Chapter 3 (T-6, Money & Banking) [11-18/06/25]

Question 1

What is Money?

Answer 1

Money is a “genrally acceptable medium of exchange”.

Question 2

Properties of genrally acceptable medium of exchange?

Answer 2

1. Demand & Limited Supply.
2. Store of Value - Intrincis or Fiat.
3. Authentication.
4. Denomination.

Question 3

How is Modern Money created by the CB?

Answer 3

By buying assets and creating liablities in return, in form of Currency notes.

Question 4

Why does seller accepts it?

Answer 4

1. Trust - Trust in the issuing entity and his ability to discharge the liablity, acceptance by others.
2. Legal Tender - He is legally bound to accept it as a means for repayment of debt.

Question 5

Reason for RBI procurring Govt Bonds and not diamond?

Answer 5

A]
1. Limited supply of Gold.
2. Increasing Population & demand for MOE.
3. Gold-like properties of Govt bonds.

B]
Diamond’s value is SUBJECTIVE & VOLATILE.

Question 6

What is a BOND? Can an individual issue a bond?
What properties makes it similar to gold.

Answer 6

1] A Bond is a debt instrument, which is used by entities(govt, coorporations) to raise money from public or institutional investors.

2] No, an individual cannot issue a bond coz its SEBI & RBI regulated, needs regulatory approval, credit rating,etc.

3] Least-risk, stable prices, large d&s.

Question 7

RBI’s Balance sheet(Assets & Liablities)

Answer 7

Assets - (Gold, Foreign Currency) - Appreciating Assets. (Bonds, Lending to other banks) - Interest bearing assets.

High Powered Money - Currency, Deposits with RBI(Govt&Banks), Borrowing of RBI.

Question 8

Explain the nature of Seneorage

Answer 8

Seigneorage refer’s to the profits of the RBI, which are ‘incidental’, most of this are transferred to the GOI, some is kept as buffer and remaining are used for RBI’s opreational cost, maintainence cost, salaries, promotions, etc. fact - RBI has its own banking system for its employees.

Question 9

Primary focus of RBI, while buying assets?

Answer 9

‘Adequate’ amount of ‘trustworthy’ assets in the economy.

Question 10

People’s trust on RBI is dependent on Govt.

Answer 10

Most of assets of RBI are in form of the goverment bond. Hence, People’ confidence on the RBI is dependent on thier trust upon the govt to pay the bonds.

Question 11

What is Demand of Money and primary reason for DOM.

Answer 11

DOM refers to the amount of money demanded at any point in the economy. Demand primarily comes from 3 purposes :

1. Transaction P
2. Precautionary P
3. Speculative P

Question 12

Explain transaction demand of money, and it is dependent upon which factors?

Answer 12

“Transaction demand for money refers to the amount of money people hold to carry out day-to-day transactions. It depends on the total value of transactions (nominal income) and is inversely related to the velocity of money. It reflects present or immediate spending needs—not future uncertainties.”

Question 13

Explain how the Velocity of Money affects the Demand of Money.

Answer 13

“The velocity of money reflects the rate at which money is exchanged in an economy. A declining velocity may indicate economic stagnation, prompting central banks to inject more money into the system to maintain demand.”

Question 14

What is Speculative Demand Of Money and factors influencing it.

Answer 14

When people in an economy genrally hold money, expecting the prices of assets to fall, it is called speculative demand of money. Interest rates and asset prices are its main influencing factors.

Question 15

Explain “Liquidity Trap”.

Answer 15

When the Interest rates are at lowest[r=r(min)], the money demand function is highly elastic, that is for any more money which is added in the economy all all that would be speculative in nature that is people will hold money and wont buy any assets, this situation is known as “liquidity trap”.

Question 16

What if, due to limited asset supply, poeple are unable to buy assets, then money hence would be in money form, in this case the cash held will be speculative?

Answer 16

No, because the people are NOT expecting the prices of asset to go down.

Question 17

Expression of Money demand

Answer 17

M_d = kY - hi,

where, k=money people hold(transaction&precautionary),
Y=Incomes,
h=Speculative Demand w.r.t Interest rates,
i=Interest rates.

Question 18

Who creates money and what is Money Supply?

Answer 18

Money is created by the RBI as legal tender and by the Banks through credit creation process.

Money Supply is the total amount of money available in the economy at any given point of time.

Question 19

What is ‘Cost Of Money’, and it is dependent upon?

Answer 19

Cost of money is simply value of money, which is the “Interest Rates”. COM is a function of demand&supply. Since supply is controlled by RBI it can influence its cost by increasing or decreasing the supply.

