Money, Banking, and Public Finance

Multiple Choice Questions (MCQs)

1.Which of the following is the most important function of money?

a) Store of value

b) Unit of account

c) Medium of exchange

d) Standard of deferred payment

Correct Answer: c) Medium of exchange

 

2.A system where goods and services are exchanged directly without the use of money is called:

a) Monetary exchange

b) Barter system

c) Credit system

d) Financial market

Correct Answer: b) Barter system

 

3.Which of the following is NOT a primary function of commercial banks?

a) Accepting deposits

b) Advancing loans

c) Issuing currency

d) Credit creation

Correct Answer: c) Issuing currency

 

4.The process by which commercial banks expand the money supply through loans and advances is known as:

a) Deposit mobilization

b) Credit creation

c) Fund transfer

d) Discounting bills

Correct Answer: b) Credit creation

 

5.The 'lender of last resort' function is performed by:

a) Commercial banks

b) Government

c) Central Bank

d) World Bank

Correct Answer: c) Central Bank

 

6.Which function of the Central Bank involves managing the country's foreign exchange reserves?

a) Banker to the Government

b) Banker's Bank and Supervisor

c) Custodian of Foreign Exchange Reserves

d) Controller of Credit

Correct Answer: c) Custodian of Foreign Exchange Reserves

 

7.Public finance deals with the finances of:

a) Private individuals and firms

b) The government

c) Commercial banks

d) International organizations

Correct Answer: b) The government

 

8.Which of the following is a primary objective of public finance?

a) Maximizing private profit

b) Optimal allocation of resources for social welfare

c) Minimizing government debt at all costs

d) Controlling individual spending habits

Correct Answer: b) Optimal allocation of resources for social welfare

 

9.A government budget is considered 'balanced' when:

a) Total receipts exceed total expenditures.

b) Total expenditures exceed total receipts.

c) Total receipts equal total expenditures.

d) Revenue receipts equal capital receipts.

Correct Answer: c) Total receipts equal total expenditures.

 

10.A 'surplus budget' indicates that:

a) Government expenditure is greater than government receipts.

b) Government receipts are greater than government expenditure.

c) Government expenditure equals government receipts.

d) The government is borrowing heavily.

Correct Answer: b) Government receipts are greater than government expenditure.

 

11.Which of the following is a difference between public and private finance?

a) Public finance aims at profit maximization, private finance aims at social welfare.

b) Public finance can borrow from within and outside the country, private finance has limited borrowing capacity.

c) Public finance follows the principle of marginal utility, private finance follows the principle of maximum social advantage.

d) Public finance has secrecy, private finance has publicity.

Correct Answer: b) Public finance can borrow from within and outside the country, private finance has limited borrowing capacity.

 

12.The Central Bank's primary objective as 'controller of credit' is to:

a) Encourage all banks to give as many loans as possible.

b) Regulate the money supply and credit conditions in the economy.

c) Provide loans directly to individuals.

d) Act as a guarantor for all commercial bank loans.

Correct Answer: b) Regulate the money supply and credit conditions in the economy.

 

13.A 'deficit budget' is often used by the government to:

a) Control inflation.

b) Stimulate aggregate demand during a recession.

c) Reduce public debt.

d) Encourage private savings.

Correct Answer: b) Stimulate aggregate demand during a recession.

 

14.Which of the following functions of money implies that it can be used for future payments?

a) Medium of exchange

b) Unit of account

c) Store of value

d) Standard of deferred payment

Correct Answer: d) Standard of deferred payment

 

15.One of the main objectives of a government budget in a developing economy is:

a) Ensuring price stability.

b) Reducing economic inequalities.

c) Promoting economic growth.

d) All of the above.

Correct Answer: d) All of the above.

 

Short Questions

What is money?

Answer: Money is anything that is generally accepted as a medium of exchange for goods and services, as well as for the repayment of debts. It serves as a universally accepted unit of account and a store of value.

 

List any two primary functions of money.

Answer: Two primary functions of money are:

 

Medium of Exchange: It facilitates transactions by eliminating the need for a double coincidence of wants inherent in a barter system.

 

Unit of Account (or Measure of Value): It provides a common unit for valuing goods, services, assets, and debts, simplifying economic calculations.

 

What is a commercial bank?

Answer: A commercial bank is a financial institution that primarily accepts deposits from the public (e.g., savings accounts, current accounts) and uses these deposits to advance loans and make investments, with the aim of earning profit.

 

Mention any two functions of a commercial bank.

Answer: Two functions of a commercial bank are:

 

Accepting Deposits: Collecting money from individuals and firms in various types of accounts (savings, current, fixed).

 

Advancing Loans: Providing credit facilities to individuals and businesses for various purposes (e.g., personal loans, business loans, mortgages).

 

What is a Central Bank?

