NCERT Solutions for class 12th Economics Part B Chapter 3 Money and Banking

NCERT Textbook Questions Solved

Question 1. What is the barter system? What are its drawbacks?

Ans. When wants were not so multiple, goods were exchanged for goods. Exchange is a sign of interdependence. Barter system of exchange is a system in which goods are exchanged for goods. For example: In a village community, 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. But with the multiplicity of wants and greater need for exchange, barter system proved to be inefficient system of exchange.

Following are the drawbacks of barter system:

1. Lack of double coincidence of wants: Double coincidence of wants implies that goods in possession of two different individuals must be useful and needed by each other. But it is a rare occurrence. It is difficult to find a person who wants your horse and at the same time possess a cow that you want to buy. Accordingly, under the barter system, exchange remained extremely limited.

2. Lack of a common unit of value: Under barter system, the price of each commodity would have to be defined in terms of other commodities. For example: if somebody asks, “What is the value of your car”? I can answer Rs.5 lakhs or so, but the same answer is not possible under barter system. Under such a system, my car would be valued in terms of wheat, horses, vegetables, furniture etc. simply because there is no money. It limits the amount of trade.

3. Lack of standard of future/deferred payments: With commodity exchange it is not possible to have a satisfactory unit of future payments like salaries,interest, loan etc. It causes the problem of choice of goods, or the composition of goods to be delivered in the future.

4. Lack of a store of value: Due to lack of money in a barter economy, wealth is stored in terms of goods. But it is subject to some problems such as cost of storage, loss of value, difficulty in quick disposition without loss. It is difficult to store potatoes, tomatoes, grains etc. So in case of commodities it is difficult for people to store their purchasing power.

Question 2. What are the main functions of money? How does money
overcome the shortcomings of a barter system?

Ans. Money finds its origin in the need to facilitate exchange.Therefore money is generally defined as a thing that is commonly accepted as a medium of exchange. Definition of money: According to Fisher,` Money is what money does.’ In the words of Crowther, Money can be defined as anything which is generally acceptable as a means of exchange and also acts as a measure and of value. Money is a function of four; medium, standard, unit and store. Money is anything which performs following four functions:

  1. Medium of exchange
  2. General acceptability i.e. standard of deferred payments
  3. Store of value
  4. Unit of value


1. Medium of Exchange: Money acts as a medium of exchange. It means that money acts as an intermediary for the goods & services in an exchange transaction. In the absence of money, Barter system used to prevail (exchange of goods for goods). Its major drawback was lack of double co-incidence of wants. Without money our complicated economic system based on specialization would have been impossible.This function removes the problem of double coincidence of wants.

2. A Store of Value: Individuals try to save a part of their income for their future needs. This is called store of value. It was not possible under barter system as many goods and all services can’t be stored for future use. Money allows us to store purchasing power, through which we can exercise our claim on goods and services in the future. This function removes the problem of lack of store of value.

3. A Unit of Account: Unit of account means that the value of each good or service is measured in the monetary unit. Money works as a common denominator into which the value of all goods and services is expressed. Money can be used purely for accounting purpose without any physical existence. Each and every thing needs a unit to be measured. Money acts as a measure of value. Value of all goods and services can be determined in terms of money.This function removes the problems of lack of unit of account.

4. A Standard of Deferred Payments: It means a payment to be made in future can be denominated in terms of money in just the same way as can a payment to be made today. Here, money is acting as a unit of account with added dimension of time. Credit has become the life and blood of a modern economy. The debtors make a promise that they will make payment on some future date. In those situations money acts as a standard of deferred payments.This function removes the value of lack of standard of deferred payments.

Question 3. What is transaction demand for money? How is it related to the value of transactions over a specified period of time?

Ans. When money is demanded for transaction motive i.e. to buy goods and services, it is called transaction demand for money. It is a direct function of income i.e. more will be the income, more will be transaction demand for money and vice-versa. Symbolically,
M(d,t) = k.Y

More will be transactions over a period of time, morewill be transaction demand for money. People like to keep their money in liquid form (cash) to meet their day-to-day expenses during the period between the receipt and spending of their money. The necessity for liquidity on this account arises to bridge the gap between the receipt of income and its spending. An individual or a firm receives income at a particularfixed time while its spending is spread over a period of time and in order to meet these expenses, as and when they arise money in cash is needed. The amount of money which an individual needs for such expenses depends upon his income. This motive for liquidity has been called by Keynes as ‘transaction motive*. Liquidity preference on account of this motive is interestinelastic.

Question 4. Suppose a bond promises rs.500 at the end of two years with no intermediate return. If the rate of interest is 5 per cent per annum what is the price of the bond?
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Question 5. Why is speculative demand for money inversely related to the rate of interest?

