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Class 12 Economics Chapter 3 Money and Banking System
Selected Questions & Answers
A. Very Short Answer Type Questions: (Marks for each – 1)
1. What is the velocity of circulation of money? H. S. ’15
Ans: The number of times a unit of money is used to complete transactions within a specified period is called the velocity of circulation of money.
2. What is meant by ‘double coincidence of wants’?
Ans: In a barter system, the mutual matching of wants between two parties involved in exchange is called ‘double coincidence of wants’.
3. What is fiat money?
Ans: The money which is declared by the government through an order as a medium of exchange is called ‘fiat money’.
4. What is meant by money supply?
Ans: All types of money held by the public at a particular point of time together constitute the money supply.
5. What is the currency-deposit ratio?
Ans: The currency-deposit ratio is the ratio of currency held by the public to the deposits held by the public in banks.
6. What is the reserve-deposit ratio?
Ans: The reserve-deposit ratio is the proportion of total deposits that commercial banks keep as reserves.
7. What is the relationship between the market rate of interest and the price of bonds?
Ans: There is an inverse relationship between the market rate of interest and the price of bonds.
8. What is meant by reserve requirement ratio?
Ans: The portion of total deposits which commercial banks are required to keep as reserves instead of lending is called the reserve requirement ratio.
9. What is meant by the currency-deposit ratio?
Ans: The ratio of currency held by the public to the deposits kept by the public in banks is called the currency-deposit ratio.
10. What is meant by broad money?
Ans: The aggregate of paper notes, small coins, demand deposits, and time deposits of commercial banks is called broad money.
11. What is meant by narrow money?
Ans: The aggregate of paper notes, small coins, and demand deposits with commercial banks is called narrow money.
12. Write the full form of SLR.
Ans: Statutory Liquidity Ratio.
13. Write the full form of CRR.
Ans: Cash Reserve Ratio.
14. What is limited legal tender?
Ans: The legal tender by which payments can be made only up to a limited amount is called limited legal tender.
15. What is unlimited legal tender?
Ans: The money by which payments of any amount can be made is called unlimited legal tender.
16. How many types of legal tender are there and what are they?
Ans: There are two types of legal tender: unlimited legal tender and limited legal tender.
17. What is money as a unit of account?
Ans: The money which is used for maintaining accounts is called money as a unit of account.
18. What is the name of the central bank of India?
Ans: Reserve Bank of India.
19. What is liquidity trap?
Ans: When at a very low rate of interest the speculative demand for money becomes infinitely elastic and the demand curve becomes horizontal, that horizontal portion of the curve is called the liquidity trap.
20. What is meant by market rate of interest?
Ans: The rate of interest at which commercial banks lend to individuals and business firms is called the market rate of interest.
21. How many nationalised banks are there in India at present?
Ans: The number of nationalised banks in India has changed after bank mergers. At present, there are 12 public sector banks.
22. How many banks were nationalised on 14 July 1969?
Ans: 14 banks.
23. What is a central bank?
Ans: The apex financial institution that controls the money and banking system of a country is called the central bank.
24. What is meant by bank rate?
Ans: The rate of interest at which the central bank lends to commercial banks is called the bank rate.
25. What is a fixed deposit account?
Ans: The account in which money is deposited in a bank for a fixed period is called a fixed deposit account.
26. Define commercial bank.
Ans: An institution that accepts deposits from the public and provides loans as required is called a commercial bank.
27. What is Cash Reserve Ratio?
Ans: The portion of total deposits that commercial banks are required tokeep with the central bank is called the Cash Reserve Ratio.
28. What is Statutory Liquidity Ratio?
Ans: The proportion of total demand and time deposits which commercial banks are required to maintain in the form of liquid assets is called the Statutory Liquidity Ratio.
29. In the equation of transactions demand for money, what does T denote?
Ans: T denotes the total value of transactions that take place within as pecified period.
30. A person earns Rs. 700 per month. What is his average cash balance?
Ans: Monthly income = Rs. 700.
Average cash balance = (700 + 0) ÷ 2 = Rs. 350.
31. How does a commercial bank determine the creditworthiness of a person?
Ans: A commercial bank determines the creditworthiness of a person on the basis of his movable property or the collateral documents submitted for repayment of the loan.
32. What is the lending rate of a commercial bank?
Ans: The lending rate is the rate at which banks lend to borrowers, whereas the rate paid to depositors is the borrowing rate of the bank.
