Key Concept: Fiat Money

c) They are legal tender

[Solution Description] Currency notes are termed fiat money because they do not have intrinsic value or backing by physical commodities like gold but are recognized as legal tender by government decree.

Key Concept: Cashless Society

c) Faster transaction processing

[Solution Description] A cashless society offers benefits such as improved transaction speed due to electronic processing, reducing manual handling of cash.

Key Concept: Commercial Banks

a) Creating credit through accepted deposits

[Solution Description] Commercial banks accept deposits from individuals and businesses and create credit by lending out these deposits. This activity is fundamental to increasing the money supply in the economy.

Key Concept: Advanced Scenario Analysis, Critical Analysis

c) \$432.6 billion

[Solution Description]

Initially, the transaction demand for money is:

$$M_d^T = k \cdot P \cdot Y = 0.2 \cdot 2000 = 400 \text{ billion dollars}$$

With a 5\% increase in real GDP and a 3\% increase in the average price level, the new nominal GDP is:

$$(1.05 \cdot 1.03) \cdot 2000 = 1.0815 \cdot 2000 = 2163 \text{ billion dollars}$$

Therefore, the new transaction demand is:

$$M_d^T = 0.2 \cdot 2163 = 432.6 \text{ billion dollars}$$

Key Concept: Store of Value

b) Store of value

[Solution Description] The store of value function of money means it retains value over time, which allows individuals to save and use it later.

Key Concept: Broad Money Components

c) Total deposits with Post Office savings organizations.

[Solution Description] M4 includes all components of M3, which itself includes M1 plus the net time deposits of commercial banks. M4 further includes total deposits with Post Office savings organizations that are not considered part of M3. Therefore, this is the additional component present in M4.

Key Concept: Loan Creation Limit

c) \$1700

[Solution Description]

The amount that can be lent out is calculated as:

$$\text{Amount to Lend} = \text{Total Deposits} – (\text{CRR} \times \text{Total Deposits})$$

Where CRR is 15\% or 0.15. Therefore,

$$\text{Amount to Lend} = 2000 – (0.15 \times 2000) = 2000 – 300 = 1700 \text{\ dollars}$$

Key Concept: Role of Central Bank

b) Adjusting interest rates

[Solution Description] One of the primary tools used by the central bank to control inflation is the adjustment of interest rates through monetary policy operations.

Key Concept: Liquidity Trap, Speculative Demand

b) Both Assertion and Reason are true, but Reason is NOT the correct explanation of Assertion.

[Solution Description]

When interest rates become extremely low, close to $$r_{min}$$, using the formula for speculative demand for money $$M_d^S = \frac{r_{max} – r}{r – r_{min}}$$, the denominator $$(r – r_{min})$$ approaches zero. As this happens, $$M_d^S$$, or speculative demand, tends towards infinity because division by a number approaching zero results in a very large value. This aligns with the behavior expected in a liquidity trap where people prefer holding cash over bonds due to negligible returns on bonds. The reason elaborates that speculative demand indeed decreases as the interest rate increases, which is true but does not explain why it approaches infinity during a liquidity trap; hence reason is not the correct explanation.

Key Concept: Outright vs Repo Operations

b) Repo

[Solution Description] Repo operations are temporary because they involve agreements to repurchase securities at a future date, which temporarily injects liquidity into the banking system until the repurchase occurs.

Key Concept: Interest Rates

b) Spread

[Solution Description] The ‘spread’ refers to the difference between the interest rates that commercial banks charge borrowers and those they pay to depositors. It reflects the bank’s profit on its lending activities.

Key Concept: Loan Impact on Balance Sheet

d) Increase by Rs 100

[Solution Description] When a bank grants a loan, it credits the borrower’s account with the amount of the loan. This increases the total deposits because the borrower can now withdraw or use this money. The increase is equal to the amount of the loan, hence the total deposits increase by Rs 100.

Key Concept: Economic Impact

b) Liquidity crunch causing business disruptions

[Solution Description]

The major economic challenge during demonetisation was liquidity crunch. With the sudden withdrawal of high-value currency notes, there was an immediate shortage of cash available in the economy which affected daily transactions and overall business operations.

Key Concept: Currency Issuance

c) Central Bank

[Solution Description]

In most countries, the central bank is the authority responsible for issuing currency. It manages the monetary policy and ensures the stability of the nation’s currency.

Key Concept: Speculative Demand Curve

d) It increases significantly

[Solution Description] At a rate slightly above $$r_{min}$$, the speculative demand $$M_d^S$$ becomes very high because the denominator ($$r – r_{min}$$) in the formula $$\frac{r_{max} – r}{r – r_{min}}$$ approaches zero, making the fraction large.

Key Concept: Transaction Motive

b) Real GDP and price level

[Solution Description] Transaction demand for money increases with an increase in real GDP and price level because more transactions require more money.