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TEST-8 EXPLANATION PDF

October 6th, 2019

Lesson 3
Monetary System
Monetary System ..................................................... 2 Money Multiplier ............................................ 15
Functions of Money ............................................. 2 Narrow Money versus Broad Money .............. 16
Medium of Exchange ........................................ 2 Policy Tools to Control Supply of Money ........ 17
Unit of Account ................................................. 2 Distinction between Quantitative Tools and
Qualitative Tools ................................................ 18
Store of Value ................................................... 2
Monetary Policy: Meaning, Goal, Types and
Types of Money.................................................... 3
Process ............................................................ 19
Commodity Money ........................................... 3
Meaning ............................................................. 19
Fiat Money ........................................................ 3
Goal .................................................................... 19
Fiduciary Money ............................................... 3
Types .................................................................. 19
Commercial Bank Money ................................. 4 Monetary Policy – Framework and Process ...... 21
Demand for Money .............................................. 4 Demonetization .................................................. 22
Linkage with Transaction, Income and Interest MCQs for Practice................................................... 23
Rate ................................................................... 4
MCQs with Answer & Explanation ......................... 24
Transaction Motive ........................................... 4
Interest Rate......................................................... 5
Aggregate Income ................................................ 6
Price Level ............................................................ 6
Speculative Motive ........................................... 6
Liquidity Trap and Speculative Demand for
Money .................................................................. 7
Precautionary Motive ....................................... 7
Supply of Money .................................................. 7
Role of Central Bank ......................................... 7
Reserve Bank of India - Establishment ................. 7
Main Functions of RBI .......................................... 7
Role of Commercial Banks ................................ 9
Understanding the Process of Deposit and Loan
(Credit) Creation by Banks ................................... 9
Key Concepts: Assets, Liabilities, Fractional
Reserve Banking, Cash Reserve Ratio, Statutory
Liquidity Ratio, and Monetary Base ............... 10
Assets .................................................................10
Liabilities ............................................................11
Fractional Reserve Banking ................................11
Cash Reserve Ratio .............................................12
Statutory Liquidity Ratio ....................................12
Key DifferenceS between CRR and SLR ..............13
Monetary Base ...................................................13
Money Creation by Banking System ............... 14
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 ▪ The likelihood of a double coincidence of wants,
MONETARY SYSTEM however, is small and makes the exchange of
goods and services rather difficult.
FUNCTIONS OF MONEY ▪ Money effectively eliminates the double
coincidence of wants problem by serving as a
medium of exchange that is accepted in all
Money, in and of itself, is nothing. It can be a shell, transactions, by all parties, regardless of whether
a metal coin, or a piece of paper with a historic image they desire each others' goods and services.
on it, and the value that people place on it has
nothing to do with the physical value of the money. UNIT OF ACCOUNT

Money derives its value by being a medium of KEY DEFINITION

exchange, a unit of measurement and a storehouse
for wealth. Money allows people to trade goods and Unit of account: The role of money as a yardstick
services indirectly, understand the price of goods for measuring and comparing values of different
(prices written in rupees correspond with an amount commodities.
in your wallet), and gives us a way to save for larger
purchases in the future. ▪ Money also functions as a unit of account,
providing a common measure of the value of
Money is valuable merely because everyone knows goods and services being exchanged.
everyone else will accept it as a form of payment. ▪ Knowing the value or price of a good, in terms of
Money is often defined in terms of the three money, enables both the supplier and the
functions or services that it provides. Money serves purchaser of the good to make decisions about
as a medium of exchange, as a store of value, and as how much of the good to supply and how much
a unit of account. of the good to purchase.

MEDIUM OF EXCHANGE STORE OF VALUE

KEY DEFINITION KEY DEFINITION

Medium of exchange: The principal function of Store of value: Wealth can be stored in the form
money is facilitating commodity exchanges. of money for future use. This function of money is
referred to as store of value.
Barter exchange: Exchange of commodities
without the mediation of money. ▪ In order to be a medium of exchange, money
must hold its value over time; that is, it must be
Double coincidence of wants: A situation where a store of value. If money could not be stored for
two economic agents have complementary some period of time and still remain valuable in
demand for each others’ surplus production. exchange, it would not solve the double
coincidence of wants problem and therefore
▪ Money's most important function is as a would not be adopted as a medium of exchange.
medium of exchange to facilitate transactions. ▪ As a store of value, money is not unique; many
Without money, all transactions would have to other stores of value exist, such as land, works
be conducted by barter, which involves direct of art, and even precious metals and stamps.
exchange of one good or service for another. ▪ Money may not even be the best store of value
▪ The difficulty with a barter system is that in order because its purchasing power decreases with
to obtain a particular good or service from a inflation.
supplier, one has to possess a good or service of
equal value, which the supplier also desires. In KEY DEFINITION
other words, in a barter system, exchange can
take place only if there is a double coincidence Purchasing Power: Purchasing power is the value
of wants between two transacting parties. of a currency expressed in terms of the amount of
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 goods or services that one unit of money can buy. ▪ Commodity money is closely related to (and
Purchasing power is important because, all else originates from) a barter system, where goods
being equal, inflation (rise in prices) decreases the and services are directly exchanged for other
amount of goods or services you would be able to goods and services. Commodity money
purchase. facilitates this process because it acts as a
generally accepted medium of exchange.
▪ The critical thing to note about commodity
TYPES OF MONEY money is that its value is defined by the intrinsic
value of the commodity itself. In other words,
KEY DEFINITION the commodity itself becomes money. Examples
of commodity money include gold coins, beads,
Fiat money: Money with no intrinsic value. shells, spices, etc.

Legal tender: Money issued by the monetary FIAT MONEY

authority or the government which cannot be
refused by anyone. ▪ Fiat money gets its value from a government
order (i.e., fiat). That means, the government
Commodity Money: Commodity money is money declares fiat money to be legal tender, which
whose value comes from a commodity of which it requires all people and firms within the country
is made. Commodity money consists of objects to accept it as a means of payment. If they fail to
having value or use in themselves (intrinsic value) do so, they may be fined or even put in prison.
as well as their value in buying goods. ▪ Unlike commodity money, fiat money is not
backed by any physical commodity. By
Fiduciary Money: Fiduciary money refers to definition, its intrinsic value is significantly lower
money backed up by trust between the payer and than its face value. Hence, the value of fiat
payee. money is derived from the relationship between
supply and demand.
Commercial Bank Money: The term commercial ▪ Most modern economies are based on a fiat
bank money describes the portion of a currency money system. Examples of fiat money include
which is made of book money – debt generated by coins and bills.
commercial banks. It is the opposite of the terms ▪ According to RBI data, the cost of printing
central bank money, base money and sovereign banknotes is as follows:
money, which denote legal tender issued by a o Rs 5 - Rs 0.48
central bank or monetary authority. o Rs 10 - Rs 0.96
o Rs 20 - Rs 1.5
Virtually anything can be considered money, as long o Rs 50 - Rs 1.81
as it performs what we call the three major o Rs 100 - Rs 1.79
functions of money (i.e., medium of exchange, store
of value, unit of account). With this in mind, it is not This implies that intrinsic value of a note with face
surprising that there were different types of money value Rs 100 is only Rs 1.79
throughout history. The four most relevant types of
money have been discussed below: commodity FIDUCIARY MONEY
money, fiat money, fiduciary money, and
▪ Fiduciary money depends for its value on the
commercial bank money.
confidence that it will be generally accepted as a
COMMODITY MONEY medium of exchange.
▪ Unlike fiat money, it is not declared legal tender
▪ Commodity money is the simplest and, most by the government, which means people are not
likely, the oldest type of money. It builds on required by law to accept it as a means of
scarce natural resources that act as a medium of payment. Instead, the issuer of fiduciary money
exchange, store of value, and unit of account. promises to exchange it back for a commodity or
fiat money if requested by the bearer.
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▪ As long as people are confident that this promise ▪ Since the quantum of transactions to be made
will not be broken, they can use fiduciary money depends on income, it should be clear that a rise
just like regular fiat or commodity money. in income will lead to rise in demand for money.
▪ Examples of fiduciary money include cheques, ▪ Also, when people keep their savings in the form
banknotes, or drafts. of money rather than putting it in a bank which
gives them interest, how much money people
COMMERCIAL BANK MONEY keep also depends on rate of interest.
▪ Specifically, when interest rates go up, people
▪ Commercial bank money can be described as
become less interested in holding money since
claims against financial institutions that can be
holding money amounts to holding less of
used to purchase goods or services. It represents
interest-earning deposits, and thus less interest
the portion of a currency that is made of debt
received. Therefore, at higher interest rates,
generated by commercial banks.
money demanded comes down.
▪ More specifically, commercial bank money is
created through what we call fractional reserve TRANSACTION MOTIVE
banking. Fractional reserve banking describes a
process where commercial banks give out loans KEY DEFINITION
worth more than the value of the actual
currency they hold. Transaction demand: The amount of money
▪ At this point just note that in essence, needed to cover the needs of an individual, firm,
commercial bank money is debt generated by or nation. That is, transaction demand for money
commercial banks that can be exchanged for is a measure of how much of a certain currency
“real” money or to buy goods and services. people need in order to buy the goods and
services they use. Generally speaking, if an
economy is healthy, there is a high transaction
QUESTION 1
demand for money because people are buying
Q. Which one of the following statements
more goods and services. Conversely, if an
correctly describes the meaning of legal tender
economy is in trouble, people buy fewer goods
money? [2018]
and services.
(a) The money which is tendered in courts of law
to defray the fee of legal cases
▪ The principal motive for holding money is to
(b) The money which a creditor is under
carry out transactions.
compulsion to accept in settlement of his
▪ If you receive your income weekly and pay your
claims
bills on the first day of every week, you need not
(c) The bank money on the form of cheques,
hold any cash balance throughout the rest of the
drafts, bills of exchange, etc.
week; you may as well ask your employer to
(d) The metallic money in circulation in a country
deduct your expenses directly from your weekly
Answer: B
salary and deposit the balance in your bank
account. But our expenditure patterns do not
DEMAND FOR MONEY normally match our receipts.
▪ People earn incomes at discrete points in time
and spend it continuously throughout the
LINKAGE WITH TRANSACTION,
interval.
INCOME AND INTEREST RATE
▪ Suppose you earn Rs 100 on the first day of
▪ The demand for money tells us what makes every month and run down (spend) this balance
people desire a certain amount of money. evenly over the rest of the month. Thus, your
▪ Since money is required to conduct transactions, cash balance at the beginning and end of the
the value of transactions will determine the month are Rs 100 and 0, respectively. Your
money people will want to keep: the larger is the average cash holding can then be calculated as
quantum of transactions to be made, the larger (Rs 100 + Rs 0) ÷ 2 = Rs 50, with which you are
is the quantity of money demanded. making transactions worth Rs 100 per month.