“By increasing money supply through accommodative policy (e.g., reducing repo rate), the RBI lowers the cost of money, stimulating investment and growth. Conversely, in an inflationary scenario, tightening liquidity increases interest rates, curbing excess demand.”

Question 20

Why does RBI increases or decreases the Money Supply.

Answer 20

For promoting Growth & controlling inflation.

Question 21

What comprises of Money Supply? What are narrow and broad money.

Answer 21

“Money Supply is the total stock of money held by the public at a particular point in time. It comprises currency, demand deposits, and other liquid deposits with the banking system. The components of the money supply are categorized by the RBI into different measures (M1, M2, M3, M4) based on their decreasing order of liquidity.”

Narrow Money - M1(CIC + DD with bank) & M2(M1 + P.O. D.D)
Broad Money - M3(M1+T.D with banks) & M4(M3+P.O. Deposits)

M2&M4 have become irrelevant today.

Question 22

What is Cash Deposit Ratio?

Answer 22

Cash Reserve Ratio (CRR) is the proportion of a bank’s Net Demand and Time Liabilities (NDTL) that it must maintain with the RBI in the form of cash.

This cash earns no interest for the bank.

It is maintained on a fortnightly average basis.

The RBI does not specify a statutory upper or lower limit on CRR; it is determined by the RBI as per monetary policy requirements.

Question 23

What are Reserves?

Answer 23

To meet the normal demand of the depositors, banks keep reserves, but keeping reserves are costly, but they are also necessay to built people’s trust in the banking system, considereing its importance, RBI sets some minimum standards of deposits to be kept as reserves called Legal Reserve Ratio(LRR) and in India it’s known as Cash Reserve Ratio(CRR).

Question 24

What are Qualitative Monetry Policy tools?

Answer 24

“Qualitative monetary policy tools refer to the instruments used by the RBI to regulate the composition and direction of credit flow in the economy. While the impact on credit direction is known, the magnitude of their effect is not precisely quantifiable.” These are:

1. Moral Suesion - Request and Persuation
2. Margin Requirements - Diff betw loan and security aganist it.
3. Selective Credit Control - Celing.

Question 25

What are the tools of "Monetary" Policy. Types of Monetary Policy tools.

Answer 25

Tools of Monetary policy refers to the methods by which the RBI(Central Bank), control's the money supply in the economy. The types of monetary policy tools are - Quantitative & Qualitative.

Question 26

What is LRR or CRR.

Answer 26

The proportion of deposits to be held by the bank, as directed by the Central Bank.

Question 27

What are Quantitative Tools and list various types of QT.

Answer 27

Quantitative Monetry policy tool's application gives quantifibable results. 1] Open Market Operation(OMO) - RBI buys and sells assets in open market(E-Kuber). 2] Retail Direct Investment - Launched by RBI in 2021, allows everyone to participate in investing in G-Sec, etc without needing to open a demat account. Individuals can buy bonds directly from RBI autions and participate in its trading on Negotiating Dealing System-Order Mechanism(Retail Direct Gilt Account). 3] Reserve Ratio's 4] Liquidity Adjustment Facility 5] Marginal Standing Facility

Question 28

What are Reserve Ratio's

Answer 28

Reserve Ratio's are monetary policy tools used by the RBI, in which it uses reverves as a means to maintain liquidity. 1] Cash Reserve Ratio(CRR) : Amount of bank deposits which is to be kept as reserve with RBI in "cash" on "no interest", on a fort-night basis(short term) with no lower or upper limit. 2] Statutory Liquidity Ratio(SLR) : To maintain trust at resonable costs, RBI mandates bank under Banking Regulation act, 1949 to keep some deposits in its prescribed format like the Govt bonds, T-Bills, etc. Upper limit being 40% of NDTL, these assets are expected to retain their value and yield some return and can be liquadated conveniently.

Question 29

What is Liquidity Adjustment Facility.

Answer 29

Sometimes, there can be a mis-match between the liquidity with the bank and liquidity required by the bank. In this case the bank may arrange money from various sources, like from other banks(Call-Rate), increasing 'r' on the deposits, or it can ask RBI. Hence, in this case the RBI provides liquidity to the bank on a short term(overnight or 14days) on a fully secure basis(aganist G-Sec,etc), called the Repo-Rate upon which the bank pays an interest. If there is liquidity surplus with the bank it may park it with the RBI on the same basis upon which the RBI pays an interest.

