Money, Banking and Monetary Policy: Money Supply, Credit Creation and Central Bank Tools (Basics) Questions

Question 1

Define money.

Accepted Answer

**Money** is anything that is generally accepted as a **medium of exchange** and used to settle payments for goods and services.

Question 2

Write any one function of money.

Accepted Answer

One function of money is **unit of account**: it provides a common measure for expressing prices and values.

Question 3

What is bank money?

Accepted Answer

**Bank money** is money in the form of **bank deposits** which can be used for payments through cheques, cards or digital transfers.

Question 4

What is CRR?

Accepted Answer

**CRR (Cash Reserve Ratio)** is the portion of bank deposits that commercial banks must keep as **cash reserves with the central bank**.

Question 5

What is repo rate?

Accepted Answer

**Repo rate** is the interest rate at which the central bank lends funds to commercial banks against approved securities.

Question 6

State one limitation of credit creation by banks.

Accepted Answer

One limitation is **reserve requirements (CRR/SLR)**, which reduce the amount of deposits available for lending.

Question 7

Explain functions of money (any four).

Accepted Answer

Functions of money (any four):

- **Medium of exchange**: money is used to buy and sell goods/services, replacing barter.
- **Unit of account**: prices and values are expressed in a common unit (Rs., $).
- **Store of value**: wealth can be held in money form for future use (though inflation reduces value).
- **Standard of deferred payments**: enables loans/credit and payment in future.
- **Transfer of value**: money allows value to be transferred easily between persons/places.

Thus, money makes exchange and economic activity smooth and efficient.

Question 8

Explain types of money (commodity, fiat and bank money) with examples.

Accepted Answer

Types of money:

- **Commodity money**: has intrinsic value as a commodity.
  - Example: gold/silver coins historically.
- **Fiat money**: issued by government/central bank; value is based on **legal backing**.
  - Example: currency notes and coins.
- **Bank money (deposit money)**: bank deposits used for payments through cheques/cards/digital transfers.
  - Example: savings/current account balances.

Hence, modern economies mainly use fiat money and bank money.

Question 9

Explain money supply and distinguish between narrow money and broad money (brief).

Accepted Answer

### **Money Supply**

Money supply is the total stock of money available in an economy at a given time.

- **Narrow money (e.g., M1)**: includes highly liquid components like **currency with public** and **demand deposits**.
- **Broad money (e.g., M3)**: includes M1 plus less liquid deposits like **time deposits** and other near-money components.

Mini table:

| Measure | Liquidity | Typical components |
|---|---|---|
| **M1** | very high | currency + demand deposits |
| **M3** | lower than M1 | M1 + time deposits |

Thus, broad money is wider and larger in size than narrow money.

Question 10

Explain credit creation by commercial banks (process) in simple steps.

Accepted Answer

Credit creation by banks occurs when banks give loans and create deposits.

Steps (simple):
- Bank receives an initial **deposit**.
- It keeps a part as **reserves** (CRR/SLR) and lends the remaining amount.
- The loan amount is credited to borrower’s account, creating a **new deposit**.
- When this deposit moves to another bank, that bank again keeps reserves and lends the rest.

Thus, the banking system can expand total deposits and credit multiple times based on initial deposits (within limits).

Question 11

Explain limitations of credit creation by commercial banks (any three).

Accepted Answer

Limitations of credit creation (any three):

- **Reserve requirements (CRR/SLR)**: higher required reserves reduce banks’ **lendable funds**, limiting deposit expansion.
- **Cash leakages**: if the public holds more **cash** and less deposits, the multiplier process weakens.
- **Lack of loan demand / creditworthy borrowers**: even if banks can lend, weak demand or higher risk reduces credit creation.
- **Central bank policy**: tight monetary policy (repo rate ↑, OMO sales) reduces liquidity and restricts lending.

Thus, credit creation is not unlimited; it depends on reserves, public behaviour and monetary policy conditions.

Question 12

Explain monetary policy and its objectives (any four).

Accepted Answer

### **Monetary Policy**

Monetary policy refers to actions taken by the **central bank** to control **money supply** and **credit conditions**.

