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Money, Banking and
Financial Institutions
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Q. 1. What is quantity theory of money? Explain its significance in the context of understanding the
factors determining the value of money.
Ans. According to the Quantity Theory of Money the value of money depends on the quantity of money in
circulation at a given point of time in the economy. It also states that, other things remaining unchanged, the changes
in the general price level are directly proportional to the changes in the supply of money. The quantity theory of
money has two approaches:
The cash-transaction approach or Fishers version.
The cash-balances approach or the cambridge version.
Cash Transaction Approach
According to Fisher the changes in the general price level with the help of changes in the quantity of money in
circulation, its velocity of circulation and volume of transaction can be presented as:
The above statement can also be rewritten as:
P = MV/T.
That is, Aggregate supply of money = Total value of all goods and services.
According to Fisher the quantity of money in any economy depends upon the following two aspects:
The quantity of cash with the public.
The velocity of circulation of the cash.
The average number of times a currency note changes hands during a given period of time is known as its
velocity of circulation.
By assuming V and T as constant over time, Fisher established a direct and proportionate relationship between
the quantity of money and the price level. However, the Fishers, theory was criticised over the assumptions on which
the theory is based.
Cash Balances Approach
According to cash balances approach the value of money depends upon the demand for money, but the demand
for money arises on account of its function as a store of value.
This can be written as:
P = KR/M or
M = KPO or
M = KPT,



They are associated with the names of Alfred Marshall, A.C. Pigou and D.H. Robertson.
It can also be said that this theory stresses the demand side of money. The premise of the approach is that for the
convenience a certain portion of income is kept by individuals in the form of cash or liquidity.
That is this theory stresses on liquidity which is very important for the determination of equilibrium income
controlling fluctuations in the economy.
Comparison of Cash Balances Approach and Cash Transactions Approach
Robertson stated that the two equations are different observations of the same phenomenon. However, both
the approaches also have there share of dissimilarities as well.
As they provide different interpretations to the demand for money, that is, the cash transactions approach sees
money as a flow where as the cash balances approach sees the same money as stock.
In other words, the Fishers approach lays stress on the velocity of money where as the Pigovians approach
stresses on the idle balances kept as a part of the national income.
The Quantity theory of money explains the relationship between the value of money and the quantity of money
at a given point of time in an economy. It assists that the value of money is influenced, among other factors, by the
quantity of money, though the change in the quantity of money and the price level may not be by the same percentage.
Significance of the quantity theory of money:
The bank rate policy and open market operations are based on the assumption that large supply of money will
lead to higher prices.
Monetary policy always aims at controlling of prices through the management and regulation of the volume
of money in the economy.
The quantity theory of money states that increased output of goods should be emphasised in the determination
of the price level.
Q. 2. Explain the establishment, structure and functions of the State Bank of India.
Ans. Establishment of the State Bank of India: The Imperial bank was instituted in 1921 in Madras by the
amalgamation of the three presidency banks of Bombay, Calcutta and Madras.
The Imperial Bank worked as the Central Bank for the Government of India till Reserve Bank of India was established.
After the establishment of Reserve Bank of India in 1935 the Imperial Bank acted as an agent of the same.
In 1954, Reserve Bank of India appointed a committee named All India Rural Credit Survey which gave its
recommendations in favour of nationalization of the Imperial Bank of India. The report stated that The setting up of
State Bank of India as one strong, integrated, state-partnered commercial banking institution with an effective
machinery of branches spread over the whole country for stimulating banking development by providing vastly
extended remitted facilities for cooperative and other banks and followed a policy which would be in effective
consonance with the national policies adopted by Government without departing from the principle of sound business.
This recommendation was accepted by the Government and on 1st July, 1955. The Imperial Bank of India was
nationalised to be the State Bank of India.
Structure of the State Bank of India: The State Bank of India was passed in 1959. Under this Act 8 major state
associated banks were amalgamated with the State Bank of India as its main subsidiary, these banks included: Bank
of Saurashtra, Bank of Patiala, Bank of Bikaner, Bank of Jaipur, Bank of Rajasthan, Bank of Indore, Bank of
Mysore, The Hyderabad State Bank and the Travancore Bank.
Functions of State Bank of India
1. The main function of the State Bank of India is to spread banking facilities by establishing a large network of
branches all over the country to mobilize and utilise the banks resources properly.
2. It was also expected to help the Reserve Bank of India in its credit policies and in helping the Reserve Bank
of India in checking any monetary disequilibrium in the money market.
3. One of the most important functions is to promote agricultural finance and to solve the problems of small
scale industry finance.
Q. 3. What is meant by money market? Discuss the significance of money market in a modern economy.
Ans.What is Money Market?: Money market refers to the whole network of financial institutions dealing in
short-term funds which provides an outlet to lenders and a source of supply of funds to borrowers.



