TR Jain Macro 141 184

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Meaning and Evolution of Money
Forms of Money
Supply of Money-
Concept of Money Supply and Measurement of Money Supply
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I. MEANING AND EVOLUTION OF MONEY
A thing which is commonly accepted as a medium of exchange is
called money. Example: A rupee in India is money, as it is a commonly
accepted medium of exchange here. Likewise, a dollar in USA is
money, as it is a commonly accepted medium of exchange there.
In olden days, goods were exchanged for goods. There was no money.
Thus, a cobbler would make shoes in return for wheat from the farmer;
a farm worker would get grains as a reward for his labour, and so on.
This system of exchange was known as barter system. But with the
multiplicity of wants (and greater need for exchange), barter system
(a system where goods were exchanged for goods) proved to be an
inefficient system of exchange. It is then that we invented money-a
common medium of exchange. Now goods were not sold for goods.
Instead, goods were sold for money.
Initially, coins of gold and silver were introduced as money.
Subsequently, alloy metal was used for coinage, along with paper
money. And, now is the age of plastic money (in the form of cash
cards), or e-money in the form of 'electronic transfer of money' by
way of credit/debit entries in the bank accounts. Thus, the origin (and
evolution) of money is related to the need to facilitate exchange.
I
Origin of Money
Origin (and evolution) of money is related to the need to facilitate exchange. Therefore, money is
generally defined as a thing that is commonly accepted as a medium of exchange.
133
Though initially invented as a medium of exchange, gradually money
found its other uses as well:
• Money is used as a store of value. Or, money is used as an
instrument of saving.
• Money is used as a measure of value. Value of goods and services
is expressed in terms of money.
• Money is used as a standard for deferred payments (deferred
payments are those payments which are made sometimes in the
future).
Owing to its multiple functions, money has acquired a wider definition
than merely a medium of exchange. It is defined as an instrument that
serves as a medium of exchange, store of value, measure of value and
standard for deferred payments. Briefly, it is said that 'money is what
money does'.
Definition of Money
Money is what money does. It is defined as an instrument that serves as a medium of exchange,
store of value, a measure of value and a standard for deferred payments.
Basic Functions of Money
The definition of money conveys the basic functions of money These are: (i) Money acts as a medium
of exchange, (ii) Money serves as a store of value (people save in terms of money), (iii) Money is a
measure of value: market price of goods and services is expressed in terms of money, and (iv) Money
serves as a standard for deferred payments (future payments)· when business contracts are signed
on the basis of future payments, money acts as an instrument for those payments.
Barter System of Exchange

Barter system of exchange is a system in which goods are exchanged
for goods. If (as a farmer) you have surplus production of rice, you are
to look for a person who needs rice, and at the same time has (say)
cloth, which you need for yourself. It means 'double coincidence of
wants': your want for cloth must coincide with somebody's want for
rice, and you must have surplus of rice and somebody must have the
surplus of cloth. How difficult it is! What do you do these days? As
a farmer, you sell rice for money, and as a cloth merchant, you sell
your cloth for money. With money in hand, you buy whatever you
wish to buy. Thus, rice is exchanged for money, cloth is exchanged
for money. Money acts as a common medium of exchange. No such
common medium of exchange exists in the C-C economy (commodity
for commodity exchange economy) where goods are exchanged for
goods.
134 Introductory Macroeconomics

I
C-C Economy
C stands for commodity C-C economy is the one in which commodities are exchanged for
commodities or in which goods are exchanged for goods. C-C exchange refers to Barter System of
Exchange. Hence, C-C economy is an economy dominated by Barter System of Exchange.
Drawbacks of the Barter System and their Elimination

Following are the principal drawbacks of barter system of exchange.
It is with the introduction of money that these drawbacks have been
eliminated.
(1) Double Coincidence of Wants: Double coincidence of wants is
a core characteristic of the barter system of exchange. Double
coincidence of wants implies that (at a point of time), the
two individuals are in possession of such goods which they are
willing to exchange for the satisfaction of their wants. But it is not
always so simple. It is not so simple to find a person who wants
your horse and at the same time has a cow that you want to
buy. Accordingly, under the barter system, exchange remained
extremely limited. With the emergence of money (as a medium
of exchange), the problem of double coincidence of wants has
vanished. Money as a medium of exchange has separated the
acts of sale and purchase.
(2) Lack of a Common Unit of Value: What is the value of your
car? You can reply: � 5 lakh. Can you give the same answer in a
• Money has led to
barter system of exchange? Certainly not. Under such a system, the expansion of
your car would be valued in terms of horses, cows or buffaloes, exchange.
simply because there is no money (or a common unit of value). • Expansion of
exchange has led
Evolution of money has given us a common unit of value and to expansion of the
therefore, a system of accounting. markets for goods and
services.
(3) Difficulty of Future Payments or Contractual Payments: These
• Expansion of market
days you hire a worker and strike a contract to pay him (say) has led to expansion
� 10,000 p.m. What do you do in a barter system? Would you of the scale of output.
decide to pay him in terms of tables or chairs, in terms of rice or • Expansion of the
scale of output has
wheat, in terms of drugs or chocolates? Contractual payments led to GDP growth.
or future payments would certainly be very difficult under Implying growth of the
economy.
barter system of exchange. Evolution of money has facilitated
contractual payments.
(4) Difficulty of Storage of Value (Saving) and Transfer of Value: In
the C-C economy, saving is possible only by way of storage of
goods. It involves substantial storage cost as well as the fear of
capital loss (owing to natural disasters). Further, what happens
if you are to transfer your saving from one place to the other?
Money 135
Obviously, you are to transfer the goods. Which again is a
difficult task, besides being expensive. Evolution of money has
made storage and transfer of value much easier.
t>TS
Q. Introduction of money has separated the acts of 'sale' and 'purchase'. How?
Ans. Under the barter system of exchange, acts of sale and purchase of an individual must occur at the
same point of time. To buy a thing, an individual must at the same time sell something needed by the
other person. Also, sale and purchase by an individual must be of equal value.
With the introduction of money (as a medium of exchange), an individual can buy a thing with money
without selling anything at the same time. Likewise, he can sell a thing for money without buying
anything at the same time. Thus, with the introduction of money, acts of sale and purchase have
been separated.
2. FORMS OF MONEY
Some important forms of money are described as under:
(i) Fiat money and fiduciary money, and
(ii) Full bodied money and credit money.
(i) Fiat Money and Fiduciary Money

Fiat money refers to that money which is issued by order/ authority of
the government. It includes all notes and coins which the people in a
country are legally bound to accept as a medium of exchange.
Fiduciary money is that money which is accepted as a medium of
exchange because of the trust between the payer and the payee.
Example: Cheques are fiduciary money as these are accepted as a
means of payment on the basis of trust, not on the basis of any order
of the government.
(ii) Full Bodied Money and Credit Money

Full bodied money refers to money in terms of coins whose commodity
value is equal to the money value as and when these are issued.
Example: A rupee coin during the British period in India was made of
silver. Commodity value of the coin was equal to its money value at
the time of its issuing. Or, the market value of the silver contained in
the coin was equal to � 1.
Credit money refers to that money of which money value is more than
commodity value. Example: What is the market value of the metal
that the rupee coin is made of in India? Obviously, much lower than
the money value of the rupee coin. Otherwise, people would have
melted the coins and sold the metal in the market at a price greater
than one rupee.

I
Full Bodied Money:
Money Value = Commodity Value
Credit Money:
Money Value> Commodity Value
f>TS
Q. 1. Distinguish between money value of money and commodity value of money.
Ans. Money value of money refers to the value which is inscribed on a coin or written on a paper note.
Thus, money value of a paper note is what is written on it: one hundred rupees, two hundred rupees,
etc. With a two hundred rupee note, you can buy goods and services worth two hundred rupees in
the market.
Commodity value of money refers to value of the commodity (like metal) that the money is made of.
Thus, if coins are made of gold or silver (as was the practice in old days), commodity value of money
refers to the market value of the gold or silver contained in the coin.
Q. 2. Can you think of a situation when money plays no role whatsoever?
Ans. Money plays no role in a situation when there is no exchange. Example: An individual or a family
surviving on an island without any exchange (or sale and purchase of goods and services).
Q. 3. Why people hold notes and coins when it is clear that the intrinsic value (commodity value) of notes
and coins is almost negligible?
Ans. Because notes and coins are legal tenders. These are fiat money or the money backed with
authority of the government. It is unlawful not to accept notes and coins for receipts/payments.
3. SUPPLY OF MONEY
Supply of money is a stock concept. It refers to total stock of money
( of all types) held by the people of a country at a point of time.
It is important to note that the supply of money does not include:
(i) stock of money held by the government, and (ii) stock of money
held by the banking system of a country. Because, government and
the banking system of a country are suppliers of money, and the stock
of money held by the suppliers of money is never treated as a part of
the supply of money in the country.
Supply of money includes only that stock of money which is held by people, other than
suppliers of money themselves. In other words, supply of money refers to that stock of F®CUS
money which is held by those, who demand money, not by those, who supply money. ZONE
f>TS
Q. Who are the producers of money?
Ans. Producers of money refer to suppliers of money. They include:
(i) the government of the country, and
(ii) the banking system of a country, including both the central bank (which is the note issuing
authority) and the commercial banks (who add to the supply of money through demand
deposits).
Money 137
Measures of Money Supply
In India, there are four alternative measures of money supply, popularly
known as M 1, M2, M 3, and M4. Of these, only M 1 measure is discussed
here, as prescribed in the syllabus. M2, M3 and M4 measures are given
in 'Ability Zone' of the chapter for general reference.
M 1 Measure of Money Supply

According to M 1 measurement, money supply includes the following
components:
M 1 = C +DD+ OD
Here,
C: It refers to currency held by the public. It includes coins as well
as paper notes.
DD: It refers to demand deposits of the people with the commercial
banks. These are chequeable deposits which can be withdrawn
or transferred on demand.
OD: These are other deposits which include:
(i) Demand deposits with RBI of public financial institutions like
NABARD (National Bank for Agriculture and Rural Development).
(ii) Demand deposits with RBI of foreign central banks and of the
foreign governments.
(iii) Demand deposits of international financial institutions like IMF
and World Bank.
Specifically, OD does not include:
(i) deposits of the government of the country with RBI,
(ii) deposits of the country's banking system with RBI.
Net Demand Deposits and Gross Demand Deposits

Distinction may be drawn between gross demand deposits and net demand deposits with the
commercial banks. Gross demand deposits include inter-banking claims: claims of one bank against
the other. Net demand deposits do not include inter-banking claims. Inter-banking claims are not a
part of demand deposits of the people
Note of Caution
Only net demand deposits are taken as a part of money supply

Term Deposits and Demand Deposits
Term deposits are different from demand deposits:
(i) Term deposits are always for a specific period of time, like fixed deposits for a period of one
year or two years. Demand deposits are not for any specific period of time.
(ii) Depositors cannot withdraw money (in fixed deposits) as and when needed. Money in demand
deposits can be withdrawn as and when needed.
(iii) Term deposits are not chequeable deposits. Depositors cannot sign a cheque against these
deposits. Demand deposits are chequeable deposits. These are: (a) saving account deposits,
and (b) current account deposits. Depositors can sign a cheque and withdraw/transfer money
from these accounts.
Note of Caution
In the context of M 1 measurement of money supply, only demand deposits are considered as a part
of money supply, NOT the term deposits [Demand Deposits = Saving Account Deposits + Current
Account Deposits].
'
Measure of Money Supply (M 1 lJ
Cu rrency with
f
Demand Deposits of the People
i
Other Deposits
the Public with the Com mercial Banks with Reserve Ba n k
(i) Demand Deposits (ii) Demand Deposits (i ii) Demand Deposits

with Reserve Ba n k with Reserve Ba n k of of I nternational
o f Public Fina ncial Foreign Central Banks Fi nancial I n stitutions
I n stitutions (like NABARD) a n d Govern ments (like IMF and World Ba n k)
[Note: The standard practice is to consider (i) Cu rrency with the publ ic, and (ii) Demand deposits of the people
with the com mercial banks as the two principal com ponents of money supply in the economy.]
Who Su p plies Money ?

Suppliers of money include: (i) central bank of the country (RBI in
India), (ii) commercial banks, and (iii) the government.
In India, RBI is the principal supplier of money. RBI issues currency on
the basis of Minimum Reserve System. Under this system, Reserve Bank
maintains a minimum reserve of � 200 crore in the form of gold and
foreign securities. Of this reserve, value of the gold must be � 115 crore.
Commercial banks are the second significant source of money supply.
Unlike the central bank, commercial banks do not have the authority
of issuing currency. The commercial banks cannot issue notes and
coins. Yet, they are the suppliers of money as they create money by
way of demand deposits. These deposits serve as supply of money
because these are chequeable deposits. People can withdraw or
transfer money by writing cheques. Money created by the commercial
banks by way of demand deposits is called Bank Money.
Money 13 9
Government is the th i rd sou rce of money su pply i n the cou ntry. I n
I n d ia, the Min istry o f Finance issues o n e ru pee notes and coins o f al l
deno m i nation.
Bank Money and High Powered Money
Bank money refers to demand deposits (or chequeable deposits) of the people with the commercial
banks.
High powered money is the sum total of. (a) currency held by the people, (b) vault cash of the
commercial banks, and (c) cash reserves of the commercial banks with the RBI. This is called
'Monetary Base' or 'Base Money' in the economy.
Note: While currency held by the people is a part of money supply, vault cash of the commercial banks as well as
cash reserves of the commercial banks with RBI are NOT a part of money supply. As already noted, stock of
money held by the suppliers of money is never treated as a part of money supply.
i>TS
Q. 1. State the principa l com ponents of money supply.
Ans. The p ri nci pa l com ponents of money s u pply are:
( i ) Currency ( notes + coi ns) held by the pu blic.
(ii) Demand deposits of the people with the com mercia l ba nks, and
( i i i ) Other deposits (demand deposits with RBI of domestic and foreign i n stitutions other than of
the government of the country a nd com mercia l ba n ks with in the country).
Q. 2. Why are cash deposits of the government and of the commercial ba n ks with the RBI not treated as a
part of money supply?
Ans. Because government and commercia l banks a re creators/suppliers of money. And, money held by
the creators/suppliers of money is never treated as a part of money supply.
Power Points & Revision Window -----------