Ans. Rate of interest is the opportunity cost of keeping cash in hand. If more money is kept in liquid form, it gives no return which otherwise could give rate of interest.Therefore, more will be the rate of interest, less will be speculative demand for money and vice versa.
M(d,s) = – F(I

The third and the last motive for liquidity preference is the desire to earn profits. Many people may think that the rate of interest in the future will be higher and in order to take advantage of this future increase in the rate of interest, they may like to keep money in the liquid form to be invested in securities when the rates of interest actually rise. In the opposite case when the feeling is that interest rates would decline, they will invest in the present thus reducing the liquidity of money with them. Keynes has called this as ‘Speculative Motive’.Price of bonds and rate of interest are inversely related. If the rate of interest is higher, the price bond would be low and vice-versa. This can be explained with the help of an example. Say a bond of 100 has been issued which will carry 5% interest. This implies that whatever may be the price of bond but its holder will get a return of rs.5, essentially Now say the rate of interest goes upto rs.6, and then rs. 83.3 as the price of bond will ensure a return of rs.5. On the other hand, if the rate of interest declines to 4, then rs.125 as the price of bond will ensure a return of rs.5. Therefore, it is clear when rate of interest goes up, price of bond goes down and vice-versa. Now the question arises as to how much one should keep money in cash or should invest in bonds and securities. If one speculates that the rate of interest would be low in future (means a rise in the price of bonds), he would hold money in cash at present with a view to earn profits by investing in bonds in future.

On the other hand, if he expects that in future rate of interest would be higher (this means a decline in the price bonds) demand for holding cash at present would decline. Thus, if the speculated rate of interest is low, the demand for money would be higher and vice-versa. Keynes has attached the maximum importance to liquidity preference for speculative purpose. Liquidity preference for first two motives generally remains fixed. It depends upon the level of income and is interest inelastic. On the other hand, demand for money or liquidity preference for speculative motive is interest elastic, i.e., the function of interest.

Question 6. What is ‘liquidity trap’?

Ans. When rate of interest falls to such a low level that speculative demand curve becomes parallel to x-axis, it is called liquidity trap. A situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

Question 7. What are the alternative definitions of money supply in India?

Ans. Supply of money is a stock concept. It refers to the stock of money held by the public at a point of time in an economy. The money supply of an economy at any point of time is the total amount of money in
Supply of money does not include: stock of money held by the government; and Stock of money held by the banking system (i.e. both commercial and central bank) of a country.

Components of money supply

Currency with the public: It includes coins and paper notes held by the public. Currency is also known as fiat money. Fiat Money or Currency is defined as the money which under law must be accepted for all debts. Here also only currency held by the public is included. Demand deposits: These are the money deposits made by the depositor or owner of the deposit to the bank. Now bank is agreed to honour such demands or pay money on demand at any time and to whomsoever the owner of the deposit may wish. For this purpose people use cheques.
Money Stock in India: In 1977 the RBI classified money stock in India into the following four categories.
M1 = C + DD + OD
C = Currency i.e. coins and paper notes;
DD = Demand deposits with the banks;
OD = Other deposits of financial institutions, foreign central banks, foreign government with RBI It is known as NARROW MONEY.
M2 = M1+ Post office savings deposits
M3 = M1 + Net Time deposits of the public with banks
It is called BROAD MONEY.
M4 = M3 + total post office deposits (other than NSC) The RBI has redefined its parameters for measuring money supply:
M1 = Currency + Demand deposits + other deposits with the RBI
M2 = M1 + Time liabilities portion of saving deposits with banks + certificates of deposits issued by banks + term deposits maturing within a year excluding FCNR(B) Deposits.
M3 = M2 + term deposits with banks maturing over one year + Call/term borrowings of the banking system. M4 has been excluded from the scheme of monetary aggregates.

Question 8. What is a ‘legal tender’? What is ‘flat money’?

Ans. Legal tender refers to that money which is legally bound to be accepted by people. It is the money which has legal authority from the government. There may be:
(a) Limited legal tender: Coins have limited tender i.e. they can be used for transactions up to ` 100.
(b) Unlimited legal tender: Notes and currency have unlimited tender i.e. they have to be accepted for any amount of money. Flat money refers to that money which is issued by order or authority of the government. It includes all notes and coins which the people in a country are bound to accept as medium of exchange.

Question 9. What is high powered money?

Ans. High powered money is the sum total of currency and cash reserves with the banks.

Question 10. Explain the functions of a commercial bank.

Ans. Functions of commercial banks:

1. Acceptance of deposits : Banks may accept deposits in the form of demand deposits or time deposits.Deposits which are withdrawable on demand are called demand deposits. It includes current deposits and saving deposits. The deposits which can be withdrawn only after expiry of a fixed time period are called time deposits. Lower interest is paid on saving deposits, higher interest is paid on time deposits and no interest is paid on current deposits.

2. Lending of loans : Through this function banks acts as a mediator between those who want to save and those who wish to invest and thereby promotes the rate of capital formation. Banks extend loans in the form of

  • Cash credit
  • Overdrafts
  • Loans and advances
  • Discounting of bills of exchange Interest charged by the bank on various loans depends upon the amount, period, social priority, nature of security offered, and solvency of the borrower.