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▪ Hence your average transaction demand for stock of money people are willing to hold at a
money is equal to half your monthly income, or, particular point of time.
in other words, half the value of your monthly
transactions. The velocity of money, v, however, has a time
▪ Consider, next, a two-person economy dimension. It refers to the number of times every
consisting of two entities – a firm (owned by one unit of stock changes hand during a unit period of
person) and a worker. The firm pays the worker time, say, a month or a year. Thus, the left hand side,
a salary of Rs 100 at the beginning of every v.MdT, measures the total value of monetary
month. The worker, in turn, spends this income transactions that has been made with this stock in
over the month on the output produced by the the unit period of time. This is a flow variable and is,
firm – the only good available in this economy! therefore, equal to the right hand side.
▪ Thus, at the beginning of each month the worker
has a money balance of Rs 100 and the firm a We are ultimately interested in learning the
balance of Rs 0. On the last day of the month the relationship between the aggregate transaction
picture is reversed – the firm has gathered a demand for money of an economy and the
balance of Rs 100 through its sales to the (nominal) GDP in a given year.
worker. The average money holding of the firm
as well as the worker is equal to Rs 50 each. The total value of annual transactions in an economy
▪ Thus, the total transaction demand for money in includes transactions in all intermediate goods and
this economy is equal to Rs 100. The total services and is clearly much greater than the nominal
volume of monthly transactions in this economy GDP. However, normally, there exists a stable,
is Rs 200 – the firm has sold its output worth Rs positive relationship between value of transactions
100 to the worker and the latter has sold her and the nominal GDP.
services worth Rs 100 to the firm.
▪ The transaction demand for money of the An increase in nominal GDP implies an increase in
economy is again a fraction of the total volume the total value of transactions and hence a greater
of transactions in the economy over the unit transaction demand for money. Thus, in general,
period of time. equation MdT = k.T can be modified in the following
way:
In general, therefore, the transaction demand for
money in an economy, MdT, can be written in the MdT = kPY
following form:
Where,
MdT = k.T Y – Real GDP
P – General price level or the GDP deflator
where, The above equation tells us that transaction
T – Total value of (nominal) transactions in the demand for money is positively related to the real
economy over unit period income of an economy and also to its average price
k – A positive fraction level.

(1/k) * MdT = T So, the transactions demand for money depends on

three things:
or
INTEREST RATE
v. MdT = T ▪ As we have noted above, the interest rate is in
effect the price of holding money balances. It is
where, v = 1/k is the velocity of circulation. the income I forego when I hold money balances.
▪ If the interest rate goes up, cost of holding
Note that the term on the right hand side of the money balance increases, so people will hold a
above equation, T, is a flow variable whereas money lower level of money balance.
demand, MdT, is a stock concept – it refers to the

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▪ If the interest rate falls, cost of holding money (d) an increase in the level of income and
balance decreases, and people may be inclined employment
to hold a higher level of money balance. Answer: B
AGGREGATE INCOME
▪ If the volume of income and output produced in
the goods markets increases, then clearly there
will be a larger volume of transactions and
exchanges taking place.
▪ People will need to hold a larger volume of
money to meet all these transactions and make
payments.

PRICE LEVEL
▪ If prices rise, then people will need to hold a
higher level of money balances to meet their
payments transactions.
▪ If prices fall, people will need a lower volume of SPECULATIVE MOTIVE
money balances to support a given level of
KEY DEFINITION
transactions.
Speculative Demand for Money: The demand for
KEY DEFINITION
money to take advantage of an investment
opportunity. In Keynesian economics an investor
Velocity of Circulation of Money: The velocity of
can hold money or bonds. If it is felt that the
money (or the velocity of circulation of money") is
interest rate is going to rise (meaning the price of
a measure of the number of times that the
bonds will fall) the investor will hold money until
average unit of currency is used to purchase goods
the fall in the price of bonds is realized.
and services within a given time period.
Liquidity trap: A situation of very low rate of
Stock: A stock is measured at one specific time,
interest in the economy where every economic
and represents a quantity existing at that point in
agent expects the interest rate to rise in future and
time (say, January 01, 2020), which may have
consequently bond prices to fall, causing capital
accumulated in the past. Example: Capital stock –
loss. Everybody holds her wealth in money and
it is the total value of equipment, buildings, and
speculative demand for money is infinite.
other real productive assets in an economy.
Another example can be the stock of money
Bonds: A paper bearing the promise of a stream of
people are holding at any given time.
future monetary returns over a specified period of
time. Issued by firms or governments for
Flow: A flow variable is measured over an interval
borrowing money from the public.
of time. Therefore, a flow would be measured per
unit of time (say a year). Example – value of
▪ Money, like other stores of value, is an asset. The
transactions that people may undertake in any
demand for an asset depends on both its rate of
given month, quarter or a year.
return and its opportunity cost.
▪ Typically, money holdings provide no rate of
QUESTION 2 return and often depreciate in value due to
Q. Supply of money remaining the same when inflation. The opportunity cost of holding money
there is an increase in demand for money, there is the interest rate that can be earned by lending
will be [2013 - I] or investing one's money holdings.
(a) a fall in the level of prices ▪ The speculative motive for demanding money
(b) an increase in the rate of interest arises in situations where holding money is
(c) a decrease in the rate of interest perceived to be less risky than the alternative of