The funds which are borrowed against different types of credit instruments such as bills of exchange, short-term
securities, promissory notes and treasury bills drawn for a short period are known as near money.
The basic difference between the money and the capital market is concerned with the supply and demand for
long-term investible funds where the money markets particularly deals with only short-term funds.
To add more, the capital markets deals in bonds, stocks, and shares of corporate sector and mortgage credit for
long-term period where the money market deals with short-term needs such as, working capital requirements of
business concerns, individual borrowings, etc.
In other words, money market is the market in which short-term funds are borrowed and lent. This is a network
of financial institution which provides a common place for the lenders and borrowers of funds.
In a modern economy the money market provides the following benefits:
It serves as a highly organised commercial banking system.
It ensures institutions a smooth path by continuous supply of negotiable securities like bills of exchange,
treasury bills, short-term government bonds, etc.
It also ensures the efficiency and effectiveness of the central bank of the country.
An effective money market also ensures the uniformity of interest rates in various sub-markets for the free
flow of funds.
Well developed money market lends to large number of sub-markets with each specialising in short term
Q. 4. Discuss the factors from which the need for international finance arises.
Ans. Need for International Finance
Since the balance of payments of most of the countries is usually in disequilibrium which means that there is
either a surplus or a deficit in the balance of payments, which requires short-term funds from surplus to deficit
Where as the long-term capital flow between the countries is based on the following factors:
The foreign capital needs of developing countries.
The investment opportunities available abroad.
The factors from which the need for international finance arises can be broadly classified as:
Short-term factors
Long-term factors.
Need for short-term funds arises due to deficit in the balance of payment or unfavourable balance of payment.
When net claims of an economy against the rest of the world arising from the transactions in the financial year is
negative it is known as unfavourable or deficit balance of payments.
The items included in the balance of payment include:
Commodity exports and imports
Invisibles, exports and imports
Unilateral transfers
Capital receipts and transfers
Gold movement.
The unfavourable balance of trade can also be responsible for unfavourable balance of payment. Unfavourable
balance of trade implies excess of imports over imports.
On the other hand the basic reason for long-term capital needs is the development of countries.
The world economy can be classified as capital surplus and capital deficit economies. Long-term capital is
basically needed for private foreign investment and foreign aid.
Foreign investments take place when nationals of a country make investments in the shares and debentures of
the foreign companies. Foreign aid on the other hand refers to official loans and grants to less developed countries by
developed nations and international financial institutions.
Q. 5. What is the problem of international liquidity? Discuss various proposals to augment the supply of
international liquidity?



Ans. The IMF and International Liquidity: International liquidity refers to gold and foreign exchange reserves
position at the international level. The demand for international liquidity originating from deficits in the balance of
payments is met from the following sources:
The official gold and foreign exchange reserves of the various countries.
Gold and foreign exchange reserves with the IMF.
The SDRs.
The Problem of International Liquidity
It was after World War II that the supply of international liquidity has not increased as fast as the demand for the
same even though the persistent deficits in the USAs balance of payments enhanced the supply of the international
liquidity; however it created the problem of crisis of confidence in the dollar.
Proposals for Raising International Liquidity
Though there were many proposals which were given post the World War II however the ones which received
much attention however which still could not be adopted due to various reasons are:
Raising the price of gold provided by Roy Harrod and Jacques Rueff, Economic Advisor to President de
Gaulle of France.
The Triffin Plan provided by Robert Triffin.
The Bernstein Plan provided by E.M. Bernstein.
Role of Special Drawings Rights
So as to meet the growing demand for international liquidity the IMF has created a new reserve asset known as
the Special Drawings Rights, which are mere book keeping entries in the accounts of member countries and the IMF
itself, that is, they are not directly usable.
So as to be used for meeting foreign debt obligations the SDRs need to be converted into national currencies.
They have been created in small quantities and have been allocated to member countries in direct proportion of their
Currently the standing of SDRs is about 5% on the international liquidity. The value of SDRs has been fixed on
the basis of a currency basket which is composed of the currencies of the worlds five largest exporting countries.