NCERT Solutions for Class 12 Macro Economics Chapter 3 Money and Banking

CBSE Class 12 Macroeconomics Chapter 3 Solutions

The solutions and exercise of NCERT solutions for Class 12 Macroeconomics Chapter 3 give the reason why money is an essential factor in India and how it facilitates exchange under RBI’s control.

The fourteen questions in the solution deal with functions of money demand and equations related to it.

1. What is a barter system? What are its drawbacks? 

Ans: In ancient times, the barter system was used to exchange things. It was a method of exchanging one commodity, product, or set of goods for another. For example, if a person has 1 kg of sugar and wants 1 kg of jaggery in trade, he can do so if someone else is prepared to exchange sugar for jaggery. A commodity for commodity exchange was the name given to this activity. It was also supplanted by the monetary system. 

The following are some of the disadvantages of the barter system:

1. Double Coincidence of Wants: It is one of the assumptions that led to the downfall of the barter system. The double coincidence of wants indicates that two individuals will only exchange commodities and services if they both require the goods of the other.

2. Indivisibility of Goods: This refers to another significant disadvantage of the barter system. In the event of items that lose their utility when divided into components, the barter system of exchange was not applicable.

3. Common Measure of Value: One of the most significant causes for the barter system's collapse. Because there is no universal measure of worth in the barter system, determining a set ratio for exchanging commodities and services is problematic.

4. Store of Value:  Refers to one of the reasons for the barter system's collapse. In the barter system, value is stored in the form of commodities including cereal grains and livestock.

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

Ans: The most liquid of all assets is money. It is globally accepted and may thus be easily swapped for other commodities. Money is defined as something that is widely recognised by people as a medium of exchange for goods and services.

 Function of money are divided into two categories:

1. Primary Function.

2. Secondary Function.

Primary or Main Functions:

a. Medium of Exchange: Money is a medium of exchange, which means it can be used to buy and sell products and services. Goods were swapped for goods in the absence of money. This necessitated a two-fold alignment of desires. As a result, communication was difficult and so limited. The act of sale and purchase are now separated by the introduction of money, and the double coincidence of desires is no longer required. Exchange is now considerably easier and, as a result, limitless. This has increased an economy's total level of economic activity. Rather than being subsistence-oriented, production is now market-oriented.

b. Measure of Value: Money is a unit of account that acts as a measure of value. The worth of each commodity or service is quantified in monetary units, which is referred to as the unit of account. In the barter system, where one commodity was valued in terms of the other, determining value was extremely difficult.  There was no universal monetary unit. The introduction of money has alleviated this problem.

Secondary of Substantiary functions: 

1. Standard of Deferred Payments: Standard of deferred payments: Deferred payments are those that are made at some point in the future. Deferred payments, for example, have never been easier than they are now. When we borrow money from someone, we must pay back both the principal and the interest. Making such transactions in terms of products and services is tough. Because money retains a constant value over time, using it as a standard for postponed or delayed payments greatly simplifies borrowing and lending processes.

2. Store of Value: Money can be used to transmit purchasing power from the present to the future. Money is a form of wealth storage. Although wealth can be held in other ways, money is the most cost-effective and practical option. Individuals can use it to cover unexpected expenses, such as medical bills, and to pay off future debts.

Money has been able to overcome the disadvantages of the barter system in the following ways:

1. Money, as a means of exchange, has solved the major problem of the barter system i.e. double coincidence of wants. It distinguishes between the activities of selling and buying goods and services, allowing both parties to achieve maximum pleasure.

2. Various items had different values under the Barter system, and there was no standard nomenclature to describe their exchange ratios. Money, on the other hand, is the yardstick by which the value of other goods is expressed. The relative values of any two commodities become easy to compare.

3. It is extremely difficult to store items for future use in a barter economy. The majority of the commodities are perishable, necessitating a large amount of storage space and transit costs. Money, on the other hand, may be easily saved for later use. It is the most practical and cost-effective method of storing profits and capital. It has the advantage of widespread acceptance and a consistent value when compared to other items.

