Test: Money And Banking - 2 - UPSC MCQ

The Reserve Bank of India (RBI) today gave freedom to banks in deciding their base rate. “Banks may choose any benchmark to arrive at the base rate for a specific tenor that may be disclosed transparently,” RBI said, as it released the final guidelines this evening.

Lending rate is for:
The lending rate refers to the interest rate at which commercial banks lend money to the public. The correct answer is D: Public by the commercial banks. Here is a detailed explanation:
Definition:
- The lending rate is the interest rate charged by banks to borrowers for loans or credit facilities.
- It is an essential tool used by banks to determine the cost of borrowing for individuals and businesses.
Explanation:
- Commercial banks are financial institutions that accept deposits from the public and provide loans and other financial services.
- They set the lending rates based on various factors such as the cost of funds, operating expenses, risk assessment, and market conditions.
- The lending rate can vary for different types of loans, such as personal loans, home loans, business loans, etc.
- Commercial banks determine the lending rate based on their own internal policies and guidelines.
Importance of the Lending Rate:
- The lending rate plays a crucial role in the economy as it affects borrowing costs for individuals and businesses.
- Higher lending rates make borrowing expensive, which can discourage investments and economic growth.
- Lower lending rates can stimulate borrowing and investment, leading to economic expansion.
- Central banks also influence lending rates through monetary policy measures, such as adjusting the benchmark interest rates or implementing reserve requirements.
Conclusion:
The lending rate is set by commercial banks and is applicable to the public. It is an important factor in determining the cost of borrowing for individuals and businesses.

Open market operations (OMO) refer to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Securities' purchases inject money into the banking system and stimulate growth, while sales of securities do the opposite and contract the economy. The Federal Reserve (Fed) facilitates this process and uses this technique to adjust and manipulate the federal funds rate, which is the rate at which banks borrow reserves from one another.

Open market operations refer to the buying and selling of government securities by the central bank in order to control the money supply in the economy. These operations are conducted by the central bank of a country.
The correct answer to the question is D: Central bank.
Explanation:
Open market operations are an important tool used by central banks to regulate the money supply in the economy and influence interest rates. Here is a detailed explanation of open market operations:
What are open market operations?
- Open market operations involve the buying and selling of government securities, such as Treasury bills, bonds, and notes, in the open market.
- The central bank conducts these operations to influence the reserves held by commercial banks and ultimately control the money supply in the economy.
How open market operations work:
- When the central bank wants to increase the money supply, it buys government securities from commercial banks and other financial institutions in the open market.
- By purchasing these securities, the central bank injects additional money into the banking system, increasing the reserves held by commercial banks.
- This increase in reserves allows commercial banks to lend more money, which results in more money circulating in the economy.
Benefits of open market operations:
- Open market operations provide flexibility to the central bank in managing the money supply.
- By adjusting the volume and frequency of these operations, the central bank can effectively influence interest rates and stabilize the economy.
- Open market operations are considered an important monetary policy tool as they can be implemented quickly and have a direct impact on the financial markets.
In conclusion, open market operations are conducted by the central bank in order to regulate the money supply and influence interest rates. Commercial banks, rural banks, and the World Bank do not directly engage in open market operations.

Answer:

Introduction:

Currency notes and coins are an essential part of the monetary system. They serve as a medium of exchange and a store of value. Different terms are used to describe currency notes and coins, depending on their characteristics and the legal status they hold. The options provided in the question are:

A: Flat money

B: Legal tenders

C: Fiat money

D: Both b and c

Explanation:

1. Flat Money:

Flat money refers to currency notes and coins that have value because the government declares them as legal tender. However, the term "flat money" is not commonly used and might not accurately describe currency notes and coins.

2. Legal Tenders:

Legal tenders are currency notes and coins that are recognized by law as a means of payment. They must be accepted by creditors as payment of debts. Legal tenders are issued by the government or central bank and are widely accepted within the country. Examples of legal tenders include the US dollar, Euro, British pound, etc.