Question 30

How does the Liquidity Adjustment Facility acts as a tool of Monetary Policy.

Answer 30

LAF is a monetary policy tool through which the banks adjust their liquidity mis-match. If the RBI increases the Repo Rate then the bank will also increase the interest rate, resulting in overall less credit demand, resulting in less money supply. If the RBI increase its RRR then the banks will park more of their funds will the CB, resulting in reduced money supply.

Question 31

Long Term Repo Operations

Answer 31

Same Repo and RRR concept with increased duration of liquidity(1-3years), introduced in pandemic.

Question 32

Variable Repo and Variable Reverse Repo.

Answer 32

Variable Repo - The RBI provides money to the bank through the auction based mechanism and interest rates are market determined. VRR- Same.

Question 33

Standing Deposit Facility.

Answer 33

Liquidity Absorbtion Tool introduced by the RBI, which allows the bank to park their surplus without any collateral. pandemic.

Question 34

Marginal Standing Facility.

Answer 34

The limited violation of SLR due to high credit demand, maximum of 1% of NDTL. This freed-up G-Sec is used for borrowing by the banks from the RBI at a penal rate called the MSF rate.

Question 35

What is a "Bank Rate".

Answer 35

Rate at which the RBI used to lend money earlier, although this has been discontinued since early 2000 and now is a dormant rate, used only in some penal provision.

Question 36

What is unconventional Monetary Policy Tool.

Answer 36

Market Sterlization Scheme. Used when traditional monetary tools fail to manage money supply (M₀ and Mₛ), especially during large foreign capital inflows. Problem: Sudden foreign investment increases demand for domestic currency (₹), leading to excessive liquidity, and potential inflation. Mechanism: Foreign investors convert foreign currency ($) into ₹ via banks. Banks sell $ to RBI, increasing ₹ in circulation. This raises the money supply (M₀), which could drive up inflation. Limitations of conventional tools: Raising rates like CRR/SLR imposes a high interest burden. Open Market Operations (OMO) are ineffective in large volumes, causing bond prices to fall and yields to rise, leading to losses for investors and banks. Solution (MSS): Government issues MSS bonds to absorb the excess ₹. Money raised from these bonds is kept with RBI and not spent, thus sterilizing the liquidity Government bears the interest cost on these bonds. Impact: Prevents inflation. Keeps economy stable and attractive for further foreign investments.

Question 37

The Mundell-Fleming Trilemma.

Answer 37

The Mundell-Fleming Trilemma, also known as the Monetary Policy Trilemma, posits that it is impossible for a country to simultaneously achieve all three of the following policy goals: 1. A fixed exchange rate 2. Free capital movement (open capital account) 3. An independent monetary policy According to the trilemma, a country can only pursue two out of these three objectives at any given time. Attempting to achieve all three simultaneously leads to economic instability or policy ineffectiveness. For example, if a country wants to maintain a fixed exchange rate and allow free capital movement, it must give up control over its domestic monetary policy.

Question 38

Inflation Targetting Framework.

Answer 38

Inflation targeting is a monetary policy strategy where the central bank (in India, the RBI) sets an explicit target for the inflation rate and steers monetary policy tools to achieve it. Hence, in 2015 it was decided that primary objective of RBI is to keep inflation within a tolerance range. that is (+ - 4%) of CPI-C. This decision is now taken by 6 member committtee(MPC) - 3 from RBI(GG, 2Dy GG) and 3 nominated by the govt, decisions are made public and the MPC meets usually after every 2months.

Question 39

What is 'Effectiveness of Monetary Policy'.

Answer 39

We access the effictiveness of monetary policy thorough the effectiveness of transmission of monetary decisions to bank lending rates.

Question 40

Evolution of Banks Lending Rates.

Answer 40

Pre-LPG = The banks were highly regulated by the Central Banks, and hence could not take any independent decision, the market forces were ignored. Post-LPG = Initiation of lineancy, Hence, Prime Lending Rate(PLR). PLR - Rate at which the banks lend money. Was non-transperant, hence corruption. Base Rate - To counter the inefficiencies, declared PLR rates. MCLR - Banks are required to declare the formula of calulating 'r' in a prescribed format.

Question 41

What is 'External Benchmarking'?

Answer 41

In 2019, RBI further modified MCLR guidelines, such that the variable cost should be benchedmarked to some external sector 'r'.

Question 42

Call Rate?

Answer 42

Interest Rate that prevails in inter-bank call market. MIBOR - Mumbai Inter-Bank Offered Rate, it is the standard call rate.