Money and Banking

Money is anything that is generally accepted as a medium of exchange, and it removes the difficulties of the barter system, especially the lack of a double coincidence of wants. In this chapter you will study the functions of money: medium of exchange, measure of value or unit of account, store of value and standard of deferred payments. You will learn what makes up the supply of money in India, held by the public as currency notes, coins and demand deposits, and the RBI's measures M1 and M3. The chapter explains how commercial banks create money through credit creation. Because banks keep only a fraction of their deposits as reserves and lend the rest, an initial deposit leads to a multiple increase in total deposits, measured by the money multiplier, 1/LRR. You will study the Reserve Bank of India as the central bank: issuer of currency, banker to the government, banker's bank and lender of last resort, and its tools of credit control such as repo rate, reverse repo rate, bank rate, CRR, SLR and open market operations.

Detailed Worksheet: Money and Banking Section A - Definitions (10 marks) 1. What is meant by double coincidence of wants? How does money solve this problem? (2 marks) 2. Explain money as a store of value and as a standard of deferred payments. (2 marks) 3. Define the cash reserve ratio and the statutory liquidity ratio. (2 marks) 4. What is high powered money? State its components. (2 marks) 5. Distinguish between repo rate and reverse repo rate. (2 marks) Section B - Calculations and Applications (15 marks) 6. The legal reserve ratio is 20% and a bank receives fresh deposits of Rs 1,000 crore. Calculate the money multiplier, the total deposits created and the total credit created. (3 marks) 7. If the legal reserve ratio is 10%, calculate the money multiplier. How much initial deposit is needed to create total deposits of Rs 50,000 crore? (3 marks) 8. From the following data (Rs crore), calculate M1 and M3: currency held by the public 30,000, demand deposits of banks 50,000, other deposits with RBI 2,000, net time deposits of banks 1,00,000. (3 marks) 9. With a legal reserve ratio of 25% and an initial deposit of Rs 1,000, show the first three rounds of credit creation (deposits, reserves and loans in each round) and calculate the total deposits finally created. (3 marks) 10. A bank receives a fresh deposit of Rs 10,000 crore. Calculate total deposits created when the CRR is 10% and when it is raised to 20%. Explain the effect on the money supply and why the RBI may raise the CRR. (3 marks) Section C - Diagrams (10 marks) 11. Draw a flowchart showing the process of credit creation by commercial banks for three rounds, with LRR = 20% and initial deposit of Rs 100. (4 marks) 12. Draw a chart showing the functions of the Reserve Bank of India as a central bank. (3 marks) 13. Draw a chart classifying the instruments of monetary policy into quantitative tools (repo rate, reverse repo, bank rate, CRR, SLR, OMO) and qualitative tools (margin requirements, moral suasion, credit rationing). (3 marks) Section D - Analysis and Higher-order Thinking (15 marks) 14. Explain how the RBI can use repo rate, CRR and open market operations to control inflation. Explain the effect of each on the lending capacity of banks and on aggregate demand. (5 marks) 15. Explain the process of money creation by commercial banks with a numerical example. State three limitations on the credit creation power of banks. (5 marks) 16. Analyse why the RBI is called the lender of last resort and the banker's bank. What would happen to public confidence in banks if there were no central bank? Give an example of how the RBI protected depositors in a crisis. (5 marks) Instructions: Time allowed 2 hours. Attempt all sections. Show all formulae and working in numericals (Rs crore). Draw neat flowcharts.