33. Why is it necessary for the Reserve Bank of India to keep reserves from commercial banks?
Ans: It is necessary for the Reserve Bank of India to maintain reservesfrom commercial banks in order to effectively regulate the reservere quirements of those banks.
34. Why is it costly for commercial banks to keep reserves with the Reserve Bank of India?
Ans: It is costly because the amount kept as reserves could otherwise be lent out for interest-earning investment purposes.
35. What is the name of the monetary authority that issues paper currency in India?
Ans: Reserve Bank of India.
36. In the modern economic system, people hold cash for two motives. One is the transaction motive; what is the other?
Ans: Speculative motive.
37. What is high-powered money?
Ans: The total financial liabilities of the monetary authority of a country are considered as the monetary base or high-powered money.
38. Fill in the blank: The speculative demand for money has a ——— relationship with the market rate of interest. H. S. ’15
Ans: Inverse.
39. What is the average transactions demand for money of an individual?
Ans: The average transactions demand for money of an individual is halfof his monthly transactions.
B. Short Questions and Answers (Marks for each–2)
1. What is inflation?
Ans: Inflation is a situation in which the general price level of goods risesand the value of money falls. Inflation occurs due to causes such as increasein money supply, deficit financing, circulation of black money, rise in demand resulting from population growth, increased investment, and rise ingovernment expenditure.
2. What is the difference between time deposit and demand deposit? H. S. ’18
Ans: The differences between time deposit and demand deposit are: Time deposits have a fixed or specified period. But in the case of demand deposits, there is no such time restriction. In time deposits, the depositor cannot withdraw money as per his immediate need before maturity. But in demand deposits, the depositor can withdraw money according to his wish. Cheques cannot be used in time deposits. But in demand deposits, the facility of using cheques is available.
3. What is the significance of bank rate as an instrument of RBI?
Ans: The Reserve Bank of India is the apex bank of all banks. All commercial banks borrow funds from it at interest. The RBI determines the rate of interest and can change it. When the bank rate changes, all banks have to adjust their lending accordingly. When the bank rate is low or high, it encourages banks to borrow more or less from the RBI, because borrowing becomes cheaper or more expensive. Thus, by changing the bank rate, the RBI influences the credit creation and lending activities of commercial banks.
4. Mention the defects of the barter system.
Ans: The defects of the barter system are:
(a) Exchange is not possible without double coincidence of wants.
(b) It is not suitable in the case of indivisible goods.
(c) There is difficulty in determining the proper value of goods.
(d) It is not convenient for deferred payments.
5. Explain the reserve-deposit ratio.
Ans: Out of the total deposits collected from the public, banks use a part for lending and investment and keep the remaining part as reserves. These reserves include cash held by banks and deposits kept with the Reserve Bank of India. The ratio of total reserves kept by commercial banks to their total deposits is called the reserve-deposit ratio. Banks use these reserves to meet the withdrawal demands of depositors.
6. What is the currency-deposit ratio? Why does it increase during festivals?
Ans: The currency-deposit ratio is the ratio of the amount of money held by the public in cash form to the amount kept as bank deposits. During festivals, people convert a part of their bank deposits into cash to meet additional expenditure. Therefore, the currency-deposit ratio increases during festival periods.
7. Mention two functions of a central bank.
Ans: Two functions of a central bank are:
(a) It issues paper currency, that is, it prints and supplies notes.
(b) It acts as the banker to the government and as the banker’s bank.
8. Mention two functions of a commercial bank.
Ans: Two functions of a commercial bank are:
(a) It mobilises savings and provides loans.
(b) It creates credit or deposit money.
9. Write three objectives of bank nationalisation in India.
Ans: Three objectives of bank nationalisation in India were:
(a) To provide adequate agricultural credit.
(b) To eliminate private ownership and concentration of control in banks.
(c) To expand bank branches rapidly in rural and backward areas and to mobilize savings.
10. Mention two sources of supply of foreign exchange. H. S. ’19
Ans: Two sources of supply of foreign exchange are:
(a) Increase in exports of the country.
(b) Investment of capital abroad.
11. Write the meaning of flexible exchange rate. H. S. ’18
Ans: A system in which the exchange rate of a currency is determined by the forces of demand and supply in the foreign exchange market without intervention by the central bank is called a flexible or floating exchange rate system.
