Miss Vidya A.

Dukare

Department of Economics

RPD PU College of Arts and Commerce

PU II Economics Notes

Chapter 3 Money and Banking

I. Answer the following questions in 12 sentences. (4 Marks)
1. Money acts as a convenient unit of account. Explain this sentence with example.
Ans: money acts as a convenient unit of account. The value of all goods and services can be
expressed in monetary units. When we say that the value of a certain wristwatch is Rs.500 we
mean that watch can be exchanged for Rs.500 units of money, where a unit of money is rupees
in this case.
For example: if the price of a pencil is Rs.2 and that of a pen is Rs.10 we can calculate the relative
price of a pen with respect to a pencil, therefore one pen is worth of 5 pencils. The same notion
can be used to calculate the value of money itself with respect to other commodities. If the
prices of all commodities increase in terms of money, then there will be general increase in the
price level, the value of money in terms of any commodity will decreases.

2. Briefly explain the functions of money.

Ans: a) Monopoly of note issue: under section 22 of the RBI Act, the bank has the sole right to
issue currency notes of all denominations of RS.10, 20, 50, 100, 200, and 500 in the country. It
has to maintain reserve in the form of gold, silver, and foreign exchange against issue of currency
notes.
b) Banker to the government: the RBI acts as a banker agent and advisor to the government. The
RBI performs the same functions as the commercial banks perform to their customers, as it
receives deposits from the government and advances loans to it. The RBI act as an agent to the
government in respect to country’s relations with international institutions like IMF and World
Bank.
c)Banker’s bank: the activities of all commercial banks are controlled and managed by the RBI.
The branch expansions, liquidity of assets etc. every commercial bank has to maintain certain
portion of its total deposits in the form of cash reserve with the RBI.
d) Lender of last resort: the role of RBI, that of being ready to lend banks at all times is another
important function of the central bank and due to this central bank is said to be the lender of
last resort. Commercial banks can approach the RBI during any financial crises.
e) controller of credit: RBI controls the money supply in the economy in various ways. The tools
used by the central bank can be quantitative or qualitative. Like CRR, SLR and open market
operation or moral suasion, margin requirement etc.

3. Write a note on legal definitions of money.

Ans: Legal definitions: Narrow and Broad money
The total stock of money in circulation among the public at a particular point of time is called
money supply. RBI publishes figures for four alternative measures of money supply as follows,
M1= CU + DD
M2= M1 + saving deposits with post office saving banks
M3= M1 + time deposits of commercial banks
M4= M3 + total deposits with post office saving organizations
Where CU is currency held by the public and DD, demand deposits held by the commercial banks.
M1 and M2 are known as narrow money. M3 and M4 are known as broad money. M1 is most liquid and
easiest for transactions where as M4 is least liquid of all.

4. Write a brief note on transitionary and speculative motive of demand for money.
Ans: a) Transactionary motive: holding money is to carry out transactions is called transaction
demand for money.
The principal motive for holding money is to carry out transactions. We make expenditure to
fulfill our day-to-day needs. Usually, people receive income at certain intervals of time such as a
week, a month etc. which is to be consumed throughout the period till the next receipt. Thus,
people have a tendency to hold money in cash for various transaction purpose.
This demand for money is a positive function of money.
MdT= f (y)
MdT = transaction demand for money
f = Functional relationship between income and transaction demand for money
y= income of the individual
b) Speculative motive: it refers to the demand for money that people hold as idle cash balance to
speculate with the aim of earning capital gains and profits.
Beside cash, people also tend to hold wealth in the form of property, gold, bond, shares etc.
hence this demand is inversely related to the expected rate of interest.
MdS = f (ie)
MdS = speculative demand for money
f = shows functional relationship between speculative demand and expected rate of interest.
ie = expected rate of interest.

II. Answer the following questions in 20 sentences. (6marks)

1. Explain the functions of money. How does money overcome the short comings of a barter
system?
Ans: 1) Medium od exchange: the main function of money is that it serves as a medium of
exchange. This function of money has eliminated the problem of double coincidence of wants
which was the main difficulty under the barter system.
2) measure of value: money serve as a common unit of value. The value of all goods and services
can be expressed in terms of money. Money has provided a common yardstick to measure the
value of goods and services.
3) convenient unit of account: the value of all goods and services can be expressed in monetary
units. When we say that the value of watch is Rs.500 units, it means it can be exchanged for 500
units of money.
4) store of value: this function implies that money can be easily saved and used for future needs.
It was difficult under the barter system. If we deposit money in the bank, we can also earn
interest on that.
 5)standard of deferred payments: money can be used for future payments. Deferred payments
refer to the future payments and contractual payments such as loan, salaries etc. which was
absent under the barter system.
6) transfer of value: with the help of money, values and wealth can be transferred easily from
one place to another. If the person is moving to another place, then he can cell off his property
and can purchase the same at new place. Therefore, it implies that with the help of money
purchasing power can be transferred which was difficult under the barter system.

2. Write the story of Goldsmith Lala on the process of deposits and loan( credit) creation by
commercial banks.

3. Explain the open market operation.

4. Requirements of reserves acts as a limit to money (credit) creation. Explain.