By DeeCee – Divine Classes

Answer Key
Ch – Money & Banking,
Government Budget
Ans 1. Standard of Deferred Payments: Money as a standard of deferred payments means that money
acts as a 'standard for payments, which are to be made in future. Every day, millions of transactions
take place in which payments are not made immediately. Money encourages such transactions and
helps in capital formation and economic development of the economy.

This function of money is significant because:

• Money as a standard of deferred payments has simplified the borrowing and lending operations. •

It has led to the creation of financial institutions.

Ans 2.

a) Currency and Coins with the Public:

• It consists of paper notes and coins held by the public. Remember, any currency held with the
government and banks are not to be included.

• Currency money is also termed as Fiat Money. Fiat Money is defined as money which is under the
fiat or order from the government to act as money, i.e. under law, it must be accepted for all
debts.

• It is also termed Legal Tender Money as it can be legally used to make payment of debts or other
obligations.

b) Demand Deposits of Commercial Banks:

• Demand deposits are deposits, which can be encased by issuing cheques at any time by the
account holders.

• A demand deposit is treated as equal to currency held as it is readily accepted as a means of

payment.

• It must be noted that demand deposits are taken on a net basis, i.e. inter/bank deposits are
excluded.

• While calculating M1 only demand deposits are considered as a part of the money supply and
not the Term Deposits.

Ans 3. Measure of Value (Unit of Value):

• Money as a measure of value means that money works as a common denomination, in which
 values of all goods and services are expressed.
• By reducing the value of all goods and services to a single unit (i.e. price), it becomes very easy
to find out the exchange ratios between them and comparing their prices.
• This function facilitates maintenance of business accounts, which would be otherwise
impossible.

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• Money helps in calculating relative prices of goods and services. Due to this reason, it is regarded
as a 'Unit of Account'. For instance, 'Rupee (₹)' is the unit of account in India, 'Pound (£)' in
England and so on.

Ans 4. Money supply:

• Money supply refers to the total volume of money held by the public at a particular point in
time in an economy.
Components of money supply:
1) Currency with Public:
• It consists of paper notes and coins held by the public. Remember, any
currency held with the government and banks are not to be included.
• Currency money is also termed as Fiat Money. Fiat Money is defined as money
which is under the fiat or order from the government to act as money, i.e.
under law, it must be accepted for all debts.
• It is also termed Legal Tender Money as it can be legally used to make
payment of debts or other obligations.
2) Demand Deposits of Commercial Banks:
• Demand deposits are deposits, which can be encased by issuing cheques at
any time by the account holders.
• A demand deposit is treated as equal to currency held as it is readily accepted
as a means of payment.

Ans 5. Medium of Exchange:

• Money, as a medium of exchange, means that it can be used to make payments for all
transactions of goods and services. It is the most essential function of money. Money has the
quality of general acceptability. So, all exchanges take place in terms of money.
• This function has removed the major difficulty of lack of double coincidence of wants and
inconveniences associated with the barter system.
• Use of money allows purchase and sale to be conducted independently of one another. • This
 function of money facilitates trade and helps in conducting transactions in an economy. •
Money has no power to satisfy human wants, but it commands power to purchase those
things, which have utility to satisfy human wants.

Ans 6. Money creation or credit creation:

• Through the process of money creation, commercial banks can create credit, which is in far
excess of the initial or primary deposits.

• This process can be better understood by making two assumptions:

a) The entire commercial banking system is one unit and is termed a "Banks".

b) All receipts and payments in the economy are routed through banks.

• The deposits held by banks are used for giving loans. However, banks cannot use the whole
deposit for lending.

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• It is legally compulsory for the banks to keep a certain minimum fraction of their deposits as
reserves, known as (Legal Reserve Ratio) LRR.

• Let us now understand the process of money creation through an example:

1) Suppose, initial or primary deposits in banks are ₹ 1,000 and LRR is 20%. It means, banks are
required to keep only ₹ 200 as cash reserve and are free to lend ₹ 800.

2) Suppose Borrowers withdraw the entire amount of ₹ 800 for making payments. The money
spent by the borrowers comes back into the banks in the form of a deposit. As all the
transactions rotated through the bank hence, it will increase the demand deposits of the bank
by ₹ 800.

3) With the new deposits of ₹ 800, banks keep 20% as cash reserves and lend the balance ₹ 640,
which is used by the borrowers for making payments, which again comes back into the bank. In
this round, the deposits raised by ₹ 640.