3. Fiat Money:

Fiat money is a type of currency that has value because the government declares it as legal tender, but it is not backed by a physical commodity such as gold or silver. The value of fiat money is based on the trust and confidence of the people using it. Most modern currencies, including currency notes and coins, are examples of fiat money.

4. Both B and C:

The correct answer is option D, "Both b and c." Currency notes and coins are both legal tenders and fiat money. They are recognized by law as a means of payment and derive their value from the government's declaration.

Conclusion:

Currency notes and coins are commonly referred to as legal tenders and fiat money. They serve as a medium of exchange and are recognized by law as a means of payment. It is important to use and handle them responsibly to maintain the stability of the monetary system.

The lender of last resort is a function of the central bank.
The lender of last resort is a critical function performed by central banks to ensure the stability and liquidity of the financial system. Here's a detailed explanation:
Definition:
The lender of last resort is an entity, typically the central bank of a country, that provides financial support to commercial banks or other financial institutions when they are unable to obtain adequate liquidity from other sources. The goal is to prevent systemic financial crises and maintain the stability of the banking system.
Role of the central bank as the lender of last resort:
1. Liquidity provision: The central bank acts as a lender of last resort by providing emergency liquidity to banks facing a liquidity shortage. This helps banks meet their short-term obligations and prevents a potential bank run or panic.
2. Confidence building: By acting as the lender of last resort, the central bank reassures depositors and creditors that the banking system is stable and that their funds are safe. This helps maintain public confidence in the financial system.
3. Systemic risk management: The central bank's role as the lender of last resort helps manage systemic risk in the financial system. By providing liquidity to troubled banks, it prevents their failure, which could have a domino effect on other banks and the broader economy.
4. Collateralized lending: The central bank typically provides emergency loans to banks against collateral, such as government bonds or high-quality assets. This ensures that the central bank's support is backed by adequate security.
5. Terms and conditions: The central bank sets specific terms and conditions for providing emergency liquidity to banks. These terms may include interest rates, repayment periods, and collateral requirements.
6. Monitoring and supervision: As the lender of last resort, the central bank plays a crucial role in monitoring and supervising banks to ensure their financial soundness and prevent excessive risk-taking that could lead to liquidity problems.
In conclusion, the lender of last resort function is an essential role performed by central banks to safeguard the stability and liquidity of the financial system. By providing emergency liquidity, building confidence, and managing systemic risk, central banks play a crucial role in maintaining a stable banking system.

What is the currency deposit ratio (cdr)?

The currency deposit ratio (cdr) is a financial ratio that measures the proportion of money held by the public in currency to that held in bank deposits. It is used to analyze the preference of individuals and businesses to hold cash versus depositing it in banks.

Explanation:

When answering this question, it is important to provide a detailed explanation of the currency deposit ratio (cdr) and its components. Here is a breakdown of the answer:

Definition:
- The currency deposit ratio (cdr) is a financial ratio that measures the proportion of money held by the public in currency to that held in bank deposits.
Components of the cdr:
- Money held by the public in currency: This refers to the amount of money that individuals and businesses hold in physical cash, such as banknotes and coins.
- Money held by the public in bank deposits: This refers to the amount of money that individuals and businesses deposit in banks, which can be accessed through various types of accounts, such as savings accounts or checking accounts.
Interpretation:
- A higher currency deposit ratio indicates a larger proportion of money held in currency compared to bank deposits. This suggests a preference for holding physical cash rather than depositing it in banks.
- A lower currency deposit ratio indicates a larger proportion of money held in bank deposits compared to currency. This suggests a preference for depositing money in banks rather than keeping it as physical cash.
Uses of the cdr:
- The currency deposit ratio is used by economists and policymakers to understand the behavior and preferences of individuals and businesses regarding cash and bank deposits.
- It can be used as an indicator of the liquidity preference of the public, which can have implications for monetary policy and banking regulations.
Summary:
- The currency deposit ratio (cdr) is a financial ratio that measures the proportion of money held by the public in currency to that held in bank deposits.
- It helps to understand the preference of individuals and businesses for holding physical cash versus depositing it in banks.
- A higher cdr indicates a higher proportion of money held in currency, while a lower cdr indicates a higher proportion of money held in bank deposits.
- The cdr is used by economists and policymakers to analyze liquidity preferences and inform monetary policy decisions.

