.
Standard of deferred payment.
4.
Store of value

i) ii) iii)
Explain any two
Medium of exchange: - It is generally accepted means of payment for exchange of goods and services.
Unit of value: - All goods and services can be given one unique value (Price) by expressing them in terms of money. It is common unit of measurement of all goods
Standard of deferred payment: Deferred payments means those payments which are to iv) be made in future. Money not only acts as a medium of exchange for current transactions but also future payments like salaries, pension, interest etc,
Store of value : Value remains constant, its not perishable easily portable, requires less place to store & there-It is liquid store of value. It is no storage cost.
3.
Explain the M1 components of money supply.
M1 = C + DD + OD
C = Currency held by public (currency & coins ).
Demand Deposits (DD ) :- Only net demand deposits of banks are included in money supply, as other part of demand deposit that represents inter-bank deposits held by one bank with another does not constitute demand deposit held by public.
Other Deposit (OD) with RBI :- These are the deposits held by the RBI of all economic units except the government and banks. OD includes demand deposits of public financial institution (like IDBI) foreign central banks, foreign government, the IMF, the
World Bank etc.
4.
Explain the banker to government function of the central bank.
The central bank acts as a banker, agent and financial adviser to the government.
As a banker: It maintains the accounts of the central as well as state governments. It receives deposits from government and make shot term advances to the government.
As a fiscal agent: The central bank collects taxes and other payments on behalf of the government.
As a Financial adviser: The central bank gives advice to the government on economic, monetary, financial and fiscal matters such as deficit financing, foreign exchange etc,.
6 mark question.
1.
Explain the quantitative methods to control credit adopted by central bank?
1. Cash Reserve Ratio (CRR ) :- It is a certain ratio of commercial banks net demand deposits & times liabilities which it has to keep with central bank RBI as cash.
If RBI increases CRR, Banks have to keep larger percentage of their deposits with RBI, their credit giving ability decreases and money supply decreases. Similarly if RBI decreases CRR
,money supply increases,
2, Statutory Liquidity Ratio (SLR ) :- It is the ratio or percentage of net total demand & time liabilities of commercial banks which they have to keep in form of liquid assets as excess reserves.
3. Open Market Operations (OMO ) :- It is the buying and selling of government security by the Central Bank from/to the public and banks on its own account.
Sale of government securities will reduce reserves. When it wants to expand credit, these securities are bought from the market.
4. Bank Rate Policy
Bank rate is the rate at which Central Bank lends funds to commercial banks.
If bank wants to expand credit, it reduces bank rate and for contracting credit, this rate is increased.
Prepared by P.Ramesh Kumar PGT (ECO) JNV UNA (H.P)