C. Medium Length Questions & Answers (Marks for each–4)
1. What is meant by ‘mutual non-coincidence of wants’?
Ans: Mutual non-coincidence of wants refers to a situation where the wants of one person do not correspond with the wants of another person. For the barter system to function effectively, the wants of two individuals must be complementary. For example, if one person wants rice in exchange for cloth and another person wants cloth in exchange for rice, there is mutual coincidence of wants. But if the owner of cloth wants mustard oil instead of rice, then it is called mutual non-coincidence of wants. This problem is a major limitation of the barter system.
2. Write three demerits of money.
Ans: The three demerits of money are:
(1) Improper use of money may create situations like inflation or deflation in the economy. During inflation, buyers suffer loss, and during deflation, sellers suffer loss.
(2) Through the use of money, inequality in income distribution may arise.
As a result, a gap develops between the rich and the poor in society.
(3) Many people develop excessive greed for money. Under its influence, some individuals commit crimes, leading to moral degradation in society.
3. Explain the role of the Reserve Bank of India as the lender of last resort.
Ans: In the Indian monetary system, the Reserve Bank of India acts as the guarantor of commercial banks. When commercial banks face liquidity problems due to excessive withdrawal of deposits through lending or other reasons, the Reserve Bank of India provides loans to them. By doing so, it ensures that depositors can withdraw their savings without difficulty. Thus, the Reserve Bank of India acts as the saviour of commercial banks and performs the function of lender of last resort.
D. Essay-type Questions and Answers (Marks for each–6)
1. Describe the functions of money. H.S. ’18, ’19
Or
How does money remove the difficulties of the barter system? H.S. ’18
Ans: The principal functions of money are discussed below:
(1) Medium of exchange: Money is used as a medium of exchange for all goods and services. Through money, buyers and sellers complete transactions in the market. A buyer pays a certain amount of money to obtain a specified quantity of goods.
(2) Measure of value: Money acts as a measure of value. The value of all goods and services is expressed in terms of money. The amount of money paid to purchase a commodity is called its price.
(3) Store of value: People desire to save a portion of their income. Money facilitates this saving function because it possesses durability and can be conveniently stored. Unlike many other commodities, money does not easily perish. Through savings, money can later be converted into goods and services.
(4) Standard of deferred payments: Money serves as the standard for settling debts. All credit transactions, including borrowing and lending, are conducted in terms of money. In this way, money removes the difficulties of the barter system by eliminating the problem of double coincidence of wants, providing a common measure of value, enabling storage of purchasing power, and facilitating deferred payments.
2. Discuss the importance of money in a modern economy.
Ans: Money plays a significant role in a modern economy:
(1) Determination of economic objectives: Money facilitates decisions regarding what to produce, how to produce, and for whom to produce. The allocation and distribution of resources becomes easier through monetary calculation.
(2) Importance in the financial system: Money supports the development of savings and credit institutions such as banks and other financial organizations. The government’s annual budget, including total Income, expenditure, and borrowing is expressed in monetary terms.
(3) Importance in economic development: For implementing development projects, resources must be mobilized. These resources are collected through monetary means. By increasing savings and capital formation, developing countries can accelerate economic growth and reduce backwardness.
(4) Price determination: In the market, prices of goods are determined in monetary terms through the interaction of buyers and sellers. Money thus helps establish equilibrium between demand and supply.
(5) Importance in distribution: The value of factors of production and output is measured in money. Producers’ income and expenditure, as well as profit and loss in trade and commerce, are expressed in monetary terms.
3. Describe the functions of commercial banks. H.S. ’15, ’17
Ans: The main functions of commercial banks are discussed below:
(1) Collection of savings: The primary function of a commercial bank is to accept deposits from the public. It collects money from individuals, institutions, and business firms and pays interest to depositors.
(2) Granting of loans: Commercial banks lend the money collected from depositors to individuals and business firms at a higher rate of interest. They generally provide short-term loans, though sometimes long-term loans are also granted.
(3) Creation of credit: Commercial banks create credit or deposit money. Deposits are of two types—primary (cash) deposits and secondary (derivative)deposits. From primary deposits, banks create secondary deposits. This process is known as credit creation.
(4) Other functions: Commercial banks also perform various subsidiary services such as payment of utility bills, safe custody of valuables and documents, and transfer of money from one place to another.
4. Describe the main functions of the central bank (Reserve Bank of India). H.S. ’16, ’18
Ans: The principal functions of the central bank are as follows:
(1) Issue of paper currency: The central bank has the sole authority to issue paper currency. At present, currency is issued under the minimum reserve system, which requires a specified amount of gold and foreign exchange reserves. In India, this function is performed by the Reserve Bank of India.