3. Agency Services : An Agent is one who acts on behalf of someone else. Banks acts as the agent of its customers in following ways:

  • Collection of Bills, Promissory Notes And Cheque
  • Collection of Dividends, Interests, Premium Etc.
  • Purchase and Sale of Securities and Shares.
  • Acting as a trustee or nominee when so nominated
  • Making regular payments such as regular premiums Etc.

4. General Services: A modern bank performs following general services for its clients:

  • Issue of Letter Of Credit, Traveler Cheque, Bank Drafts etc.
  • Locker Facility
  • Underwriting Of Shares
  • Conducting Economic Survey
  • Supplying Trade Information And Vital Statistics

Question 11. What is money multiplier? How will you determine its value? What ratios play an important role in the determination of the value of the money multiplier?

Ans. In the process of credit creation, a commercial bank can create credit equal to a multiple of its primary deposits. Smbolically, Money multiplier can be shown as follows:
K = 1/LRR
Where K = money Multiplier and
LRR= Legal Reserve ratio = sum total of cash reserve ratio and statutory liquidity ratio

Example: Suppose the Cash Reserve Ratio is 20% and a person deposits rs.10,000/- with Bank of India. This is primary deposit. The bank keeps rs.2000 as CRR and balance of 8000 is used for granting credit. Now suppose Bank of India lends 8000 to Mr. A and Mr. A pays a cheque of 8000 to Mr. B, who has an account in Bank Of baroda. Then Bank Of Baroda receives rs.8000 as primary deposit. It keeps 1,600 (20%) as CRR and excess amount of rs.6,400 is used for giving credit. Now if, Mr. C is granted this loan and Mr.C gives a cheque of rs. 6,400 to another person who may deposit it in Bank of Maharashtra. Bank of Maharashtra will keep rs.1,280 as CRR and issue a loan of rs.5,120. This process continues until the original excess reserves of rs.8000 with the first Bank of India, have been parceled out among various banks and have been required resources. As a result, the aggregate of derivative deposits in the entire banking system, approximates 5 times the initial derivative deposit over a period of time.
Let us explain with the help of table:

In the above example., the credit expansion is five times the initial excess reserve of rs.8,000 when CRR is 20%.
TC =(PD – PCR)/CRR × 100
Where TC = Total Credit
PD = Primary Deposit.
PCR = Primary cash Reserve.
CCR = Cash Reserve Ratio.
Cash Creation = (10000 – 2000)/20 × 100 = 8000/20 × 100 = 40,000
The Credit Multiplier depends on CRR.
r = CRR
If CRR is 20 % then, credit multiplier will be The Multiple expansion of credit is the inverse of CRR maintained by banks. Higher the CRR, Lower the expansion of credit and vice-versa.


The bank deposit multipler, discussed above, is based on the following assumptions:-

  1. There is no leakage from the banking system. All the money should remain with banking system.
  2. The banks must receive new deposits.
  3. They must be willing to make loans or buy securities.
  4. The CRR remains constant through all the stages.
  5. People must be willing to borrow.
  6. The business conditions are normal.
  7. There is no credit control policy of central bank.
  8. There should be popular banking habit in the country and a well developed banking system.

Question 12. What are the instruments of monetary policy of RBI? How does RBI stabilize money supply against exogenous shocks?

Ans. The main tools of commercial banks are exhibited as quantitative and qualitative tools. Quantitative tools control total volume of credit and qualitative tools control direction of credit. These are explained in the chart given below:

Question 13. Do you consider a commercial bank ‘creator of money’ in the economy?

Ans. Commercial Banks are an important source of money supply in the form of demand deposits. The basis measure of money supply has two components i.e. currency with public and demand deposits in commercial banks. The currency is created by the Central Bank i.e. the Reserve Bank of India (RBI) and is called High Powered Money. Demand deposits are created by the commercial banks and are called Bank Money. Therefore, we do consider commercial bank as creator of money in the economy. It can be clarified through following example. Commercial banks receive deposits from the public. The depositors are free to withdraw their deposit amounts through cheques. The bank uses these deposits to give loans. But the banks cannot use the whole of deposit for this purpose. It is legally compulsory for the banks to keep a certain minimum fraction of these deposits as cash. This fraction is called the Legal Reserve Ratio (LRR). This function of the bank is the basis of deposit or credit or money creation. How much are the deposits created depends upon the initial deposits by the public and the Legal Reserve Ratio. this ratio is fixed by RBI.

It has following two components:
1. A part of LRR is to be kept with RBI and this partratio is known as Cash Reserve Ratio (CRR); called the Statutory Liquidity Ratio (SLR).

Process of credit/money creation

  • Initial deposit in the bank = rs.100
  • LRR = 25% i.e. banks keep only rs.25 as cash reserve.
  • Maximum amount that a bank can lend = rs.75.
  • All the transactions are routed through bank.

Question 14. What role of RBI is known as ‘lender of last resort’?

Ans. Central bank is under an obligation to provide funds to commercial banks in the times of crisis. The aim is that no sound and genuine transaction should be restricted or abandoned due to shortage of funds. Commercial banks approach the central bank as a last resort in distress. The central bank advances loan to the commercial banks, subject to certain terms and conditions.

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