Objectives (any four):
- **Price stability**: control inflation and maintain stable purchasing power.
- **Economic growth**: support investment and output by providing adequate credit.
- **Full employment**: encourage economic activity to reduce unemployment.
- **Financial stability**: maintain stability of banking and financial system.
- **Exchange rate stability**: reduce excessive currency fluctuations.

Thus, monetary policy balances growth with inflation control.

Question 13

Explain tools/instruments of monetary policy (RBI tools) with a table (exam-style).

Accepted Answer

### **Tools of Monetary Policy (RBI Tools) — Exam-Style**

The central bank uses quantitative and qualitative tools to control money supply and credit.

#### **Quantitative tools**

| Tool | Meaning | Effect when increased |
|---|---|---|
| **CRR** | cash kept with RBI as % of deposits | lendable funds ↓, credit ↓ |
| **SLR** | liquid assets held as % of deposits | lending capacity ↓ |
| **Repo rate** | RBI lends to banks | borrowing cost ↑, interest rates ↑ |
| **Reverse repo** | RBI borrows from banks | banks park funds with RBI, liquidity ↓ |
| **OMO** | RBI buys/sells govt securities | sell → liquidity ↓; buy → liquidity ↑ |

#### **Qualitative/Selective tools**
- **Moral suasion** (guidelines/appeals)
- **Selective credit control** (margin requirements, sectoral limits)

**Conclusion:** By using these tools, the RBI influences **liquidity**, **interest rates**, and the overall **availability of credit** in the economy.

Question 14

Explain credit creation with deposit multiplier (basic) and a small flowchart.

Accepted Answer

### **Credit Creation and Deposit Multiplier (Basic)**

Banks keep a fraction of deposits as reserves and lend the rest. When loans are credited into accounts, they become new deposits, enabling further lending. This creates a multiple expansion of deposits in the banking system.

#### **Deposit/Credit multiplier**
In the simplest case:
- **m = 1 / r**
Where:
- **m** = multiplier
- **r** = reserve ratio (as a fraction)

Example (quick):
- If **r = 0.10 (10%)**, then **m = 1/0.10 = 10**.
So, an initial deposit of Rs. 1,000 can create up to Rs. 10,000 deposits in the ideal case (subject to leakages).

Flowchart (simplified):

```text
Deposit (D)
  ↓ keep reserves (rD)
  ↓ lend (1−r)D
Loan credited → becomes new deposit → repeat across banks
  ↓
Multiple expansion of deposits/credit
```

**Conclusion:** Actual multiplier is smaller in reality due to cash leakages, excess reserves, and lack of loan demand.

Question 15

Explain how monetary policy affects business decisions (interest rate, credit, and exchange rate channels) with examples.

Accepted Answer

### **How Monetary Policy Affects Business Decisions**

Monetary policy influences firms through multiple channels. Key channels are:

#### **1) Interest rate channel**
- When **repo rate/market interest rates rise**, bank loan rates increase.
- Firms face higher cost of borrowing → they may postpone **investment** and cut expansion.
- Example: high interest rates reduce housing/vehicle demand, so related industries face lower sales.

#### **2) Credit (bank lending) channel**
- Tight policy (CRR/SLR ↑, liquidity ↓) reduces banks’ lending capacity.
- Working capital becomes difficult for firms, especially SMEs → production may slow.
- Example: stricter credit reduces inventory financing and delays procurement.

#### **3) Exchange rate channel**
- Interest rate changes can affect currency value.
- Currency appreciation can make exports less competitive; depreciation raises import costs.
- Example: depreciation increases cost of imported raw materials, raising production cost.

Mini summary table:

| Channel | Policy tightening effect | Business impact |
|---|---|---|
| Interest rate | rates ↑ | investment ↓, EMI-sensitive demand ↓ |
| Credit | lending ↓ | working capital stress |
| Exchange rate | currency moves | export/import costs change |

**Conclusion:** By changing interest rates and liquidity, monetary policy directly shapes business costs, demand, and profitability.

Money, Banking and Monetary Policy: Money Supply, Credit Creation and Central Bank Tools (Basics)

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