Money i s a nyth i n g w h i c h i s co m m o n ly acce pted as a med i u m of exc h a n ge. I t has been i nvented to
overco me the difficu lties of barte r system of exch a nge.
Barter System of Exchange is the syste m i n w h i c h co m mod ities a re excha nged fo r co m mod ities. This is
l also ca l led co m mod ity fo r com mod ity exc h a n ge economy or 'C-C economy'.
Drawbacks ( i ) It req u i res d o u b l e coi ncidence of wa nts which is h a rd to fi n d .
( i i ) I t lacks a com m on u n it o f excha nge.
( i i i ) I t lacks the syste m of futu re payments or defe rred payments.
( iv) I t lacks the syste m of sto rage and tran sfer of va l ue.
j l •
Forms of Money
Fiat Money is that mo ney which is issued by ord e r (a utho rity) of the govern ment.
Fiduciary Money i s that money which is acce pted as a med i u m of excha nge beca use of the
trust between the paye r and the payee .
Full Bodied Money: M oney va l u e = Com m od ity va l u e of money.
j
Credit Money: Money va l u e of coi n s a n d notes > Com m od ity va l u e of coi n s a n d notes .
Suppl y o f Money is a stock concept. I t refers to stock of money availa ble with the pu blic/people a t a poi nt o f time.
• stock of Money with the govern ment a n d the b a n k i n g system of the co u ntry is not considered as
a part of money s u p ply.
Components of Money Supply: Cu rrency with P u b l ic + De m a n d Deposits with Com m e rcial Ba n ks + Other
Deposits with the Rese rve Ba nk.

rEX E RC I S Ej
1 . Objective Type Questions (Remem bering & U ndersta n d i n g based Quest i ons)
A. M u lt i p l e Choice Questions
Choose t h e correct option:
1. Barter system refers to that system wherei n :
( a ) goods a re excha nged for goods
(b) goods a re not excha nged at a l l
( c ) goods a re excha nged for domesti c currency
( d ) goods a re excha nged for foreign cu rrency
2 . Which of the following is a typical cha racteristic of the barter system ?
(a) A com mon med i u m o f excha nge (b) Dou b l e coincidence of wants
(c) A com mon u n it of accou nt (d) A sta n d a rd for d eferred payments
3. Which of the following is a com monly accepted d efi n ition of money?
(a) Any good which is com m o n ly used as a store of va l u e
( b ) Any good w h i c h is excha nged for g o l d a t a fixed rate
(c) Any good which is accepta ble to a ba n k
( d ) Any good which is com m o n ly accepted a s a med i u m of excha nge
4. Money which is accepted as a med i u m of excha nge beca u se of the trust between the paye r and the
payee is ca l led :
(a) fu l l bodied money ( b ) cred it money
(c) fiat money ( d ) fiduciary money
5 . F u l l bodied money is that money whose money va l u e a n d com mod ity va l u e a re :
(a) eq u a l i n the ma rket ( b ) declared as eq u a l by the government
(c) d i fferent i n the market ( d ) declared as eq u a l by the R B I
6. Money that is issued by the a uthority o f the government is ca l l e d :
(a) fu l l bodied money ( b ) cred it money
7. When money va l u e of money exceeds commod ity va l u e of money, it is ca l l ed :
( a ) fu l l bodied money ( b ) cred it money
8. Money as a sta n da rd for deferred payme nts has led to the emergence of:
(a) com mod ity ma rket ( b ) fi n a ncial ma rket
(c) both (a) a n d ( b ) ( d ) n o n e o f these
9 . Which of the fol l owing is the com ponent of M 1 measu re of money su p p ly?
(a) Term deposit (b) Demand deposits
(c) Cash reserves of the com m e rcial ba n ks ( d ) None of these
10. Ba n k money is that money which is:
(a) pri nted by RBI ( b ) pri nted by the governm ent
(c) generated i n the form of cred it creation ( d ) none of these
Money 141
11. Who supplies money i n I n d ia ?
(a) T h e RBI ( b ) The com mercia l b a n ks
(c) The governm ent ( d ) All of these
12. Dema nd de posits i n c l u d e :
(a) cheq ueable deposits ( b ) d eposits which ca n be withd rawn on d e m a n d
(c) fixed d eposits for a period of ti me ( d ) both (a) a n d ( b )
13. I n I n d ia, there a re fou r a lte rnative measures o f money su pply: M 1, M 2 , M 3 a n d M 4, o f these M 1 =
(a) Cu rrency with people
(b) Cu rrency with people + Demand d eposits
(c) Cu rrency with people + Demand d eposits + Other deposits with the Reserve Ba n k
(d) N o n e o f these
14. Supply of money is a :
( a ) flow va ria b l e (b) stock va riable
( c ) rea l fl ow ( d ) none of these
15. I n I n d ia , coins a re issued by:
(a) State Ba n k of I n d ia (b) Reserve Ba n k of I n d i a
(c) M i n istry of Fina nce ( d ) M i nistry o f U rban Develop ment
16. I ntrod uction of money has:
(a) sepa rated the acts of sale and p u rchase of a n i n d ivid u a l
(b) com bi ned t h e acts o f s a l e a n d p u rchase o f a n i n d ivid u a l
(c) expa n d ed the scope o f sale a n d p u rchase
(d) both (a) a n d (c)
17. Which of the fol l owing systems is followed by Reserve Ba n k of I n d ia for issuing cu rrency?
(a) Proportionate system ( b ) S i m p l e d e posit syste m
(c) M i n i m u m reserve system ( d ) Fixed fid uciary issue system
18. H igh powered money is equ a l to :
(a) money s u p p l ied by the RBI only
(b) tota l s u p ply of money i n the economy
(c) notes a n d coi n s held by the people
(d) money ( n otes a n d coi ns) held by the people, va u lt cash of the com m e rcial ba n ks as wel l as cash
reserves of the com mercia l b a n ks with the RBI
Answers
1. (a) 2. (b ) 3 . (d) 4. (d ) 5 . (a) 6. (c) 7. ( b) 8. (b ) 9. ( b) 10. (c)
11. (d) 12. (d) 13. (c) 14. ( b) 15. (c) 16. (d ) 17. (c) 18. (d)
B . Fill i n the B la n ks
Choose appropriate word and fi ll in the blank:

1. A t h i ng which is com m o n ly accepted as a med i u m of excha nge is ca l led
(co m m od ity/m oney)
2 . A system where goods a re excha nged for goods is known as
( b a rter system of exchange/moneta ry system of excha nge)

3. Evo l u tion of money has fac i l itated _______ (cu rre nt payments/contractual payments)
4. M a i n cha racteristic of money is _______ ( l i q u id ity/sol i d ness)
5. _______ va l u e of a paper n ote is what is written o n it. ( M oney/Commod ity)
6. _______ money is accepted as a med i u m of excha nge beca use of the trust between the
payer a n d the payee. ( Fiat/Fiduciary)
7. U nder the barte r system of exchange, acts of sa le a n d pu rchase of an i n d ivid u a l occu r at the
_______ point (s) of ti me. (sa me/d ifferent)
8. _______ refers to tota l stock of money held by the people of a cou ntry at a poi nt of
ti me. (Su pply of money/De m a n d for money)
Answers
1. money 2 . ba rter system of excha nge 3 . contractual payments 4. liquidity
5 . M oney 6. Fiduciary 7. sa me 8. Supply of money
C. Tru e or Fa lse
State whether the fol lowing statements are True or False:
1. C-C economy is a n economy d o m i n ated by ba rter syste m of excha nge. (True/Fa lse)
2. In ba rter system, defe rred payments a re made i n the form of goods. (True/Fa lse)
3. I n case of cred it money, money va l u e is less than com m od ity va l u e . (True/Fa lse)
4. Expa nsion of excha nge has led to expa nsion of the ma rkets for goods a n d services. (True/Fa lse)
5. Fiat money i nclu des a l l notes and cheq ues which the people in a cou ntry a re lega l ly
bou nd to accept as a med i u m of excha nge. (True/Fa lse)
6. S u pply of money incl udes stock of money held by the government. (True/Fa lse)
7. Com m e rcial ba n ks add to the s u p p ly of money t h rough demand deposits. (True/Fa lse)
8. O n ly net demand deposits a re ta ken as a pa rt of money s u p ply. (True/Fa lse)
Answers
1. True 2. True 3 . Fa lse 4. True 5 . Fa lse 6. Fa lse 7. True 8. True
D. Matc h i n g the Correct State ments
I . From the set of statements given in Column I and Column II, choose the correct pair of statements:
Column I Column I I
(a) F u l l bodied money (i) Money va l u e > Co m m od ity va l u e of money
(b) Term deposits ( i i ) Chequeable de posits
(c) Barter system of excha nge ( i i i ) Goods a re excha nged fo r money
(d) G ross demand de posits (iv) Does not include i nte r-banking claims
(e) High powe red money (v) Base money i n the economy
Answer
(e) H igh powered money - (v) Base money in the economy
Money 143
II. Identify the correct sequence of alternatives given in Column II by matching them with respective
items in Column I:
Column I Column I I
(a) Govern ment o f a cou ntry ( i ) Lega l tenders
( b) Supply of money ( i i ) Cheques
(c) RBI ( i i i ) Supplier of mo ney
(d) F i d u ciary money (iv) Principal supplier of money
(e) Notes a n d coins (v) A stock concept
Answers
(a) - (i i i) , ( b) - (v), (c) -( iv) , (d ) - (i i) , (e) - (i )
E . 'Very Short Answe r' Objective Type Questions

1. What is barter system of excha nge?
Ans. Barter system of excha nge is a system in which goods a re exchanged for goods. Money as a med i u m
o f excha nge does not exist.
2. Define C-C economy.
Ans. C-C economy refers to that economy i n which com m od ities a re excha nged for com mod ities or i n
which goods a re excha nged for goods.
3 . What d o you mean by double coi ncidence of wa nts?
Ans. Dou ble coi ncidence of wants mea ns that goods in possession of two different i n d ivid u a l s a re needed
by each other at the same ti m e .
4. What is meant b y money?
Ans. Money ca n be defi ned as somet h i n g that is ge nera l ly accepted as a med i u m of excha nge a n d acts as
a measu re and a store of va l u e .
5 . What is fiat money?
Ans. Fiat money refers to money backed with order (a uthority) of the government.
6. What is fiduciary money?
Ans. Fiduciary money is the money backed with m utual trust between the payer a n d the payee.
7. Define fu l l bodied money.
Ans. F u l l bodied money refers to money i n terms of coi n s whose com m od ity va l u e is e q u a l to the money
va l u e as a n d when these a re issued .
8. What is cred it money?
Ans. Credit money is the money of which money va l u e (face va lue) is more than com mod ity va l u e ( i ntri nsic
va l u e ) .
9. What is ba n k money?
Ans. Ba n k money is the money created by the com m e rcial ba n ks in the form of demand deposits, ove r
a n d above cash de posits of the peop l e with the ba n ks.
10. Define h igh powered money.
Ans. H igh powered money refers to moneta ry base or base money i n the cou ntry. It incl udes:
(i) cu rre ncy held by the people, (ii) va u lt cash of the com mercial ban ks, a n d ( i i i ) cash reserves of the
com m e rcial ba n ks with the R B I .
11. Define money supply.
Ans. Money supply refers to the tota l qua ntity or stock of money ava i l a ble i n the economy at a point of ti me.

12. Write the com ponents of money s u p p ly.
Ans. (i) Cu rre ncy with the people,
( i i ) Demand de posits with commercia l ba n ks, a n d
( i i i ) Other deposits.
13. Who a re the s u p p l iers of money in India?
Ans. (i) The government of the cou ntry,
( i i ) The centra l b a n k of the cou ntry, a n d
( i i i ) T h e com m e rcial ba n ks.
1 4 . Defi n e d e m a n d deposits.
Ans. Demand deposits of com m e rcial b a n ks a re those deposits which ca n be withd rawn from the ba n k on
demand or by writing a cheque a ny ti me.
15. Defi n e term d eposits.
Ans. Term d eposits a re those deposits which ca n n ot be wit h d rawn from the ba n k as a n d when needed or
by writi ng a cheq ue a ny ti me. These de posits i nvolve a lock- i n period .
2. Rea so n - based Questions (Co m p re h e n s i o n of the S u bject - m atter)
Read the fo l l owi n g state m e nts ca refu l l y. Write Tru e or Fa lse with a rea so n .
1 . Dou b l e coi n cidence o f wa nts i s a n essenti al req u i rement o f excha nge.
Ans. Fa lse. Though it is an essenti a l req u i rement for the ba rter economy, in a money economy, excha nge
ca n ta ke place without d o u b l e coi ncidence of wa nts.
2 . Face va l u e of money is a l ways greater than its i ntrinsic va l u e .
A n s . Fa lse. In case coi n s a re made of gol d a n d si lver, i ntrinsic va l u e of money may over ti me exceed its face
va l u e .
3 . Stock o f money with t h e money iss u i ng a uthorities is a n i m po rtant compon ent o f money s u p ply.
Ans. Fa lse. Sup ply of money d oes n ot i n c l u d e the stock of it with the money iss u i ng authorities.
4. Fiat money is the same as fiduciary money.
Ans. Fa lse. Fiat money is the money backed with o rder of the government whereas fiduciary m oney is the
money backed with the m utual trust between the payer a n d the payee.
5 . Money supply includes demand deposits of the people with the com mercia l ba n ks.
Ans. True. Dema n d deposits of the peop l e with the commercia l ba n ks is a component of money s u p ply.
Beca use, these deposits a re converted i n cash j u st by writing a cheq ue.
6. Dou b l e coi n cidence o f wa nts is a typica l featu re o f moneta ry system o f excha nge.
Ans. Fa lse. Dou b l e coincidence of wants is a typica l featu re of barte r system of excha nge.
7 . Money has sepa rated the acts of sale and p u rchase.
Ans. True. With the i ntrod uction of money, a n i n d ivid u a l ca n buy or sel l a t h i ng without sel l i ng or buying
a nyt h i ng in retu r n .
8. There is no med i u m o f excha nge in the b a rter system .
A n s . Fa lse. U nder ba rter system, goods themselves a re the med i u m of excha nge for goods. Of cou rse,
there is no common med i u m of excha nge l i ke money.
9. There is no common u nit of va l u e i n barter system .
Ans. True. There i s a lack of com m o n u n it o f excha nge i n barter syste m . Evol ution o f money offered a
com m o n u n it of va l u e .
Money 145
10. Money may be used as a commod ity.
Ans. True. It ha ppens when i ntrinsic va l u e (co m m od ity va lue) of money exceeds its face va l u e (money
va l u e ) .
1 1 . Credit money i s the money received as a credit from the ba n ks.
Ans. Fa lse. Credit money is money whose money va l u e is more than its com mod ity va l u e .
1 2 . Moneta ry system o f excha nge facil itates m u c h greater excha nge than the b a rter system .
A n s . True. Beca use moneta ry system ( u n l i ke ba rter syste m ) d oes n ot req u i re d o u b l e coincidence o f wa nts.
13. M 1 measure of money supply i nc l udes only notes and coin s held by the people.
Ans. Fa lse.
M 1 = N otes a n d coi n s held by the people + Demand Deposits + Other Deposits.
14. M o n ey su pply in the economy refers to only the fiat money issued by the R B I .
A n s . Fa lse. Money s u p p ly i n the economy i nc l u des both fi a t money ( backed b y authority o f the R B I ) a s
wel l as fi d u c i a ry money ( backed b y mutual trust betwee n the payer a n d the payee).
15. Com mercia l banks play no rol e i n the stock of money supply i n the economy.
Ans. Fa lse. Com m e rcial ba n ks contribute to the stock of money s u p p ly i n the economy by way of cred it
creation.
1 6 . Cash reserves with the ba n ks a re a n i m po rta nt com ponent o f money supp ly.
Ans. Fa lse. Cash reserves with the b a n ks a re not a com ponent of money s u p p ly. Beca use cash reserves of
the s u p p l i e rs of money is not treated as a part of money s u p p ly.
3. HOTS & Applications

