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CLASS XII ENJOY ECONOMICS BY MUKESH MISHRA

5 & 6.MONEY AND BANKING
1. Define Money.
Money is anything which is generally accepted as a medium of exchange, measure of value,
store of value and means for standard of deferred payment. The term ‘money’ is used to cover
all such things like coins, currency notes, cheques etc., which are used to conduct business
transactions and settlement of business claims. It must be noted that ‘money’ can be any
commodity chosen by common consent, as an instrument of exchange of goods and services.

2. What is meant by Money Supply?

Money supply refers to total volume of money held by public at a particular point of time in an
economy. It includes ‘money held by public only’. It is a ‘Stock concept’, i.e. it is concerned with a
particular point of time.

3. Write the components of money supply Or measures of money supply.

Till 1967-68, Reserve Bank of India used only the narrow measure of money supply. But, since
1977, four alternative measures of money supply (M1, M2, M3 and M4) have been evolved:
M1: It is the first and basic measure of money supply. It is also known as ‘transaction money’ as
it can be directly used for making transactions.
M1 = Currency and coins with public + Demand deposit of commercial banks + Other deposits
with RBI
Currency and coins with public: It consists of paper notes and coins held by the public.
Remember, any currency held with the government and banks is not to be included.
Demand deposit of commercial banks: It refers to demand deposits of the public with the
commercial banks. Demand deposits are the deposits which can be encashed by issuing cheques
at any time by the account holders.
Other deposits with Reserve bank of India: It include deposits held by the RBI on behalf of
foreign banks and government, public financial institutions, World Bank, IMF etc. however, it
does not include deposits of the Indian Government and commercial banks with RBI.

4. Define Commercial bank.

Commercial bank is an institution which performs the function of accepting deposits, granting
loans and making investment, with the aim of earning profits. State bank of India (SBI), Punjab
national bank (PNB), Allahabad bank, Canara bank are some examples of commercial bank in
India.

5. Define Central bank.

Central bank is an ‘apex’ body that controls, operates, regulates and directs the entire banking
and monetary structure of the country .India’ central bank is reserve bank of India (RBI). RBI
was established in April 1, 1935 under reserve bank of India Act passed in 1934.

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CLASS XII ENJOY ECONOMICS BY MUKESH MISHRA
6. State the main functions of Central Bank.
The RBI performs the following functions:
i) Currency Authority or Bank of Issue
Central bank has the sole authority for issue of currency in the country. In India, reserve
bank of India (RBI) has the sole right of issuing paper currency notes (except one-rupee
notes and coins which are issued by ministry of finance).
All the currency issued by the Central bank is its monetary liability, Central bank is
obliged to back the currency with assets of equal value, to enhance the public
confidence in paper currency.
ii) Banker to the government
The reserve bank of India acts as a banker, agent and a financial advisor to the
central government and all the state government (except that the Jammu and Kashmir).
As a banker, it carries out all banking business of the government. It maintains current
account for keeping their cash balance.
It accepts receipt and makes payment for the government and carries out exchange,
remittance and other banking operations.
As an agent, the central bank also has the responsibility of managing the public debt.
As a financial advisor, the central bank advises the government from time on
economic, financial and monetary matters.
iii) Banker bank and supervisor: It acts as a a garden for the commercial banks. As
defined earlier, it controls, organizes, regulate, directs and supervise the commercial
banks and also plays the important role of banker to the banks. In this capacity, a
Central Bank:
a) Maintains CRR: Commercial banks are required to keep a part of their total
deposits with the commercial banks in the form of cash. This is known as CRR. In
India presently CRR is 4%.
b) Advances loans: These advances generally take the form of rediscounting of bills of
exchange. For this facility of advancing loans to commercial banks, the central bank
charges interest from them. The interest rate is what is known as bank rate.
c) Acts as the lender of The Last Resort: As the lender of The Last Resort the central
bank assumes the responsibility of meeting on legitimate demands for funds by
commercial banks under emergency conditions. If the central bank does not rescue
a commercial bank, it has to go bankrupt and close down its operations.
iv) Cleaning house: As central bank holds the cash reserves of all commercial banks, it
becomes easier and more convenient for it to act as their clearing house. All commercial
banks have their accounts with the central banks. Therefore, the central bank can easily
settle claims of various commercial banks against each other, by making debit and
credit entries in their accounts.
v) Custodian of Foreign Exchange Reserves: It is the primary responsibility of the
central bank to stabilise the external value of the national currency, the Indian National
Rupee. The central bank keeps gold and foreign currencies as reserves against note
issue, and also meets adverse balance of payment with other countries. If the situation
demands it may directly or indirectly intervene to stabilize the home currency vis-a-vis
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CLASS XII ENJOY ECONOMICS BY MUKESH MISHRA
foreign currencies. It also manages foreign currencies apart from helping the
government in tackling the Balance of payments situations.
vi) Controller of Credit: In Modern times, credit control is considered as the most crucial
and important function of a central bank. The primary objective of credit control is to
remove causes responsible for instability in price fluctuations which, in turn, are related
to the supply of money.
By controlling the supply of credit, the central bank and exercise an effective control
over economic activity, and manipulate it in the desired directions.
The central bank regulates and controls the volume and direction of credit by using
quantitative and qualitative controls.

