ASSIGNMENT:- MONEY AND CREDIT CHAPTER -2 MACROECONOMICS

ASSIGNMENT:-   MONEY AND BANKING 

CHAPTER -2 

MACROECONOMICS 

Q. 1  What is Money?

Money is anything that has the general acceptability as a common medium of exchange & as

a common measure of the value of the commodities.

Q. 2 What is a Barter system?

It refers to the exchange of goods for goods. In other words, it refers to the direct exchange of goods & services with another.

Q. 3 Define the term Money Supply & state its constituents.

It refers to the total stock of money in an economy at any point in time, held by the general public i.e. the private individuals and business firms (money is in the disposable form). In other words, it is the amount of money that is in circulation in an economy at a given point in time. The two constituents of money supply are currency held by the general public & demand deposits of the general public held by the Commercial Banks. Thus, M1 = C + DD+O

Q. 4 Define the term Commercial bank.

A Commercial bank is a financial institution that performs the function of accepting deposits from the public & advancing loans. These banks act as the financial intermediary between the idle resources & the productive sources of resources.

Q. 5 What are the different types of deposits held by Commercial Banks?

a) Current account deposits or Chequeable deposits are payable on cheques & the depositors can withdraw their deposits whenever they like. This account is generally maintained by the traders for day to day transactions. The banks pay no interest on this deposit.

b) Saving Account deposits are those deposits on which the bank pays interest which is less than the interest paid on the fixed deposits. The bank imposes some restrictions on its withdrawal. The purpose of this deposit is to encourage & mobilize small savings.

c) Fixed or Time Deposits refer to the deposits which are accepted for the specified period & which are not payable on demand before the expiry of the period. The bank pays a relatively high rate of interest on this deposit.

The variant of this deposit is a Recurring Deposit whose purpose is to encourage regular savings by the people. This deposit is based upon the installment payment for a fixed period of time on which the interest is paid after the maturity of the account.

Define the term Central Bank & explain its functions.

A Central Bank is an apex institution which directs, control, regulates & supervises the monetary system of a country. The central bank is the monetary authority that leads all banking & non – banking institutions. The name of the Central bank in India is Reserve Bank of India (RBI) which is established in 1935. The RBI occupies the highest position in the money & capital market.

Functions

1. It has the monopoly of issuing currency notes. It has the exclusive right to issue the currency notes in the country which leads to the uniformity of the currency throughout the nation. Moreover, this enables it to have total control over the total money supply of the country which leads to the strengthening of the monetary policy during the crisis time.

2. It acts as a banker of the govt. as it accepts the deposits of the govt. & makes payment on behalf of it, gives financial advice, & advances the loans in the crisis times, remit the surplus funds of Govt., purchase & sell Govt. securities on its behalf.

3. It acts as a banker's bank in the form of lender of last resort, facilitates clearing house facilities & remit the surplus funds, supervises the banking activities & regulates credit- deposits of the Banks. Since RBI is the guardian of all the banks, the banks can get the benefit of easy & early credit during their financial requirements. As a facilitator of clearing, the RBI makes early settlement of financial claims & debts of the banks. As a result, the banks don't face any problem of cash liquidity, & thus they need not remain depending on the bank credit or capital funds of the banks. As a regulator & supervisor, the banks are not in the position of any malpractice & the entire banking system remains transparent & accountable to the public.

4. It acts as a custodian of gold reserves & the nation's stock of foreign exchange reserve. The purchase & sale of Gold & foreign exchange at the global level is done by RBI only. As a custodian, RBI is responsible for maintaining the stock of gold & forex reserves & the determination of their prices.

5. It acts as a controller of credit which is one of the most important functions. Since it is an apex institution, therefore can play an effective role to combat or correct the inflationary or deflationary pressures of an economy. The RBI controls credit by using Quantitative(General) & Qualitative(Selective) credit control methods. The tools under quantitative methods are Bank/Repo rate, Reserve repo rate, CRR & SLR, Open market operations. Under selective methods, RBI uses Margin, credit quota & rationing, moral suasion & direct action, etc.