4. The lack of a sufficient standard for deferred payments in the barter system makes credit transactions problematic. At the time of repayment, the borrower may not be able to obtain products of the same quality. Future payments, on the other hand, are expressed in terms of money due to its widespread acceptance. Money has made borrowing and lending easier, as well as encouraging capital production.

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

Ans: The desire for conducting or meeting day-to-day transactions is referred to as transaction demand for money. This motive can be viewed from the perspective of consumers, who require money to carry out their daily business operations, i.e., income motive, and businesspeople, who require money to carry out their daily business activities, i.e., a commercial motive In the context of current individual and business unit transactions, the transaction motive relates to the demand for money. People earn money at different times of the year, but they consume the same amount throughout the year. People are more prone to keep money for transactional purposes as a result of this. 

The following is an explanation of the relationship between transaction value and transaction demand for money: 

In an economy $\left(\mathrm M_{\mathrm T}^{\mathrm D}\right)$, the transaction demand for money can be stated as:

$\left(\mathrm M_{\mathrm T}^{\mathrm D}\right)=\mathrm{KT}\\\Rightarrow\dfrac1{\mathrm K}\mathrm M_{\mathrm T}^{\mathrm D}=\mathrm T\\\Rightarrow\mathrm{vM}_{\mathrm T}^{\mathrm D}=\mathrm T $

Where,

$v = \dfrac1{\mathrm K}$, represents velocity of circulation of money

T = Total value of transaction in the economy over a period of time

K is a positive fraction

$\mathrm M_{\mathrm T}^{\mathrm D}$= Stock of money held by people at a particular point of time.

The total value of transactions is favourably associated to the transaction demand for money, but the velocity with which money is moved is adversely related.

4. Suppose a bond promises Rs. 500 at the end of two years with no intermediate return. If the rate of interest is 5 percent per annum what is the price of the bond?

Ans: Let the price of the bond be Rs. p

$\mathrm A=\mathrm p\left(1+\dfrac{\mathrm r}{100}\right)^{\mathrm n}$

It is given that

A = Rs. 500

r = 5%

n = 2 years

Substituting the values in the formula

$500=\mathrm p\left(1+\dfrac5{100}\right)^2\\500=\mathrm p\left(1+\dfrac1{20}\right)^2\\500=\mathrm p\left(1+\dfrac{21}{20}\right)^2\\500=\mathrm p\left(\dfrac{441}{400}\right)\\\mathrm p=\dfrac{200000}{441}=453.51\;$

So, p = Rs. 453.51

Therefore, the price of the bond is Rs. 453.51.

5. Why is speculative demand for money inversely related to the rate of interest?

Ans: The inverse relationship between speculative demand for money and the rate of interest is that when interest rates rise, speculative demand for money falls, and vice versa. As a result, the speculative demand for the money curve slopes downward to the right. There are two possibilities:

1. People will convert their money into bonds if the market rate of interest is very high and predicted to diminish in the future, i.e. the price of a bond rises, anticipating capital gain from bond-holding. As a result, there is little speculative demand for money.

2. People change their bonds into money in order to avoid future capital loss if interest rates are low and people anticipate that they will rise in the future, i.e. decreasing bond prices anticipating capital loss from bond ownership. They keep cash on hand because they believe that non-monetary assets such as bonds will generate little income, lowering the cost of money keeping.

6. What is a 'liquidity trap'?

Ans: The liquidity trap occurs when an expansionary monetary policy fails to raise interest rates or income, and hence fails to encourage economic growth. The liquidity trap is monetary policy's most extreme effect. It's a circumstance in which the general population is willing to hold on to whatever amount of money is offered at a particular interest rate. They do so because of dread of negative outcomes such as deflation and conflict.