1. What is meant by an ideal su pply of money?
Ans. Ideal money su pply is that a m o u nt of money s u p p ly which keeps the tota l p u rchasing powe r in a
state of balance with the s u p p ly of goods a n d services i n the economy, so that the economy does n ot
s l i p i nto i nflationary or deflationary situations.
2 . Commod ity va l u e of money has never been greater than the face va l u e (or money va l u e) . Is it true?
Ans. N o, the given statement is fa lse. I n good old days when coi n s were made of gol d a n d si lver, commod ity
va l u e of money ( referring to the va l u e of meta l conta i ned in the coi ns) wou l d someti mes exceed the
face va l u e of coins which is why coi n s we re someti mes melted a n d sold as a meta l .
3 . I s i t true that high powered money refers t o cash reserves o f t h e com mercial banks with t h e centra l
bank?
Ans. N o, it is i n correct. H igh powe red money refers to ( i ) cu rrency with p u b l ic, ( i i ) va u lt cash of the
com m e rcial ban ks, a n d (iii) cash reserves of the com m e rcial ba n ks with the R B I .
4. Money becomes a com mod ity when i ntrinsic va l u e o f money exceeds its face va lue. Defend o r
refute.
Ans. Yes, the above statem e nt is correct. Beca u se when i ntrinsic va l u e exceeds face va l u e of money (as
it often h a p pened i n case of gol d and si lver coi ns), money is used as a com m od ity ( i m plying meta l
content of money is sold as a com m od ity) .
5 . A curb on high powered money wi l l lead to a curb on the creation of cred it by the com me rcial banks
i n the economy. Do you agree?
Ans. Yes, the given state ment is correct. This is beca use h igh powe red money i nc l u des cu rrency with the
p u b l i c as wel l as cash reserves of the commercia l ba n ks with the R B I . It serves as a moneta ry base for
the creation of credit i n the economy. A c u rb o n high powered m oney wi l l defi n itely lead to a curb
on the creation of credit by the commerci a l b a n ks.

4. Ana lysis & Eva l uation
1. Expl a i n how i ntroduction of money has led to the expa nsion of ma rkets.
Ans. Following observations may be noted in this rega rd :
( i ) I ntrod u ction of money has led to the expansion of markets t h rough the expa nsion of excha nge .
Beca use, ba rter syste m of excha nge req u i res 'do u b l e coi ncide nce of wa nts' w h i l e the moneta ry
syste m d oes not.
( i i ) Money has led to the emergence of fi n a ncial market and fi n a n c i a l i ntermed ia ries ( b a n ks
a n d other fi n a ncial i n stitutions). Ava i l a b i l ity of fu nds, both for pu rpose of con s u m ption a n d
i nvestme nt, has su bsta nti a l ly i ncreased . Conseq ue ntly, markets have expa nded .
( i i i ) I ntrod u ction of money has boosted the mobil ity of ca pita l across d iffere nt pa rts of the worl d .
T h i s has l e d t o the expa nsion o f g l o b a l ma rkets t h rough F D I (foreign d i rect i nvestment).
2 . Do you agree with the view that the excess of money su pply hinders the process of economic
growt h ? G ive reasons.
Ans. Yes, it is correct to say that the excess of m oney su pply h i nd e rs the process of economic growt h . The
fol lowi ng reasons exp l a i n this point of view:
(i) Excess of money s u p ply is a situation when p u rchasing power (also ca l led l i q u i d ity) with
the people is more than the existi ng ma rket va l u e of the goods and services ava i l a b l e i n the
economy. Conseq uently, pressu re of demand mou nts up on the ava i l a ble s u p p ly of goods a n d
services. Th is l e a d s t o a rise i n the genera l price leve l .
( i i ) If excess supply o f money conti n ues t o persist, t h e situation o f rising price leve l a lso conti n ues
to persist. This is ca l led a situation of i nflation-a situation of 'price s p i ra l'.
( i i i ) Persistent i nflati on leads to a rise in the rate of i nte rest. I m plying that the cost of i nvestment
tends to rise.
( iv) H igh cost of i nvestment leads to a cut i n the vol u m e of i nvestment.
(v) When i nvestment decli nes, the GDP growth a lso decli nes.
Th us, excess s u p p ly of money tends to h i nd e r the p rocess of economic growt h . It l owe rs the growth
rate of rea l G D P.
5. C B S E Questions-Past 5 yea rs
(With Answers o r Reference to the Text for Answers)
1. State the mea n ing a n d com po ne nts of mo ney s u p p l y. [CBSE Delhi 201 7]
[ Page 137, 138]
2 . Demand de posits i n c l u d e (choose the correct a lternative ) :
(a) saving accou nt de posits a n d fixed deposits
(b) saving accou nt de posits and cu rrent acco u nt deposits
(c) cu rrent acco u nt deposits and fixed deposits
(d) a l l types of deposits [CBSE {Al} 201 7]
[(b)]
3 . Exp l a i n "d ifficu lty i n storing wea lth" p roblem faced i n the barte r system of excha nge.
[ Page 135, 136] [CBSE (Al} 201 7]
4. Defi ne money. List its com ponents. [CBSE {F) 201 7]
[ Page 134
Com pone nts of money a re : ( i ) notes, ( i i ) coi n s, ( i i i ) b a n k's cheq ues a n d d rafts, ( iv) e-money.]
Money 147
5 . State the two components of M 1 meas u re of money s u p p ly. [CBSE 2018]
Or
State a ny two com ponents o f M 1 measu re o f money s u p ply. [CBSE 2019 {58/1/1)]
[ Page 138]
6. Defi ne "de m a n d deposits". [CBSE 2019 {58/4/1)]
[ Page 139]
6. N C E RT Questions (With H i nts to A n swers)
1. What is a barter syste m ? What a re its d rawbacks?

[ H i nt : Ba rter system is a system where goods a re excha nged for goods.
Drawbacks:
(i) It req u i res d o u b l e coi ncidence of wa nts.
( i i ) It lacks com mo n u n it of excha nge .
( i i i ) It lacks conve n i e nt means of storage of va l u e . ]
2 . H ow does money overcome the shortco m i ngs o f a ba rter system ?
[ H i nt: U se of money ove rcomes the d rawbacks of ba rter system of excha nge i n the fol lowi ng m a n ner:
( i ) Use of money as a med i u m of excha nge has overcome the d ifficu lty of dou ble coincidence of
wants. Accord i ngly, excha nge has tended to expa n d .
( i i ) Money facil itates storage o f va l u e just i n terms o f p a p e r clai ms, avo i d i ng the storage o f goods
u nd e r barter syste m .
( i i i ) Money acts as a sta n d a rd u n i t o f va l u e which is a bsent.
( iv) Money acts as an instru ment of defe rred payments. N o such i n stru ment is ava i la b l e in the barte r
system of excha nge.]
3 . What a re the a lternative defi n itions of money s u p ply in I n d i a ?
[ H i n t: M 2 , M 3 , a n d M 4 (see Abil ity Zone for deta i ls).]
4. What is 'fiat money' ?
[ H i nt : F iat money refers to money backed with ord e r (authority) of the government.]
5 . What is high powe red money?
[ H i nt: H igh powered money means cash (coins a n d n otes) with the people a n d cash rese rves of the
com m e rcial ba n ks.]
7. M isce l l a neous Q uestions a n d Reference to the Text for Answers
A. Questions of 3 & 4 m a r ks each

1. Exp l a i n the evo l u tion of money. [Page 1 33, 134]
2. Defi ne barter system of excha nge. State a ny two shortco m i ngs of barter system of excha nge.
[Page 134-136]
3. Exp l a i n a ny one problem faced in the barter syste m . H ow has money solved this problem?
[Page 1 35, 136]
4. G ive mea n i ng of money. State its d i fferent forms. [Page 1 34, 136, 1 3 7]
5 . Exp l a i n the i m porta nt forms of money. [Page 136, 137]
6. What is mea nt by money s u p p ly? State M 1 measu re of money s u p p ly. [Page 1 3 7, 138]

B . Questions of 6 ma rks each
1. State the l i m itations (d rawbacks) of ba rter syste m of excha nge. H ow a re these l i m itations removed
with the i ntrod uction of money? [Page 1 35, 136]
2 . "Money is what money d oes." Exp l a i n . [Page 1 33, 134]
3. Defi ne money s u p p ly. State a n d exp l a i n the d iffe rent com ponents of money s u p ply. [Page 1 3 7, 138]
4. H ow does RBI classify the s u p p ly of money? [Page 1 3 7, 138]
DOs and DON'Ts

1. You must u ndersta nd that barter system of exchange is a characteristic of backward economies or
prim itive economies. Moneta ry system of exchange is a cha racteristic of modern economies. G rowth
of an economy (from an underdeveloped economy to a developed economy) is deeply related to the
growth of monetary system of exchange.
2. Storage of money should not be m i sunderstood as 'idle cash' with the people. People hold money
(i) to meet thei r routine transactions, (ii) to cope with thei r emergent needs i n the near futu re, and ( i i i)
for pu rpose of i nvestment (buyi ng shares a n d bonds).
3. I n I ndia, RBI issues all paper notes, but not the one rupee note. Also, it does not issue coins. Al l coins and
one rupee notes are issued by M i n i stry of Finance, Government of India, under the Indian Coi nage Act.
However, circulation of the entire cu rrency (including notes and coins) is conducted only by the R B I .
....__. • M 2 , M 3 , M 4 Measures of Money Supply

M 2 Measurement
M 2 is a boarder concept of money sup ply compared to M 1 . Bes i des a l l the
components of M 1 , it also i ncludes savi ngs of the people with the post offices.
Thus,
M 2 = M 1 + Deposits with Post Office Saving Bank Account
M 3 Measurement
M 3 is also a broader concept of money supply compared to M 1 . Bes ides a l l the
components of M 1 , it also i ncl udes (net) time depos its (or fixed deposits/term
deposits) of the people with the commerc i a l ba n ks. Th us,
M 3 = M 1 + Net Time Deposits with the Commercial Banks
M 4 Measurement
M 4 con cept of money supply is sti l l b roader-it is broader than even M 3 .
Bes i des a l l the components of M 3 , it a l so i ncludes tota l depos its with the post
offi ces (other than in the form of N ational Saving Certificate) .
Th us,
M 4 = M 3 + Total Deposits with Post Offices
I
(other than i n the form of National Sav i n g Certificate)
Aggregate Monetary Resources of the Country
If money supply in the country is measured using M 3 measure, it is called 'aggregate
monetary resources' of the country.
Money 149
• 'Narrow Money' and 'Broad Money' Concepts of Money Supply
The d i stinction between na rrow money and broad money is someti mes d rawn
with reference to the measure u sed for esti mati ng tota l money supply in the
cou ntry. If M 1 or M 2 measures a re used, then it is known as 'na rrow money'
con cept of money supply. If M 3 or M 4 measures are used, then it is known as
'broad money' concept of money supp ly.
• Ind ian Monetary System
A moneta ry system refers to the form of money which circulates i n the economy
by way of order/authority of the govern ment. I n d i a is using pa per cu rrency.
Accord i ng ly, I ndian monetary system is descri bed as a Paper Currency Sta ndard .
Pa per cu rrency does not excl ude the use of meta l coi n s . Both meta l coins and
paper notes are cred it mo ney i n I n d i a . The o n ly difference is that w h i l e coi ns
a re of s m a l l denom i nation, pa per notes are of l a rge denominati on.
Note Carefully
-Coins in I nd i a a re l i m ited leg a l ten der.
- Paper notes i n I nd i a a re u n l i m ited legal tender.
It means that coi ns can be used to settle payments only of l i m ited va l ue; pa per
notes can be used to settle payments of u n l i m ited va l ue.
• What Governs N ote Issuing i n I n d i a?
Note issuing i n I n d ia is governed by M i n i m u m Reserve System . The entire
cu rrency issued has the backi ng of m i n i m u m gold reserves. Two poi nts m ust
be carefu lly u n derstood in this context:
(i) Gold reserves a re j u st the m i n i m u m reserves (� 1 1 5 crore) . These are not
proportionate to the cu rrency i n c i rc u l ation.
(i i) Money with the people is entirely 'credit money'. It can not be converted
i nto b u l l ion-si lver or gold by the i ssu i n g authority. G o l d reserves a re j u st a
backi ng, not the stock to convert pa per notes i nto gold .
• The Concept of Liquidity
Li q u i d ity of an asset refers to its converti b i l ity i nto money/cas h . Faster an
asset can be converted i nto cash, more liquid it is. Obviously, money itself is
the most liquid asset.
Cheq ueable depos its/d emand depos its are highly l i q u i d assets . Accord i n g ly,
we can state that M 1 inclu des only those components of money supply which
a re most l i q u i d .
Term depos its or ti me depos its/fixed depos its a re not chequea b l e deposits.
These can not be withdrawn by issuing a cheque. These depos its are, therefore,
l ess l i q u i d than the dema nd depos its .
Accord i n g ly, M 3 and M 4 measures of money supply include such components
of money supply which are less l i q u i d .
Ill

