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Chapter Analysis
Intermediate17 pages • EnglishQuick Summary
Chapter 3 in Macroeconomics discusses the fundamental concepts of money and banking. It highlights the functions of money, such as facilitating exchange, serving as a unit of account, and maintaining value over time. The chapter delves into the process of money supply and the role of financial institutions, particularly central and commercial banks. It explains critical topics like the creation of money supply and the tools used by the Reserve Bank of India to control money supply, including open market operations and reserve ratios.
Key Topics
- •Functions of money
- •Demand and supply of money
- •Money creation by banks
- •Role of the central bank
- •Open market operations
- •Monetary policy tools
- •Liquidity trap
- •Demonetization
Learning Objectives
- ✓Understand the primary functions of money in an economy.
- ✓Explain how money supply is regulated and controlled.
- ✓Describe the process of money creation by the banking system.
- ✓Identify the monetary policy instruments used by the Reserve Bank of India.
- ✓Analyze the effects of central bank actions on the money supply.
- ✓Understand the concept and implications of a liquidity trap.
Questions in Chapter
What is a barter system? What are its drawbacks?
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What are the main functions of money? How does money overcome the shortcomings of a barter system?
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What is transaction demand for money? How is it related to the value of transactions over a specified period of time?
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What are the alternative definitions of money supply in India?
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What is a ‘legal tender’? What is ‘fiat money’?
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What is High Powered Money?
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Explain the functions of a commercial bank.
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What is money multiplier? What determines the value of this multiplier?
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What are the instruments of monetary policy of RBI?
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Do you consider a commercial bank ‘creator of money’ in the economy?
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What role of RBI is known as ‘lender of last resort’?
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Additional Practice Questions
Explain how the money multiplier effect works with an example.
mediumAnswer: The money multiplier effect refers to the increase in final income arising from any new injection of spending. Suppose a bank receives new deposits of Rs 1,000, and the reserve ratio is 10%. The bank can lend Rs 900 of this deposit. The borrower pays this Rs 900 to someone who deposits it into their bank. The bank can then lend 90% of Rs 900 (Rs 810), and so on. This process results in a total monetary expansion greater than the original deposit.
Describe the role of the Reserve Bank of India in controlling the money supply.
mediumAnswer: The Reserve Bank of India controls money supply through various tools like the bank rate, open market operations, and the cash reserve ratio. For instance, by changing the cash reserve ratio, RBI influences the amount of deposit banks need to hold, thus controlling their ability to create new money.
What are open market operations and how do they influence the economy?
mediumAnswer: Open market operations involve the buying and selling of government securities in the market to expand or contract the amount of money in the banking system. When the central bank buys securities, it injects money into the economy, and when it sells securities, it takes money out of circulation.
How does the concept of liquidity trap affect the demand for money?
hardAnswer: A liquidity trap occurs when interest rates are low, and savings rates are high, making monetary policy ineffective. In such a scenario, despite an increase in the money supply, demand for money does not change, as people hoard cash instead of investing.
Discuss the impact of demonetization on the money supply and banking sector.
hardAnswer: Demonetization involves stripping a currency unit of its status as legal tender. It impacts money supply by reducing the amount of physical currency in circulation, initially causing a cash crunch but eventually leading to increased deposits in banks as people convert old notes. This also leads to a temporary reduction in the velocity of money.