4) The deposits keep on increasing in each round by 80% of the last round deposits. At the same
time, cash reserves also go on increasing, each time by 80% of the last cash reserve.

• Deposit creation comes to end when total cash reserves become equal to the initial
deposit.
Deposits (₹) Loans (₹) Cash reserves
(₹) (LRR=20%)

Initial deposit 1,000 800 200

 Round 1 800 640 160

Round 2 640 512 128

Round 3 512 410 102

------ ------ ----- ----

----- ------ ------ ----

Total 5,000 4,000 1,000

5) From the above table, we have observed that initial deposits are the "five times" of reserves
maintained by the banks. This "five times" is nothing, just only the value of the "Money
Multiplier".
Money Multiplier is the number by which total deposits can increase due to a given change in
deposits. It is inversely related to legal reserve ratio.
Example: Calculate the total deposit created if the initial deposit is ₹ 1,000 crores and LRR is
12.5%.
Solution: Given, LRR is 12.5% or 0.125
Money Multiplier = 1
1
������=

0.125= 8
Initial Deposit = ₹ 1,000 crores
Total Deposit = Initial Deposit × Money Multiplier = 1,000 × 8 = ₹ 8,000 crores.

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Ans 7. Banker to the government:

• The Reserve Bank of India acts as a banker, agent, and financial advisor to the Central
Government and all the state governments.
• It maintains a current account for keeping its cash balances.

• It accepts receipts and makes payments for the government and carriers out of the
exchange, remittance, and other banking operations.
• It also gives loans and advances to the government for temporary periods. The
government borrows money by selling treasury bills to the central bank.
• As a financial advisor, the central bank advises the government from time to time on
economic, financial, and monetary matters.
• As an agent, the central bank also has the responsibility of managing public debt.

Ans 8. Open market operations:

 • Open market operations refers to buying and selling of the Government securities in the market
to either suck or pump liquidity in the economy. In open market operations the central banks
mainly sell and buy government securities to control the money available with bank, when the
central bank decides to suck out the liquidity in the banking sector they introduce more bonds,
and when they want to liquefy the banks with more money they start buying back the
government securities.
• Based on the bond availability or price the banks cost to buy money from other banks reserve will
be affected thus it effects the interest rate of advances and deposits in banking system has a
whole.
• Assume if the Central bank sees that more money is available with banks and the rate of interest
for credits is getting low due to excess money available in the sector and competition among
peers, then money will be loosed out to economy, and inflation peeks up.
• Seeing this and anticipating future impact Central bank will formulate policy and they introduce
government securities at better rates for the banks to buy and the money from banks will be
sent to central bank now the banks have less cash and also to buy from other banks the cost will
be proportional to the government bond rates so there will be slow increase in the rate to buy
money for lending thus it boosts demand for money and deposit rate will be increased and since
cost of the deposits increased the rate at which lending happens also increases. This how the
credit is controlled using open market operations.

Ans 9. Lender of the last resort:

• When commercial banks fail to meet their financial requirements from other sources, they

approach the central bank to give loans and advances as a lender of the last resort. • Central
Bank assists these banks through discounting of approved securities and bills of exchange.
• By offering loans to commercial banks in situations of emergency, central bank plays the role
of guarantor for them and maintains a sound and healthy banking system in the economy. Ans 10.
Banker’s bank and Supervisor:
• There should be some agency to regulate and supervise the proper functioning of
commercial banks in a country.
• Being the Apex bank, the Central Bank acts as the banker to other banks.

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• In this sense, it bears the same relationship with commercial banks as the latter maintains
with the general public.
• As the banker to banks, the central bank functions in three capacities:
a) Custodian of cash reserves/Cash Reserve Ratio (CRR):
• Commercial banks are required to keep a certain proportion of their deposits
(CRR) with the central bank.
 • In this way, the central bank acts as a custodian of the cash reserves of
commercial banks.
b) Lender of the last resort:
• When commercial banks fail to meet their financial requirements from other
sources, they approach the central bank to give loans and advances as a lender
of the last resort.
• Central Bank assists these banks through discounting of approved securities and
bills of exchange.
c) Clearing house:
• As the central bank holds the cash reserves of all the commercial banks, it
becomes easier and more convenient for it to act as their clearing house.
• All commercial banks have their accounts with the central bank.