•
•
•
Money Creation by the Commercial Banks
The Central Bank: Meaning and Functions
Control of Money Supply by the Central Bank (RBI in India)
,,
I. MONEY CREATION BYTHE COMMERCIAL BANKS
In the previous chapter, we noted that the commercial banks are an
important source of money supply in the economy. Unlike the central
bank, the commercial banks do not have the authority of issuing
currency: they cannot issue notes or coins. Yet, they are the suppliers
of money as they create money by way of demand deposits. In the
present chapter, we discuss the process of money creation by the
commercial banks: how exactly the commercial banks create money?
Process of Money Creation by the Commercial Banks
Following observations explain the process of money creation by the
commercial banks:
(i) Banks receive cash deposits from the people. These are called
'primary deposits'.
(ii) Banks lend money many times more than their cash reserves.
(iii) Money is lent by the commercial banks not in the form of cash,
but in the form of 'credit entry' in the accounts of the borrowers.
These credit entries are known as secondary deposits.
(iv) The borrowers can issue cheques against 'credit' (loans) in their
accounts. The cheques circulate in the economy as money.
(v) Primary deposits + Secondary deposits
= Demand deposits held by the people in the commercial banks
151
(vi) Total demand deposits with the banks are many times more than
the cash reserves of the commercial banks. This is because the
commercial banks know (by way of their historical experience)
that all the depositors would not show up in the banks to
withdraw all their deposits by way of cash.
(vii) If experience shows that withdrawals are generally around 10 per
cent of demand deposits, the banks need to keep only 10 per
cent of deposits as cash reserves.
(viii) All demand deposits (held by the people) serve as money supply
in the economy, just like cash held by the people.
(ix) Demand deposits serving as money supply is called bank money.
This is money created by the banks. Because this is circulating in
the system not in the form of cash, but in the form of cheques
issued by the banks to the holders of demand deposits.
Illustration
Let us illustrate the process of credit creation with the help of an example.
For the sake of simplicity, we assume that:
(i) There is a 'single banking system' in the economy and initially,
the bank receives deposits of� 1,000.
(ii) CRR = 10% and it does not change. This reflects cash reserves of
the commercial banks as a percentage of their demand deposits.
Table 1 shows how the system would work for the creation of money:
Table 1. Creation of Money in a Single Banking System
Rounds Deposits Loans Cash Reserves (�)
(�) (� ) (CRR = 10%)
1st Round 1,000 900 100
2nd Round 900 810 90
3rd Round 810 729 81
(and so on till all excess reserves are exhausted)
Total 10,000 9,000 1,000
• In the first round, bank receives deposits of� 1,000.

• The cash reserves to tackle the liability of� 1,000 is equal to� 100
(because cash reserve ratio is = 10% of total deposits). Implying
that the banks have excess reserves = � 1,000 - � 100 = � 900
which they can use for the purpose of lending.
• When these excess reserves are loaned out, deposits of the banks
are raised by� 900. The banks need to hold cash reserves as 10%
of� 900 or� 90. Now, excess reserves of the bank is� 900 -� 90 =
� 810 which can be loaned. This process continues till total demand
deposits are� 10,000 and cash reserves are� 1,000.

Thus, if cash reserve ratio is equal to 10%, initial deposits of� 1,000
allows the bank to create demand deposits up to� 10,000. So that,
Demand Deposits = Cash Reserves
C�R x
1
= X t 1, 000
1O%
= 10 X � 1,000 = � 10,000
Summing up, we can say that money creation by the commercial
banks depends on two principal factors, as under:
(i) Cash Balances with Commercial Banks which they can use as
cushion money (emergency fund) for the creation of credit.
Higher these cash balances, greater the money creation (or credit
creation) capacity of the commercial banks, and
(ii) CRR: Higher the CRR, lower the capacity to create money.
Besides the CRR (cash which the commercial banks ought to keep),
the banks may hold excess reserves, as 'vault cash'. Higher the vault
cash, lower would be the capacity to create money.
Primary and Secondary Deposits
Primary deposits are cash deposits with the commercial banks by the people. These
F@CUS
ZON
are a part of total demand deposits of the banks. E
Secondary deposits are those deposits which arise on account of loans by the banks
to the people. T hese are also a part of total demand deposits of the banks.
Important to note it is, that while primary deposits indicate savings of the depositors
with the banks, secondary deposits indicate borrowings of the depositors from the banks.
Secondary deposits are also called Derivative Deposits.
Total Demand Deposits of the Commercial Banks
= Primary Deposits of the Commercial Banks + Secondary Deposits of the
Commercial Banks.
CRR and Credit Multiplier

In India, CRR is determined not by the commercial banks themselves
but by the RBI (Reserve Bank of India). Therefore, it is also called LRR
(Legal Reserve Ratio).
Also, the commercial banks are required to keep the stipulated
(legally required) cash reserves not with themselves, but with the RBI
(of course, the banks can keep excess reserves as 'vault cash' with
themselves).
Once CRR is known (as fixed by the RBI), we can find out 'credit
multiplier', or the number of times the commercial banks can create
credit, per unit of their cash reserves with the RBI.
Banking 153
Credit multiplier is found in terms of the following equation:
1
k=
CRR
Here, k = Credit multiplier.
CRR = Cash reserve ratio.
Example: If CRR = 10%, then
w
1 = 100 =
k= 10
10%
It implies that if CRR = 10% then the commercial banks can credit
money 1O times of their cash reserves with the central bank. Thus:
if cash reserves are =�10,000, the commercial banks can create credit,
as per the following equation:
Credit Creation or Money Creation = � 10, 000
x 1�%
= �10, 000
100
X --:io =�1, 00, 000
Note that this is the maximum amount of money (credit) that the
commercial banks can create given their cash reserves. This is because
CRR is legally determined by the RBI, and the commercial banks must
comply with it.
F@CUS
Z N
Credit Multiplier
O E k
I
= CRR
Here, k = Credit multiplier, CRR = Cash reserve ratio.
In India, CRR is fixed by the RBI.Accordingly, credit multiplier indicates the maximum amount
of money that the commercial banks can create; given their cash reserves with the RBI.
2. THE CENTRAL BANK

The central bank is an apex bank that controls the entire banking
system of a country. It is the sole agency of note issuing and controls
the supply of money in the economy. It serves as a banker to the
government and manages forex (foreign exchange) reserves of the
country. Reserve Bank of India (RBI) is the central bank of India.
Functions of the Central Bank

Principal functions of the central bank are as under:
(1) Bank of Issuing Notes: Central bank of a country has the exclusive
right (monopoly right) of issuing notes. This is called Currency
Authority function of the central bank. The notes issued by the
central bank are an unlimited legal tender.

(2) Banker to the Government: Central bank is a banker, agent, and
financial advisor to the government.
• As a banker to the government, it manages accounts of the
government.
• As an agent to the government, it buys and sells securities on
behalf of the government.
• As an advisor to the government, it frames policies to regulate
the money market.
(3) Bankers' Bank and Supervisory Role: As a Bankers' Bank, it has
almost the same relation with other banks in the country as
a commercial bank has with its customers. Three observations
need to be noted in this context:
(i) The central bank accepts deposits from the commercial
banks, and offers them loan.
(ii) The central bank provides 'Clearing House' facility to the
commercial banks. It is a cheque clearing facility provided at
one centre to all the banks.
(iii) In its supervisory role, the central bank ensures that the
commercial banks show compliance to its directives,
particularly relating to CRR and SLR. The central bank
changes CRR, SLR as and when required. It ensures that
the commercial banks show compliance to these changes so
that the desired targets are achieved.
(4) Lender of the Last Resort: It means that if a commercial bank fails
to get financial accommodation from anywhere, it approaches
the central bank as a last resort. Central bank advances loan to
such a bank against approved securities. By offering loans to
the commercial banks in situations of emergency, the central
bank ensures: (i) that the banking system of the country does
not suffer any set-back, and (ii) that money market remains
stable.
(5) Custodian of Foreign Exchange: Central bank is the custodian
of nation's foreign exchange reserves. It also exercises 'managed
floating' to ensure stability of exchange rate in the international
money market. Managed floating refers to the sale and purchase
of foreign exchange with a view to achieving stability of exchange
rate for the domestic currency.
(6) Clearing House Function: Central bank performs the function
of a clearing house. Let us take an example to understand this
function. Supposing, Bank A receives a cheque of� 10,000 drawn
Banking 155
on Bank B, and Bank B receives a cheque of� 15,000 drawn on
Bank A. Both, Banks A and B have their accounts with the central
bank. The cheques of both the banks are cleared through their
accounts with the central bank. This is how the central bank acts
as a clearing house. It avoids transfer of cash between the banks
and reduces requirement of cash.
(7) Control of Credit: The principal function of the central bank is to
control the supply of credit in the economy. It implies increase or
decrease in the supply of money in the economy by regulating
the 'creation of credit' by the commercial banks. The central bank
needs to control the supply of money to cope with the situations
of inflation and deflation. During inflation, the supply of money
is reduced and during deflation, it is increased. Section 3 of the
chapter gives a detailed description of how the central bank
controls supply of money in the economy.
Performing all these functions, the central bank focuses on growth
with stability. (Growth refers to a sustained rise in GDP. Stability refers
to the elimination of inflationary and deflationary situations in the
economy.)
The Central Bank and A Commercial Bank-The Difference
f@C
� OUS
Z N
The Central Bank
- _ _ _ _ - _ _ _ _ _ - _ _ _ _ _+-_(_ _A _ c_om
1--- _)_ _ _ - _ _ al
(z Th e centr bank is the apex bank
A Commercial Bank
_ _ _ _ _ - _ _ _ _ _ _ - _ _ _ _ _ - - - --1
mercial bank is that fi nancial
E the bank of all banks in the country.
i)
institution which accepts deposits
All commercial banks function under from the general public and offers
the control of the central bank. loans to the people for purpose of
It accepts deposits from the consumption and investment.
commercial banks and advances
loans to them. But, it does not deal
with the general public.
(ii) Th e central bank regulates the (ii) A commercial bank only contributes
supply of money, besides being the to the supply of money by way of
principal source of money supply in credit creation.
the economy.
(iii) Th e central bank is a custodian (iii) A commercial bank is not a custodian
of forex reserves of the country. of forex reserves of the country.
It conducts 'managed floating' However, it deals in the sale and
to regulate exchange rate of the purchase of foreign exchange for
domestic currency. purpose of profit.
(iv) Th e central bank is a note issuing (iv) A commercial bank is not a note
authority. It is a currency authority issuing authority. It is not a currency
of the country. authority.
(v) Th e central bank focuses on growth (v) A commercial bank focuses on profit
and stability of the economy. maximisation.

t>TS
Q. What is the significance of centralised cash reserves with central bank?
Ans. Two observations need to be noted in this context:
(i) Centralised cash reserves enable the RBI to offer financial help to the commercial banks during
emergencies. It is called 'financial accommodation' by the RBI. Banks get financial accommodation
(or financial help) in times of emergency.
(ii) Centralised cash reserves enable the RBI to exercise control over the commercial banks. Because
these reserves depend on CRR (fixed by RBI in India) and by varying the CRR, the RBI can increase
or decrease the credit creation capacity of the commercial banks. Accordingly, money supply in
the economy is regulated.
3. CONTROL OF MONEY SUPPLY (OR CREDIT

SUPPLY) BY THE CENTRAL BANK (RBI IN INDIA)
The central bank adopts various measures to control the supply of
money in the economy. Largely, these measures relate to credit supply
by the commercial banks. These are broadly classified as:
(A) Quantitative Instruments, and
(B) Qualitative Instruments.
Following is a brief description of these instruments. It may be noted
that these instruments are used to decrease the supply of money
when there is inflationary spiral in the economy and to increase the
supply of money when there is deflationary spiral in the economy.
(A) Quantitative Instruments of Credit Control

Quantitative instruments are those instruments of credit control
which focus on the overall supply of money in the economy. Supply of
money is lowered to tackle inflation, and it is raised to tackle deflation.
Following is a brief description of these instruments:
(1) Bank Rate: Bank rate refers to the rate of interest at which the
RBI lends money to the commercial banks. It relates to instant
(immediate) loan requirement of the commercial banks.
The increase (or decrease) in bank rate is often followed by
increase (or decrease) in the market rate of interest (the interest
rate charged by the commercial banks from the general public).
Accordingly, the cost of credit (also called the cost of capital)
changes in the market. When bank rate is increased, market
rate of interest is also increased. Accordingly, the cost of capital
increases. This lowers the demand for credit and therefore, the
supply of money tends to fall. Accordingly, inflation is corrected.
Banking 157
On the other hand, when bank rate is decreased, market rate
of interest is also decreased. Accordingly, the cost of capital
decreases. This increases demand for credit and therefore, supply
of money tends to rise. Accordingly, deflation is corrected.
I
Rise in Bank Rate----. Rise in market rate of interest----. Rise in cost of capital----. Fall in demand
for credit----. Fall in the supply of money----. Inflation is controlled.
Fall in Bank Rate----. Fall in market rate of interest----. Fall in cost of capital----. Rise in demand
for credit----. Rise in the supply of money----. Deflation is controlled.
(2) Open Market Operations: Open market operations refer to the

sale and purchase of securities in the open market by the RBI on
behalf of the government. By selling the securities (like, National
Saving Certificates-NSCs) in the open market, the RBI soaks
liquidity (cash) from the economy. And, by buying the securities,
the RBI releases liquidity.
When liquidity is soaked (as during inflation), cash reserves of
the commercial banks are squeezed. Implying a cut in their credit
creation capacity. On the other hand, when liquidity is released
(as during recession/deflation), cash reserves of the banks tend to
rise. Implying a rise in credit creation capacity of the commercial
banks.
Thus, inflation is corrected by selling the securities and soaking
liquidity, while deflation is corrected by buying the securities
and releasing liquidity.
Sale of Securities by the RBI ----. Soaks liquidity and leads to a fall in cash reserves of the
commercial banks ----. Fall in credit creation capacity of the commercial banks ----. Fall in money
supply----. Inflation is controlled.
Purchase of Securities by the RBI----. Releases liquidity and leads to a rise in cash reserves of the
commercial banks----. Rise in credit creation capacity of the commercial banks----. Rise in money
supply----. Deflation is controlled.
Two Types of Open Market Operations