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 lending the money or investing it in some other Precautionary Motive: A desire to hold cash in
asset. order to be able to deal effectively with
▪ For example, if a stock market crash seemed unexpected events that require cash outlay.
imminent, the speculative motive for
demanding money would come into play; those ▪ In Keynesian economics, precautionary demand
expecting the market to crash would sell their for money is a need for money resulting from an
stocks and hold the proceeds as money. unforeseen situation. Medical bills following an
▪ According to John Maynard Keynes, the higher accident are an example of precautionary
the rate of interest, the lower is the speculative demand.
demand for money. When interest rates are ▪ According to John Maynard Keynes, people keep
high, people expect them to fall going ahead. If savings accounts, as well as some stocks and
the interest rate is going to fall (meaning the commodities, in order to cover precautionary
price of bonds will rise) the investor will hold demand if and when it occurs.
bonds until the fall in the interest rate is realized. ▪ The precautionary demand for money, together
▪ Similarly, the lower the rate of interest, the with the transactions demand for money (that
higher is the speculative demand for money. is, money held on a day-to-day basis to finance
When interest rates are low, people expect them current expenditures on goods and services) and
to rise going ahead. If the interest rate is going the speculative demand for money (that is,
to rise (meaning the price of bonds will fall) the money held to purchase bonds in anticipation of
investor will hold money until the fall in the a fall in their price) constitute the money
bond prices is realized. demand schedule.
LIQUIDITY TRAP AND SPECULATIVE
DEMAND FOR MONEY SUPPLY OF MONEY
▪ It is a situation where the interest rate is so low
that people prefer to hold money (liquidity
ROLE OF CENTRAL BANK
preference) rather than invest it.
▪ In a liquidity trap, consumers choose to avoid Central Bank is a very important institution in a
bonds and keep their funds in savings because of modern economy. Almost every country has one
the prevailing belief that interest rates will soon central bank. India’s central bank is the ‘Reserve
rise (which would push bond prices down). Bank of India’.
Because bonds have an inverse relationship to
interest rates, many consumers do not want to RESERVE BANK OF INDIA - ESTABLISHMENT
hold an asset with a price that is expected to ▪ The Reserve Bank of India was established on
decline. April 1, 1935 in accordance with the provisions
▪ Low interest rates alone do not define a liquidity of the Reserve Bank of India Act, 1934.
trap. For the situation to qualify as a liquidity ▪ The Central Office of the Reserve Bank was
trap, there has to be a lack of bondholders initially established in Calcutta but was
wishing to keep their bonds and a limited supply permanently moved to Mumbai in 1937. The
of investors looking to purchase them. Instead, Central Office is where the Governor sits and
the investors are prioritizing strict cash savings where policies are formulated.
over bond purchasing. ▪ Though originally privately owned, since
▪ If investors are still interested in holding or nationalisation in 1949, the Reserve Bank is fully
purchasing bonds at times when interest rates owned by the Government of India.
are low, even approaching zero percent, the
MAIN FUNCTIONS OF RBI
situation does not qualify as a liquidity trap.
MONETARY AUTHORITY
PRECAUTIONARY MOTIVE ▪ Formulates, implements and monitors the
monetary policy.
KEY DEFINITION ▪ Objective: maintaining price stability while
keeping in mind the objective of growth.

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REGULATOR AND SUPERVISOR OF THE KEY DEFINITION
FINANCIAL SYSTEM
▪ Prescribes broad parameters of banking
Central Bank: A country's main bank whose
operations within which the country's banking
responsibilities include the issue of currency, the
and financial system functions.
administration of monetary policy, open market
▪ Objective: maintain public confidence in the
operations, and engaging in transactions designed
system, protect depositors' interest and provide
to facilitate healthy business interactions.
cost-effective banking services to the public.
MANAGER OF FOREIGN EXCHANGE Monetary Policy: The actions and inactions a
▪ Manages the Foreign Exchange Management central bank takes to control a country's money
Act, 1999. supply. Generally speaking, monetary policy refers
▪ Objective: to facilitate external trade and to the setting of interest rates. If the central bank
payment and promote orderly development and sets low interest rates, it increases the supply of
maintenance of foreign exchange market in money by easing the availability of credit. This
India. promotes economic growth but in the long term
can cause inflation. On the other hand, the central
ISSUER OF CURRENCY
bank may adopt a restrictive monetary policy by
▪ Issues and exchanges or destroys currency and
setting high interest rates, which constricts credit
coins not fit for circulation.
and slows or eliminates growth while reducing
▪ Objective: to give the public adequate quantity
inflation.
of supplies of currency notes and coins and in
good quality.
Foreign exchange (FOREX): Any type of financial
▪ Reserve Bank is the only institution which can
instrument that is used to make payments
issue currency.
between countries is considered foreign
DEVELOPMENTAL ROLE exchange. The list of instruments includes
▪ Performs a wide range of promotional functions electronic transactions, paper currency, checks,
to support national objectives. and signed, written orders called bills of exchange.
REGULATOR AND SUPERVISOR OF PAYMENT
AND SETTLEMENT SYSTEMS Foreign Exchange Market: A market for the
▪ Introduces and upgrades safe and efficient trading of currencies. For example, one may buy
modes of payment systems in the country to dollars or sell pounds on a forex market.
meet the requirements of the public at large.
▪ Objective: maintain public confidence in Lender of last resort: The function of the
payment and settlement system monetary authority of a country in which it
provides guarantee of solvency to commercial
RELATED FUNCTIONS banks in a situation of liquidity crisis or bank runs.
▪ Banker to the Government: performs merchant
banking function for the central and the state
governments; also acts as their banker.
▪ Banker to banks: maintains banking accounts of QUESTION 3
all scheduled banks. Q. The accounting year of the Reserve Bank of
▪ When commercial banks need more funds in India is: [1998]
order to be able to create more credit, they may (a) April-March
go to market for such funds or go to the Central (b) July-June
Bank. Central bank provides them funds through (c) October-September
various instruments. This role of RBI, that of (d) January-December
being ready to lend to banks at all times is Answer: A
another important function of the central bank,
and due to this central bank is said to be the
QUESTION 4
lender of last resort.
Q. Consider the following statements regarding
Reserve Bank of India: [2001]
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 1. It is a banker to the Central Government 4. winding-up of banks
2. It formulates and administers monetary policy Select the correct answer using the codes given
3. It acts as an agent of the Government in respect below:
of India (a) 1 and 4 only
4. It handles the borrowing programme of (b) 2, 3 and 4 only
Government of India (c) 1, 2 and 3 only
Which of these statements are correct? (d) 1, 2, 3 and 4
(a) 1 and 2 Answer: D
(b) 2, 3 and 4
(c) 1, 2, 3 and 4
(d) 3 and 4 ROLE OF COMMERCIAL BANKS
Answer: C
Commercial banks accept deposits from the public
and lend out part of these funds to those who want
QUESTION 5 to borrow. The interest rate paid by the banks to
Q. In India, the interest rate on savings accounts depositors is lower than the rate charged from the
in all the nationalized commercial banks is fixed borrowers. This difference between these two types
by [2010] of interest rates, called the ‘spread’ is the profit
(a) Union Ministry of Finance appropriated by the bank.
(b) Union Finance Commission
(c) Indian Banks’ Association
(d) None of the above. UNDERSTANDING THE PROCESS OF DEPOSIT
AND LOAN (CREDIT) CREATION BY BANKS
Answer: D
SIMPLIFIED EXAMPLE