• Therefore, the central bank can easily settle claims of various commercial banks
against each other, by making debit and credit entries in their accounts.
• As a Supervisor, the central bank regulates and controls the commercial bank.
The regulation of banks may be related to their licensing, branch expansion,
liquidity of assets, management, merging, winding up, etc. The control is
exercised by periodic inspection of banks and the returns filed by them.

Ans 11. Cash reserve ratio = (primary deposit / total deposit) x 100 = (2,500 / 20,000) x 100 = 12.5 %
Multiplier refers to the number of times the commercial banks multiplies the primary deposit in the
credit creation process in order to create total deposits. Multiplier = 1/ Cash reserve ratio = 100 / 12.5 =
8 times

Ans 12. The different instruments of credit control used by the Reserve Bank of India are: (any two)

Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR), the Bank Rate Policy, Selective Credit
Control (SCC), Open Market Operations (OMOs). (explain)

Ans 13. Cash Reserve Ratio (CRR):

• It refers to the minimum percentage of net demand and time liabilities, to be kept
by commercial banks with the central bank.
• A change in CRR affects the ability of commercial banks to create the credit. • For
instance, an increase in CRR reduces the excess reserves of commercial banks and
limits their credit-creating power.
Ans 14. Legal reserve requirements:

• According to legal reserve requirements, commercial banks are obliged to maintain reserves.
Commercial Banks are required to maintain reserves on two accounts:
i) Cash Reserve Ratio (CRR):

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• It refers to the minimum percentage of net demand and time liabilities, to be

kept by commercial banks with the central bank.
• An increase in CRR reduces the excess reserves of commercial banks and limits
their credit-creating power.
ii) Statutory Liquidity Ratio (SLR):
• It refers to the minimum percentage of net demands and time liabilities that
commercial banks are required to maintain themselves.
• An increase in SLR reduces the ability of banks to give credit and vice-versa.
Ans 15. Reducing inequalities in income and wealth:
• Economic inequality is an inherent part of every economic system.

• The government aims to reduce such inequalities of income and wealth, through its
budgetary policy.
• The government aims to influence the distribution of income by imposing taxes on the
rich and spending more on the welfare of the poor.
• It will reduce the income of the rich and raise the standard of living of the poor, thus
reducing inequalities in the distribution of income.

Ans 16.
Basis Direct Taxes Indirect Taxes

Impact Direct taxes are levied on Indirect taxes are levied on goods
individuals and companies. and services.

Shift of The burden of a direct tax cannot The burden of an indirect tax can
burden be shifted, i.e. impact and be shifted, i.e. impact and
incidence are on the same person. incidence on different persons.

Nature They are generally progressive. They are generally proportional.

Coverage They have limited reach as they do They have a wide coverage as
not reach all the sections of the they reach all sections of
economy. society.

Example Income tax and wealth tax. Sales tax and goods and services tax.

Ans 17.
Basis Revenue Receipts Capital Receipts

Meaning They neither create a liability nor They either create any liability or
reduce any asset of the reduce any asset of the
government. government.
 Nature They are regular and recurring They are irregular and non-recurring.
in nature.

Future There is no future obligation In the case of certain capital

obligation to return the amount. receipts (like borrowings), there is
a future obligation to return the
amount along with interest.

Examples Tax revenue (like income tax, Borrowings, Disinvestment, etc.

goods, and services tax, etc.) and
non-tax revenue (like interest,
fees, etc.)

Ans 18.

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1. Recovery of a loan is a capital receipt because it reduces the assets of the government. 2.
Corporation tax is a revenue receipt because revenue receipts are those money receipts that do
not create any corresponding liabilities or cause any reduction in the assets of the government. 3.
Dividends on investments made by the government is a capital receipt because capital receipts
refer to those money receipts which either create a liability for the government or cause a
reduction in assets of the government.
4. Sale of a public undertaking is a revenue receipt revenue receipts are those money receipts that
do not create any corresponding liabilities or cause any reduction in the assets of the
government.

Ans 19.
1. Subsidies is a revenue expenditure as revenue expenditure refers to the estimated expenditure in
a fiscal year which does not create assets for the government or reduction in liabilities. 2. Grants
given to the state government is a revenue expenditure as it does not cause any reduction in the
assets and we know, revenue expenditure refers to the estimated expenditure in a fiscal year which
does not create assets for the government or reduction in liabilities. 3. Repayment of loans is a
capital expenditure as it causes reduction in liabilities of the government.
4. Construction of school buildings is not a revenue expenditure because revenue expenditure
refers to the estimated expenditure in a fiscal year which does not create assets for the
government or cause reduction in liabilities for the government.

