Explain the concept of ‘deficient demand’ in macroeconomics. Also explain the role of Bank Rate in correcting it.


Deficient demand refers to the situation when aggregate demand (AD) is less than the aggregate supply (AS) corresponding to full employment level of output in the economy.
The situation of deficient demand arises when planned aggregate expenditure falls short of aggregate supply at the full employment level. It gives rise to deflationary gap. Deflationary gap is the gap by which actual aggregate demand falls short of aggregate demand required to establish full employment equilibrium.

Reasons for deficient demand:
1. Decrease in Propensity to consume: A decrease in consumption expenditure, due to fall in the propensity to consume, leads to deficient demand in the economy.
2. Increase in taxes: AD may also fall due to imposition of higher taxes. It leads to decrease in disposable income and, as a result, the economy suffers from deficient demand.
3. Decrease in Government Expenditure: When government reduces its demand for goods and services due to fall in public expenditure, it leads to deficient demand.
4. Fall in Investment expenditure: Increase in the rate of interest or fall in the expected returns lead to decrease in the investment expenditure. It reduces the AD and gives rise to deficient demand.
5. Rise in Imports: When international prices are comparatively less than the domestic prices, then it may lead to a rise in imports, implying a cut in the aggregate demand.
6. Fall in Exports: Exports may fall due to comparatively higher prices of domestic goods or due to increase in the exchange rate for domestic currency. This will lead to deficient demand.

Role of Bank Rate in Correcting Deficit Demand:
The term ‘Bank Rate’ refers to the rate at which central bank lends money to commercial banks as the lender of last resort. During deficient demand, the central bank reduces the bank rate in order to expand credit. It leads to fall in the market rate of interest which induces people to borrow more funds. It ultimately leads to increase in the aggregate demand.

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Do you consider a commercial bank 'creater of money' in the economy? Explain.
or
Commercial banks are called factories of credit or manufacturer of money. Explain.
or
Explain the process of money (or credit) creation by commercial banks with the help of a numerical example. 

Commercial banks create credit in the form of demand deposits. Remember ‘demand deposits’ and ‘currency with public’ are two basic components of money supply. Broadly, when a bank receives cash deposits from the public, it keeps a fraction of deposit as cash reserve and uses the remaining amount for giving loans to earn interest income. This fraction is called Legal Reserve Ratio (LRR) (which has two components — CRR and SLR). LRR is the minimum ratio (fraction) of demand deposits fixed by Central Bank which is legally compulsory for every commercial bank to keep as cash reserves. In the process of lending money, banks are able to create credit through secondary deposits many times more than the initial deposit (primary deposit). How? (Primary deposits are cash deposits whereas secondary deposits arise due to loans given by the banks to people.)
Process of money (credit) creation. Suppose a man, say x, deposits र 2000, with a bank and the LRR is 10% which means the bank keeps only the minimum required र 200 as cash reserve. The bank can use the remaining amount र 1800 (= 2000 - 200) for giving loan to someone. (Mind, loan is never given in cash but it is reflected as demand deposit in favour of borrower.) The bank lends र 1800 to, say y, who is actually not given loan but only (demand deposit) account is opened in his name and the amount is credited to his account. This is the first round of credit creation in the form of secondary deposit (र 1800) which equals 90% of primary (initial) deposit. Again 10% of Y‘s deposit (i.e., र 180) is kept by the bank as cash reserve and the balance र 1620 (= 1800 – 180) is advanced to, say z. The bank gets new demand deposit. This is second round of credit creation which is 90% of first round of increase of र 1800. The third round of credit creation will be 90% of second round of र 1620. This is not the end of the story. The process of credit creation goes on continuously till derivative deposit (secondary deposit) becomes zero. In the end volume of total credit created in this way becomes multiple of initial (primary) deposit. The quantitative outcome is called money multiplier. If the bank succeeds in creating total credit of say, र 18,000, it means bank has created 9 times of primary (initial) deposit of र 2000. This is what is meant by credit creation. In short money (or credit) creation by commercial banks is determined by (i) amount of initial (primary) deposits, and (ii) LRR. The multiple is called credit creation or money multiplier. Symbolically:
Credit creation = Initial space deposit space cross times space 1 over LRR.
Money multiplier. It means the multiple by which total deposit increases due to initial (primary) deposit. Money creation (or credit creation) is the inverse of LRR.
If LRR = 10%, i.e., 0.1, then money multiplier equals space fraction numerator 1 over denominator 0.1 end fraction space equals space 10.
Smaller the LRR, larger would be the size of money multiplier.
The following tree diagram depicts broad classification of commercial banks in India.

Commercial banks create credit in the form of demand deposits. Rememb

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What is money multiplier? How will you determine its value? What ratios play an important role in the determination of the value of the money multiplier?


Money Multiplier. Money multiplier (m) is the ratio of total money supply (M) to the stock of high powered money (H) in the economy.