QUESTION 6
▪ Once there was a goldsmith named Lala in a
Q. The Reserve Bank of India (RBI) acts as a
village.
bankers’ bank. This would imply which of the
▪ In this village, people used gold and other
following? [2012 - I]
precious metals in order to buy goods and
1. Other banks retain their deposits with the RBI.
services. In other words, these metals were
2. The RBI lends funds to the commercial banks
acting as money.
in times of need.
▪ People in the village started keeping their gold
3. The RBI advises the commercial banks on
with Lala for safe-keeping. In return for keeping
monetary matters.
their gold, Lala issued paper receipts to people
Select the correct answer using the codes given
of the village and charged a small fee from them.
below:
Slowly, over time, the paper receipts issued by
(a) 2 and 3 only
Lala began to circulate as money.
(b) 1 and 2 only
▪ This means that instead of giving gold for
(c) 1 and 3 only
purchasing wheat, someone would pay for
(d) 1, 2 and 3
wheat or shoes or any other good by giving the
Answer: D
paper receipts issued by Lala. Thus, the paper
receipts started acting as money since everyone
in the village accepted these as a medium of
exchange.
▪ Now, let us suppose that Lala had 100 Kgs of
QUESTION 7 gold, deposited by different people and he had
Q. The Reserve Bank of India regulates the issued receipts corresponding to 100 kgs of gold.
commercial banks in matters of [2013 - I] At this time Ramu comes to Lala and asks for a
1. liquidity of assets loan of 25 kgs of gold. Can Lala give the loan? The
2. branch expansion 100 kgs of gold with him already has claimants.
3. merger of banks ▪ However, Lala could decide that everyone with
gold deposits will not come to withdraw their
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 deposits at the same time and so he may as well ▪ A bank must, therefore, balance its lending
give the loan to Ramu and charge him for it. activities so as to ensure that sufficient funds are
▪ If Lala gives the loan of 25 kgs of gold, Ramu available to repay any depositor on demand.
could also pay Ali with these 25 kgs of gold and
Ali could keep the 25 kgs of gold with Lala in KEY CONCEPTS: ASSETS, LIABILITIES,
return for a paper receipt. FRACTIONAL RESERVE BANKING,
▪ In effect, the paper receipts, acting as money, CASH RESERVE RATIO, STATUTORY
would have risen to 125 kgs now. LIQUIDITY RATIO, AND MONETARY
BASE
▪ It seems that Lala has created money out of thin
air! The modern banking system works precisely ASSETS
the way Lala behaves in this example.
REAL LIFE EXAMPLE Balance sheet is a record of assets and liabilities of
any firm. Conventionally, the assets of the firm are
▪ Commercial banks mediate between individuals recorded on the left-hand side and liabilities on the
or firms with excess funds and lend to those who right-hand side. Accounting rules say that both sides
need funds. People with excess funds can keep of the balance sheet must be equal or total assets
their funds in the form of deposits in banks and must be equal to the total liabilities.
those who need funds, borrow funds in form of
home loans, crop loans, etc. An asset is a resource with economic value that an
▪ People prefer to keep money in banks because individual, corporation or country owns or controls
banks offer to pay some interest on any with the expectation that it will provide a future
deposits made. Also, it may be safer to keep benefit.
excess funds in a bank, rather than at home, just
as people in the example above preferred to Bank assets are the physical and financial
keep their gold with Lala instead of keeping at "property" of a bank, what a bank owns. While a
home. bank commonly owns physical property (buildings,
▪ In the modern context, given cheques and debit land, furniture, equipment), the bulk of a bank's
cards, having a demand deposit makes assets are financial--legal claims on the property or
transactions more convenient and safer, even the wealth of others. The two most notable asset
when they do not earn any interest. (Imagine categories are loans (which generate interest
having to pay a large amount in cash – for revenue) and reserves (which keep deposits safe).
purchasing a house.)
▪ What does the bank do with the funds that have A bank has four main categories of assets listed on
been deposited with it? Assuming that not its balance sheet:
everyone who has deposited funds with it will 1. Physical Assets: This includes the buildings, land,
ask for their funds back at the same time, the furniture, and equipment owned by the bank.
bank can loan these funds to someone who While this is what most people probably think of
needs the funds at interest (of course, the bank as assets, it is relatively minor for most banks.
has to be sure it will get the funds back at the 2. Loans: The second asset category, the most
required time). important one for all banks, is loans. Loans are
▪ So, the bank will typically retain a portion of the the primary source of interest revenue. While a
funds to repay whenever they demand their loan is a liability for the borrower (since he has
funds back, and loan the rest. to repay the loan someday, and also pay interest
▪ Since banks earn interest from loans they make, on the loan), it is an asset for the bank, for the
any bank would like to lend the maximum lender (since bank earns interest on loans). This
possible. However, being able to repay asset includes loans to consumers (home loans,
depositors on demand is crucial to the bank’s personal loans, automobile loans, credit card
survival. Depositors would keep their funds in a loans) and businesses (real estate development
bank only if they are fully confident of getting loans, capital investment loans).
them back on demand. 3. Reserves: The third asset category is reserves.
While this is small in amount, it is extremely
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 important. Reserves are what banks use for daily savings accounts, certificates of deposit, money
transactions, such as processing cheques or market deposits, repurchase agreements.
enabling cash withdrawals. Banks use reserves 3. Other Liabilities: Most banks also have a few
to ensure the security of deposits. Two varieties other liabilities. Specifically, Bank might borrow
of reserves worth noting are vault cash (the from sources other than typical household and
actual paper currency and coins that is kept in business customers that provide deposits. Two
the bank, that is, in the vault) and central bank common sources of funds are loans from other
deposits (deposits that banks keep with the banks and central bank loans (loans from the
Reserve Bank of India to clear cheques and assist Reserve Bank of India).
in other banking activities).
4. Investment Securities: The fourth asset category
QUESTION 8
is investment securities. These act as a buffer
Q. From the balance sheet of a company, it is
between loans and reserves. They are safer than
possible to: [1999]
loans, but not as safe as reserves. They pay
(a) judge the extent of profitability of this
more interest than reserves, but not as much as
company
loans. If a bank has a few extra reserves, but is
(b) assess the profitability and size of the
not ready to lock in loans for the long term, then
company
investment securities are the answer. An
(c) determine the size and composition of the
important item in this category is Government of
assets and liabilities of the company
India’s securities (T-Bills and G-Secs).
(d) determine the market share, debts and assets
of the company
LIABILITIES Answer: C

A liability, in general, is an obligation to, or

something that you owe somebody else. Liabilities
QUESTION 9
are defined as a company's legal financial debts or
Q. Which of the following is not included in the
obligations that arise during the course of business
assets of a commercial bank in India? [2019]
operations.
(a) Advances
(b) Deposits
Bank liabilities are the debts incurred by a bank,
(c) Investments
what a bank owes. While a bank is bound to have
(d) Money at call and short notice
traditional business liabilities and debts (for
Answer: B
electricity, office supplies, employee wages), the
bulk of a bank's liabilities are financial--legal claims
that depositors have over banks. The most FRACTIONAL RESERVE BANKING
important liability category is deposits--financial
wealth that others have placed with the bank for The modern banking system practices what is
safekeeping. The bank owes this wealth to these termed fractional-reserve banking. Banks keep only
depositors. a fraction of their deposits set aside as reserves to
conduct day-to-day transactions. These reserves
A bank has three main categories of liabilities listed take the form of either cash in the bank (vault cash)
on its balance sheet: or deposits with Reserve Bank of India. The
1. Transactions Deposits: The most important reminder of the deposits is used for interest-paying
liability is transactions deposits. This, of course, loans.
is the technical name for chequing accounts.
Make note that while chequing accounts are Fractional-reserve banking makes it possible for
assets for customers, they are liabilities for banks to simultaneously act as financial
Bank. Bank owes these deposits to customers. intermediaries, matching up borrowers and lenders,
2. Other Types of Deposits: As a full-service bank, and maintain the safety and liquidity of financial
has other types of deposits, too. Bank offers wealth.

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TWO GOALS STATUTORY LIQUIDITY RATIO

Fractional-reserve banking makes it possible for Every bank must have a specified portion of their
banks to pursue two goals, that is, to provide two Net Demand and Time Liabilities (NDTL) in the form
valuable services for the economy. of cash, gold, or other liquid assets by the day’s end.
▪ Profitability: Banks pursue profit as a financial
intermediary with revenue generated from The ratio of these liquid assets to the demand and
interest on loans. Because banks are profit- time liabilities is called the Statutory Liquidity Ratio
seeking businesses, they must receive revenue to (SLR).
generate profit and to remain in business. They
do this primary through interest charged for Liquid assets are those assets that one can easily
lending. convert into cash – gold, treasury bills, govt-
▪ Safekeeping: Banks pursue safety of deposits approved securities, government bonds, and cash
and money supply stability by keeping a portion reserves.
of deposit in reserve. As depository institutions,
banks acquire the funds used for lending through NDTL refers to the total demand and time liabilities
deposits. Banks must keep customer deposits (deposits) of the public that are held by the banks.
safe or they will have no funds that can be used
for interest-generating loans. Demand deposits consist of all liabilities, which the
bank needs to pay on demand. They include current
Banks must balance these two goals. Focusing too deposits, demand drafts, balances in overdue fixed
much on profitability is likely to limit the ability to deposits, and demand liabilities portion of savings
keep deposits safe. Focusing too much on bank deposits.
safekeeping is likely to limit the ability to generate
profit. Time deposits consist of deposits that will be repaid
on maturity, where the depositor will not be able to
CASH RESERVE RATIO
withdraw his/her deposits immediately. Instead,
he/she will have to wait until the lock-in tenure is
The Reserve Bank of India or RBI mandates that
over to access the funds. Fixed deposits, time
banks store a proportion of their deposits in the
liabilities portion of savings bank deposits, and staff
form of cash so that the same can be given to the
security deposits are some examples.
bank’s customers if the need arises.
The Reserve Bank of India has the authority to
The percentage of cash required to be kept in
increase this ratio up to 40%. An increase in the ratio
reserves, vis-a-vis a bank’s total deposits, is called
constricts the ability of the bank to inject money into
the Cash Reserve Ratio.
the economy.
The cash reserve is either stored in the bank’s vault
RBI employs SLR regulation to have control over the
or is sent to the RBI. Banks do not get any interest
bank credit. SLR ensures that there is solvency in
on the money that is with the RBI under the CRR
commercial banks and assures that banks invest in
requirements. The bank cannot use this money for
government securities.
investment or lending.