Ans 20. Implications of Revenue Deficit:

1) It indicates the inability of the government to meet its regular and recurring expenditures in
the proposed budget.
2) It implies that the government is dissaving, i.e. the government is using up savings from other
sectors of the economy to finance its consumption expenditure.
3) It also implies that the government has to make up this deficit from capital receipts, i.e.,
through borrowings or disinvestment. It means a revenue deficit either leads to an increase in
liability in the form of borrowings or reduces the assets through disinvestment.
4) The use of capital receipts for meeting the extra consumption expenditure leads to an
 inflationary situation in the economy.
5) Higher borrowings increase the future burden in terms of loan amount and interest
payments.
6) A high revenue deficit gives a warning signal to the government to either curtail its
expenditure or increase its revenue.
The measures to reduce revenue deficit are as follows:
1) Reduce expenditure:
• Government should take serious steps to reduce its expenditure and avoid unproductive
or unnecessary expenditures.
2) Increase revenue:
• Government should increase its receipts from various sources of tax and non-tax revenue.

Ans 21. Fiscal Deficit:

• Fiscal deficit refers to the excess of total expenditure over total receipts (excluding
borrowings) during the given fiscal year.
• Fiscal Deficit = Total Expenditure – Total Receipts excluding borrowings

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• The extent of the fiscal deficit is an indication of how far the government is spending beyond
its means.
• Total receipt excluding borrowings includes:
i) Revenue Receipts
ii) Capital Receipts excluding borrowing (or non-debt creating capital receipts such as the
recovery of loan or proceeds from disinvestment).
Implications of fiscal deficit:
1) Debt trap
2) Inflation
3) Foreign dependence
4) Hampers future growth

Ans 22. Primary Deficit:

• Primary deficit refers to the difference between the fiscal deficit of the current year and
interest payments on the previous borrowings.
• Primary Deficit = Fiscal Deficit – interest payments

• The total borrowing requirement of the government includes the interest commitments on
accumulated debts. The primary deficit reflects the extent to which such interest
commitments have compelled the government to borrow in the current period.

Implications of primary deficit are:

1) It indicates how much of the government borrowings are going to meet expenses other than
the interest payments.
 2) The difference between fiscal deficit and primary deficit shows the number of interest
payments on the borrowings made in past.
3) A low or zero primary deficit indicates that interest commitments (on earlier loans) have
forced the government to borrow.

Ans 23.
Basis Revenue Expenditure Capital Expenditure

Meaning Revenue expenditure neither Capital expenditure either

creates any asset nor reduces any creates an asset or reduces the
liability of the government. liability of the government.

Purpose It is incurred for the normal running It is incurred mainly for the
of government departments and acquisition of assets and
the provision of various services. granting of loans and
advances.

Nature It is recurring in nature as such It is non-recurring.

expenditure is spent by the
government on day-to-day activities.

Examples Salary, pension, interest, etc. Repayment of borrowings,

expenditure on acquisition
of capital assets, etc.

Ans 24. Government budget is the statement of planned receipts and expenditure of the government
during a year. Government seeks to allocate resources with a view to balance goals of all the sections
of the society. Government budget is used as an effective tool in the process of employment
generation.

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1. Investment in infrastructure- Government should invest in various infrastructure development

projects like roads, railways, bridges, dams etc. This generates employment opportunities for the
huge number of population.
2. Government schemes- Government time to time launches various schemes to generates employment
in both rural and urban areas. For example- MGNREGA, PMKVY etc.
3. Skill development training programmes- Government should launch various skill center to provide skill
training to the people. Stitching, weaving etc.

Ans 25. Primary deficit is the difference between fiscal deficit(borrowings) and interest
payments. Therefore, primary deficit = fiscal deficit - interest payments
= borrowings - interest payments
= 240000 - 160000
= 80000 crores
Ans 26. Interest payments which is 13500 crores is 30 % of primary deficit, then the primary deficit is
45000 crores.
Fiscal deficit = primary deficit + interest payments = 45000 +13500 =58500
crores. Ans 27. a) Revenue deficit = revenue expenditure - revenue receipts
= revenue expenditure - ( tax revenue - non tax revenue)
= 80 - (47+10) = 80 - 57 = 23
b) Fiscal deficit is equivalent to the borrowings. Therefore, fiscal deficit = 32.
c) Primary deficit = Borrowings - interest payments = 32 - 20 = 12.