There are two types of open market operations (i) outright, and (ii) repo
Outright open market operations are permanent in nature. These are as discussed above. The other
type is known as repo open market operations. In such type of operations, there is a promise of
repurchase and resale of securities (unlike in the first type).
(3) Repo Rate: The rate at which the RBI (central bank) offers short
period loans to the commercial banks by buying the government
securities in the open market is called 'Repo Rate'. In fact, it is
a Repurchase Rate. A repurchase agreement is signed by both

the parties stating that the securities will be repurchased by the
commercial banks on a given date at a predetermined price.
In other words, the RBI issues a loan cheque to the commercial
banks by buying from them the government securities. But, it
carries the agreement of repurchase of securities by the commercial
banks at the predetermined date and at a predetermined price.
During inflation, the cost of capital is increased by increasing the
repo rate. This lowers the demand for credit and accordingly, the
supply of money in the economy, as desired. On the other hand,
during deflation, the cost of capital is reduced by reducing the
repo rate. This increases the demand for credit and accordingly,
the supply of money in the economy, as desired.
I
Rise in Repo Rate --.. Rise in cost of capital --.. Fall in demand for credit --.. Fall in supply of
money by the commercial banks --.. Inflation is controlled.
Fall in Repo Rate --.. Fall in cost of capital --.. Rise in demand for credit --.. Rise in supply of
money by the commercial banks --.. Deflation is controlled.
(4) Reverse Repo Rate: The rate at which the RBI (central bank)
accepts deposits from the commercial banks (through government
securities) is called 'Reverse Repo Rate'. It is also called Reverse
Repurchase Rate. In this case, a reverse repurchase agreement
is signed by both the parties stating that the securities will be
repurchased on a given date at a predetermined price. Reverse
repo rate allows the commercial banks to generate interest
income.
When reverse repo rate is lowered, banks are discouraged to
park their surplus funds with the RBI. Instead, the banks may use
these funds as (RR-funds with the RBI. This leads to a rise in credit
supply (money supply) by the commercial banks. Accordingly,
supply of money is enhanced in the economy, as desired to
control deflation. On the other hand, a rise in reverse repo rate
may induce the commercial banks to park more funds with the
RBI to generate interest income. This lowers their capacity to
offer (RR-funds to the RBI for the creation of credit. Accordingly,
supply of money is reduced in the economy, as desired to control
inflation.
Fall in Reverse Repo Rate --.. Less funds are parked by the commercial banks with the RBI to
generate interest income --.. More funds are used as CRR-funds with the RBI, for the creation of
credit --.. Supply of money increases --.. Deflation is controlled.
Rise in Reverse Repo Rate --.. More funds are parked by the commercial banks with the RBI to
generate interest income --.. Less funds are used as CRR-funds with the RBI, for the creation of
credit --.. Supply of money decreases --.. Inflation is controlled.
Banking 159
(5) Cash Reserve Ratio (CRR) : It refers to the minimum percentage
of a bank's total deposits required to be kept with the RBI. It is
fixed by the RBI and is varied from time to time to regulate the
supply of money in the economy.
When the supply of money is to be increased, CRR is lowered, and
when the supply of money is to be reduced, CRR is raised.
I
Rise in CRR ---. Rise in cash reserves for a given amount of demand deposits ---. Fall in money
supply of the commercial banks ---. Inflation is controlled.
Fall in CRR ---. Fall in cash reserves for a given amount of demand deposits ---. Rise in money
supply of the commercial banks ---. Deflation is controlled.
(6) Statutory Liquidity Ratio (SLR): Every bank is required to

maintain a fixed percentage of its assets in the form of liquid
assets, called SLR. The liquid assets include: (i) cash, (ii) gold,
and (iii) unencumbered approved securities. The rate of SLR
(like that of CRR) is fixed by the RBI and is varied from time to
time. To decrease the supply of money (as during inflation), the
central bank increases SLR. Accordingly, funds available for CRR
deposits (for the creation of credit) are reduced. Conversely, SLR
is reduced to increase the supply of money (as during deflation)
in the economy. Accordingly, funds available for (RR-deposits
(for the creation of credit) are increased.
Rise in SLR ---. Rise in liquid assets to be held by the commercial banks with themselves ---. Fall
in the availability of funds for CRR-deposits with the RBI ---. Fall in money supply of the commercial
banks ---. Inflation is controlled.
Fall in SLR ---. Fall in liquid assets to be held by the commercial banks with themselves ---. Rise in
the availability of funds for CRR-deposits with the RBI ---. Rise in money supply of the commercial
banks ---. Deflation is controlled.
(B) Qualitative Instru ments of Credit Control

Qualitative instruments are those instruments of credit control which
focus on select sectors of the economy. These instruments are used
to increase or decrease the supply of money to select sectors of the
economy. (These are those sectors which are the principal source of
instability in the economy.) Broadly, the qualitative instruments are
placed in three categories, as under:
(1) Margin Requirement : The margin requirement refers to the
difference between the current value of the security offered for
loan (called collateral) and the value of loan granted. Suppose, a
person mortgages his house worth � 1 crore with the bank for a
loan of� 80 lakh. The margin requirement in this case would be
� 20 lakh. The margin requirement is raised when the supply of

money needs to be red uced . The margi n req u i rement is lowered
when the su pply of money is to be i ncreased . Often the margi n
I
req u i rement is kept high fo r specu l ative (trad ing) activities .
Rise in Margin Requirement ---+ Fall in demand for credit ---+ Fall in supply of credit by the
commercial banks ---+ Fall in money supply ---+ Inflation is controlled.
Fall in Margin Requirement ---+ Rise in demand for credit ---+ Rise in supply of credit by the
commercial banks ---+ Rise in money supply ---+ Deflation is controlled.
(2 ) Rationing of Credit: Rationing of credit refers to fixation of credit

quotas for d ifferent business activities. Rationing of credit is
introduced when the supply of credit is to be checked particularly
for speculative activities in the economy. The RBI fixes credit quota
for d ifferent business activities. The commercial banks cannot
exceed the quota limits while granting loans. This restricts the
supply of money in the economy, and inflation is controlled . On the
other hand , rationing of credit (if already in practice) is withdrawn
I
to increase the supply of money. This controls deflation.
Introduction of Credit Rationing ---+ Decreases the supply of credit by the commercial banks
---+ Decreases the supply of money ---+ Inflation is controlled.
Withdrawal of Credit Rationing ---+ Increases the supply of credit by the commercial banks
---+ Increases the supply of money ---+ Deflation is controlled.
(3 ) Moral Suasion : It is l i ke rendering an advice to the commerci al

banks by the RBI to follow its d i rectives . The ban ks are advised
to restrict loans d u ri n g inflation , and be li be ral in lend i ng d u ri ng
deflatio n . 'persuasion' and
'pressu re'. The RBI
Check the followi ng flow chart for a summary statement o f the tries to persuade the
quantitative as wel l as qual itative instru me nts of cred it contro l : com merc i al ba nks to
follow its d i rectives, but
if persuation does not
Instruments of Credit Control work, it uses the req u i red
pressu re as an a pex
b ank of the cou ntry.
If p ressu re also does
Qualitative not work, the RBI can
'o a Instruments
>- >- use d i rect action which
U
= -o
..O
ru
Vl t:; Ba nk Rate i ncl udes derecog nition
QJ a5 ...,
v,
§:i o
c Margin
{
O Vl
0... u of the concerned bank.
o::
.tc § Repo Rate Req u i rement As a n i nstrument of
� � QJ
.._ Q) ..s::.. .._ -0 monetary policy, 'mora l
...C +-' +-' +-'
f--
0::
ru
G.J
� u
v, .._
Reverse Repo Rate Rationing suasion' works both as a
- of Cred it q u a ntitative i nstrument
..., 0�
{
V)
u QJ ro QJ c
>."D - C ...,
Cash Reserve Ratio as wel l as a q u a l itative
=
0 v, O
QJ E u
::J O::
Moral Suasion i nstru ment. However,
Cl... v, _c 2 :� Statutory Liq uid ity Ratio often it is classified as a
o .g ;_ 1,; 13 q u a l itative i n strument.
S: ru ..o c �
I-'- 0:: -� � Open Ma rket Operations
ru o
Banking 161
t>TS
Q. What is selective credit control?
Ans. It refers to discri m inatory policy of the central ba nk relating to select sectors of the economy. Flow of
credit to certain sectors (priority sectors) may be encou raged with a view to stim u lating production i n
these sectors. This is a positive application o f selective credit controls. On t h e other hand, t h e centra l
b a n k may decide t o restrict t h e availability o f cred it t o certai n (non-priority) sectors. Generally,
d u ri ng periods of i nflation, availability of credit for speculative activities ( l i ke storage of food grains)
is d iscou raged. This is a n egative a pplication of the selective credit controls.
Power Poi nts & Revision Window ------------

Money Creation by the Commercial Banks: Com m e rc i a l b a n ks contri bute to moneysupply by creating cred it.
They d o it by adva ncing loans ( i n terms of demand d eposits)
m a ny ti m es more t h a n their cash reserves. They d o it o n the
basis of their h istorica l experience that the d epositholders
n ever turn u p e n mass to withd raw their d e posits. That, the
l i a b i l ity towa rds the depositholders ca n be ma naged by kee ping
o n ly a s m a l l percentage of d eposits as cash rese rves.
Credit M u ltiplier = � . It shows the n u m b e r of ti m es the com m e rc i a l ba n ks ca n create c redit per u n it
C R
of thei r cash rese rves with t h e RBI. In I n d ia, C R R i s fixed by t h e R B I .
The Central Bank i s a n a pex b a n k o f t h e e nti re b a n ki ng system of a cou ntry. R B I i s t h e centra l ba n k o f I n d i a .
� Functions: ( i ) Ba n k o f iss u i ng n otes, ( i i ) Ba n ke r t o t h e gover n m e nt, ( i i i ) Ba n ke rs' ba n k a n d s u p e rvisory role,
(iv) Le n d e r of t h e l a st resort, (v) Custod i a n of foreign exc h a nge, (vi) C l e a ri ng house fu nction, (vi i ) Control
of c red it.
Control of Money Supply by the Central Bank
Monetary Pol icy is t h e p o l i cy to co ntro l t h e supply of credit/ m o n ey in t h e eco n omy. It a i ms at correcting
t h e situations of i nflati o n a n d d efl ation i n t h e eco n o my. I n stru m e nts of m o n eta ry pol icy
j
a re b roa d l y classified a s : ( i ) Qua ntitative i nstru m e nts, a n d ( i i ) Qua l itative i nstru ments.
These a re a lso ca lled 'i nstru m e nts of cre d it contro l'.
Quantitative Instruments of Monetary Policy:
( i ) Th ree p o l i cy rates: ( a ) Ba n k rate, ( b ) Repo rate, a n d (c) Reve rse re po rate.
( i i ) Two pol icy ratios: (a) C R R, a n d (b) S L R .
( i i i ) Open m a rket operations.
Qua litative Instruments of Monetary Policy:
( i ) M a rgi n req u i re m e nt,
( i i ) Rati o n i ng of cred it, a n d
( i i i ) M o ra l s u a s i o n .