Answer: A Central Bank is the apex financial institution in a country that controls the money supply, regulates the banking system, and acts as a banker to the government and other commercial banks. It is typically a non-profit organization focused on macroeconomic stability.

 

List any two functions of a Central Bank.

Answer: Two functions of a Central Bank are:

 

Issuer of Currency (Bank of Issue): It has the sole authority to issue currency notes and coins in the country.

 

Controller of Credit (Monetary Policy): It regulates the money supply and credit conditions in the economy using various tools (e.g., repo rate, reserve requirements) to achieve macroeconomic objectives like price stability and economic growth.

 

What is Public Finance?

Answer: Public Finance is the branch of economics that studies the role of the government (public authorities) in the economy. It deals with government revenue (tax and non-tax), government expenditure, public debt, and financial administration.

 

 

State one key difference between Public Finance and Private Finance regarding their objective.

Answer: Public finance primarily aims at maximizing social welfare and promoting economic stability/growth, whereas private finance (of individuals/firms) primarily aims at maximizing individual profit or utility.

 

What is a government budget?

Answer: A government budget is an annual financial statement that presents the estimated receipts and estimated expenditures of the government for the coming fiscal year. It outlines the government's financial plan and economic policies.

 

Differentiate between a balanced budget and an unbalanced budget.

Answer:

 

Balanced Budget: Occurs when the government's estimated total receipts are exactly equal to its estimated total expenditures for a fiscal year.

 

Unbalanced Budget: Occurs when the government's estimated total receipts are not equal to its estimated total expenditures. It can be either a surplus budget (receipts > expenditure) or a deficit budget (receipts < expenditure).

 

 

Long Questions (5 Marks each)

1.Explain the primary and secondary functions of money in detail. Why is money considered essential in a modern economy compared to a barter system?

Answer:

 

Meaning of Money:

Money is anything that is generally accepted as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. It is a social invention to facilitate exchange and overcome the limitations of the barter system.

 

Functions of Money:

 

A. Primary Functions (Core Functions):

 

Medium of Exchange:

 

Explanation: This is the most crucial function. Money acts as an intermediary in the exchange of goods and services. Instead of directly bartering goods, individuals sell their goods for money and then use that money to buy other goods they desire.

 

Eliminates: The "double coincidence of wants" problem, where two parties must both desire what the other has to offer for an exchange to occur.

 

Benefit: Greatly enhances efficiency of transactions and expands the scope of trade.

 

Unit of Account (or Measure of Value):

 

Explanation: Money provides a common denominator or standard unit for measuring the value of diverse goods, services, and assets. All prices in an economy are expressed in monetary units (e.g., rupees, dollars).

 

Benefit: Simplifies valuation, accounting, and economic calculations. Without it, valuing thousands of goods against each other in a barter economy would be incredibly complex.

 

B. Secondary Functions (Derived from Primary Functions):

 

Store of Value:

 

Explanation: Money serves as a means to hold wealth or purchasing power over time. Individuals can save money today to spend it in the future.

 

 

Conditions: For money to be an effective store of value, its value should be relatively stable over time (i.e., not suffer from high inflation).

 

Benefit: Enables saving and accumulation of wealth, facilitating future consumption and investment.

 

Standard of Deferred Payment:

 

Explanation: Money serves as a standard for future payments or contracts. Debts and future obligations (like loans, salaries, interest payments) are typically expressed and settled in monetary terms.

 

Benefit: Facilitates lending and borrowing, which are essential for investment and economic growth. It enables the creation of credit markets.

 

Transfer of Value:

 

Explanation: Money facilitates the transfer of value from one person to another or from one place to another (e.g., remitting money). While related to medium of exchange, it specifically highlights the ease of shifting purchasing power.

 

Why Money is Essential in a Modern Economy vs. Barter System:

 

Money is essential because it fundamentally solves the inherent inefficiencies and limitations of a barter system:

 

Eliminates Double Coincidence of Wants: In a barter system, a person wanting to trade shoes for rice must find someone who not only wants shoes but also has rice to offer. Money removes this arduous requirement.

 

Facilitates Specialization and Division of Labor: Without money, specializing in producing a single good (e.g., baking bread) would be difficult as one would constantly need to find direct traders for all other needs. Money allows individuals to specialize, produce for the market, and then buy diverse goods, leading to greater efficiency and productivity.

 

Reduces Transaction Costs: Searching for suitable trading partners and negotiating exchange rates for every transaction is time-consuming and costly in a barter system. Money drastically reduces these costs.

 

Enables Economic Calculation: Without a common unit of account, comparing the value of different goods, calculating profits/losses, or assessing investment returns would be nearly impossible, hindering economic planning and decision-making.

 

Promotes Capital Formation and Investment: Money's function as a store of value and standard of deferred payment makes saving, lending, and borrowing feasible, which are critical for capital formation and long-term investment.