In that circumstance, open market activities used to implement monetary policy have no effect on the interest rate or the level of income. The interest rate is unaffected by monetary policy in a liquidity trap. At short-term zero percent interest rates, there is a liquidity trap. When the interest rate is zero, the public will not want to keep any bonds because money, which pays zero percent interest as well, has the advantage of being useful in transactions.

Therefore, if there is no interest rate, an increase in money supply will not persuade anyone to buy bonds, lowering the rate of interest on bonds below zero. 

$\mathrm M_{\mathrm s}^{\mathrm d}=\dfrac{{\mathrm r}_\max-\mathrm r}{\mathrm r-{\mathrm r}_\min}$

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

Ans: The total stock of money of all forms - currency as well as demand deposits - held by the inhabitants of a country at any given time is referred to as the money supply.

Features of Money Supply:

1. It contains money held solely by the public. The term "public" refers to the money-using sector, which includes both individuals and businesses. It excludes the money-creating sector, namely the government and banking system, because their cash balances do not enter actual circulation in the country.

2. It's a 'Stock Concept,' meaning it's about a specific point in time.

Money supply in India is quantified in a variety of methods, including ${\mathrm M}_1,{\mathrm M}_2,{\mathrm M}_3, and {\mathrm M}_4$ measurements. Every measurement has its own set of components, ranging from the most liquid to the most hard.  

${\mathrm M}_1,{\mathrm M}_2,{\mathrm M}_3, and\; {\mathrm M}_4$ are listed in order of descending liquidity. To put it another way, ${\mathrm M}_1$ has the most liquidity whereas ${\mathrm M}_4$ has the least.

So, ${\mathrm M}_1=\;\mathrm C\;+\mathrm{DD}\;+\mathrm{OD}$

Where,

C = Public currency

DD = Net demand deposits of the bank

OD = Other deposits held by RBI

${\mathrm M}_2={\mathrm M}_1+\;\mathrm{Savings}\;\mathrm{of}\;\mathrm{the}\;\mathrm{people}\;\mathrm{with}\;\mathrm{Post}\;\mathrm{offices}$

${\mathrm M}_2$ includes the components of ${\mathrm M}_1$ as well as the savings of the people of the Post office.

${\mathrm M}_3={\mathrm M}_4+\mathrm{Net}\;\mathrm{time}\;\mathrm{deposits}\;\mathrm{with}\;\mathrm{commercial}\;\mathrm{banks}$

${\mathrm M}_3$ is the most commonly used measure of money of ${\mathrm M}_1$ commercial banks.

$\;{\mathrm M}_4={\mathrm M}_3+\;\mathrm{Total}\;\mathrm{deposits}\;\mathrm{with}\;\mathrm{post}\;\mathrm{offices}\;\mathrm{excluding}\;\mathrm{National}\;\mathrm{Savings}\;\mathrm{Certificate}$

8. What is a ‘legal tender’? What is ‘fiat money’?

Ans: The term "legal tender" or "legal money" refers to money that is subject to the laws of the land. It is money that is issued by a monetary authority or the government and cannot be denied as payment for transactions by anyone. The government issues an order defining money, and that money becomes legal currency. Everyone is obligated to accept it in exchange for products and services, as well as for the repayment of obligations.Legal tender money includes currency, paper notes, and coins, which cannot be refused as payment for transactions or as a means of exchange.

The currency that a government declares to be legal tender is called fiat money but is

not backed by a physical asset. The value of fiat money is determined by the connection between supply and demand rather than the worth of the commodity used to make the money.

9. What is High Powered Money?

Ans: High Powered Money is  the money that the RBI and the government create, with the public holding the currency and banks holding the cash reserves. It is distinct from money in that money is made up of demand deposits, whereas cash reserves are used to create demand deposits.

So, to sum up, high powered money is H = C + R

Where,

H = High powered money

C = Currency

R = Cash Reserves of Commercial Banks

10. Explain the Functions of a Commercial Bank.

Ans: A commercial bank is a type of financial organisation that handles all transactions involving the deposit and withdrawal of money for the public, as well as the provision of loans for investment purposes and other similar activities.

