1.

Money and Banking (4 Marks)

Concept & Functions of Money

 Money: Anything that is generally accepted as a means of exchange, a measure of

value, and a store of value.

I. Primary Functions

 Medium of exchange: Used to make payments for all transactions of goods and
services.

 Measure of value: it is used as a common denomination in which the values of all

goods and services are expressed.

II. Secondary Functions

 Standard of deferred payments: Makes future payments (loans, installments) easy,

facilitating of borrowing and lending.

 Store of value: Used to transfer purchasing power from the present to the future (it
is the most liquid asset).

 Transfer of value: Makes transferring the value of goods and services simple across
large distances.

Money Supply Aggregates ($M_1, M_2, M_3, M_4$)

The Reserve Bank of India (RBI) uses four measures of money supply, ranked from most
liquid to least liquid:

1. M1 (Narrow Money)

This is the most liquid measure of money supply. It includes money that can be used
immediately for transactions.

 Formula:

M1 = {Currency with the public} + {Demand deposits with the banking system} {Other
deposits with the Central Bank}

 Key Components: * Currency: Paper notes and coins held by consumers and
businesses.

o Demand Deposits: Money in current accounts and savings accounts that you
can withdraw at any time via checks, ATMs, or digital transfers.

2. M2

This expands slightly on M1 by including short-term, highly accessible savings that aren't
technically part of commercial bank demand deposits.
  Formula:

M2 = M1 +Savings deposits with Post Office savings banks

 Why it's separate: Post office savings are very safe and liquid, but historically, they
couldn't be drawn upon via checks as easily as commercial bank deposits.

2. M3 (Broad Money)

This is the most commonly used measure of the total money supply in an economy. It factors
in large, time-bound investments.

 Formula:

M3 = M1 +{Time deposits with the banking system}

 Key Components: * Time Deposits (Fixed Deposits / Recurrent Deposits): Money

locked in the bank for a specific duration. You can't instantly swipe a card against an
FD, but it represents massive purchasing power held by the public.

4. M4

The broadest measure of all, taking into account absolutely everything, including long-term
post office resources.

 Formula:

M4 = M3 + {Total deposits with Post Office savings organisations (excluding National Savings
Certificates)

 Note: National Savings Certificates (NSCs) are excluded because they are locked up
for a long time and function more like government bonds than money.

Key Comparison Summary

To help keep them straight, remember these two fundamental rules of the aggregates:

Aggregate Classification Liquidity Main Focus

$M_1$ Narrow Money Highest Immediate transactions / Cash

$M_2$ Narrow Money High Cash + Post Office savings

$M_3$ Broad Money Low Economy's overall liquidity / Bank FDs

$M_4$ Broad Money Lowest The entire monetary landscape

Banking: Commercial vs. Central Banks

Definitions

 Commercial Bank: A financial institution that accepts deposits from the public,
provides loans, creates credit/money, and offers cheque facilities.

 Central Bank: The apex monetary institution that controls the entire money and
banking system of a country.

Comparison Table (OONPS)

Basis Commercial Bank Central Bank

To bring economic stability to

Objective To earn profit.
the country.

A single unit within the broader The apex body controlling the
Status
banking system. entire system.

Only one central bank exists per

Number Can be many in number.
country.

Public Maintains direct relations with the No direct relations with the
Relation general public. public.

Can operate by the private or It is entirely a government

Ownership
public sector. agency.

Functions of Central Bank

The Central Bank regulates the country's currency and banking system using its core
institutional powers:

 Currency Authority: Holds the exclusive legal right to issue currency notes.

 Banker’s Bank and Supervisor: Accepts cash reserves (CRR) and deposits from
commercial banks, provides them with loans, and guides/supervises them against
future threats.

 Lender of Last Resort: Advances loans to commercial banks during an extreme

liquidity crisis when no other sources are available.

 Custodian of Gold and Foreign Exchange Reserves: Manages and stores the nation's
foreign currency and gold reserves.
  Controller of Credit and Money Supply: Uses quantitative and qualitative monetary
tools to control credit creation by commercial banks to ensure price stability.