 

Supports Large-Scale Production and Trade: Complex modern economies with mass production, credit systems, and global trade would be impossible to operate without a universally accepted medium of exchange and unit of account.

 

In conclusion, money acts as the lubricant for the economic engine, allowing for a far more complex, efficient, and specialized economy than could ever exist under a primitive barter system.

 

2.Explain the meaning and key functions of a Commercial Bank. How do commercial banks play a crucial role in the process of 'credit creation' and what are its limitations?

Answer:

 

Meaning of Commercial Banks:

A commercial bank is a financial institution that accepts deposits from the public, primarily for the purpose of lending and investment. It operates to earn profit, provides various financial services, and serves as a key intermediary in the financial system.

 

Key Functions of Commercial Banks:

 

Commercial banks perform a variety of functions, broadly categorized into primary and secondary functions:

 

A. Primary Functions:

 

Accepting Deposits: This is the most fundamental function. Banks attract funds from individuals and businesses by offering various types of deposit accounts:

 

Current Deposits: Highly liquid, no interest, suitable for businesses for frequent transactions.

 

Savings Deposits: Interest-bearing, allows limited withdrawals, popular among individuals for saving.

 

Fixed Deposits (Time Deposits): Higher interest rates, fixed tenure, withdrawals before maturity incur penalties.

 

Recurring Deposits: Regular fixed sum deposited over a period, earning interest.

 

Advancing Loans (Giving Credit): Banks use the funds collected from deposits to provide loans and advances to individuals, businesses, and government. This is their main source of income. Types of loans include:

 

Cash Credit: Short-term advances against security.

 

Overdraft Facility: Allows current account holders to withdraw more than their balance, up to a limit.

 

Demand Loans: Repayable on demand.

 

Term Loans: Loans for fixed periods (e.g., housing loans, business expansion loans).

 

Discounting Bills of Exchange: Providing immediate cash against a bill before its maturity date.

 

Credit Creation: This is a unique and crucial function, enabling banks to create money in the economy (explained below).

 

B. Secondary Functions:

 

Agency Functions: Performing various services as agents for their customers (e.g., collection of cheques/bills, payment of utility bills, transfer of funds, acting as executor/trustee).

 

General Utility Functions: Providing services for the general public (e.g., locker facilities, issuing debit/credit cards, foreign exchange transactions, underwriting shares/debentures, internet banking).

 

Role of Commercial Banks in Credit Creation:

 

Commercial banks are central to the process of credit creation, also known as deposit creation or money creation. This process involves the expansion of demand deposits (which are a form of money supply) through the banks' lending activities.

 

Mechanism: When a bank receives an initial deposit (primary deposit), it does not keep the entire amount as reserves. Instead, it lends out a portion of it, keeping only a fraction as reserves (based on the Cash Reserve Ratio or CRR mandated by the Central Bank).

 

The loan amount is typically not given in cash but credited to the borrower's account in the same or another bank.

 

When the borrower uses this money (e.g., to pay a supplier), it again flows into someone else's account in some bank, becoming a new deposit.

 

This new deposit, in turn, allows that bank to lend out a portion (less the CRR), and the process continues in a chain.

 

This continuous lending and re-depositing creates multiple times the original deposit in the form of new demand deposits (credit).

 

The total credit created is determined by the money multiplier (1/CRR).

 

Example: If CRR is 10% and an initial deposit is ₹1000:

 

Bank 1: Keeps ₹100, lends ₹900.

 

Bank 2 (receives ₹900): Keeps ₹90, lends ₹810.

 

Bank 3 (receives ₹810): Keeps ₹81, lends ₹729.

 

And so on...

 

Total deposits created = Initial deposit ×(1/CRR) = ₹1000 ×(1/0.10) = ₹10,000.

 

Limitations of Credit Creation:

 

Cash Reserve Ratio (CRR): The higher the CRR set by the Central Bank, the lower the lending capacity of commercial banks, thus limiting credit creation.

 

Repo Rate/Bank Rate: A higher repo rate (rate at which banks borrow from the Central Bank) increases borrowing costs for commercial banks, discouraging lending and limiting credit creation.

 

Public Demand for Cash: If the public chooses to hold more cash (and less in bank deposits), it reduces the amount of reserves available for banks to lend, thereby limiting credit creation.

 

Borrowing Demand: Banks can only create credit if there is sufficient demand for loans from viable borrowers. A lack of demand for loans (e.g., during a recession) will limit credit creation.

 

Creditworthiness of Borrowers: Banks are constrained by the need to assess the creditworthiness of borrowers. They cannot lend recklessly.

 

Banking Habits of the Public: The extent to which people use banking services (depositing money rather than holding cash) affects the base for credit creation.

 

Government Policy and Regulations: Various government and Central Bank regulations (e.g., sectoral lending targets, prudential norms) can also limit the banks' ability to create credit.