The Cash Reserve Ratio (CRR) is indeed a percentage of total deposits that commercial banks are required by law to keep with the central bank. However, the way the statement is phrased makes it sound as if the central bank keeps this reserve with the commercial banks, which is the opposite of the actual arrangement.

The correct statement should say that the commercial banks keep a percentage of their deposits as a reserve with the central bank, not the other way around.

Therefore, the statement as given is:

b) False

Most Liquid Asset: Money
- Liquidity refers to the ease with which an asset can be converted into cash without significant loss of value.
- Among the given options, money is considered to be the most liquid asset.
- Here's why:
1. Definition of Money:
- Money is a medium of exchange that is widely accepted in transactions for goods and services.
- It includes physical currency (coins and banknotes) as well as digital forms (bank deposits and electronic transfers).
2. Characteristics of Money:
- Acceptability: Money is universally accepted as a means of payment.
- Divisibility: Money can be divided into smaller units to facilitate transactions of varying values.
- Portability: Money is lightweight and easy to carry.
- Durability: Physical money is designed to withstand wear and tear.
- Uniformity: Money of the same denomination is standardized and identical.
- Stability: Money holds its value over time and is not subject to rapid depreciation.
3. Liquidity of Money:
- Money is highly liquid because it can be readily used to facilitate transactions and is widely accepted as a medium of exchange.
- It can be easily converted into goods, services, or other assets without significant loss of value.
- Cash, in particular, is the most liquid form of money as it can be used directly for transactions.
4. Comparison with Other Assets:
- Gold: While gold is a valuable asset, it is not as liquid as money. It needs to be sold in a market, which may involve finding a buyer and potential price fluctuations.
- Land: Land is considered a less liquid asset as it requires time and effort to sell. The process involves finding a buyer, negotiating terms, and completing legal procedures.
- Treasury Bonds: While treasury bonds are relatively liquid due to their tradability in financial markets, they may not be as immediately accessible as money.
Conclusion:
- Money, with its universal acceptance, divisibility, portability, durability, uniformity, stability, and immediate usability, is considered the most liquid asset.
- It offers the highest level of liquidity compared to other options like gold, land, and treasury bonds.

The correct option is Option A. 

If Reserve Bank of India wants to decrease the money supply in order to check inflation then they will use the quantitative measures of their monetary policy which includes: 

(i) Selling bonds in open market: Open market operation (OMO) is a monetary policy by the central bank in which the bank deals in the sale and purchase of securities and bonds in the open market to control the supply of money in the economy. By selling the securities and bonds, the central bank soaks liquidity from the economy that reduces the purchasing power in the economy which controls the situation of inflation.  

(ii) Increase in CCR: Cash Reserves Ratio (CRR) refers to the proportion of total deposits of the commercial banks which they must keep as reserves with the central bank in the form of cash. By increasing the cash reserve ratio, the commercial banks has to maintain more cash with the central bank which  reduces their credit creation capacity and therefore money supply in the economy also reduces which corrects the situation of inflation.

(iii) Hiking bank rate: Bank rate is the rate charged on the loans offered by the Central bank to the commercial banks without any collateral. Bank rate is a quantitative credit control measure under the monetary policy of the government as it controls the overall supply of the money in the economy. During inflation, bank rate is increased to reduce the total money supply in the economy by reducing the amount of credit creation by the commercial banks.

The services administered by 
government and paid for collectively through taxation are known as public goods. 

Examples of public goods are National defense, Roads, National forests. 

But, if we talk about cars, they are the mixed public goods.