The Cash Reserve Ratio in India is decided by RBI’s QUESTION 10

Monetary Policy Committee in the periodic Q. Which of the following terms indicates a
Monetary and Credit Policy. mechanism used by commercial banks for
providing credit to the government? [2010]
If the current CRR rate is 4%, a bank is required to (a) Cash Credit Ratio
store 4% of the total NDTL or the Net Demand and (b) Debt Service Obligation
Time Liabilities in the form of cash. (c) Liquidity Adjustment Facility
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 (d) Statutory Liquidity Ratio HOLDING
Answer: D ▪ In CRR, the cash reserve is maintained by the
banks with the Reserve Bank of India.
▪ In the case of SLR, the securities are kept with
the banks themselves which they need to
maintain in the form of liquid assets.

MONETARY BASE

The monetary base includes the three financial

assets over which the central bank (Reserve Bank of
India, RBI) has more or less complete control. They
are (1) currency held by the non-bank public and in
QUESTION 11 circulation throughout the economy, (2) vault cash
Q. In the context of Indian economy, which of the held by commercial banks and currency out of
following is/are the purpose/purposes of circulation, and (3) Reserve deposits that
‘Statutory Reserve Requirements’? [2014 - I] commercial banks keep with central banks.
1. To enable the Central Bank to control the
amount of advances the banks can create The RBI can control all three of these items as a
2. To make the people’s deposits with banks safe means of implementing monetary policy. It controls
and liquid the printing of currency, which is the primary
3. To prevent the commercial banks from making component of currency in circulation and vault cash.
excessive profits The RBI can specify exactly how many notes of
4. To force the banks to have sufficient vault cash different denominations are to be printed. If it does
to meet their day-to-day requirements not authorize the printing, then the printing does not
Select the correct answer using the code given happen.
below:
(a) 1 only Even more important, the RBI has extensive control
(b) 1 and 2 only over Reserve deposits that commercial banks are
(c) 2 and 3 only obligated to hold. It can change the total amount of
(d) 1, 2, 3 and 4 Reserve deposits of commercial banks through
Answer: B open market operations--the buying and selling of
government bonds.
THREE BLOCKS IN THE BASE
KEY DIFFERENCES BETWEEN CRR AND SLR
The three components of the monetary base are
FORM OF RESERVE currency in circulation, vault cash, and Reserve
▪ The CRR requires banks to have only cash deposits.
reserves with the RBI. 1. Currency in Circulation: This is the paper
▪ In the case of SLR, banks are asked to have currency and metal coins that is held by the non-
reserves of liquid assets which include cash, gold bank public, that is, in circulation throughout the
and government securities. economy. The nonbank public consists of
consumers, businesses (other than banks), and
RETURN
▪ Banks don’t earn returns on money parked as government agencies. This is the currency that
CRR. can be used to purchase goods, make payments,
▪ Banks earn returns on money parked as SLR. and complete transactions.
2. Vault Cash: This is the paper currency and metal
PURPOSE coins that is kept in the bank, that is, in the vault.
▪ The Central Bank controls the liquidity in the This cash is used, quite literally, to "cash"
Banking system with CRR. cheques and otherwise to satisfy currency
▪ SLR is used to control the bank’s leverage for withdrawal demands of depositors.
credit expansion.

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3. Reserve Deposits: This is deposits that banks Due to this control, the monetary base is often
keep with the RBI to clear cheques and assist in used as a guide for monetary policy.
other banking activities.

The combination of currency in circulation and vault MONEY CREATION BY BANKING

cash is the total amount of paper currency and SYSTEM
metal coins issued by the government. The
The process of money creation by the commercial
combination of vault cash and Reserve deposits is
bank starts as soon as people deposit money in their
bank reserves.
respective bank accounts.
KEY DEFINITION
After receiving the deposits, as per the central bank
guidelines, the commercial bank maintains a portion
Reserves: Reserves are the deposits that banks
of total deposits in the form of reserves (CRR & SLR).
literally hold in "reserve" to satisfy customer
withdrawals.
The remaining portion left after maintaining
reserves out of the total deposits received is then
Fractional Reserve Banking: A method of banking
lent by the commercial bank to the general public in
activity in which banks keep less than 100 percent
the form of credit, loans and advances.
of their deposits in the form of bank reserves and
use the rest for interest-paying loans. Fractional-
Now assuming that all transactions in the economy
reserve banking makes it possible for banks to
are routed though the commercial bank, the money
function as profit-seeking financial intermediaries
borrowed by borrowers will again come back to the
(matching up lenders and borrowers) while
commercial bank in the form of deposits.
ensuring the safety and liquidity of deposits,
especially checkable deposits that are part of the
The commercial banks again keep a portion of the
economy's money supply.
deposits as reserves and lends the rest. The deposit
of money by the people in the banks and the
Cash Reserve Ratio (CRR): The fraction of their
subsequent lending of loans by the commercial
deposits which the commercial banks are required
banks is a never-ending process.
to keep with RBI.
It is due to this continuous process that the
Statutory Liquidity Ratio (SLR): The fraction of
commercial banks are able to create credit money
their total demand and time deposits which the
multiples times that of the initial deposits.
commercial banks are required by RBI to invest in
specified liquid assets.
The process of creation of money is explained with
the help of the following numerical example.
Reserve deposit ratio: The fraction of their total
deposits which commercial banks keep as
Suppose, initially the public deposited Rs 10,000
reserves.
with the commercial bank. Assume the reserve
deposit ratio requirement to be 20%.
High powered money: Money injected by the
monetary authority in the economy. Consists
Therefore, the commercial bank will keep Rs 2,000
mainly of currency.
as reserve and lend the balance amount of Rs 8000
(Rs 10,000 – Rs 2,000) in the form of loans and
Monetary Base: The combination of currency held
advances to the general public.
by the nonbank public, vault cash held by banks,
and Federal Reserve deposits of the banks. Also
Now, if all transactions taking place in the economy
termed high-powered money, these are the three
are routed only though the commercial bank, then
monetary components over which the Federal
the money borrowed by borrowers is again routed
Reserve System has relatively complete control.
to the bank in the form of deposits.

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Hence, in the second round there is an increment in the money supply is affected by any change in the
the deposits with the commercial bank by Rs 8,000 amount of deposits. It equals ratio of increase or
and the total deposits with the commercial bank decrease in money supply to the corresponding
now rises to Rs 18,000 (i.e., Rs 10,000 + Rs 8,000). increase and decrease in deposits.

Now, out of the new deposits of Rs 8,000, the The money multiplier effect arises due to the
commercial bank will keep 20% as reserves (i.e. Rs phenomenon of credit creation.
1,600) and lend the remaining amount (i.e. Rs 6,400). ▪ When a commercial bank receives an amount A,
its total reserves are increased.
Again, this money will come to the commercial bank ▪ The bank is required by the central bank to hold
and in the third round, the total deposits rises to Rs only an amount equal to r × A in hand to meet
24,400 (i.e. Rs 18,000 + Rs 6,400). the demand for withdrawals, where r is the
required reserve ratio.
The same process continues and with each round the ▪ The bank is allowed to extend the excess
total deposits with the commercial bank increases. reserves i.e. (A − r × A) as loans.
However, in every subsequent round the cash ▪ When the borrower keeps the whole amount of
reserves diminishes. The process comes to an end loan in bank (it is assumed), it increases its total
when the total cash reserves (aggregate of cash reserves by an amount equal to (A − r × A).
reserves from all rounds of deposit-lending) ▪ Again, the bank is required to hold only a
becomes equal to the initial deposit of Rs 10,000 that fraction of this second round of deposits and it
were initially held by the commercial bank. can lend out the rest.
▪ This cycle continues such the ultimate increase
As per the above schedule, with the initial deposits in money supply due to an initial increase in
of Rs 10,000, the commercial banks have created a checking deposits of amount A is equal to m ×
credit of Rs 50,000. A, where m is the money multiplier.
▪ The opposite happens in case of a decrease in
KEY DEFINITION deposits through the same mechanism.