 

Thus, commercial banks are not only facilitators of transactions but also active creators of money, subject to the regulatory environment and economic conditions.

 

3. What is Public Finance? Differentiate between Public Finance and Private Finance based on objectives, sources of income, nature of expenditure, borrowing, and budget preparation. Briefly explain the meaning and objectives of a government budget.

Answer:

 

Meaning of Public Finance:

Public finance is the study of the financial activities of the government (central, state, and local). It deals with how governments raise revenue (through taxes, fees, borrowing), how they spend that revenue, and how these activities affect the economy (e.g., resource allocation, income distribution, economic stability, and growth).

 

Basis of Differentiation	Public Finance (Government)	Private Finance (Individuals/Firms)
1. Objective	Social welfare maximization, economic stability, growth, equity.	Profit maximization (firms) or Utility maximization (individuals).
2. Sources of Income	Primarily compulsory taxes (income tax, GST), fees, fines, profits from public enterprises, borrowing.	Primarily earnings (wages, salaries, profits, rent, interest), gifts, limited borrowing.
3. Nature of Expenditure	Determines expenditure first (based on needs/objectives), then finds sources of income. Focus on collective needs (defense, infrastructure).	Income determines expenditure. Focus on individual needs/wants.
4. Borrowing	Can borrow on a very large scale (domestically and internationally); can resort to deficit financing (printing money - Central Bank).	Limited borrowing capacity based on creditworthiness and assets; cannot print money.
5. Secrecy vs. Publicity	High degree of publicity and transparency (budgets are public documents, audited).	Generally secretive and confidential (financial statements are private).
6. Budget Period	Usually annual or biennial budgets with fixed financial years.	Flexible, can be daily, weekly, monthly, or yearly based on needs.
7. Principle	Principle of Maximum Social Advantage (balancing social benefits and costs of expenditure/taxation).	Principle of Marginal Utility/Profit Maximization (balancing individual benefit vs. cost).
8. Compulsion	Can exercise compulsion (e.g., compulsory taxes); sovereign power.	Cannot compel others to provide funds or goods.
9. Adjustment	Adjusts income (taxes) to meet expenditure needs.	Adjusts expenditure to meet available income.

Government Budget: Meaning and Objectives

 

Meaning of Government Budget:

A government budget is an annual financial statement that outlines the government's estimated receipts (revenue) and estimated expenditures for the upcoming fiscal year. It serves as a comprehensive plan that details the government's financial management and its economic policies to achieve various socio-economic objectives.

 

Objectives of a Government Budget:

 

The primary objectives of a government budget are:

 

Reallocation of Resources: The budget helps in reallocating resources according to the social and economic priorities of the country. Through taxation (discouraging harmful goods) and subsidies (encouraging socially desirable goods), the government influences production patterns.

 

 

Reducing Income and Wealth Inequalities: The government uses progressive taxation (higher income, higher tax rate) and expenditure on welfare programs (subsidies, social security, public goods for the poor) to reduce disparities in income and wealth distribution.

 

Economic Stability: The budget is a crucial tool for achieving macroeconomic stability.

 

Controlling Inflation: In inflationary periods, the government can aim for a surplus budget or reduce spending/increase taxes (contractionary fiscal policy).

 

Correcting Deflation/Recession: During a recession, the government can opt for a deficit budget or increase spending/reduce taxes (expansionary fiscal policy) to boost aggregate demand and employment.

 

Economic Growth: The budget aims to promote sustainable economic growth. This is achieved by:

 

Making public investments in infrastructure (roads, power, education, health).

 

Providing incentives for private sector investment.

 

Managing fiscal deficits to ensure macroeconomic stability conducive to growth.

 

Management of Public Enterprises: The budget provides funds for the functioning and expansion of public sector enterprises, which contribute to national output and employment.

 

Regional Balance: Through specific expenditure programs and tax incentives, the government can promote balanced economic development across different regions of the country, reducing regional disparities.

 

Balanced vs. Unbalanced Budget, Surplus vs. Deficit Budget:

 

Balanced Budget: When Estimated Government Receipts = Estimated Government Expenditure. It signifies financial prudence but may not be suitable for all economic situations (e.g., not good for recession).

 

Unbalanced Budget: When Estimated Government Receipts



= Estimated Government Expenditure.

 

Surplus Budget: When Estimated Government Receipts > Estimated Government Expenditure. This indicates that the government is collecting more revenue than it is spending. A surplus budget is generally used during inflationary periods to reduce aggregate demand.

 

 

Deficit Budget: When Estimated Government Receipts < Estimated Government Expenditure. This indicates that the government is spending more than it is collecting. A deficit budget is often used during recessions or periods of slow growth to stimulate demand, create employment, and boost economic activity. It leads to increased public debt.