M1 includes:
- Currency with public: This refers to the physical notes and coins in circulation that are held by individuals and businesses.
- Post Office savings deposits: These are deposits made by individuals in their post office savings accounts, which are considered as a part of the M1 money supply.
- Term deposits in RBI: This refers to the term deposits made by individuals and businesses with the Reserve Bank of India (RBI), which are included in the M1 money supply.
- Term deposits: These are deposits made by individuals and businesses in commercial banks for a fixed term, which are also considered as a part of the M1 money supply.
Explanation:
M1 is a measure of the money supply that includes the most liquid forms of money in an economy. It represents the total amount of money that is readily available for spending and can be used for transactions.
The components of M1 include currency with the public, which refers to the physical notes and coins held by individuals and businesses. This is the most tangible form of money and is readily accepted in transactions.
Post Office savings deposits are also included in M1. These are deposits made by individuals in their post office savings accounts, which are considered part of the money supply as they can be easily converted into cash and used for transactions.
Term deposits in RBI are also included in M1. These refer to the deposits made by individuals and businesses with the Reserve Bank of India (RBI). Although these deposits have a fixed term, they are included in M1 as they can be easily converted into cash if needed.
Finally, term deposits made by individuals and businesses in commercial banks are also considered part of M1. These deposits have a fixed term but can be easily converted into cash through early withdrawal or by taking a loan against the deposit.
Overall, M1 includes the most liquid forms of money in an economy, which can be readily used for transactions and spending.

M2 is a calculation of the money supply that includes all elements of M1 as well as "near money." M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds and other time deposits.

Answer:

One of the types of deposit accounts offered by commercial banks is a savings account. A savings account is a popular choice for individuals to deposit their money and earn interest on their savings.

Here are some key points about savings accounts:

• Savings accounts allow individuals to deposit their money with a bank and earn interest on their savings.


• The interest rates offered on savings accounts may vary from bank to bank.


• Savings accounts provide a safe and secure way to store money.


• Individuals can access their savings accounts and withdraw money as needed.


• Some savings accounts may have minimum balance requirements.


• Savings accounts may offer additional features like online banking and ATM access.


• Interest earned on savings accounts is typically taxable.


• Savings accounts are often used by individuals to save for short-term goals or emergencies.

It is important to note that while savings accounts provide a safe and convenient way to store money, the interest rates offered on savings accounts are generally lower compared to other investment options. Therefore, individuals looking for higher returns may opt for other types of investment accounts like mutual funds or share holdings.

Barter system is now replaced by Monetary system

• The barter system was an ancient method of exchanging goods and services without the use of money.


• Under the barter system, individuals directly traded their goods or services for other goods or services they needed.


• However, the barter system had several limitations:




• Lack of a common measure of value: It was difficult to determine the value of different goods and services in terms of each other.


• Double coincidence of wants: Both parties had to have a mutual desire for each other's goods or services, which made direct exchanges less likely.


• Lack of divisibility: Some goods or services were not easily divisible, making it challenging to exchange them for smaller items.




• The monetary system, on the other hand, replaced the barter system and introduced the use of money as a medium of exchange.


• Money serves as a common measure of value, making it easier to compare the worth of different goods and services.


• With the introduction of money, individuals can exchange their goods or services for money and use that money to acquire other goods or services they desire.


• The monetary system also overcomes the limitations of the barter system:




• Money eliminates the need for a double coincidence of wants as individuals can sell their goods or services for money, which can be used to purchase any other goods or services.


• Money is divisible, allowing for more flexible exchanges and transactions.

Therefore, the barter system has been replaced by the monetary system, where money is used as a medium of exchange, making transactions more efficient and convenient.

