CBSE Class 12 Economics HOTs Money And Banking Set 02

UNIT 2 MONEY AND BANKING

MONEY : Money is anything that is generally acceptable as a
1. Medium of exchange
2. Measure of value
3. Store of value
4. Means for standard of deferred payment

Money supply (M1) : total stock of money in circulation held by public at a given point of time. Money supply is a stock concept.

Symbolically, \( M1= C + DD + OD \), where
C = Currency held by public.
DD = Demand Deposits.
OD = Other deposits with RBI

Demand Deposits : demand deposits are the deposits which can be withdrawn from the bank on demand or by writing a cheque any time.

Question. Define money supply. What are its components?
Answer: Money supply is the total stock of money in circulation held by the public at a given point of time. Its components (M1) are currency held by the public (C), demand deposits (DD), and other deposits with RBI (OD).

Question. Define demand deposits.
Answer: Demand deposits are those deposits with commercial banks which can be withdrawn on demand or through cheques at any time.

Question. The authority that issues coins in India is....................... . (Choose the correct alternative)
(a) RBI
(b) Ministry Of Finance
(c) SBI
(d) CBI
Answer: (b) Ministry Of Finance

Question. ___________ regulates money supply in India.
Answer: RBI (Reserve Bank of India)

Question. _____________ and _____________are the main source of money supply in an economy.
Answer: Central Bank; Commercial Banks

Banking

• Central bank is an Apex body that controls, operates, regulate and directs the entire banking and monetary structure of the country. In India it is Reserve Bank of India.

FUNCTIONS OF CENTRAL BANK: ->

i. BANK OF ISSUE: - It has the sole authority to issue currency in country (except one-rupee notes and coins). It has following advantages: -
a. It leads to uniformity in Note circulation
b. It gives the central bank power to influence the money supply because currency with public is a part of money supply.

ii. Banker to the Government: - It acts as a Banker, agent and financial advisor to the central and state government. It carries out all banking business of the Government and maintains current account for keeping cash balances of the government. It accepts receipts and makes payments and also give loans and advances to the government.

iii. Bankers Bank and Supervisor: - It performs following function: -
a. Custodian of cash Reserves: - Commercial banks must keep a proportion of the net total deposits with Central Bank as cash Reserves
b. Lending of last resort: - When commercial bank faces financial crisis, they approach Central Bank which gives them loans and advances
c. Clearing house function: - Since the central bank holds a cash reserve of all commercial banks it also acts as a clearing house for these banks by making debit and credit entries in their accounts to settle claims.
d. Supervisor: - It supervises the functioning of commercial banks. It makes rules regarding licensing, management, branch expansion liquidation etc.

PROCESS OF MONEY/DEPOSIT CREATION: -

Money creation is a process in which a commercial bank creates total deposit far excess of the initial deposits. It depends upon: - a) Amount of initial fresh deposit. b) legal reserve ratio

Example Table (LRR = 20%):
Initial Deposit: 1000 | Loan: 800 | Cash Reserve: 200
Round 1: 800 | Loan: 640 | Cash Reserve: 160
Round 2: 640 | Loan: 512 | Cash Reserve: 128
Total Deposits: 5000 | Total Loans: 4000 | Total Reserves: 1000

As required the bank keep 20% of Rs.1000 (initial deposits) i.e., Rs.200 as cash reserves and lend the remaining Rs.800. Those who borrows use the money for making payments. We assume those who receives these payments put the money back into their bank accounts. This creates a fresh deposit of Rs.800. The bank again keeps 20% i.e., Rs.160 and lends Rs.640. In this way the money goes multiplying leading to total money creation of Rs.5000

\( \text{Money Multiplier} = 1/\text{LRR} \)

\( \text{Money Creation} = \text{Initial deposit} \times 1/\text{LRR} \)
\( = 1000 \times 1/0.2 = 5000 \)

Question. Explain the “Banker’s Bank function of the Central Bank.
Answer: As a banker's bank, the Central Bank acts as a custodian of cash reserves of commercial banks, provides them with 'lending of last resort' during financial crises, and facilitates clearing house operations to settle inter-bank claims.

Question. What do you mean by credit money Creation? Explain the process of money creation by the commercial banks with the help of Numerical Example!
Answer: Credit money creation is the process where commercial banks create secondary deposits from primary deposits. For example, with Rs.1000 initial deposit and 20% LRR, banks keep Rs.200 and lend Rs.800. This Rs.800 returns as a new deposit. This repeats until total deposits reach Rs.5000 (\( 1000 \times 1/0.2 \)).

Question. Define Bank Rate.
Answer: Bank rate is the rate at which the central bank lends money to commercial banks for their long-term requirements.