6. It promotes the economic growth & development of the country by erecting the financial institutions in the rural areas, providing direct loans to the farmers, framing the policies in favor of trade & industry, collect the economic information’s & publish through its various journals which further helps the govt. & other institutions to adopt the correct policies etc.

Q. Explain how does aCommercialBankcreatescredit(money supply).

Credit creation by the banks is determined by (i) the number of initial deposits and ii) the legal reserve ratio (LRR). It is assumed that all the money that goes out of banks is redeposited into the banks, and LRR consists of CRR & SLR.

A Commercial Bank accepts deposits from the general public & creates a primary account deposit. This creates liability for the bank & asset for the depositor. It is also referred to as an active deposit. From the active deposits the banks deduct the legal reserves to be kept in Central Bank (RBI), & the rest (excess reserves) are used in loans & investment. When a bank gives loans & advances, it creates another deposit known as derivative deposits or secondary account deposits on the name of the debtor. This leads to the creation of a new primary account, & thus the new primary deposits keep on increasing until the credit multiplier stops working. Greater the LRR, smaller the amount of total final deposits, & vice versa.

An Illustration to explain the process of credit creation:

Let the LRR be 20% and there is a Fresh/Primary/Initial/Deposit Account of Rs 10000. The banks keep 20% ie Rs 2000 as cash and lend the remaining Rs 8000 to a borrower by opening a new account, called Loan/Secondary/Derived Account.

 ROUNDS INITIAL DEPOSIT

1 10000

2 8000

---- ---- ----

TOTAL 50000 10000 40000

Here we assume that all the banking transactions will be through monetary instruments

viz cheques etc.

As assumed, the amount of Rs 8000 will come back to the banks as a fresh deposit from which once again the bank will keep 20% ie Rs.1600 as LRR and rest Rs 6400 will be lent to some other borrower. The bank now creates another secondary account which will once again become a primary account. This process continues and the money goes on multiplying till the sum of LRR and the fresh deposit amount is the same or the new deposit becomes nil. Finally, when we add the total money creation, we get Rs 50000 as the total deposit creation.

Total credit creation = Initial deposit X 1/LRR = 10000 X 1/20% = 10000 X 100/20 = Rs

50000

Q. DefinethetermsLRR,CRR,SLR,Repo&ReverseReporate,CreditMultiplier.Legal Reserve Ratio: It refers to the minimum portion of total net demand & time deposits of Commercial Banks which have to be maintained with Central Bank & themselves as cash liquid assets. There are two legal reserves viz. CRR & SLR.

Cash Liquidity Ratio: It refers to the minimum portion of total net deposits of Commercial Banks which have to be maintained with the Central Bank. During inflation or deflation, the CRR is regulated by RBI to control inflation or deflation. During inflation, CRR is increased to restrict the credit by making it dearer, while it is reduced during deflation to expand the money supply in the economy by making it cheaper.

Statutory Liquidity Ratio: It refers to that portion of total deposits that have to be maintained by the Banks themselves in the form of liquid cash assets against the securities of Govt. & RBI.

Repo rate ie Repurchase rate of interest refers to the interest paid by the Commercial Banks to RBI against the loans & advances taken by them from RBI to meet the short term needs. By changing the Repo rate, RBI can regulate the money supply. It is different from Bank Rate in a way that Bank rate is charged against the loans taken by commercial banks for long term needs.

Reverse Repo Rate refers to the interest received by the Commercial Banks from the Central banks against the parking of funds by the commercial banks. By increasing RRR, the RBI can encourage Commercial Banks to park more funds so as to restrict the money supply in the economy. By reducing RRR, the RBI discourages the parking of funds which helps to induce more credit in the economy to resolve the issue of deflation.

Credit Multiplier refers to the amount by which the initial deposit multiplies into a larger amount of final deposits. It is equal to 1/LRR. Thus, credit multiplier is inverse to LRR