Money Creation: The process in which the Formula for money multiplier,
banking system creates chequeable deposits by
lending excess reserves. The total amount of Money Multiplier = 1 / Required Reserve Ratio
chequeable deposits (and money) created by the
banking system depends on the amount of excess Required reserve ratio is the fraction of deposits
reserves available and the reserve requirement which a bank is required to hold in hand. It can lend
ratio specifying the reserves needed to back up out an amount equals to excess reserves which
deposits. The money creation process is the equals (1 − required reserves).
movement of reserves from bank to bank, with
each bank using excess reserves to make loans Higher the required reserve ratio, lesser the excess
(and checkable deposits), then keeping a fraction reserves, lesser the banks can lend as loans, and
of the reserves to back up newly created deposits. lower the money multiplier. Lower the required
The deposit expansion multiplier captures the reserve ratio, higher the excess reserves, more the
money creation process, indicating the amount of banks can lend, and higher is the money multiplier.
chequeable deposits created if the banking
reserve acquires a given amount of excess In the above relationship it is assumed that there is
reserves. no currency drainage, i.e. the borrowers keep 100%
of the amount received in banks.

MONEY MULTIPLIER QUESTION 12

Q. The money multiplier in an economy increases
Money multiplier (also known as monetary with which one of the following? [2019]
multiplier) represents the maximum extent to which (a) Increase in the cash reserve ratio
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 (b) Increase in the banking habit of the population Broad money: Narrow money + time deposits held
(c) Increase in the statutory liquidity ratio by commercial banks and post office savings
(d) Increase in the population of the country organisation.
Answer: B
Aggregate monetary resources: Broad money
without time deposits of post office savings
NARROW MONEY VERSUS BROAD organisation (M3).
MONEY

Money supply, like money demand, is a stock QUESTION 13

variable. The total stock of money in circulation Q. The sum of which of the following constitutes
among the public at a particular point of time is Broad Money in India? [1997]
called money supply. 1. Currency with the public
2. Demand deposits with banks
RBI publishes figures for four alternative measures 3. Time deposits with banks
of money supply, viz. M1, M2, M3 and M4. They are 4. Other deposits with RBI.
defined as follows: Select the answer using the code given below:
(a) 1 and 2
▪ M1 = CU + DD + ‘Other’ deposits with RBI (b) 1, 2 and 3
▪ M2 = M1 + Savings deposits with Post Office (c) 1, 2, 3 and 4
savings banks (d) 1, 2 and 4
▪ M3 = M1 + Net time deposits of commercial Answer: C
banks
▪ M4 = M3 + Total deposits with Post Office savings
QUESTION 14
organisations (excluding National Savings
Certificates) Q. Consider the following: [2002]
1. Currency with the public
where, CU is currency (notes plus coins) held by the 2. Demand deposits with banks
public and DD is net demand deposits held by 3. Time deposits with banks
commercial banks. The word ‘net’ implies that only Which of these are included in Broad Money (M3)
deposits of the public held by the banks are to be in India?
included in money supply. The interbank deposits, (a) 1 and 2
which a commercial bank holds in other commercial (b) 1 and 3
banks, are not to be regarded as part of money (c) 2 and 3
supply. (d) 1, 2 and 3
Answer: D
M1 and M2 are known as narrow money. M3 and
M4 are known as broad money. These measures are QUESTION 15
in decreasing order of liquidity. Q. Consider the following liquid assets: [2013 - I]
M1 is most liquid and easiest for transactions 1. Demand deposits with the banks
whereas M4 is least liquid of all. M3 is the most 2. Time deposits with the banks
commonly used measure of money supply. It is also 3. Saving deposits with the banks
known as aggregate monetary resources. 4. Currency
The correct sequence of these assets in the
KEY DEFINITION decreasing order of liquidity is
(a) 1-4-3-2
Narrow money: Currency notes, coins and (b) 4-3-2-1
demand deposits held by the public in commercial (c) 2-3-1-4
banks. (d) 4-1-3-2
Answer: D

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POLICY TOOLS TO CONTROL SUPPLY Reserve Bank by dipping into their Statutory
OF MONEY Liquidity Ratio (SLR) portfolio up to a limit at a
penal rate of interest. This provides a safety
Reserve Bank of India is the only institution which valve against unanticipated liquidity shocks to
can issue currency. When commercial banks need the banking system.
more funds in order to be able to create more credit, ▪ Bank Rate: It is the rate at which the Reserve
they may go to market for such funds or go to the Bank is ready to buy or rediscount bills of
Central Bank. Central bank provides them funds exchange or other commercial papers. The Bank
through various instruments. This role of RBI, that of Rate is published under Section 49 of the Reserve
being ready to lend to banks at all times is another Bank of India Act, 1934. This rate has been
important function of the central bank, and due to aligned to the MSF rate and, therefore, changes
this central bank is said to be the lender of last automatically as and when the MSF rate changes
resort. alongside policy repo rate changes.
▪ Cash Reserve Ratio (CRR): The average daily
The RBI controls the money supply in the economy balance that a bank is required to maintain with
through various instruments. the Reserve Bank as a share of such per cent of
its Net demand and time liabilities (NDTL) that
▪ Repo Rate: The (fixed) interest rate at which the the Reserve Bank may notify from time to time in
Reserve Bank provides overnight liquidity to the Gazette of India.
banks against the collateral of government and ▪ Statutory Liquidity Ratio (SLR): The share of
other approved securities under the liquidity NDTL that a bank is required to maintain in safe
adjustment facility (LAF). A high repo rate signals and liquid assets, such as, unencumbered
that access to money is expensive for banks and government securities, cash and gold. Changes
lesser credit will flow into the system in SLR often influence the availability of
▪ Reverse Repo Rate: The (fixed) interest rate at resources in the banking system for lending to
which the Reserve Bank absorbs liquidity, on an the private sector.
overnight basis, from banks against the ▪ Open Market Operations (OMOs): These include
collateral of eligible government securities both, outright purchase and sale of government
under the LAF. A high reverse repo rate implies securities, for injection and absorption of
that banks can get safe returns if they park their durable liquidity, respectively.
money with RBI; therefore, Banks may either ▪ Market Stabilisation Scheme (MSS): This
park their money with RBI or they may lend at a instrument for monetary management (very
still higher rate of interest to borrowers. Thus, similar to Sterilisation) was introduced in 2004.
high reverse repo rate either constricts credit, or Surplus liquidity of a more enduring nature
makes it expensive. arising from large capital inflows is absorbed
▪ Liquidity Adjustment Facility (LAF): The LAF through sale of short-dated government
consists of overnight as well as term repo securities and treasury bills. The cash so
auctions. Progressively, the Reserve Bank has mobilised is held in a separate government
increased the proportion of liquidity injected account with the Reserve Bank.
under fine-tuning variable rate repo auctions of
range of tenors. The aim of term repo is to help KEY DEFINITION
develop the inter-bank term money market,
which in turn can set market based benchmarks Bank rate: The rate of interest payable by
for pricing of loans and deposits, and hence commercial banks to RBI if they borrow money
improve transmission of monetary policy. The from the latter in case of a shortage of reserves.
Reserve Bank also conducts variable interest rate
reverse repo auctions, as necessitated under the Repo (Repurchase Agreement): Repo is a money
market conditions. market instrument, which enables collateralised
▪ Marginal Standing Facility (MSF): A facility under short term borrowing and lending through
which scheduled commercial banks can borrow sale/purchase operations in debt instruments.
additional amount of overnight money from the Under a repo transaction, a holder of securities

