NCERT Solutions for Class 12 Economics Macroeconomics Chapter 3: Money and Banking

Chapter at a glance

Concept	Key point
Barter	Direct exchange of goods; needs double coincidence of wants
Functions of money	Medium of exchange, unit of account, store of value (and standard of deferred payment)
Demand for money	Transaction demand ; speculative demand – inversely related to interest rate
Money supply (RBI)	M1 = CU + DD (+ other deposits with RBI); M2 = M1 + savings deposits with post office savings banks; M3 = M1 + net time deposits of banks; M4 = M3 + total deposits with post offices
Legal tender / fiat money	Cannot be refused in settlement of payments / no intrinsic value, money by government order
High powered money	H = Currency held by public + Reserves of commercial banks (vault cash + deposits with RBI)
Money multiplier
Monetary policy instruments	Quantitative – open market operations, bank rate, repo and reverse repo rate, CRR, SLR; qualitative – margin requirements, moral suasion, selective credit controls
RBI roles	Bank of issue, banker to government, banker’s bank and lender of last resort, controller of credit

Exercises

Answer

A barter system is a system of exchange in which goods are directly exchanged for goods, without the use of money.

Drawbacks

1. Lack of double coincidence of wants – a seller must find a buyer who has what he wants and wants what he has.
2. No common measure of value – the value of each good must be expressed in terms of every other good.
3. Indivisibility of goods – goods like a cow cannot be divided to exchange for small items.
4. Difficulty in storing wealth – goods are perishable or costly to store.
5. Difficulty in deferred payments – no standard for future payments.

Barter is direct exchange of goods for goods; its drawbacks are lack of double coincidence of wants, no common measure of value, indivisibility of goods, and difficulty in storing value and making deferred payments.

Answer

Functions of money

1. Medium of exchange – money is accepted in exchange for all goods and services.
2. Unit of account (measure of value) – values of all goods are expressed in money (prices).
3. Store of value – money can be saved and used in the future, as it is durable and liquid.
4. Standard of deferred payments – future payments (loans) are expressed in money.

How money overcomes barter’s problems

• As a medium of exchange, it removes the need for double coincidence of wants – a person sells goods for money and buys what he wants with it.
• As a unit of account, it provides a common measure of value.
• Money is divisible, so small transactions are possible.
• As a store of value, it allows wealth to be stored easily.
• It provides a standard for deferred payments.

Money serves as a medium of exchange, unit of account, store of value and standard of deferred payment, thereby removing the need for double coincidence of wants, providing a common measure, allowing division, storage of wealth and deferred payments.

Answer

Transaction demand for money is the demand for money to carry out day-to-day transactions – purchases of goods and services – because receipts and payments do not coincide in time.

It is directly proportional to the value of transactions over a period:

where is the total value of (nominal) transactions per unit of time and is a positive fraction (the reciprocal of the velocity of money). Since the value of transactions is closely related to nominal income (), we can also write . As the value of transactions (or nominal income) rises, transaction demand for money rises.

It is the demand for money to finance day-to-day transactions; it varies directly with the value of transactions: (or ).

Answer

The RBI publishes four measures of money supply:

M1 and M2 are narrow money; M3 and M4 are broad money. M1 is the most liquid; M4 the least. M3 is the most commonly used measure (aggregate monetary resources).

M1 = CU + DD + other deposits with RBI; M2 = M1 + post office savings deposits; M3 = M1 + net time deposits of banks; M4 = M3 + total post office deposits (excluding NSC).

Answer

• Legal tender – money that cannot be refused by anyone in settlement of any kind of transaction (payment of debts), because it is backed by law. Currency notes and coins issued by the RBI and the Government of India are legal tender. (Cheques are not legal tender.)
• Fiat money – money that has no intrinsic value (its value as a commodity is far less than its face value) and acts as money by order (fiat) of the government. Paper notes and coins are fiat money.

Legal tender is money that cannot be refused in settlement of transactions by law; fiat money is money without intrinsic value that serves as money by government order (e.g. currency notes and coins).

Answer

High powered money (H), also called reserve money or the monetary base, is the total liability of the monetary authority (RBI). It consists of:

• = currency held by the public;

  

• = reserves of commercial banks (cash in their vaults and deposits with the RBI).