rEX E RC I S Ej
1 . Obj ective Type Questions (Remem bering & U ndersta n d i n g based Questions)
A. M u lt i p l e Choice Questions
Choose the correct option:
1. In the context of com mercial ba n k, which one of the following statements is correct?
(a) N ote-iss u i n g authority of the cou ntry
( b ) Creates cred it on the basis of cash rese rves
(c) Accepts deposits of the genera l p u b l i c
( d ) Both ( b ) a n d ( c )
2 . Commerci a l ba n ks create money b y way of:
(a) ti me de posits (b) d e m a n d deposits
(c) trea s u ry b i l l s ( d ) b i l l o f excha nge
3 . Which of the fol l owing is not concerned with ban king orga n isation?
(a) Ba n k rate ( b ) Fisca l deficit
(c) Cred it creation ( d ) Cash rese rve ratio
4. Credit ca rds issued by the ba n ks :
(a) enco u rage cons u m e r s pe n d i n g ( b ) i ncrease aggregate demand i n the economy
(c) both (a) a n d ( b ) ( d ) none of these
5 . The m a i n aim of the commercial ba n ks is:
(a) socia l welfa re ( b ) to earn profits
(c) to p rovide services to the people ( d ) none of these
6. Maxi m u m credit that the com mercia l ba n ks ca n lega lly create depends on their:
(a) gol d reserves ( b ) cash rese rves with the R B I
(c) statutory l i q u i d ity ratio ( d ) term deposits
7. Term deposits a re those :
(a) against which no cheq ue ca n be issued ( b ) aga i n st which n o i nterest is paid to the de positors
(c) which a re a part of M 1 supply of money ( d ) none of these
8. The percentage of demand deposits which the com mercia l banks a re lega l ly req u i red to m a i nta i n
as t h e i r liquid assets is ca lled:
(a) C R R ( b ) re po rate
(c) SLR ( d ) reverse repo rate
9. SLR req u i res the com mercia l ba n ks to build their liquid assets by way of:
(a) reserves of cash (b) reserves of gold
(c) reserves of u nencu mbered secu rities ( d ) a l l of these
10. Centra l ba n k is a n a pex bank of the cou ntry that:
(a) controls the enti re ba nking system of the cou ntry
( b ) issues cu rrency
(c) acts as a ba n ker to the government
( d ) a l l of these
Banking 163
1 1 . I n I n d ia, the centra l ba n k is:
(a) Federa l Rese rve System ( b ) Federa l System
(c) Reserve Ba n k of I n d i a (d) both (a) and ( b )
1 2 . Maxi m u m credit that t h e commercia l ba n ks ca n lega lly create is i n d icated by:
1 1 1
(a) ( b ) __ X
SLR CRR Cash reserves with the R B I
(c) ! x Tota l deposits (d) ! x Cash reserves with the R B I
c R c R
13. Credit control mea ns:
(a) contraction of credit o n ly
(b) extension of credit o n ly
(c) extension a n d contraction of money s u p ply
(d) none of these
14. Which of the following is not the i nstru ment of credit control?
(a) CRR ( b ) SLR
(c) Bank rate ( d ) M a n aged fl oati ng
15. Which of the fol l owing does not come under q u a ntitative methods of moneta ry pol icy?
(a) Open market operations ( b ) Cash rese rve ratio
(c) M o ra l suasion ( d ) Repo rate
16. Open market operations as an i nstru ment of credit control a re performed by:
(a) the centra l b a n k of the cou ntry ( b ) the commercia l b a n k of the cou ntry
(c) both (a) a n d ( b ) ( d ) n o n e o f these
17. With a n increase i n m a rgin req u i rement, ava i l a b i l ity of cred it i n the economy:
(a) increases (b) decreases
(c) u ncha nged (d) none of these
18. If i nflation is to be com bated, the R B I :
(a) ra ises SLR a n d lowers CRR ( b ) l owers SLR a n d ra ises CRR
(c) ra ises both CRR as wel l as SLR ( d ) none of these
19. If recession is to be com bated :
(a) ba n k rate needs to be lowered
(b) CRR needs to be l owered
(c) both (a) and ( b )
(d) repo rate needs t o be l owered a n d CRR needs t o be ra ised
20. Reverse repo rate :
(a) ge nerates i nterest i ncome (b) is increased to curb inflation
(c) is n ot a pol icy rate ( d ) both (a) a n d ( b )
Answers
1. (d) 2. (b) 3. (b) 4. (c) 5. (b) 6. ( b ) 7. (a) 8. (c) 9 . (d) 10. ( d )
1 1 . (c) 12. ( d ) 13. ( c ) 14. (d) 15. (c) 16. (a) 17. ( b ) 18. (c) 19. (c) 20. ( d )
1 64 Introductory Macroeconomics
B. Fill i n the Bla n ks
Choose appropriate word and fil l in the blank:
1. Com m e rcial ba n ks contribute to the s u p ply of money by way of
( loans i n cash/loans i n d e m a n d de posits)
2. deposits a rise o n acco u nt of loans by the b a n ks to the people.
( Pri m a ry/Secon d a ry)
3. In case, a commercial b a n k fa i l s to get fi n a ncial acco m m odation from a nywhere, it a p p roaches the
_______ as a last resort. (cooperative b a n k/centra l bank)
4. _______ relates to i n sta nt ( i m mediate) loa n req u i rement of the commercia l b a n ks .
( B a n k rate/Repo rate)
5. Demand Deposits = Pri m a ry deposits + ( Ba n k de posits/Secon d a ry de posits)
6. By sel l i ng the secu rities i n the open ma rket, the RBI _______ l i q u i d ity (cash) from/i nto
the economy. (soa ks/releases)
7. Rati o n i ng of credit is the method to control money s u p p ly i n the economy.
(q ua ntitative/q ua I itative)
8. As an advisor to the gove rnment, centra l b a n k fra mes pol icies to reg u l ate the
(ca pita l market/money ma rket)
9. Centra l ba n k con d u cts to regulate excha nge rate of the domestic cu rrency.
( m a n aged floati ng/d i rty floati ng)
10. Liq u id assets of the commercial b a n ks which they a re req u i red to m a i nta i n as a m i n i m u m percentage
of their tota l deposits refer to (cash rese rve ratio/statutory l i q u i d ity ratio)
Answers
1. loans in demand deposits 2. Secondary 3. centra l ba n k 4. Ba n k rate
5. Secondary deposits 6. soa ks 7. q u a l itative 8. money ma rket
9. managed floating 10. statutory liquidity ratio
C. True or Fa lse
State whether the fol lowing statements are True or False:
1. I n I n d ia, LRR is determi ned by the com m e rcial ba n ks themse lves . (Tru e/Fa lse)
2. B a n ks lend money m a ny ti mes more than their cash reserves w i t h the R B I . (Tru e/Fa lse)
3. H igher the CRR, h igher is the ca pacity t o create money. (True/Fa lse)
4. The centra l b a n k focuses on growth a n d sta b i l ity of the economy. (Tru e/Fa l s e )
5. Open ma rket operations a re con d u cted by the R B I to reg u l ate the s u pply of money. (Tru e/Fa lse )
6. When the s u p p ly o f money is t o be increased, CRR is ra ised . (True/Fa lse)
7. Credit creation is the principal fu nction of the centra l ba n k. (Tru e/Fa lse)
8. M a rgin req u i rement is a q u a ntitative method of credit contro l . (True/Fa lse)
9 . T h e n otes issued b y the centra l b a n k a re a n u n l i m ited lega l tender. (Tru e/Fa lse)
10. With rati o n i ng of credit, s u p p ly of money is red uced . (True/Fa l s e )
Answers
1 . Fa lse 2 . True 3 . Fa lse 4. True 5 . True 6. Fa lse 7 . False 8. Fa lse 9. True 10. True
Banking 165
D. M a tc h i n g the Correct Statements
I . From the set of statements given in Column I and Column II, choose the correct pair of statements:
Column I Column I I
(a) SLR (i) Fixed by the commercia l ba n ks
(b) Primary deposits ( i i ) Derivative de posits
(c) Commerc i a l bank (iii) Advisor to the gove rnment
(d) Central b a n k ( iv) P rovides 'Clearing House' facil ity
(e) Secondary de posits (v) Not a part of total demand deposits of the b a n ks
Answer
( d ) Centra l ba n k -( iv) Provides 'Clearing House' facility
II. Identify the correct sequence of alternatives given in Column II by matching them with respective
items in Column I:
Column I Column I I
(a) D e m a n d deposits 1
(i)
CRR
(b) Central b a n k ( i i ) Fixed b y the R BI
(c) Money m u lti p l ie r ( i i i ) Re purchase rate
1
(d) Repo rate ( iv) x Cash Rese rves
CRR
(e) CRR (v) An apex ba n k of the cou ntry
Answers
( a ) - (iv), ( b ) -( v ), ( c ) - ( i ), ( d ) - ( iii ), ( e ) - ( ii )
E . 'Very S h o rt Answer' Objective Type Questions

1. Defi ne credit m u ltiplier.
Ans. Credit m u lti plier is the reci p roca l of CRR (cash reserve rati o ) .
Cred it M u lt i p l i e r =
C�R
2. Defi ne pri m a ry deposits.
Ans. Pri m a ry de posits a re cash deposits with the com m e rcial ba n ks by the people. These a re a part of
demand deposits of the b a n ks.
3 . What a re secondary deposits?
Ans. Seco n d a ry deposits a re those deposits which a rise on acco u nt of loans by the b a n ks to the people.
These a re reflected as a part of d e m a n d de posits of the b a n ks. These a re a lso ca l led derivative
deposits.
4. What is a centra l ba n k?
Ans. A centra l b a n k is a n a pex i n stitution of a cou ntry that controls a n d reg u lates the moneta ry a n d
fi nancial system o f the cou ntry.
5. Defi ne CRR.
Ans. CRR (cash reserve ratio) refers to the lega l ly req u i red cash reserves of the com m e rcia l b a n ks with the
centra l bank as a perce ntage of thei r tota l deposits.

6. What is SLR?
Ans. SLR (statutory l i q u i d ity ratio) refe rs to l i q u i d assets of the commercia l b a n ks which they a re req u i red
to m a i nta i n as a m i n i m u m percentage of their tota l deposits .
7. Defi ne ba n k rate .
Ans. The b a n k rate is the rate at which the centra l ba n k of the cou ntry offers loans to the commercia l
b a n ks by d iscou nti ng the secu rities. It is a lso ca lled d isco u nt rate : the rate at which secu rities a re
d iscou nted for pu rpose of loans. It d oes n ot i nvolve a ny col late ral, a n d it d oes not a l l ow rep u rchase
of secu rities.
8. What is re po rate?
Ans. Repo rate is the rate of i nterest at which commerci a l b a n ks ca n ra ise short-te rm loans from the
centra l b a n k .
9 . What is reve rse re po rate?
Ans. Reverse re po rate is the rate of i nterest at which com m e rcial b a n ks ca n park their surplus fu nds with
the centra l ba n k, for short period of ti me.
10. What do you mean by open market operations?
Ans. Open ma rket operations refer to the sale and p u rchase of government secu rities in the open ma rket
by the centra l b a n k of the cou ntry.
1 1 . Defi ne m a rgin req u i rement.
Ans. M a rgin req u i rement refers to the d ifference between market va l u e of the secu rity offe red for loans
a n d the a m o u nt of loans offe red by the com m e rcial ba n ks .
12. Defi ne mora l suasio n .
A n s . Mora l suasion refers to persuasion as wel l as pressu re exercised by the centra l b a n k on the commercia l
b a n ks to be restricted a n d selective i n l e n d i n g d u ri ng i nflation, a n d to be l i be ra l i n l e n d i n g d u ring
deflati o n .
2 . Reason- based Questions (Com prehension o f the S u bject-matter)
Read t h e fol lowi ng statem ents ca refu l l y. Write Tru e or Fa lse with a reason .
1. H igher CRR i m p l ies higher capacity to create cred it.
Ans. Fa lse. H igher CRR i m plies lower ca pacity of the com m e rcial ba n ks to create credit. Beca use, cred it
m u lti p l i e r is the reci p roca l of CRR.
2. By purchasing govern ment secu rities i n the open ma rket, the centra l ba n k i ntends to release more
money s u p p l y i n the market.
Ans. True. Ce ntra l ba n k buys government secu rities with a view to increase the money s u p ply. P u rchase
of secu rities by the centra l bank leaves more money with the people. It a lso increases l i q u i d ity of the
com m e rcial ba n ks to create more credit (in te rms of demand d eposits ) .
3 . M a rgin requ i re ment is ra ised b y t h e centra l ba n k with a view t o i ncreasing money supply.
Ans. Fa lse. To increase money s u p ply, the centra l b a n k l owe rs the m a rgi n req u i rement so that people a re
i n d u ced to ra ise loans a n d the b a n ks a re a b l e to create more cred it by way of loans.
4. During periods of depression, com mercia l ba n ks a re a dvised to follow dear money policy.
Ans. Fa lse. To c u rb depression, s u p p ly of money needs to be i ncrease d . Accord i ngly, commerci a l b a n ks
a re advised to p u rsue cheap money policy.
5 . The centra l ba n k is a lender of last resort.
Ans. True. A centra l ba n k adva n ces loan to a commercia l b a n k when the latter fa i l s to get fi n a ncia l
accommodation from a nywhere aga i n st a p p roved secu rities.
Banking 167
6. The centra l ba n k is a ba n ker to the government.
Ans. True. As a ba n ker to the government, centra l ba n k keeps the accou nts of a l l government b a n ks a n d
ma nages government treasu ries.
7. The com mercia l ba n k has the currency a uthority.
Ans. Fa lse. The centra l ba n k is the sole issu i ng a uthority i n the cou ntry. It has the exclusive right of note
iss u i ng.
8. I n I n d ia, CRR a n d SLR a re fixed by the com mercia l ba n ks themselves.
Ans. Fa lse. I n I n d ia, CRR a n d SLR a re fixed by the R B I .
9. Dem a n d deposits a re e q u a l t o cash deposits with t h e commercial banks.
Ans. Fa lse. Cash de posits a re o n ly primary deposits with the com m e rcial b a n ks. Deposits created by way
of loans a re seco n d a ry deposits.
Demand De posits = Pri m a ry de posits + Seco n d a ry deposits
10. Secondary deposits of a com mercial bank a re always less than its pri m a ry deposits.
Ans. False. Secondary deposits are many ti mes more than the primary deposits of a commercial bank. Because,
primary deposits are cash deposits. A com mercial ban k can park its cash with RBI as 'cash reserves'. It ca n
lega l ly create secondary deposits (by way of loans) many times more than their cash reserves.
11. When CRR is ra ised, credit creation by the com mercial ba n ks is not necessarily red uced .
Ans. True. Beca use commercia l b a n ks may have some excess reserves .
12. CRR and SLR work opposite to each other.
Ans. Fa lse. CRR a n d SLR a re com p l e menta ry to each other. A rise i n these ratios controls the creation of
credit, a n d vice versa.
13. Ma rket rate of i nterest tends to be positively related to the ba n k rate.
Ans. True. I ncrease o r decrease i n b a n k rate is often fol l owed by increase or decrease i n the ma rket rate
of i nterest.
14. Repo rate is the rate of i nterest charged by the ba n k on com mod ity loans.
Ans. Fa lse. Repo rate is that rate at which centra l bank offers short-term loans to com m e rcial ba n ks .
15. H igher repo rate i m p l ies h i g h e r credit creation ca pacity o f t h e ba n ks.
Ans. Fa lse. H igher repo rate i m p l ies l ower cred it creation ca pacity of the ba n ks . Beca use, b a n ks a re n ot
i n d u ced to borrow l i q u i d ity (cash ) from the RBI for e n l a rging their cred it-ma rket.
16. The com mercial ba n ks design a l l i nstru ments of moneta ry policy and the centra l bank controls them.
Ans. Fa lse. Centra l bank designs all i n stru ments of moneta ry pol icy a n d a lso controls the m .
1 7 . The com mercia l ba n ks a re t h e controller o f money supply.
Ans. Fa lse. The centra l ba n k controls the money supply i n the economy. The com m e rcial b a n ks o n ly
contri bute to money s u p p ly by way of cred it creation.
18. The centra l ba n k issues cu rrency on the basis of CRR.
Ans. Fa lse. Centra l ba n k does not issue cu rrency on the basis of CRR. The ratio CRR i m pacts cred it creation
ca pacity of the com m e rcia l b a n ks.
3. HOTS & Applications

1. If the com mercial ba n ks buy govern ment secu rities, their ca pacity to create credit is red uced . Do
you agree?
Ans. Yes, the given statem e nt is correct. By a l lowi ng or i n d ucing the commercial b a n ks to buy government
secu rities, the centra l b a n k soa ks cash ba l a n ces of the com m e rcial b a n ks which they cou l d use to
create credit. Accord i n gly, the credit creation capacity of the com m e rcial ba n ks is red uced .
2. Is it correct that when m a rgins a re ra ised, demand for loans is negatively i m pacted?
Ans. When m a rgi ns a re ra ised, the d iffe rence between the ma rket va l u e of the secu rity offered for loans
a n d va l u e of loans gra nted becomes high. It is now expensive for the people to ta ke loans from the
b a n ks. Therefore, demand for loans red uces i n the economy. Thus, the given i nformation is correct.
3. Is repo rate an i nstru ment of qualitative credit control?
Ans. N o, repo rate is a n i n stru ment of q u a ntitative cred it contro l . It i m p acts the ava i l a b i l ity of cred it across
a l l sectors of the economy.
4. If CRR is lowered, i nvestment demand m ust rise. Defend or refute.
Ans. Yes, the above statem e nt is correct. If CRR is l owered, cred it creation capacity of the com m e rcia l
b a n ks is e n h a nced . H igher ava i l a b i l ity of cred it a n d at l ower i nte rest rate m u st lead to a rise i n
i nvestment demand.
5 . H ow is qua ntitative credit control d ifferent from qual itative credit control?
Ans. Quantitative cred it control refe rs to overa l l cred it control i n the economy, affecti ng all sectors of
the economy eq u a l ly a n d without d iscri m i n atio n . Qua l itative cred it control refers to se lective cred it
control that focuses on a l l ocation of credit to d ifferent sectors of the economy. Flow of credit is
e ncou raged to the priority sectors, w h i l e it is d iscou raged to the non-p riority sectors .
6. Com mercia l ba n ks create credit o n ly on the advice o f the government. Is i t true?
Ans. N o, this is fa lse. Com m e rcial b a n ks do not create cred it only on the advice of the govern ment.
H oweve r, t h e i r capacity to c reate cre d i t d e p e n d s o n cred it p o l i cy of t h e centra l ba n k of the
co u nt ry.
7. Com mercia l ba n ks do not h ave the note issu ing a uthority, but they do contri bute to m oney supply
i n the economy. Com ment.
Ans. Yes, the give n statement is correct. The centra l b a n k is the sole a uthority of issu i n g n otes in the
cou ntry. H owever, by advancing loans t h rough credit creation, com m e rcial b a n ks contribute to
money s u p p ly in the economy.
8. What role does CRR play in the creation of credit by the com mercia l ba n ks?
Ans. CRR (cash reserve ratio) sets a l i m it u p to which commercia l b a n ks ca n lega l ly create cred it.
Exa m ple: If CRR = 4%, it i m p l ies that the com m e rcial b a n ks ca n create cred it ( by way of loans)
maxi m u m u p to 25 ti mes ( � = 25 ) of their cash reserves with the R B I .