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 sells them to an investor with an agreement to (b) lending by commercial banks to industry and
repurchase at a predetermined date and rate. trade
Repo rate is nothing but the annualised interest (a) purchase and sale of government securities
rate for the funds transferred by the lender to the by the RBI
borrower. (b) None of the above
Answer: C
Reverse Repo: A reverse repo is the mirror image
of a repo. For, in a reverse repo, securities are
QUESTION 19
acquired with a simultaneous commitment to
Q. The terms ‘Marginal Standing Facility Rate’
resell.
and ‘Net Demand and Time Liabilities’,
sometimes appearing in news, are used in
Open market operation: Purchase or sales of
relation to [2014 - I]
government securities by the central bank from
(a) banking operations
the general public in the bond market in a bid to
(b) communication networking
increase or decrease the money supply in the
(c) military strategies
economy.
(d) supply and demand of agricultural products
Answer: A
Sterilisation: Intervention by the monetary
authority of a country in the money market to
keep the money supply stable against exogenous
or sometimes external shocks such as an increase
in foreign exchange inflow. QUESTION 20
Q. With reference to Indian economy, consider
the following [2015-I]
1. Bank rate
QUESTION 16
2. Open market operations
Q. Bank Rate implies the rate of interest: [1995]
3. Public debt
(a) paid by the Reserve Bank of India on the
4. Public revenue
Deposits of Commercial Banks
Which of the above is/are component/
(b) charged by Banks on loans and advances
components of Monetary Policy?
(c) payable on Bonds
(a) 1 only
(d) at which the Reserve Bank of India discounts
(b) 2, 3 and 4
the Bills of Exchange
(c) 1 and 2
Answer: D
(d) 1, 3 and 4
Answer: C
QUESTION 17
Q. The banks are required to maintain a certain
ratio between their cash in hand and liquid DISTINCTION BETWEEN QUANTITATIVE
TOOLS AND QUALITATIVE TOOLS
assets. This is called: [1998]
(a) SBR (Statutory Bank Ratio)
The RBI controls the money supply in the economy
(b) SLR (Statutory Liquid Ratio)
in various ways. The tools used by the Central bank
(c) CBR (Central Liquid Reserve)
to control money supply can be quantitative or
(d) CLR (Central Liquid Reserve)
qualitative.
Answer: B
Quantitative tools, control the extent of money
supply by changing the CRR/SLR, or bank rate or
QUESTION 18 open market operations.
Q. In the context of Indian economy, ‘Open
Market Operations’ refers to [2013 - I] Qualitative tools include persuasion by the Central
(a) borrowing by scheduled banks from the RBI bank in order to make commercial banks discourage

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or encourage lending which is done through moral
suasion. Qualitative also called selective credit The amended RBI Act also provides for the inflation
control instruments work through regulation of target to be set by the Government of India, in
margin requirement, credit rationing, regulation of consultation with the Reserve Bank, once in every
consumer credit and direct action. five years. Accordingly, the Central Government has
notified in the Official Gazette 4 per cent Consumer
Price Index (CPI) inflation as the target for the
QUESTION 21
period from August 5, 2016 to March 31, 2021 with
Q. Which one of the following is not an
the upper tolerance limit of 6 per cent and the lower
instrument of selective credit control in India?
tolerance limit of 2 per cent.
[1995]
(a) Regulation of consumer credit
The Central Government notified the following as
(b) Rationing of credit
factors that constitute failure to achieve the
(c) Margin requirements
inflation target:
(d) Variable cash reserve ratios
(a) the average inflation is more than the upper
Answer: D
tolerance level of the inflation target for any three
consecutive quarters; or
MONETARY POLICY: MEANING, GOAL, (b) the average inflation is less than the lower
TYPES AND PROCESS tolerance level for any three consecutive quarters.

TYPES
MEANING
Monetary policy comes in two basic varieties--
Monetary policy is controlling of the quantity of
expansionary and contractionary.
money in circulation for the expressed purpose of
stabilizing the business cycle and reducing the EXPANSIONARY MONETARY POLICY
problems of unemployment and inflation.
Expansionary monetary policy or easy money
In older times, monetary policy was undertaken by results if the RBI increases the money supply and
printing more or less paper currency. In modern lowers interest rates and is the recommended policy
economies, monetary policy is undertaken by to counter a slowdown in GDP growth.
controlling the money creation process performed Expansionary moves include:
through fractional-reserve banking. ▪ The decreases in the repo rate/Bank rate/MSF
rate: As these rate falls, corporations and
The Reserve Bank of India is India’s monetary consumers can borrow more cheaply.
authority responsible for monetary policy. This ▪ Purchases of government securities: As RBI
responsibility is explicitly mandated under the purchases government securities from financial
Reserve Bank of India Act, 1934. In theory, it can institutions, it increases money supply in the
control the fractional-banking money creation market.
process and the money supply through open market ▪ Reductions in the reserve ratio (CRR/SLR): The
operations, repo rate, and reserve requirements. central bank seeks to encourage increased
lending by banks by decreasing the reserve ratio,
GOAL which is essentially the amount of capital a
commercial bank needs to hold onto when
The primary objective of RBI’s monetary policy is to
making loans.
maintain price stability while keeping in mind the
objective of growth. Price stability is a necessary
Expanding the money supply results in lower
precondition to sustainable growth.
interest rates and borrowing costs, with the goal to
boost consumption and investment.
In May 2016, the Reserve Bank of India (RBI) Act,
1934 was amended to provide a statutory basis for
What impact does government borrowing from RBI
the implementation of the flexible inflation
have on money supply?
targeting framework.
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 (b) 2 and 4 only
When government borrows money from RBI, it goes (c) 1 and 3 only
into circulation through transactions. (d) 2, 3 and 4
Answer: C
The government may pay the people it employs, buy
goods and services, give subsidies, and so on. Part of
QUESTION 24
this money is kept by the recipients and the rest goes
back into bank accounts. Q. If the interest rate is decreased in an economy,
it will [2014 - I]
A government servant who receives a salary keeps a (a) decrease the consumption expenditure in the
fraction of it at home and puts the rest in his bank economy
account to earn some interest. The businessmen (b) increase the tax collection of the Government
who sell their goods or services to the government (c) increase the investment expenditure in the
and get money in their bank accounts use only a part economy
of that to carry on their business, while the rest stays (d) increase the total savings in the economy
in the bank. Answer: C

As we can see from above, deposits received by QUESTION 25

banks increase. At this stage money multiplier can Q. When the Reserve Bank of India reduces the
kick in resulting in creation of more money by banks. Statutory Liquidity Ratio by 50 basis points,
which of the following is likely to happen? [2015-
Hence government borrowing from RBI can lead to I]
an increase in money supply (an expansionary effect (a) India's GDP growth rate increases drastically
on money supply). (b) Foreign Institutional Investors may bring
more capital into our country
QUESTION 22
(c) Scheduled Commercial Banks may cut their
Q. The lowering of Bank Rate by the Reserve Bank lending rates
of India leads to [2011 - I] (d) It may drastically reduce the liquidity to the
(a) more liquidity in the market banking system
(b) less liquidity in the market Answer: C
(c) no change in the liquidity in the market
(d) mobilization of more deposits by commercial CONTRACTIONARY MONETARY POLICY
banks
Answer: A Contractionary monetary policy or tight money
occurs if the RBI decreases the money supply and
raises interest rates and is the recommended policy
QUESTION 23
to reduce inflation. Contractionary moves include:
Q. Which of the following measures would result
▪ The increases in the repo rate/Bank rate/MSR
in an increase in the money supply in the
rate: As these rate rises, corporations and
economy? [2012 - I]
consumers borrowings become more expensive.
1. Purchase of government securities from the
▪ Sales of government securities: As RBI sells
public by the Central Bank
government securities to financial institutions, it
2. Deposit of currency in commercial banks by
decreases money supply in the market.
the public
▪ Increase in the reserve ratio (CRR/SLR): The
3. Borrowing by the government from the
central bank seeks to discourage increased
Central Bank
lending by banks by increasing the reserve ratio.
4. Sale of government securities to the public by
the Central Bank
Contracting the money supply results in higher
Select the correct answer using the codes given
interest rates and borrowing costs, with the goal to
below:
control inflation.
(a) 1 only
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 o Call money is a method by which banks
lend to each other to be able to maintain
QUESTION 26
the cash reserve ratio.
Q. When the Reserve Bank of India announces an
o The interest rate paid on call money is
increase of the Cash Reserve Rate, what does it
known as the call rate.
mean? [2010]
o It is a highly volatile rate that varies from
(a) The commercial banks will have less money to
day to day and sometimes even from
lend
hour to hour.
(b) The Reserve Bank of India will have less
▪ Section 45ZB of the amended RBI Act, 1934 also
money to lend
provides for an empowered six-member
(c) The Union Government will have less money
monetary policy committee (MPC) headed by
to lend
the Governor of the RBI to be constituted by the
(d) The commercial banks will have more money
Central Government by notification in the
to lend
Official Gazette.
Answer: A
▪ The MPC determines the policy interest rate
required to achieve the inflation target.
QUESTION 27 ▪ The Reserve Bank’s Monetary Policy
Q. An increase in the Bank Rate generally Department (MPD) assists the MPC in
indicates that the [2013 - I] formulating the monetary policy. Views of key
(a) Market rate of interest is likely to fall stakeholders in the economy, and analytical
(b) Central Bank is no longer making loans to work of the Reserve Bank contribute to the
commercial banks process for arriving at the decision on the policy
(c) Central Bank is following an easy money repo rate.
policy ▪ The Financial Markets Operations Department
(d) Central Bank is following a tight money policy (FMOD) operationalises the monetary policy,
Answer: D mainly through day-to-day liquidity
management operations.
▪ The Financial Markets Committee (FMC) meets
daily to review the liquidity conditions so as to
MONETARY POLICY – FRAMEWORK AND ensure that the operating target of the weighted
PROCESS average call money rate (WACR) is anchored
around the repo rate.
▪ The amended RBI Act explicitly provides the
legislative mandate to the Reserve Bank to
operate the monetary policy framework of the QUESTION 28
country. Q. Which of the following statements is/are
▪ The framework aims at setting the policy (repo) correct regarding the Monetary Policy
rate based on an assessment of the current and Committee (MPC)? [2017]
evolving macroeconomic situation; and 1. It decides the RBI’s benchmark interest rates.
modulation of liquidity conditions to anchor 2. It is a 12-member body including the Governor
money market rates at or around the repo rate. of RBI and is reconstituted every year.
Repo rate changes transmit through the money 3. It functions under the chairmanship of the
market to the entire the financial system, which, Union Finance Minister.
in turn, influences aggregate demand – a key Select the correct answer using the code given
determinant of inflation and growth. below:
▪ Once the repo rate is announced, the operating (a) 1 only
framework designed by the Reserve Bank (b) 1 and 2 only
envisages liquidity management on a day-to- (c) 3 only
day basis through appropriate actions, which (d) 2 and 3 only
aim at anchoring the operating target – the Answer: A
weighted average call rate (WACR) – around the
repo rate.
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DEMONETIZATION
Demonetisation was a new initiative taken by the
Government of India in November 2016 to tackle the
problem of corruption, black money, terrorism and
circulation of fake currency in the economy.