  

It is called “high powered” because the money supply is a multiple of it (through the money multiplier).

High powered money is the total liability of the RBI: currency held by the public plus reserves of commercial banks (vault cash and deposits with RBI); money supply is a multiple of it.

Answer

1. Accepting deposits – demand deposits (current, savings) and time deposits (fixed); banks pay interest on most deposits.
2. Advancing loans – to firms and households (cash credit, overdraft, term loans, discounting bills), earning interest.
3. Credit creation – by lending a large part of deposits and keeping only a fraction as reserves, banks create deposits many times their reserves.
4. Agency functions – collecting cheques, paying bills, buying/selling securities, acting as trustee.
5. General utility functions – lockers, letters of credit, ATMs, online banking, foreign exchange.

The main functions are accepting deposits and lending; the difference between interest charged on loans and paid on deposits is the bank’s profit.

Commercial banks accept deposits, advance loans, create credit, and provide agency and general utility services.

Answer

Money multiplier is the ratio of the stock of money (M) to the stock of high powered money (H):

Determinants

1. Currency deposit ratio (cdr) – the ratio of currency held by the public to their deposits with banks. A higher cdr means less money with banks to lend, so a smaller multiplier.
2. Reserve deposit ratio (rdr) – the proportion of deposits banks keep as reserves (CRR, SLR and excess reserves). A higher rdr means smaller lending and a smaller multiplier.

Since rdr < 1, the multiplier is greater than 1. E.g. if cdr = 0 and rdr = 0.2, mm = 1/0.2 = 5.

The money multiplier is M/H = (1 + cdr)/(cdr + rdr); it is determined by the currency–deposit ratio and the reserve–deposit ratio, falling as either rises.

Answer

Quantitative instruments

1. Open market operations – buying/selling government securities in the open market. Purchase increases high powered money and money supply; sale reduces it.
2. Bank rate – the rate at which RBI lends to commercial banks (long-term). A higher bank rate makes borrowing costlier and reduces money supply.
3. Repo rate – the rate at which RBI lends short-term money to banks against securities. Reverse repo rate – the rate at which RBI borrows from banks. Raising repo reduces credit.
4. Cash Reserve Ratio (CRR) – the fraction of deposits banks must keep with RBI. A higher CRR reduces credit creation.
5. Statutory Liquidity Ratio (SLR) – the fraction of deposits banks must keep in liquid assets (cash, gold, approved securities). A higher SLR reduces lending.

Qualitative instruments – margin requirements, selective credit control, moral suasion, rationing of credit.

Open market operations, bank rate, repo and reverse repo rates, CRR and SLR (quantitative), and margin requirements, selective credit controls and moral suasion (qualitative).

Answer

Yes. Commercial banks create money (credit) through the process of deposit creation:

1. Banks keep only a fraction of deposits as reserves (say 20 %) and lend the rest.
2. The amount lent is spent and comes back to the banking system as fresh deposits.
3. Banks again lend a part of these deposits, and so on.

Thus an initial deposit of ₹ 100 with a reserve ratio of 0.2 can lead to total deposits of . Since demand deposits are part of money supply (M1), banks expand money supply many times their reserves. The extent depends on the reserve ratio and the currency deposit ratio.

Yes – by keeping only a fraction of deposits as reserves and lending the rest, which returns as new deposits, banks create deposits (money) many times their reserves.

Answer

When commercial banks face a financial crisis – e.g. a bank run, when depositors rush to withdraw their money and the bank is unable to pay – the RBI comes to their rescue by providing funds (liquidity) to them. It stands ready to lend to banks when no one else will. This role of RBI, assuring depositors that their money is safe and preventing the collapse of the banking system, is called lender of last resort.

RBI’s role of providing funds to banks in a crisis (such as a bank run), when they cannot get money elsewhere, to protect depositors and the banking system.

Topic checklist

• ☒ Barter and functions of money (Q 1, 2)
• ☒ Demand for money (Q 3)
• ☒ Money supply, legal tender, fiat money, high powered money (Q 4–6)
• ☒ Commercial banks and money creation, money multiplier (Q 7, 8, 10)
• ☒ RBI and monetary policy instruments (Q 9, 11)

Total questions answered: 11 of 11