Symbolically:

where m represents money multiplier, M total money supply and H represents stock of high powered money.

Clearly value of multiplier m is greater than 1 (M > 1) because increment in M exceeds H initially injected by RBI. Money supply in the economy is determined by the size of multiplier (m) and the amount of high powered money (H).

Suppose the value of m = 1.5 and that of H = र 1000 crores. Then total money supply (H) will be 1000 x 1.5 = र 1500 crores. In short, this is the process of money creation.

Since,

M /H = (1 + cdr) / (cdr + rdr)

Hence, the current deposit ratio (cdr) and reserve deposit ratio (rdr) play an important role in the determination of money multiplier.

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Explain the concept of ‘excess demand’ in macroeconomics. Also explain the role of ‘open market operation’ in correcting it.


Excess demand refers to the situation when aggregate demand (AD) is more than the aggregate supply (AS) corresponding to full employment level of output in the economy. It is the excess of anticipated expenditure over the value of full employment output.

Due to the excess of aggregate demand, there exists a difference (or gap) between the actual level of aggregate demand and full employment level of demand. This difference is termed as inflationary gap. This gap measures the amount of surplus in the level of aggregate demand. Graphically, it is represented by the vertical distance between the actual level of aggregate demand (ADE) and the full employment level of output (ADF). In the figure, EY denotes the aggregate demand at the full employment level of output and FY denotes the actual aggregate demand. The vertical distance between these two represents inflationary gap.

Following are the reasons for Excess Demand:
1. Rise in the Propensity to consume: Excess demand may arise because of increase in consumption expenditure due to rise in the propensity to consume or fall in propensity to save.
2. Reduction in taxes: It may also occur due to increase in disposable income and consumption demand because of decrease in taxes.
3. Increase in Government Expenditure: Rise in government demand for goods and services due to increase in public expenditure will also result in excess demand.
4. Increase in Investment. Excess demand can also arise when there is increase in investment due to decrease in rate of interest or increase in expected returns.
5. Fall in Imports: Decrease in imports due to higher international prices in comparison to domestic prices may also lead to excess demand.
6. Rise in Exports: Excess demand may also arise when demand for exports increases due to comparatively lower prices of domestic goods or due to decrease in the exchange rate for domestic currency.

Role of Open Market Operation in curbing the Excess Demand:
In order to curb the problem of excess demand, the government can opt for open market operations (OMO). Open market operations refer to sale and purchase of securities in the open market by the central bank. It directly influences the level of money supply in the economy. During excess demand, central bank offers securities for sale. Sale of securities reduces the reserves of commercial banks. It adversely affects the bank’s ability to create credit and decreases the level of aggregate demand in the economy.



 

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Explain the functions of a commercial bank.
or
 Explain ‘acceptance of deposit’ function of commercial banks.
or
What are time deposits?
or
Explain lending function of money.