4
9. "Rate cuts might not b e imminent"-Reserve Bank of India. [The Economic Times]
Why RBI is not ready to cut the rates? Write you r opinion.
Ans. H e re, rate cut refers to repo rate . The R B I believes that a cut i n repo rate is goi ng to fuel reta i l
i nflation which is a l ready h i g h . H ence, a c u t i n repo rate (which w i l l increase money supply i n the
economy) is not recom mended .
10. RBI lowers repo rate from 5.40% to 5. 15%. {4th October, 2019]
Ana lyse the economic va lue of this statement from the viewpoi nt of ( i ) the households,
( ii ) i nvestors, and ( iii ) the economy.
Ans. A cut i n repo rate (the rate at which commercial b a n ks ca n ra ise loans from R B I ) is expected to be
fol l owed by a cut in ma rket rate of i nterest (the rate at which the commerci a l ba n ks offe r loans to the
people). It is expected to i m pact the househol ds, i nvestors, a n d the economy as u nder:
( i ) I m pact on Households: A cut i n ma rket rate of i nterest (fo l l owed by a cut i n re po rate) is expected
to i n d uce borrowi ngs for the p u rchase of con s u m e r d u ra b l es, as wel l as houses a n d flats. Also,
the existi ng loans ( ra ised aga i n st floati ng i nterest rate) w i l l now attract l ower E M I . I m plying a
d i rect moneta ry benefit to the households.
Banking 1 69
( ii ) I m pact on the I nvestors : As a resu lt of a cut i n the market rate of i nterest, the cost of borrowi ngs
( i m plying the cost of ca pita l ) wi l l red uce. Accord i n gly, i nvestment is expected to i ncrease across
a l l a reas of prod uction activity.
( iii ) I m pact on the Economy: When d e m a n d for cons u m e r d u ra bles rises, aggregate d e m a n d is
expected to rise. Aggregate demand a lso te nds to rise when i nvestment expenditure rises.
Beca use both cons u m ption expe nditure and i nvestment expenditure a re sign ificant com ponents
of aggregate dema n d . Th us, the leve l of plan ned output is expected to rise a long with the leve l
of plan ned p u rchase i n the economy. Accord ingly, the eq u i l i b r i u m G D P level is expected to rise.
I m plying a rise i n the growth rate of G D P.
4. Analysis & Evaluation

1 . H ow, i n you r opin ion, credit creation by the commerci a l ba n ks accelerates the pace of economic
growth? Write two obse rvations.
Ans. Fol l owing observations may be noted i n this rega rd :
O bservation-1: Cred it creation accelerates the process of growth by expa n d i ng the ava i l a b i l ity of
credit for pu rpose of i nvestment.
O bservation-2 : Credit creation contrib utes to the p rocess of growth by expa n d i ng size of the ma rket
(or aggregate d e m a n d ), as the ava i l a b i l ity of credit for the p u rchase of consu mer d u ra bles i ncreases.
2. H ow i m p rovement i n banking habits of the people pushes u p credit ava i l a b i l ity from the com mercial
ba n ks?
Ans. When ba n king h a b its of the people i m p rove, they sta rt hold i ng less money as cash-i n-ha n d . I nstead,
more and more money is de posited with the commerci a l b a n ks. Accord i ngly, cash rese rves of the
com m e rcial b a n ks sta rt rising. H igher cash rese rves of the ba n ks enable them to deposit more fu nds
with the R B I as CRR-de posits. If CRR rem a i n s consta nt, h igher CRR-de posits with the R B I gives the
com m e rcial ba n ks the lega l a uthority to create more credit by way of loans/credit. Accord i n gly,
ava i l a b i l ity of credit from the commerci a l b a n ks is i ncrease d .
3 . H ow ca n 'Ja n-Dhan Yojana' be used as a n i nstru ment t o i ncrease s u p p l y o f money b y t h e com mercial
ba n ks?
Ans. A la rge section of the popu lation i n I n d i a d o n ot have their b a n k accou nts. 'J an-Dhan Yojana' prom pts
people to open their b a n k accou nts . When more a n d more accou nts a re opened then some of the
cash balances with the people (or idle cash lyi ng with the people) is bou nd to reach the banking
system as cash deposits or primary deposits. This increase e n a b les com mercia l b a n ks to increase
their cash reserves with the centra l ba n k. If �CR (add itional cash rese rves with the R B I ) = � 10,000
a n d if CRR = 4%, then the add itional d e m a n d deposits the b a n ks ca n create = � x �10, 000 =
4
� 2,50,000. This is how 'J an-Dhan Yojana' may be used as a n i n stru m e nt to increase s u p ply of money
by the commerci a l b a n ks.
4. Why has the Government in I n d ia fa iled to com bat inflation even when a series of moneta ry
measures a re available in the textbook of macroeconom ics?
Ans. Moneta ry meas u res of com bati ng/contro l l i n g i nflation focus l a rgely on moderating/lowering the
demand for goods a n d services by making the ava i l a b i l ity of cred it costlier a n d d ifficu lt. It does n ot
a d d ress s u p ply side of the pro b l e m .
W h i l e the fact o f the matte r is t h a t i n I nd i a i nflation has often b e e n triggered b y ( led by) the l ow
ma rket s u p p l ies. U n less s u p p l ies a re boosted (particu l a rly the s u p ply of fa rm output) we sha l l
conti n u e t o wrestle with i nflation without ta m i n g (correcti ng) it.

5 . Ana lyse the i m pact of demonetisation ( of 500 a n d 1,000 ru pee notes) on credit creation by the
com mercia l ba n ks i n the I n d i a n economy.
A n s . De m o n etisation h a s led to h u ge de pos its of cash i n t h e co m m erci a l ba n ks . P ri m a ry d e posits of
t h e ba n ks h ave risen s i g n ifica nt ly. T h i s e n a b les t h e m to kee p h i g h e r C R R-de posits with t h e R B I .
Acco rd i ng l y, c re d it creat i o n ca pacity o f t h e com m e rc i a l b a n ks i s expected t o rise.
5. C B S E Questions-Pa st 5 yea rs
(With Answers o r Reference to the Text for Answers)
1. Exp l a i n 'government's ba n k' fu n ctio n of centra l ba n k . [CBSE Delhi 2015; {F} 2015, 201 6]
Or
Exp l a i n "ba n ker t o t h e government" fu nction of t h e centra l bank. [CBSE Delhi 201 7]
[ Page 155]
2. Exp l a i n the 'ba n k of issue' fu nction of centra l ba n k. [CBSE Delhi 2015; {Al) 2015; {F} 201 6]
[ Page 154]
3 . Government of I nd i a has recently l a u nched 'J an-Dhan Yojana' a i med at eve ry household i n the
cou ntry to have at least one bank accou nt. Exp l a i n how d eposits made u nder the plan a re going to
affect national i n come of the cou ntry. [CBSE Delhi 2015]
[With the i ntrod uction of 'J an-Dhan Yojana' by the Government of I n d ia, m i l l ions of people have
opened their b a n k acco u nt. This has e n h a n ced pri m a ry deposits of the com m e rcial b a n ks. It is on the
basis of their pri m a ry deposits (cash deposits) that the b a n ks a re able to create seco n d a ry deposits.
It leads to expa nsion of credit in the fi n a ncial market. Accord i ngly, i nvestment te nds to rise. H igher
i nvestment leads to increase i n nati o n a l i ncome of the cou ntry.]
4. Exp l a i n the "ba n ke rs' b a n k" fu nction of the centra l bank. [CBSE (Al) 2015, 201 7; {F} 2015, 201 6]
[ Page 155]
5 . Cu rrency is issued by the centra l b a n k, yet we say that com m e rcial ba n ks create money. Exp l a i n . H ow
is this money creation by com mercial b a n ks l i kely to affect the nati o n a l i ncome? Exp l a i n .
[CBSE {A l) 2015]
Or
Why do w e say that commercia l ba n ks create money w h i l e w e a lso say that t h e centra l b a n k h a s the
sole right to issue cu rrency? Exp l a i n . What is the l i kely i m pact of money creation by the com m e rcia l
b a n ks o n national i ncome? [CBSE (F) 2015]
[ M oney s u p ply has two com ponents: cu rrency a n d demand de posits. Cu rrency is issued by the centra l
b a n k whereas demand deposits a re created b y t h e commercia l b a n ks. They create money i n the
form of demand deposit related to the loans offered by them. Demand deposits of the com m e rcia l
b a n ks a re m a ny ti mes more than their cas h reserves. This is based on the historica l expe rience of the
b a n ks that cash with d rawa l of fu nds is o n ly a s m a l l perce ntage of the tota l demand deposits.
The money created by the com m e rcial ba n ks in the form of demand deposits is m a i n ly used for
i nvestment or prod uction pu rposes. Any rise i n i nvestment leads to m a ny ti mes more increase i n the
nati o n a l i ncome of a n economy, via ., the m u lti plier effect.]
6. Exp l a i n how 'ba n k rate' is h e l pfu l i n contro l l i ng credit creation? [CBSE Delhi 201 6]
[ Page 157, 158]
7. Exp l a i n how open market operations a re h e l pfu l in contro l l i ng cred it creati o n . [CBSE Delhi 201 6]
[ Page 158]
8. Exp l a i n how 'margin req u i reme nts' a re h e l pfu l in contro l l i ng cred it creati o n . [CBSE Delhi 201 6]
[ Page 160, 161]
Banking 171
9. Exp l a i n the role of cash reserve ratio i n contro l l i n g cred it creati o n . [CBS£ (Al) 2016]
[ Page 160]
10. Exp l a i n how 'repo rate' ca n be h e l pfu l in contro l l i ng cred it creati o n . [CBSE (AJ) 2016)
[ Page 158, 159]
11. Exp l a i n the role of 'reverse repo rate' in contro l l i ng cred it creati o n . [CBS£ (Al) 2016]
Or
Exp l a i n t h e role o f 'rese rve re po rate' i n contro l l i n g money s u p p ly. [ CBS£" Delhi 201 7}
[ Page 159]
12. The ratio of tota l de posits that a com mercia l b a n k has to keep with Rese rve B a n k of I n d i a is ca l l ed :
(choose the correct a lternative) [CBS£" Delhi 201 7}
(a) Statutory l i q u i d ity ratio ( b ) Deposit ratio
(c) Cash reserve ratio ( d ) Lega l rese rve ratio
[(c)]
13. Exp l a i n the p rocess of credit creation by com m e rcial b a n ks . [CBSE (Al) 201 7}
Or
Exp l a i n the money creation fu nction o f com m e rcial ba n ks . [CBSE (F) 201 7}
[ Page 151-153]
14. Repo rate is the rate at which: [CBSE (F) 201 1]
(a) com m e rcial b a n ks p u rchase government secu rities from the centra l ba n k
( b ) com m e rcial b a n ks ca n ta ke loans from t h e centra l b a n k
( c ) com m e rcial b a n ks ca n keep their deposits with t h e centra l b a n k
( d ) short-te rm l o a n s a re given b y com mercia l b a n ks
[(b)]
15. Exp l a i n the "va ryi ng reserve req u i rements" method of credit control by the centra l ba n k .
[ Page 160] [CBSf (F) 2017]
[ N ote : Va rying reserve req u i rements is the same as va rying cash reserve ratio.]
16. Credit creation by com m e rcial b a n ks is determi ned by: (choose the correct a lternative) [CBSE 2018]
(a) Cash Rese rve Rati o (CRR) ( b ) Statutory Liq u i d ity Ratio (SLR)
(c) I n itia l deposits ( d ) A l l the a bove
[(d)]
17. What is moneta ry pol icy? State a ny t h ree i n stru m e nts of moneta ry policy. [CBSE 2018]
[Moneta ry pol icy is the pol icy p u rsued by the centra l b a n k to regulate s u pply of money i n the
economy.
The three m a i n instru ments of moneta ry pol icy a re : ( i ) Repo Rate, ( i i ) Cash Reverse Ratio, and (iii) Open
M a rket Operations. Page 157-159]
18. E l a borate a ny two i n stru m e nts of credit control, as exercised by the Reserve B a n k of I n d i a .
[ Page 157-161] [CBSE 2019 (58/1/1)]
19. Defi ne credit m u lti p l i e r. What role d oes it play i n determ i n i ng the cred it creation power of the
b a n k i ng system ? Use a n u merica l i l l ustration to expla i n . [CBSE 2019 (58/1/1)]
[Credit m u lti p l i e r refers to the n u m ber of ti mes the com m e rcia l ba n ks ca n create credit per u n it of
cash reserves with the R B I . It reflects credit creation powe r of the ba n ki n g syste m in the cou ntry.
I m plying the power to i nfl uence the s u pply of money i n the economy.
I l l ustration :
1
k= [k: Credit m u lti p l ier; CRR: Cash reserve ratio]
CRR
Assu m i ng CRR = 2%
1
k = -- = 50
2%
I m plying that com m e rcial ba n ks ca n create credit 50 ti mes of their cash rese rves with the R B I .
I n case, CRR is ra ised t o 4%, i. e.,
1
k = - = 25
4%
I m plying that cred it creation power of the com m e rcial b a n ks is red uced to half. It wou l d lead to a
sign ificant cut i n money s u p ply i n the economy.]
20. Defi n e 'money m u lti p l ie r'. [CBSE 2019 (58/2/1))
[ Page 154]
21. Disti nguish between 'Qu a l itative a n d Qu a ntitative tools' of cred it control as may be used by a Centra l
Ba n k. [CBSE 2019 (58/2/1))
[ Page 157-161]
22. Discuss briefly the fol l owing fu nctions of a Centra l B a n k :
( i ) Ba n ker's ba n k .
( i i ) Lender o f last resort. [CBSE 2019 (58/2/2)]
[ Page 155]
23. Discuss briefly the "cred it control ler" fu nction of a Centra l Ba nk. [CBSE 2019 (58/2/3)]
[ Page 156-161]
24. Accord i n g to a re port forwa rded by the Reserve B a n k of I n d ia, there was a fa l l i n rate of i nflation as
measu red by Consu m e r Price I ndex (CPI) on yea r-on-year basis to 5% from 8% i n the p revious yea r.
Which of the fol lowi ng state ments rep rese nts the situation?
(a) C P I has fa l l e n ( b ) C P I has risen a t a rate l ower than the preceding yea r
(c) C P I is consta nt (d) None of the above
[(b)] [CBSE 2019 (58/3/1)]
25. Exp l a i n the p rocess of money creation by a com m e rcial b a n k using a hypothetica l n u merica l
exa m ple. [CBSE 2019 (58/3/1)]
Or
Discuss briefly the cred it creation process of the ba n king syste m, using a hypothetica l n u merica l
exa m ple. [CBS£ 2019 (58/4/3)]
[ Page 151-153]
26. State the role played by the centra l ba n k as the "lender of last resort". [CBSE 2019 (58/4/1)]
[ Page 155]
27. Exp l a i n, using a n u m erica l exa mple, how an increase in rese rve de posit ratio affects the cred it
creation powe r of the b a n k i ng system . [CBSE 2019 (58/4/1)]
[ Page 172, Q. 19]
28. Exp l a i n, using a n u m erica l exa m p l e, h ow a red u ction in rese rve deposit ratio, affects the cred it
creation powe r of the b a n k i ng system . [CBSE 2019 (58/4/2}]
k = � [k: Cred it m u lti p l ier; C R R : Cash rese rve ratio]
C R
Assu m i ng CRR = 4%
1
Accord i n gly, k = - = 25
4%
I m plying that commerci a l b a n ks ( b a n king system in the cou ntry) ca n create credit u pto 25 ti mes of
their cash rese rves with the R B I .
Banking 173
In case, CRR is cut to 2%,
1
k = - = 50
2%
I m plying that cred it creation power of the com m e rcial b a n ks is d o u b l e d . It wou ld lead to a sign ifica nt
rise in the s u p p ly of money in the economy.]
29. If lega l reserve ratio is 20%, the va l u e of money m u lti p l i e r wou l d be _______
(Choose the correct a lternative) [ CB5E 2019 (58/5/1)]
(a) 2 (b) 3
(c) 5 (d) 4
[(c)]
30. What a re p r i m a ry de posits? [CBSE 2019 (58/5/1)]
[ Page 153]
31. Exp l a i n the fol l owing fu nctions of the Centra l Ba n k :
( i ) Ba n ker's ba n k .
( i i ) Authority o f cu rrency issue. [CB5E 2019 (58/5/1)]
[ Page 154, 155]
32. Exp l a i n the fol l owing fu nctions of the Centra l Ba n k :
( i ) Lender o f last resort.
( i i ) Ba n ker to the Government. [CB5E 2019 (58/5/2)]
[ Page 155]
33. (a) Exp l a i n how u s i ng "Ba n k Rate" the Centra l Ba n k ca n reg u l ate money s u p ply i n a n economy.
( b ) What is meant by 'Repo Rate' ? [CBSE 2019 (58/5/3}]
[ Page 157, 158]
6. NCERT Questions {With Hints to Answers)

