Class 12-science NCERT Solutions Economics Chapter 3 - Money and Banking

The system which was used in the ancient times to exchange goods and services is called the barter system. People used to exchange one commodity for another commodity. For example, a person having wheat used to exchange it for rice.
Drawbacks of the barter system:
Lack of standard of deferred payments: Under the barter system, it was very difficult to make future payments. This was because the borrower may be not be able to arrange for the same good with same quality. The good might lose its value or gain value during repayment.
Transfer of wealth: It is very difficult to transfer wealth in the barter system as certain goods cannot be transferred from one place to another.
Problem of double coincidence of wants: Double coincidence of wants indicates that two persons should satisfy their individual wants. However, in the barter system, it is very difficult to satisfy individual wants.
Lack of common units of value: In the barter system, there was no availability of a common unit which can be used to measure the value of goods and services. For example, a cow cannot be exchanged in terms of wheat.

Main functions of money:
Medium of exchange: The main function of money is to act as a medium of exchange. People can buy and sell goods and services by using money.
Standard of deferred payments: Money acts as a standard of deferred payments as people can easily use it for making payments. Paying or taking loans becomes easy due to the availability of money.
Store of value: People can store value with the help of money. For example, wealth can be saved in the form of money for future use.
Measure of value: Money is used as a common unit for measuring value. Goods and services can be bought and sold through the common medium of exchange money.
Money overcomes the shortcomings of the barter system in the following ways:
The problem of double coincidence is solved by money as it satisfies the interests of buyer and seller. Money has made it easier to measure the value of goods and services. It has solved the problem of paying future payments or saving value for future use.

The demand for meeting day-to-day transactions is called transaction demand for money. People demand money for meeting their day-to-day needs. Money is a medium of exchange and has want-satisfying power.

There is a positive relationship between transaction money demand and the value of transactions over a specified period of time. Velocity of money is negatively related with the transaction demand for money. 

According to the Reserve Bank of India, there are four definitions of money. The alternative definitions of money supply in India:

M1 = C + DD

C = Currency with public

DD = Demand deposits of banks

M2 = M1+ People’s savings with post office savings account

M3 = M1 + Net time deposits with commercial banks

M4 = M3 + Total deposits with post office except national savings certificates

Currency notes and coins issued by the Reserve Bank of India as legal medium of exchange are called legal tender. Legal tender can be used for day-to-day exchange purpose.
Fiat money refers to money backed by the Government of India. This money is considered legal for the repayment of debts and loans. Fiat money does not possess inherent value. Currency notes and coins are called fiat money.

High-powered money is money which includes currency held by the public, deposits with the Government of India and commercial bank reserves with the Reserve Bank of India. It is the main responsibility of the Reserve Bank of India to create high-powered money. The following equation is used to describe high-powered money:
H = C + R
H = High-powered money
C = Currency held by the public
R = Commercial bank reserves with the Reserve Bank of India

Functions of commercial banks:

1. Acceptance of deposits: The main function of commercial banks is to open various accounts to accept deposits. Commercial banks open following accounts to accept deposits.

   1. Fixed deposit account
   2. Savings deposit account
   3. Current deposit account

2. Granting loans and advances: Another important function of commercial banks is to grant loans and advances to the public.

   Commercial banks levy higher rate of interest on the loans and grants than the rate of interest given to public on their deposits. Banks normally give short-term and long-term loans and advances to the people to meet their requirements.

3. Agency functions: Apart from granting loans and accepting deposits, commercial banks perform the following agency functions:

   1. Transferring funds from one place to another
   2. Collecting funds
   3. Assisting customers in the process of tax payments
   4. Performing a role as a trustee
   5. Collecting dividends, interest on debentures and insurance premiums
4. Credit creation: Commercial banks play an important role in the process of credit creation. Demand deposits are used by commercial banks for the credit creation process. The financial growth of the economy is dependent on the credit creation capacity of commercial banks.
5. Discounting bills of exchange: It is one of the main functions of commercial banks to provide assistance to market players by discounting bills of exchange. The rate of interest is charged by commercial banks for discounting bills of exchange.

Money multiplier is the ratio of high-powered money to the stock of money in the economy in a particular year. The following formula describes the money multiplier:

MM= Money multiplier

S = Stock of money in the economy

H = High-powered money

The value of the money multiplier is determined by the ratios of high-powered money to the stock of money in the economy. Currency held by the public and reserves with banks play an important role in determining the value of high-powered money.

Currency deposit ratio (CDR) and reserve deposit ratio (RDR) play a vital role in deciding the value of the money multiplier.

Monetary instruments of the Reserve Bank of India (RBI):

Quantitative instruments: Bank rate, open market operations, cash reserve ratio (CRR) and statutory liquidity ratio (SLR) are the main quantitative instruments of the RBI. These instruments can be used to control money supply in the economy.

Bank rate: The rate at which commercial banks borrow credit from the RBI is called the bank rate.

Open market operations: Buying and selling of securities by the RBI in the open market is called open market operations.

CRR: This refers to the reserves which commercial banks are required to keep with the RBI in the form of cash deposits.

SLR: This refers to the reserves which commercial banks are required to keep with the RBI in the form of liquid or fixed assets.

Qualitative instruments: These involve margin requirements, rationing of credit and moral suasion. These instruments are mainly used by the RBI to provide direct guidelines to commercial banks.

Yes. Commercial banks can be considered ‘creator of money’ in the economy. Commercial banks have the ability to create credit by using their demand deposits related with the loans and advances given by them to the people.
The credit multiplier process is used by commercial banks to create money in the economy.
For example, a person deposits Rs. 1000 in his savings account which becomes the demand deposit of the commercial bank. This demand deposit is used by commercial banks to create more credit.

The RBI plays a vital role in the process of saving the commercial banks from bankruptcy.
When a particular commercial bank is in financial crisis and is not able to meet its financial requirements from other sources in the market, it approaches the RBI. The RBI provides financial assistance in the form credit to that bank. This role of the RBI is known as ‘lender of last resort’. So, for smooth functioning of the banking system in the economy, the lender of last resort is the RBI.