Banking NCERT SOLUTION CLASS 12TH MACRO ECONOMICS | EDUGROWN NOTES

Textbook Question And Answer:

Q.1Explain the functions of a commercial bank?
ANSWER|:Deleted from syllabus.

Q.2 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? [3-4 Marks]
ANSWER|:

1. When the primary cash deposit in the banking system leads to multiple expansion in the total deposits, it is known as money multiplier or credit multiplier.
2. The value of Money Multiplier
   =1LRR
   where LRR = Legal Reserve Ratio.
3.  Legal Reserve Ratio: It is the minimum ratio of deposits legally required to be kept by the commercial banks with themselves and with the central bank.
4.  So, there are two ratios which play an important role in the determination of the value of the money multiplier. They are:
   (a) Cash Reserve Ratio: It refers to the minimum percentage of a bank’s total deposits, which it is required to keep with the central bank.
   (b) Statutory Liquidity Ratio: It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.

Q.3 What are the instruments of monetary policy of RBI? How does RBI stabilize money supply against exogenous shocks?
ANSWER:

1. Principal instruments of Monetary Policy or credit control of the Central Bank of a country(RBI) are broadly classified as:
   (a) Quantitative Instruments,
   • Bank Rate
   • Repo rate
   • Reverse Repo rate
   • Open Market Operations (OMO)
   • Varying Reserve Requirements (fa) Qualitative Instruments
   • Imposing margin requirement on secured loans
   • Moral Suasion
   • Selective Credit Controls (SCCs)
2.  RBI stabilize money supply against exogenous shocks in the following manner:
   (a) Bank Rate (Discount Rate)
   • Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan). The thing, which has to be remembered, is that central bank lends to commercial banks and not to general public.
   • In a situation of excess demand leading to inflation,
   > Central bank raises bank rate that discourages commercial banks in borrowing from central bank as it will increase the cost of borrowing of commercial bank.
   > It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.
   > Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.
   > Thus, expenditure on investment and consumption is reduced, which will control the excess demand.
   • In a situation of deficient demand leading to deflation,
   > Central bank decreases bank rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.
   > Decrease in bank rate makes commercial bank to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.
   > Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.
   > Thus, expenditure on investment and consumption increase, which will control the deficient demand.
   (b) Open Market Operations (OMO)
   • It consists of buying and selling of government securities and bonds in the open market by central bank.
   • In a situation of excess demand leading to inflation, central bank sells government securities and bonds to commercial bank. With the sale of these securities, the power of commercial bank of giving loans decreases, which will control excess demand.
   • In a situation of deficient demand leading to deflation, central bank purchases government securities and bonds from commercial bank. With the purchase of these securities, the power of commercial bank of giving loans increases, which will control deficient demand.
   (c) Imposing margin requirement on secured loans
   • Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.
   • So, the difference between the value of security and value of loan is called marginal requirement.
   • In a situation of excess demand leading to inflation, central bank raises marginal requirements. This
   discourages borrowing because it makes people gets less credit against their securities.
   • In a situation of deficient demand leading to deflation, central bank decreases marginal requirements. This encourages borrowing because it makes people get more credit against their securities.
   (d) Moral Suasion
   • Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.
   • In a situation of excess demand leading to inflation, it appeals for credit contraction.
   • In a situation of deficient demand leading to deflation, it appeals for credit expansion.

Q.4 Do you consider a commercial bank ‘Creator of money’ in the economy?
Or
Explain the process of money creation/deposit creation/credit creation by the commercial banking system.
Giving a numerical example, explain the process of money creation by commercial banks.

How do commercial banks create deposits? Explain.
Explain the credit creation role of commercial banks with the help of a numerical example.
Or
Explain briefly the working of money multiplier.
ANSWER: Yes, commercial bank acts as a ‘Creator of money’ in the economy. It can be explained with the help of Credit creation process:

1.  Let us assume that the entire commercial banking system is one unit. Let us call this one unit simply “banks’. Let us also assume that all receipts and payments in the economy are routed through the banks. One who makes payment does it by writing cheque. The one who receives payment deposits the same in his deposit account.
2. Suppose initially people deposit Rs 1000. The banks use this money for giving 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. The fraction is called the Legal Reserve Ratio (LRR). The LRR is fixed by the Central Bank.
3. Let us now explain the process, suppose the initial deposits in banks is Rs 1000 and the LRR is 10 percent. Further, suppose that banks keep only the minimum required, i.e., Rs 100 as cash reserve, banks are now free to lend the remainder Rs 900. Suppose they lend Rs 900. What banks do to open deposit accounts in the.names of the borrowers who are free to withdraw the amount whenever they like. Suppose they withdraw the whole of amount for making payments.
4. Now, since all the transactions are routed through the banks, the money spent by the borrowers comes back into the banks into the deposit accounts of those who have received this payment. This increases demand deposit in banks by Rs 900. It is 90 per cent of the initial deposit. These deposits of Rs 900 have resulted on account of loans given by the banks. In this sense the banks are responsible for money creation. With this round increase in total deposits is now Rs 1900 (=1000 + 900).
5. When banks receive new deposit of ?900, they keep 10 per cent of it as cash reserves and use the remaining Rs 810 for giving loans. The borrowers use these loans for making payments. The money comes back into the
   accounts of those who have received the payments. Bank deposits again rise, but by a smaller amount of Rs 810. It is 90 per cent of the last deposit creation. The total deposits now increase to Rs 2710 (=1000 + 900 + 810). The process does not end and continues till total deposit creation comes to ? 10000, ten times the initial deposit as shown in the table below.
   