1. Accept Deposits: Deposits are accepted at the bank in the form of savings, current, and fixed deposits. Surplus funds received from businesses and people are lent to meet the short-term needs of commercial operations.

2. Credit Cash: When a customer receives credit or a loan, they do not receive liquid cash. The customer's bank account is opened first, and then the funds are sent to the account. The bank is able to manufacture money through this technique.

3. Provides Loan and Advances: Another important duty of this bank is to provide loans and advances to entrepreneurs and business persons, as well as collect interest. It is the most important source of earnings for any bank.

4. Overdraft Facility: This is a loan offered to a customer in exchange for keeping their current account open and allowing them to overdraw up to a certain limit.

5. Discounting Bills of Exchange: A discount bill of exchange is a written agreement that acknowledges the sum of money to be paid for products acquired at a future date. A commercial bank's discounting strategy can also be used to clear the payment before the quoted period.

6. Locker Facilities: Customers can use a bank's locker facilities to store their valuables or papers discreetly. This service is charged at least once a year by the banks.

7. Purchasing and Selling Securities: The bank provides you with the option of buying and selling securities.

11. What is money multiplier? What determines the value of this multiplier?What ratios play an important role in the determination of the value of the money multiplier?

Ans: The money multiplier is the amount of money generated by banks for every dollar of reserves. The amount of deposits that the Federal Reserve must hold rather than lend is referred to as a reserve. In an economy, it is the ratio of money stock to high-powered money stock.

In an economy, the money multiplier is the ratio of the stock of money to the stock of high-powered money:

${\mathrm M}_{\mathrm M}=\dfrac{\mathrm M}{\mathrm H}$

Where, ${\mathrm M}_{\mathrm M}$ is the money multiplier

M = Stock of money 

H = High powered money

The value of multiplier is always more than one, and it can be calculated as follows:

M = C + DD

  = (1 + cdr)DD

where ,

M= Money supply

C= Currency held by people 

cdr= Currency deposit ratio

DD = Demand deposits

High powered money = Currency + Reserve money

H = C + R

cdrD + rdrD

D(cdr +rdr)

So, $\dfrac{\mathrm M}{\mathrm H}=\dfrac{1+\mathrm{cdr}}{\mathrm{cdr}+\mathrm{rdr}}$ which is > 1

When calculating the money multiplier, the reserve deposit ratio and currency deposit ratio are key factors to consider. The cdr is the proportion of money held by the general population compared to money held in bank deposits. The rdr is the percentage of total deposits held as reserve by commercial banks.

12. What are the instruments of monetary policy of the RBI?

Ans: The central bank's policy on the use of monetary tools within its authority to fulfil the Act's goals is referred to as monetary policy. The Reserve Bank of India (RBI) is charged for implementing monetary policy in India. The Reserve Bank of India Act, 1934, expressly mandates this obligation. 

The instruments of monetary policy of the RBI are as follows:

1. Quantitative Measures

• Varying Reserve Ratios:

• Cash Reserve Ratio (CRR): It is a portion of a bank’s total deposits that the Reserve Bank of India requires to be kept with the latter as liquid cash reserves.

• Statutory Liquidity Ratio (SLS): It is essentially the reserve requirement that banks must maintain before extending credit to customers. It is essentially the reserve requirement that banks must maintain before extending credit to customers.

• Bank Rate: The interest rate charged by a nation’s central bank to its domestic banks in order for them to borrow money is referred to as its bank rate. The interest rates charged by central banks are meant to stabilise the economy.

• High Powered Money: It is the money created by the RBI and the government, in

which the public holds the currency, and the banks hold the cash reserves. It differs from money for that money consists of demand deposits, whereas cash reserves serve as a foundation for creating demand deposits.

2. Qualitative Measures

• Open Market Operation: It refers to the central bank’s selling and purchase of

securities on the open market to and from commercial banks or the general public.