(2) Banker’s bank: The central bank acts as the bank of banks. Commercial banks are required to keep a portion of their deposits with the central bank. It inspects their accounts, provides loans, and settles inter-bank claims. Hence, it is regarded as the lender of last resort.
(3) Banker to the government: The central bank acts as the banker to the government. It provides financial assistance, offers advice on monetary matters, manages public debt, and maintains records of government receipts and expenditures.
(4) Control of credit: The central bank regulates the credit system of the country and adopts measures to control inflation.
(5) Developmental functions: It promotes the development of the banking system and links credit with productive activities to accelerate economic growth. It also provides long-term loans to agriculture and industry.
(6) Other functions: These include management and control of foreign exchange, collection of economic data, and representing the government in international financial institutions.
5. Briefly describe the objectives of the nationalisation of commercial banks in India.
Ans: On 19 July 1969, 14 commercial banks were first nationalised in India. The main objectives were:
(1) To provide cheap agricultural credit to farmers.
(2) To abolish private ownership and monopoly control of banks.
(3) To expand bank branches rapidly in rural and backward areas.
(4) To mobilise savings extensively.
(5) To give priority to lending for priority sectors.
(6) To make banking services development-oriented.
6. Explain the speculative demand for money. H.S. ’14, ’17
Ans: The concept of speculative demand for money was introduced byKeynes. According to him, the relationship between the current rate of interest and the expected future rate of interest determines how much money and bonds an individual will hold. When the rate of interest falls, individuals prefer to hold more money, expecting bond prices to fall in the future. Conversely,
when the rate of interest rises, individuals prefer to hold bonds rather than money, reducing their liquidity preference. As the rate of interest falls from rmax to rmin, speculative demand for money increases from zero to infinity.
7. What are the instruments of monetary policy of the Reserve Bank of India? Explain any two. H.S. ’15
Or
Explain three instruments of credit control used by the central bank.
Ans: The instruments of monetary policy of the Reserve Bank of India are:
(1) Bank rate policy
(2) Variation in reserve requirements
(3) Open market operations Explanation of two instruments:
(1) Bank rate policy: The bank rate is the rate at which commercial banks borrow from the central bank. When the bank rate rises, borrowing from the central bank becomes costly, reducing the lending capacity of commercial banks. When it falls, borrowing becomes cheaper, encouraging credit expansion.
(2) Variation in reserve requirements: By changing the cash reserve ratio and statutory liquidity ratio, the central bank influences the amount of reserves commercial banks must maintain. An increase in these ratios reduces money supply, while a decrease expands it.
(3) Open market operations: The central bank buys and sells government securities in the open market to regulate money supply. During inflation, it sells securities to reduce liquidity; during deflation, it purchases securities toincrease money supply.
8. Explain the concept of deficit financing.
Ans: The Reserve Bank of India is the apex bank of the country and acts as the banker to the government. Sometimes the government cannot meet its budget deficit from tax revenue and resorts to printing new currency. However, it has no direct authority to print currency; therefore, it sells government securities to the Reserve Bank of India and borrows money. The Reserve Bank then supplies funds to the government. Financing the budget deficit in this manner is called deficit financing.
9. What is the sterilisation policy of the Reserve Bank of India?
Ans: The sterilisation policy refers to measures adopted by the Reserve Bank of India to neutralise the impact of excessive foreign capital inflows on domestic money supply. When large foreign investments increase liquidity and create inflationary pressure, the Reserve Bank sells government securities in the open market to absorb excess liquidity. This process of offsetting external monetary pressures is known as sterilisation.
10. Explain the transaction demand for money with the help of a diagram.
Ans: Transaction demand for money depends on the level of national income. When the national income is Y1, the transaction demand for money is OM1. When income rises to Y2, transaction demand increases to OM2. Thus, an increase in national income leads to an increase in transaction demand for money.
11. What is the liquidity trap? Explain.
Ans: A liquidity trap is a situation in which, at a very low rate of interest, the demand for money becomes infinitely elastic. At such low rates, people expect bond prices to fall in the future and therefore prefer to hold money rather than bonds. As a result, further increases in money supply do not reduce the rate of interest. This horizontal portion of the speculative demand curve represents the liquidity trap, and it implies that the rate of interest cannot fall
to zero.