Functions of Commercial Banks.
The two most distinctive functions of a commercial bank are borrowing and lending, i.e., acceptance of deposits and lending of money to projects to earn interest. In short, banks borrow to lend. The rate of interest offered by the banks to depositors is called the borrowing rate while the rate at which banks lend out is called lending rate. The difference between the two rates is called ‘spread’ which is profit appropriated by the banks. Mind all financial institutions are not commercial bank as only those which perform dual functions of (i) accepting deposits and (ii) giving loans are termed as commercial banks. Functions of commercial banks are as under :
1. It accepts deposits. A commercial bank accepts deposits in the form of current, saving and fixed deposits. It collects the surplus balance of the individuals and firms and finances the temporary needs of commercial transactions. The first task is, therefore, the collecting of the savings of the public. This the bank does by accepting deposits from its customers. Deposits are lifeline of banks. Deposits are of 3 types as under.
(i) Current account deposits. Such deposits are payable on demand and are therefore, called demand deposits. These can be withdrawn by the depositors any number of times depending upon the balance in the account. The bank does not pay any interest on these deposits but provides cheque facilities. These accounts are generally maintained by businessmen and industrialists who receive and make business payments of large amounts through cheques.
(ii) Fixed deposits (Time deposits). Fixed deposits have a fixed period to maturity and are referred to as time deposits. These are deposits for a fixed term, i.e., period of time ranging from a few days to a few years. These are neither payable on demand nor they enjoy cheque facilities. They can be withdrawn only after the maturity of the specified fixed period. They carry higher rate of interest. They are not treated as a part of money supply. Recurring deposit in which a regular deposit of an agreed sum is made is also a variant of fixed deposits.
(iii) Saving account deposits. These are deposits whose main objective is to save. They combine the features of both current account and fixed deposits. They are payable on demand and also withdrawable by cheque. But bank gives this facility with some restrictions, e.g., a bank may allow five or seven cheques in a month. Interest paid on saving account deposits is lesser than that of fixed deposit.
Difference between demand deposits and time (term) deposits.
Two traditional forms of deposits are demand deposit and term (time) deposit. (i) Deposits which are payable by banks on demand from depositors are called demand deposits, e.g., Current A/c deposits are called demand deposits which are payable on demand either through cheque or otherwise. Term deposits are called time deposit because they are payable only after the expiry of the specified period. (ii) Demand deposits do not carry interest whereas time deposits carry a fixed rate of interest. (iii) Demand deposits are highly liquid whereas time deposits are less liquid. (iv) Demand deposits are chequable deposits whereas time deposits are not. A chequable deposit is any deposit account on which a cheque can be written.
2.    It gives loans and advances. The second major function of a commercial bank is to give loans and advances particularly to businessmen and entrepreneurs and thereby earn interest. This is, in fact, the main source of income of the bank. A bank keeps a certain portion of the deposits with itself as reserve and gives (lends) the balance to the borrowers as loans and advances in the following forms.
(i) Cash Credit. An eligible borrower is first sanctioned a credit limit and within that limit he is allowed to withdraw a certain amount on a given security. The withdrawing power depends upon the borrower's current assets, the stock statement of which is submitted by him to the bank as the basis of security. Interest is charged by the bank on the drawn or utilised portion of credit (loan).
(ii)    Demand Loans. A loan which can be recalled on demand is called demand loan. There is no stated maturity. The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower. Those like security brokers whose credit needs fluctuate generally take such loans on personal security and financial assets.
(iii)    Short-term Loans. Short-term loans are given against some security as personal loans to finance working capital or as priority sector advances. The entire amount is repaid either in one instalment or in a number of instalments over the period of loan.
Investment. Commercial banks invest their surplus funds in three types of securities (i) Government securities, (ii) Other approved securities, and (iii) Other securities. Banks earn interest on these securities.
Other functions : Apart from the above-mentioned two primary (major) functions, other functions performed by commercial banks are as follows:
3.    Overdraft facility. An overdraft is an advance given by allowing a customer keeping current account to overdraw his current account up to an agreed limit. It is a facility to a depositor for overdrawing the amount than the balance amount in his account. In other words, depositors of current account make arrangement with the banks that in case a cheque has been drawn by them which is not covered by the deposit, then the bank should grant overdraft and honour the cheque. The security for overdraft is generally financial assets like shares, debentures, life insurance policies of the account holder.
Difference between overdraft facility and loan. (i) Overdraft is made without security in current account but loans are given against security. (ii) In case of loan, the borrower has to pay interests on full amount sanctioned but in case of overdraft, borrower is given the facility of borrowing only as much as he requires. (iii) Whereas the borrower of loan pays interest on amount outstanding against him but customer of overdraft pays interest on the daily balance.
4.    Discounting bills of exchange or Hundis. A Bill of exchange represents a promise to pay a fixed amount of money at a specified point of time in future. It can also be encashed earlier through the discounting process of a commercial bank. In other words, a bill of exchange is a document acknowledging an amount of money owed in consideration of goods received. It is a paper asset signed by debtor and the creditor for a fixed amount payable on a fixed date. It works like this. Suppose A buys goods from B, he may not pay B immediately but instead give B a bill of exchange stating the amount of money owed and the time when A will settle the debt. Suppose B wants the money immediately, he will present the bill of exchange (Hundi) to the bank for discounting. The bank will deduct the commission and pay to B the present value of the bill. When the bill matures after specified period, the bank will get payment from A.
5.    Agency functions of the Bank. The bank acts as an agent of its customers and gets commission for performing agency functions as under.
(i) Transfer of funds. It provides facility for cheap and easy remittance of funds from place to place through demand drafts, mail transfers, telegraphic transfers, etc.
(ii)    Collection of funds. It collects funds through cheques, bills, hundis and demand drafts on behalf of its customers.
(iii)    Payments of various items. It makes payment of taxes, insurance premium, bills, etc. as per directions of its customers.
(iv)    Purchase and sale of shares and securities. It buys, sells and keeps in safe custody securities and shares on behalf of its customers.
(v) Collection of dividends, interest on shares and debentures are made on behalf of its customers.
(vi)    Acts as Trustee and Executor of property of its customers on advice of its customers.
(vii)    Letters of References. It gives information about, economic position of its customers to traders and provides the similar information about other traders to its customers.
6.    Financing of Foreign Trade. Commercial banks finance the foreign trade of the country by accepting or collecting bills of exchange drawn by customers.
7.    Performing General Utility Services. The bank provides many general utility services. Some of which are as under:
(i)    Issuance of traveller's cheques and gift cheques.
(ii)    Locker facility. The customers can keep their ornaments and important documents in lockers for safe custody.
(iii)    Underwriting securities issued by government, public or private bodies.
(iv)    Purchase and sale of foreign exchange (Currency).
(v) Letters of credit are issued by the banks to their customers certifying their credit worthiness.

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