Monetary Policy Tools (Used to Control Credit)

 Repo Rate: The interest rate at which the central bank lends money to commercial
banks against securities.

 Reverse Repo Rate: The interest rate at which the central bank borrows money from
commercial banks.

 Cash Reserve Ratio (CRR): The mandatory percentage of net demand and time
liabilities (NDTL) that commercial banks must keep as cash reserves with the central
bank.

 Statutory Liquidity Ratio (SLR): The mandatory percentage of liquid assets that
commercial banks must maintain with themselves.

. National Income and Related Aggregates (9 Marks)

Concepts & Distinctions

 Domestic Territory: The political/geographical frontiers of a country, including its

territorial waters, airspace, and embassies abroad.

 Intermediate Goods vs. Final Goods:

o Intermediate Goods: Used for resale or completely used up in production

within the same year. Example: Flour used by a baker to make bread.
National IncomeExcluded to avoid double counting.

o Final Goods: Purchased for final consumption or investment. Example: Bread

bought by a household. Included in National Income estimation.

2) Crucial Precautions for Value Added Method:

o Avoid double counting: the value of Intermediate Goods is not included in

estimation of national income to avoid the error of double counting.

o Exclude Second-hand Goods: Sales of second-hand goods shouldn't be

included as they were already counted in the year they were produced.
(Note: Commission or brokerage earned on them is included).

The Three Methods of Calculating National Income

A. Value Added Method (Product Method)

Calculates the net contribution made by every producing enterprise.

$$\text{Gross Value Added at Market Price (GVA}_{MP}\text{)} = \text{Value of Output} - \

text{Intermediate Consumption}$$

$$\text{Where Value of Output} = \text{Sales} + \Delta\text{Stock (Closing Stock} - \

text{Opening Stock)}$$

B. Income Method

Sum of all factor incomes earned by normal residents of a country.

$$\text{NDP}_{FC} = \text{Compensation of Employees (COE)} + \text{Operating Surplus

(Rent + Interest + Profit)} + \text{Mixed Income}$$

$$\text{National Income (NNP}_{FC}\text{)} = \text{NDP}_{FC} + \text{Net Factor Income

from Abroad (NFIA)}$$

C. Expenditure Method

Sum of final expenditures incurred on the domestic product.

$$\text{GDP}_{MP} = C + I + G + (X - M)$$

 $C$: Private Final Consumption Expenditure

 $I$: Gross Domestic Capital Formation (Investment)

 $G$: Government Final Consumption Expenditure

 $X - M$: Net Exports (Exports - Imports)

Circular Flow: 2-Sector Economy

In a simple two-sector economy (Households and Firms), the flow is continuous with no
leakages or injections:

1. Real Flow: Households provide factor services (Land, Labor, Capital, Enterprise) to
Firms and Firms provide Goods and Services to Households.

2. Money Flow: Firms pay Factor Payments (Rent, Wages, Interest, Profit) to
Households and Households spend this money as Consumption Expenditure on
firms' goods.

3. Determination of Income and Employment (7 Marks)

Aggregate Demand (AD) and Aggregate Supply (AS) Diagrams

  Aggregate Demand ($AD = C + I$): Total demand for goods and services. It starts
above the origin because of autonomous consumption ($c_0$ or $\overline{C}$).

 Aggregate Supply ($AS = C + S$): Total output produced. It forms a 45-degree line
from the origin because $AS = \text{National Income } (Y)$.

Consumption and Saving Functions

 Consumption Function: $C = \overline{C} + b(Y)$

o $\overline{C}$ = Autonomous Consumption (consumption when income $Y =

0$; financed through past savings).

o $b$ = Marginal Propensity to Consume (MPC).

 Saving Function: $S = -\overline{C} + (1-b)Y$

o Starts at a negative value ($-\overline{C}$) because when income is zero,

savings are negative (dissaving).

The Investment Multiplier ($K$)

The multiplier measures the change in final income resulting from a change in initial
autonomous investment.

 Relationship: There is a direct relationship between $K$ and MPC, and an inverse
relationship between $K$ and MPS.