1. What a re the instru ments of moneta ry pol icy of R B I ?
[Hint: I n stru m e nts o f moneta ry pol icy o f R B I a re broad ly classified as:
(a) Qua ntitative I n struments: ( i ) Ba n k Rate, ( i i ) Repo Rate, ( i i i ) Reverse Repo Rate, ( iv) CRR
(Cash Rese rve Ratio), (v) SLR (Statutory Liq u i d ity Ratio), a n d (vi) Open Ma rket Operations.
(b) Qua l itative I nstru ments: ( i ) M a rgin req u i rement, (ii) Rationing of cred it, (iii) Mora l suasion .]
2. Do you consider a com mercial b a n k 'creator of money' i n the economy?
[Hint: Yes, com m e rcial b a n ks a re an i m porta nt sou rce of creating credit in the economy. They create
cred it in the form of d e m a n d deposits rel ated to the loans offe red by the m . Demand deposits of the
com m e rcial b a n ks a re m a ny ti mes more than their cash rese rves. If cas h rese rves a re (say) � 1,000
a n d if d e m a n d deposits a re (say) � 10,000, then the com mercial b a n ks a re creati n g credit te n ti mes
of their cas h reserves. Accord i n gly, on the basis of cash reserves of � 1,000, the com mercia l b a n ks
a re contributi n g � 10,000 to the s u p ply of money.]
3 . What role of R B I is known as 'lender of last resort'?
[Hint: As a lender of last resort, the centra l ba n k sta nds as a guara ntor to the com m e rcial b a n ks
d u ri n g fi n a ncia l emergencies. A com mercia l b a n k may lose confide nce of the depositors prom pti ng
them to withd raw their deposits en mass. Si nce cash reserves of the com m e rcial b a n k a re only a
fraction of its d e m a n d de posits, its reserves may ru n out, p u s h i ng the b a n k i nto fi nancial crises. It is
the centra l bank d u ri n g such ti mes that sta nds by the com m e rcial bank as a guara ntor and saves it
from i nsolve ncy.]
7. M isce l l a neous Q uestions a n d Reference to the Text for Answers
A. Questions of 3 & 4 m a r ks each

1. State the main fu nctions of a centra l ba n k .
Or
State a ny t h ree m a i n fu nctions o f a centra l b a n k . Describe a ny o n e o f t h e m . [Page 154-156]
2. H ow is the centra l b a n k d ifferent from com m e rcial ba n k? [Page 156]
3. Exp l a i n a ny one of the fol l owing fu nctions of a centra l b a n k :
( i ) Cu rrency a uthority, a n d
( i i ) Lender o f last resort. [Page 154, 155]
4. Exp l a i n the 'ba n kers b a n k' fu nction of the centra l bank. [ Page 155]
5. Exp l a i n 'ba n ker to the government' fu nction of the centra l bank. [Page 155]
6. H ow d oes a centra l ba n k perform the fu nction of contro l l e r of cred it? [Page 156]
7. State a ny t h ree methods by which a centra l ba n k tries to control the q u a ntity of cred it.
[Page 1 5 7-1 61 ]
8. What is repo rate? H ow d oes it control the s u p p ly of cred it i n the economy? [Page 158, 159]
9. H ow d oes a centra l ba n k control the ava i l a b i l ity of credit by open ma rket operations?
Or
What a re open ma rket operations? H ow d o these work as a method of credit control? [Page 158]
B. Questions of 6 ma r ks each
1. Defi n e a centra l bank. What a re the fu nctions of centra l b a n k? [Page 154-156]
2. "Co m m ercial ba n ks create money i n the econ omy." Com m e nt. [Page 151-153]
3. H ow d oes the centra l b a n k of a cou ntry control the su pply of money in an economy? [Page 157-1 61 )
4. State the basic differe nce between q u a ntitative a n d q u a l itative instru ments of credit contro l . G ive
s u ita ble exa m ples. [Page 1 5 7-1 61 ]
DOs and DON'Ts

1. It needs to be noted with emphasis that w h i l e the commercial banks a re a source of money supply i n
t h e economy, they DO N OT have t h e authority o f issuing notes or coi n s . They a re a source o f money
supply only as creators of cred it or bank money.
2. Both C R R and SLR a re lega lly determined by the R B I . B ut, both a re independently determ i ned, as these
a re differently esti mated. N ever miss the point that w h i l e CRR has a d i rect beari ng on cred it creation by
the commercial banks (as it sets the l i m it up to which the commercial banks can legally create cred it),
SLR i mpacts cred it creation only i n d i rectly by i ncreasing or decreasing the amount of l iq u i d assets of
the commercial banks (Check text for deta i ls) .
Banking 175
.,...__. • Success of Repo Rate as an I nstrument of Credit Control
Success of repo rate pol icy as an i n stru ment of credit control depen ds on the
fol low i n g factors:
(i) Degree of Dependence of the Commercial Banks upon the Central Bank
for Loans: I f commercial banks have the i r own surp l u s fu nds which they
can uti l ise d u ri n g periods of h i g h credit needs, their dependence on the
centra l bank is red uced .
(ii) Degree of Sensitivity of Bank's Demand for Funds from the Central Bank:
Depen ding on busi ness cond itions, commercial banks may not be very
sen sitive to s m a l l vari ations in repo rate. I n such situations, repo rate
po l i cy may not be a big success.
(iii) Structure of Interest Rates in the Money Market: I f non-ba n ki n g fi n a n c i a l
i n stitutions i n t h e ma rket do not va ry thei r i nterest rates i n accordance
with what the centra l bank expects from the commercial banks, the repo
rate po l i cy may not succeed .
(iv) Overall Supply of Funds in the Market: Repo rate pol i cy may not be a
success if non-ba nking sou rces of fu nds are more popu l a r than the
banking sources.
• Success of Open Market Operations as an I nstrument of Credit Control
Success of open market operations as an instrument of cred it control depends
on the fol lowing factors
(i) Existence of Securities Market: There m ust be a wel l org a n i sed and wel l
fu ncti o n i n g ma rket for the sale and p u rchase of secu rities. I n the absence
of it, open ma rket operati ons wou l d be l ittle s i g n ifi ca nce as an i n stru ment
of monetary policy.
(ii) Excess Reserves with the Banks: If commercial banks have healthy
excess reserves as 'Vau lt Cash' they need not buy secu rities. This is the
standard practice i n developed cou ntries l i ke USA. Accord i n g ly, open
ma rket operations fa i l to be a successfu l i n stru ment of credit contro l .
• Difference between Bank Rate and Repo Rate
- Bank Rate Re o Rate -
(i) Bank rate rel ates to the loans offered by (i) Repo rate rel ates to the loans offered by
the R B I to the com merc i a l banks without the R B I to the commercial b a n ks N OT
any collatera l (secu rity for p u rpose of w ithout collatera l. The securities are
loans) . pledged as a secu rity for the loa n s .
(ii) Ba nk rate does not a l low any fac i l ity of (i i) Repo rate a l lows rep u rchase of securities .
repurchase of secu rities . The b a n k rate is The holder of securities can repurchase
s i m p l y the Rate of D i scount. them at a later date. Therefore, repo rate
is a l so called Repurchase Rate.
(ii i) Bank rate relates to borrowings by the (ii i) Repo rate rel ates to short-term borrowings
com merc i a l b a n ks to cope with the i r by the commercial banks.
i mmed iate cas h-cru n c h .
[ N ote: Ban k rate i s often h igher than the re po rate as it ( ba n k rate) re l ates to i n stant
loan req u i rem ent of the co m m ercial ban ks. ]
Ill

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Barter System of Exchange

134 Introductory Macroeconomics

Drawbacks of the Barter System and their Elimination

(i) Fiat Money and Fiduciary Money

(ii) Full Bodied Money and Credit Money

136 Introductory Macroeconomics

M 1 Measure of Money Supply

Net Demand Deposits and Gross Demand Deposits

138 Introductory Macroeconomics

(i) Demand Deposits (ii) Demand Deposits (i ii) Demand Deposits

Who Su p plies Money ?

Power Points & Revision Window -----------

140 Introductory Macroeconomics

Choose appropriate word and fi ll in the blank:

142 Introductory Macroeconomics

D. Matc h i n g the Correct State ments

E . 'Very Short Answe r' Objective Type Questions

144 Introductory Macroeconomics

2. Rea so n - based Questions (Co m p re h e n s i o n of the S u bject - m atter)

3. HOTS & Applications

146 Introductory Macroeconomics

6. N C E RT Questions (With H i nts to A n swers)

1. What is a barter syste m ? What a re its d rawbacks?

7. M isce l l a neous Q uestions a n d Reference to the Text for Answers

A. Questions of 3 & 4 m a r ks each

148 Introductory Macroeconomics

DOs and DON'Ts

....__. • M 2 , M 3 , M 4 Measures of Money Supply

150 Introductory Macroeconomics

• In the first round, bank receives deposits of� 1,000.

152 Introductory Macroeconomics

CRR and Credit Multiplier

2. THE CENTRAL BANK

Functions of the Central Bank

154 Introductory Macroeconomics

156 Introductory Macroeconomics

3. CONTROL OF MONEY SUPPLY (OR CREDIT

(A) Quantitative Instruments of Credit Control

(2) Open Market Operations: Open market operations refer to the

Two Types of Open Market Operations

158 Introductory Macroeconomics

(6) Statutory Liquidity Ratio (SLR): Every bank is required to

(B) Qualitative Instru ments of Credit Control

160 Introductory Macroeconomics

(2 ) Rationing of Credit: Rationing of credit refers to fixation of credit

(3 ) Moral Suasion : It is l i ke rendering an advice to the commerci al

Power Poi nts & Revision Window ------------

162 Introductory Macroeconomics

E . 'Very S h o rt Answer' Objective Type Questions

166 Introductory Macroeconomics

2 . Reason- based Questions (Com prehension o f the S u bject-matter)

3. HOTS & Applications

maxi m u m u p to 25 ti mes ( � = 25 ) of their cash reserves with the R B I .

4. Analysis & Evaluation

170 Introductory Macroeconomics

6. NCERT Questions {With Hints to Answers)

A. Questions of 3 & 4 m a r ks each

DOs and DON'Ts

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