Old currency notes of Rs 500, and Rs 1000 were no

longer legal tender. New currency notes in the
denomination of Rs 500 and Rs 2000 were launched.

The public were advised to deposit old currency

notes in their bank account till 31 December 2016
without any declaration and upto 31March 2017
with the RBI with declaration.
Further to avoid a complete breakdown and cash
crunch, government had allowed exchange of Rs
4000 old currency by new currency per person and
per day. Further till 12 December 2016, old currency
notes were acceptable as legal tender at petrol
pumps, government hospitals and for payment of
government dues, like taxes, power bills, etc.

This move received both appreciation and criticism.

There were long queues outside banks and ATM
booths. The shortage of currency in circulation had
an adverse impact on the economic activities.
However, things improved with time and normalcy
returned.

This move has had positive impact also. It improved

tax compliance as a large number of people were
bought in the tax ambit. The savings of an individual
were channelised into the formal financial system.
As a result, banks have more resources at their
disposal which can be used to provide more loans at
lower interest rates.

It is a demonstration of State’s decision to put a

curb on black money, showing that tax evasion will
no longer be tolerated. Tax evasion will result in
financial penalty and social condemnation. Tax
compliance will improve and corruption will
decrease.

Demonetisation could also help tax administration in

another way, by shifting transactions out of the cash
economy into the formal payment system.
Households and firms have begun to shift from cash
to electronic payment technologies.

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MCQS FOR PRACTICE Q5. Consider the following statements regarding
inflation targeting:
Q1. Consider the following statements with regard 1. It is a strategy used by the central government to
to Fiat money: stabilize the economy.
1. It does not have an intrinsic value of its own. 2. The benchmark used for targeting inflation in
2. It cannot be refused by any citizen of the country India is based on Consumer Price Index.
for settlement of any transaction. Which of the statements given above is/are
correct?
Which of the statements given above is/are
(a) 1 only
correct?
(b) 2 only
(a) 1 only (c) Both 1 and 2
(b) 2 only (d) Neither 1 nor 2
(c) Both 1 and 2
(d) Neither 1 nor 2

Q2. Which of the following best describes the

Double coincidence of wants?
(a) A situation where two economic agents have
complementary demands for each other's surplus
production.
(b) An economic situation where two economic
agents have desire for similar goods.
(c) An economic situation in which aggregate
demand is assumed to be infinitely elastic.
(d) An economic situation where the total demand in
the economy is two times the supply in the economy.

Q3. Which of the following constitutes high

powered money?
1. Currency notes
2. Coins
3. Cheques
Select the correct answer using the code given
below:
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

Q4. In the context of economy, sterilization by RBI

refers to:
(a) operations by RBI to neutralize effects of excess
inflow of foreign investments in the economy.
(b) operations by RBI to neutralize the effects of high
non performing assets on the economy.
(c) operations by the RBI to neutralize the effects of
high fiscal deficit on the economy.
(d) None of the above

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 for each other's surplus production. For instance, a
MCQS WITH ANSWER & coincidence of wants would occur when a fisherman
EXPLANATION wants a packet of rice, and a farmer who needs fish,
is willing to accept fish in exchange for his rice.
Q1. Consider the following statements with regard
Q3. Which of the following constitutes high
to Fiat money:
powered money?
1. It does not have an intrinsic value of its own.
1. Currency notes
2. It cannot be refused by any citizen of the country
2. Coins
for settlement of any transaction.
3. Cheques
Which of the statements given above is/are
Select the correct answer using the code given
correct?
below:
(a) 1 only
(a) 1 and 2 only
(b) 2 only
(b) 2 and 3 only
(c) Both 1 and 2
(c) 1 and 3 only
(d) Neither 1 nor 2
(d) 1, 2 and 3
Answer: C
Answer: A
Explanation:
Explanation:
Fiat money does not have intrinsic value like a gold
High powered money is the total liability of the
or silver coin that is they are guaranteed by the
monetary authority of the country, i.e. the RBI. It is
government but they do not have any underlying
called the monetary base or high powered money. It
value itself. Example: during the recent
consists only of currency notes and coins (in
demonetization drive, the government withdrew its circulation with the public and vault cash of
guarantee for 500 and 1000 rupee note. As they commercial banks) and deposits held by the
lacked intrinsic value (unlike gold/silver coin) these Government of India and commercial banks with
notes became useless. RBI.

Fiat money is also called legal tenders as they cannot Q4. In the context of economy, sterilization by RBI
be refused by any citizen of the country for refers to:
settlement of any transaction. (a) operations by RBI to neutralize effects of excess
inflow of foreign investments in the economy.
Q2. Which of the following best describes the (b) operations by RBI to neutralize the effects of high
non performing assets on the economy.
Double coincidence of wants?
(c) operations by the RBI to neutralize the effects of
(a) A situation where two economic agents have
high fiscal deficit on the economy.
complementary demands for each other's surplus (d) None of the above
production. Answer: A
(b) An economic situation where two economic
agents have desire for similar goods. Explanation:
(c) An economic situation in which aggregate Sterilization refers to the process by which the RBI
demand is assumed to be infinitely elastic. takes away money from the banking system to
(d) An economic situation where the total demand in neutralise the fresh money that enters the system.
the economy is two times the supply in the economy. By selling the government securities, RBI suck out
Answer: A the liquidity from the market and hence sterilizes the
economy against adverse external shocks.
Explanation:
Q5. Consider the following statements regarding
Double coincidence of wants is a situation where
inflation targeting:
two economic agents have complementary demand
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1. It is a strategy used by the central government to
stabilize the economy.
2. The benchmark used for targeting inflation in
India is based on Consumer Price Index.
Which of the statements given above is/are
correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: B

Explanation:
Inflation targeting is a monetary tool used by central
banks (not the central government) to stabilize the
economy. Doing this the RBI aims to bring in more
predictability and transparency in deciding
monetary policy, ensure price stability and control
inflation in a systematic and planned approach.

The RBI has been using headline Consumer Price

Index (Combined) inflation as the benchmark for all
monetary policy stance from April 2014 onwards.

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