The fraction of deposits kept as Cash Reserves by commercial banks is maintained by the Central Bank.
Explanation:
The Central Bank, also known as the Reserve Bank or the Monetary Authority, is responsible for regulating and supervising the banking system in a country. One of the key functions of the Central Bank is to control the money supply in the economy. To achieve this, the Central Bank mandates commercial banks to maintain a certain percentage of their deposits as Cash Reserves.
Here's a breakdown of the answer:
Rural bank: Rural banks are financial institutions that serve primarily rural areas. While they also maintain Cash Reserves, they do not regulate the fraction of deposits held as reserves by commercial banks.
World bank: The World Bank is an international financial institution that provides loans and grants to the governments of poorer countries for the purpose of pursuing capital projects. It does not regulate the fraction of deposits held as reserves by commercial banks.
Commercial banks: Commercial banks accept deposits from the public and lend money to individuals and businesses. While they do maintain Cash Reserves, the fraction of deposits held as reserves is determined by the Central Bank.
Central bank: The Central Bank is the regulatory authority that sets the reserve requirements for commercial banks. It determines the fraction of deposits that commercial banks must keep as Cash Reserves to ensure the stability of the banking system and control the money supply.
Therefore, the correct answer is D: Central bank.

Cash Reserve Ratio is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves with the central bank.

Cash Reserves Ratio (CRR) refers to the proportion of total deposit of the commercial banks which they must keep as reserves with the central bank in the form of cash deposits. In other words, these are the cash deposits of commercial banks with the central bank which they have to deposit as a legal requirement with central bank. The ratio is fixed by the central bank and is varied from time to time to control the supply of money in the economy depending upon the prevailing situation of inflation or deflation.

Explanation:
The fraction of deposits kept as Cash Reserves by commercial banks is a legal requirement. This requirement is imposed by financial regulatory authorities to ensure the stability and safety of the banking system. Here is a detailed explanation:
Definition of Cash Reserves:
Cash reserves refer to the portion of deposits that a commercial bank is required to keep in the form of cash or as deposits with the central bank. This serves as a buffer to meet customer withdrawals and other liquidity needs.
Reasons for the Legal Requirement:
The legal requirement for commercial banks to maintain cash reserves is driven by several factors:
1. Financial Stability: Cash reserves act as a safeguard against bank runs and financial crises. By holding a certain percentage of deposits as reserves, banks ensure that they have enough funds to meet customer demands for withdrawals.
2. Liquidity Management: Cash reserves help banks manage their liquidity and ensure that they have enough funds to meet short-term obligations. This is especially important during periods of economic uncertainty or financial market volatility.
3. Monetary Policy Implementation: Central banks use the reserve requirement as a tool to influence the money supply and manage inflation. By adjusting the reserve ratio, central banks can control the amount of money that banks can lend out, thus affecting the overall level of economic activity.
4. Consumer Protection: Requiring banks to maintain cash reserves helps protect depositors' funds and ensures that they can access their money when needed. This promotes confidence in the banking system and encourages individuals and businesses to deposit their money in banks.
Consequences of Non-compliance:
Failure to adhere to the legal requirement of maintaining cash reserves can result in penalties and regulatory sanctions for commercial banks. These penalties can include fines, restrictions on banking activities, or even the revocation of a bank's license to operate.
In conclusion, the fraction of deposits kept as Cash Reserves by commercial banks is a legal requirement imposed by financial regulatory authorities. This requirement aims to maintain financial stability, manage liquidity, implement monetary policy, and protect depositors' funds.

The fraction of deposits that commercial banks are required to keep as cash reserves is called the Cash Reserve Ratio (CRR).

CRR (Cash Reserve Ratio): This is the percentage of a bank's total deposits that must be kept in the form of reserves with the central bank (e.g., Reserve Bank of India in India). This helps ensure that banks maintain liquidity and can meet their withdrawal obligations.

The other options:

• LRR (Legal Reserve Ratio): This term is sometimes used interchangeably with CRR but generally refers to the total reserves that a bank must hold, which can include both cash and other forms of reserves. It’s not a commonly used term in modern banking compared to CRR.
• SLR (Statutory Liquidity Ratio): This refers to the minimum percentage of a commercial bank's net demand and time liabilities (NDTL) that it must maintain in the form of liquid assets like cash, gold, or government securities. This is different from CRR, which is specifically about cash reserves.
• PLR (Prime Lending Rate): This is the rate at which commercial banks lend to their most creditworthy customers. It is unrelated to reserve requirements.