Q.5 What role of RBI is known as ‘Lender of last Resort’? [3 Marks]
ANSWER:

1. As banker to the banks, the central bank acts as the lender of the last resort.
2. In other words, in case the commercial banks fail to meet their financial requirements from other sources, they can, as a last resort, approach to the central bank for loans and advances.
3.  The central bank assists such banks through discounting of approved securities and bills of exchange.

Short Answer Type Question:

Q.1Explain issue of currency function of Central Bank.
Or
Explain the “Bank of Issue Function” of the central Bank.
ANSWER:

1. The central bank has the sole monopoly to issue currency notes. Commercial banks cannot issue currency notes. Currency notes issued by the central bank are the legal tender money.
2. Legal tender money is one, which every individual is bound to accept by law in exchange for goods and services and in the discharge of debts.
3. Central bank has an issue department, which is solely responsible for the issue of notes.
4. However, the monopoly of central bank to issue the currency notes may be partial in certain countries.
5. For example, in India, one rupee notes and all coins are issued by the government and all other notes are issued by the Reserve Bank of India.

Q.2 Explain banker to the government function of a Central Bank.[CBSE 2013, 06C; AI 08; 10]
Or
Explain “Government’s Bank” function of Central Bank.[CBSE 2015]
ANSWER:   As a banker to the government, the central bank performs same functions as performed by the commercial banks to their customers.

1. It receives deposits from the government and collects cheques and drafts deposited in the government account.
2. It provides cash to the government as resumed for payment of salaries and wages to their staff and other cash disbursements.
3.  It makes payments on behalf of the government.
4. It also advances short term loans to the government.
5. It supplies foreign exchange to the government for repaying external debt or making other payments.

Q.3 Explain the “banker’s bank ’ function of a central bank.[Al 2015, 2007, 11, CBSE 13, Al]
ANSWER:  Central bank acts as the banker to the banks in three ways :

1.  custodian of the cash reserves of the commercial banks;
2. as the lender of the last resort; and
3. as clearing agent.

1. As a custodian of the cash reserves of the commercial banks, the central bank maintains the cash reserves of the commercial banks. Every commercial bank has to keep a certain percent of its cash reserves with the central bank by law.
2.  As Lender of the Last Resort.
   (a) As banker to the banks, the central bank acts as the lender of the last resort.
   (b) In other words, in case the commercial banks fail to meet their financial requirements from other sources, they can, as a last resort, approach to the central bank for loans and advances.
3. The central bank assists such banks through discounting of approved securities and bills of exchange.
   (c) As Clearing Agent
   (i) As the custodian of the cash reserves of the commercial banks, the central bank acts as the clearing house for these banks.
   (ii) Since all banks have their accounts with the central bank, the central bank can easily settle the claims of various banks against each other simply by book entries of transfers from and to their accounts.
   (iii) This method of settling accounts is called Clearing House Function of the central bank.

Q.4 What is Legal Reserve Ratio? Explain its components. [AI 2013, C (Set 1)]
ANSWER:

1. Legal Reserve Ratio: It is the minimum ratio of deposits legally required to be kept by the commercial banks with themselves and with the central bank.
2. It’s components are:
   (a) Cash Reserve Ratio: It refers to the minimum percentage of a bank’s total deposits, which it is required to keep with the central bank.
   (b) Statutory Liquidity Ratio: It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.

Long Question type Answer:

Q.1(i) What is meant by Cash Reserve Ratio? How does it increase the money Supply in the economy? (ii) What is meant by Open Market Operation? How does it reduce the money supply in the economy?[CBSE Sample Paper 2014][(3 + 3)]
ANSWER:

1. Cash Reserve Ratio:
   (a) It refers to the minimum percentage of a bank’s total deposits, which it is required to keep with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law.
   (b) For example, if the minimum reserve ratio is 10% and total deposits of a certain bank is ?100 crore, it will have to keep Rs 10 crore with the central bank.
   (c) To increase Money supply in an economy, cash reserve ratio (CRR) falls to 5 per cent, the bank will have to keep Rs 5 crore with the central bank, which will increase the cash resources of commercial bank and increasing credit availability in the economy, which will increase the money supply in an economy.
2. Open Market Operation:
   (a) It consists of buying and selling of government securities and bonds in the open market by central bank.
   (b) To reduce Money Supply in an economy, central bank sells government securities and bonds to commercial bank. With the sale of these securities, the power of commercial bank of giving loans decreases, which will reduce the money supply in an economy.