7. Explain the methods of Credit Control used by Central Bank.

RBI makes use of following methods of credit control:
i) Repo Rate or Bank Rate: Repo rate is the rate at which the central bank of a country
lends money to commercial banks to meet their short term needs.
Repo rate is the rate at which the central bank of a country lends money to commercial
banks to meet their long term needs.
An increase in bank/repo rate increases the cost of borrowings from the central bank. It
forces the commercial banks to increase their lending rates, which discourages
borrowers from taking loans. It reduces the ability of commercial banks to create credit.
A decrease in the repo/bank rate will have the opposite effect.
ii) Reverse Repo Rate: This is exact opposite of Repo rate. Reverse Repo rate is the rate at
which Reserve Bank of India borrows money from commercial banks. RBI makes use of
this tool when it feels that there is excess money supply in the banking system. Banks
are always happy to lend money to RBI as their money is in safe hands with a good
interest. An increase in reserve repo rate induces the banks to transfer more funds to
RBI due to attractive interest rates.
iii) Open market Operations: open market operation (OMO) refers to buying and
selling of government securities by the central bank from to the public and
commercial banks. RBI is authorized to sell and purchased treasury bills and
government securities. It does not matter whether the securities are bought or sold to
the public or banks because ultimately the amounts will be deposited in or transferred
from some bank.
Sale of securities by central bank reduces the reserves of commercial bank. It adversely
affects the bank ability to create and therefore decrease the money supply in the
economy.
Purchase of securities by central bank increase the reserve and raise the bank ability to
give credit.
iv) Legal reserve requirements (variable reserve ratio Method): According to legal
reserve requirement, commercial banks are obliged to maintain reserve. It is a very
quickly and direct method for controlling the credit creating power of commercial
banks. Commercial banks are required to maintain reserve on two accounts.

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a) Cash reserve ratio (CRR): It refers to the minimum percentage of net demand and
time liabilities, to be kept by commercial banks with the central bank. A change in
CRR affects the ability of commercial banks to create the credit.
If the central bank feels that the credit availability in the economy is in excess to what
is required, it may raise the Cash Reserve Ratio. When banks have to keep more cash
reserves with the central bank, they are left with lesser deposits, and thus, their
power to create credit decreases. The central bank will reduce the CRR to expand
credit, if the money supply is supposed to be less than required.
b) Statutory liquidity ratio (SLR): Under SLR, the commercial banks are required to
maintain with themselves a certain proportion of their total assets/deposits in the
form of liquid assets/securities.
In order to control credit, the central bank will raise SLR which will restrict
commercial banks to lend more and the money supply may be controlled as per the
requirements of the economy and vice versa.
Both of the above-mentioned tools directly affect the quantum/size of the money
supply in the economy.
v) Margin requirements: Margin is the different between the amount of loan and market
value of the security offered by the borrower against the loan. If the margin fixed by the
central bank is 40% then commercial banks are allowed to give a loan only up to 60% of
the value of security. By changing the margin requirement, the reserves bank can alter
the amount of loans made against securities by the banks. An increase in margin
reduces the borrowing capacity and money supply. A fall in margin encourages the
people to borrow more. RBI may prescribe different margins for different types of
borrowers against the security of the same commodity. Margins in necessary because if
a bank gives a loan equal to the full value of security, then bank will suffer a loss in case
of fall in price of security.

8. Explain with the help of an example the process of credit creation.

Suppose there is an initial deposits of Rs. 10000 crore in banking system and the legal reserve
ratio stands at 20%. The bank will lend 80% i.e., Rs. 8000 crore to its lenders and shall keep Rs.
2000 crore as reserves to pay off his depositors. Presuming the Uni-Bank Model without any
cash transaction, Rs. 8000 crore will come back as deposits in the 2 nd phase out of which 80%
(Rs. 6400 crore) would again be lent, keeping Rs. 1600 crore (20%) as reserves. (See table)

Process Round Deposits Loan / Credit Cash Reserves

1st 10,000 primary 8000 2000
2nd 8000 6400 1600
3rd 6400 5120 1280
4th 5120 4096 1024
…. …. …. ….
Total 50000 40000 10000

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This process will continue till an infinite period, creating total deposits of Rs.50000 crore and
credit creation of Rs.40000 crore.

Total deposits = Initial deposits x 1/LRR

= Rs.10000 cr. x 1/0.20
= Rs.50000 cr.
Credit creation = 80% of total deposits
= 80% of Rs.50000 = Rs.40000 cr.
Total reserves = 20% of total deposits
= 20% of 50000 = Rs.10000 cr.

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