• Bank Rate Policy: It refers to the central bank’s manipulation of the discount rate

in order to influence the economy’s credit condition.

• Sterilisation by RBI: The RBI’s market-based strategy in neutralising a portion or the whole monetary impact of foreign inflows is known as sterilising.

• Moral Suasion: The RBI uses this strategy to persuade commercial banks to assist in regulating the money supply in the economy.

The Reserve Bank of India (RBI) is a key player in the management of external shocks. Assume a foreigner decides to put money into Indian bonds. The foreign currency is then exchanged into Indian rupees by the bond seller at a commercial bank. The same commercial bank deposits money in the RBI, increasing assets and liabilities on the balance sheet; but, the overall reserves of the commercial bank remain unaltered.

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

Ans: Yes, commercial banks play a significant role in the economy as "money creators." They are able to generate credit by way of demand deposits. Demand deposits provide credit in excess of the initial deposits. As a result, banks build credit by making loans.

Using a bank XYZ as an example, the process of money production can be discussed. A depositor makes a Rs.20,000 deposit in his savings account, which the bank treats as a demand deposit. Based on the presumption that not all clients will withdraw their deposits on the same day, the bank keeps a minimum cash reserve of 10% of demand deposits. It extends credit to other consumers for the remaining amount of Rs.18000. This generates more deposits for the XYZ bank. As a result, the credit multiplier is:

Credit multiplier = $\dfrac{1}{CRP} =\dfrac1{10\%}= 10$

The amount of credit multiplier will enhance the money supply.

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

Ans: When a commercial bank is faced with a financial crisis and is unable to secure funds from other sources, the central bank steps in as a "lender of last resort," providing financial assistance in the form of credit. The central bank's role saves the commercial bank from failure. As a result, the central bank acts as a guarantor for commercial banks, ensuring that the financial system in the economy is sound and healthy.

NCERT Solutions for Class 12 Macroeconomics Chapter 3 Money and Banking

For all-round development of young children, the chapter is broadly categorized into topics like functions of money, barter system and fiat money and repo rate. Moreover, there are topics like a supply of money, banking system, credit creation by commercial banks, demonetization etc.

Macroeconomics Class 12 Chapter 3 includes chapters designed under expert supervision to enhance knowledge of how money works. The standard medium of exchange holds both primary and contingent functions to run a healthy economy.

The solutions deal with these ideas and offer questions to sharpen the reasoning and logical skill of students. Moreover, this solution of Chapter 3 of Macroeconomics Class 12 by Vedantu is available in PDF format to ease out the learning process.

You can refer to these solutions for revision to score high flying grades in board exams.

Important Questions from Macro Economics (Short, Long & Practice)

Short Answer Type Questions

1. What is meant by the term money supply?

2. What is meant by credit creation?

3. What is the cash reserve ratio (CRR)?

4. What is statutory liquidity ratio (SLR)?

Long Answer Type Questions

1. What do you mean by credit/money creation? Explain the process of Money creation by the commercial banks with the help of a numerical example.

2. Money acts as a yardstick of standard measure of value to which all other things can be compared. Discuss it.

3. Central bank performs the function of a clearing house. How?

Practice Questions

1. All the currency issued by the central bank is its monetary liability. How?

2. Explain the ‘Medium of Exchange’ function of money?

3. Explain the ‘Lender of Last Resort’ function of the central bank.

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• Solutions are written accurately to help students in quickly finding solutions.

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Marks Distribution of Class 12th Macroeconomics Chapter 3

The Macroeconomics Class 12 Chapter 3 is divided into knowledge (30%), understanding (50%) and application (20%). This chapter money and banking carry a total of 8 marks where two marks are rewarded for four short answer type questions.

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Referring to the NCERT solution for board exam will benefit a student in the following ways -

• Practice of crucial topics related to money and banking.

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Important Study Material Links for Class 12 Economics Chapter 3 - Money and Banking

NCERT Solutions for Class 12 Macro Economics - Chapter-wise List

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Conclusion

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