Class 12 Economics Chapter 3 Notes: Money and Banking

Covers T.R. Jain & V.K. Ohri (2026-27) ch 5-6. Based on NCERT Introductory Macroeconomics, Chapter 3 (Reprint 2026-27), the CBSE 2026-27 curriculum and the CBSE Supplementary Reading Material.

In this chapter you will learn

The drawbacks of barter and the four functions of money, with examples
The functions of the central bank (the Reserve Bank of India) and of commercial banks
How to draw up a bank balance sheet, trace credit creation round by round and solve money multiplier numericals
How CRR, SLR, bank rate, repo rate, reverse repo rate, open market operations, margin requirement and moral suasion control the money supply
The measures of money supply M1 to M4, fiat money, legal tender and demonetisation (2016)

BarterDouble coincidence of wantsMedium of exchangeUnit of accountStore of valueCentral bankHigh powered moneySpreadBalance sheetCredit creationCash Reserve RatioStatutory Liquidity RatioMoney multiplierLender of last resortOpen market operationsRepo rateReverse repo rateBank rateMargin requirementFiat moneyLegal tenderNarrow moneyBroad moneyDemonetisation

1 Barter and money

Money is the commonly accepted medium of exchange. Where there is only one person, or where people do not trade in a market (a family living on an isolated island, for example), money has no function. As soon as more than one economic agent starts transacting through the market, money becomes the main instrument that makes exchange easy.

Learn by heartDefinition 1

Exchange of goods directly for goods, without the mediation of money, is called barter exchange.

Learn by heartDefinition 2

Double coincidence of wants is the situation in which each of two persons has exactly the good the other wants, and both wish to exchange those very goods. Barter presumes it, but it rarely exists.

The book’s example: a person has surplus rice and wants clothing
She must find someone who has surplus clothing and wants exactly rice in return
As the number of people grows, the search costs of finding such a partner become prohibitive
So an intermediate good acceptable to both parties is needed; that good is money. People sell what they produce for money and use the money to buy what they need

Drawback of barter	How money removes it
No double coincidence of wants; very high search costs	Medium of exchange: everyone accepts money, so selling and buying can be done separately
No common measure of value; a separate ratio for every pair of goods	Unit of account: every value in rupees, relative prices at once
Wealth is hard to carry forward: rice is perishable, takes space, needs a buyer later	Store of value: money does not perish, costs little to store, is acceptable at any time
Hard to decide in which good loans and future payments should be fixed	Standard of deferred payments: future payments are fixed in rupees

2 Functions of money

Medium of exchange

The first and foremost function; removes the need for double coincidence

Unit of account

Value of all goods and services expressed in monetary units (rupees)

Store of value

Wealth kept in the form of money for future use

Standard of deferred payments

Future payments (loans, rent) are fixed in rupees (CBSE supplementary material)

2.1 Medium of exchange

Learn by heartDefinition 3

Money acts as a medium of exchange: goods are sold for money and bought with money. Barter is extremely difficult in a large economy because of the high cost of looking for suitable persons to exchange one’s surplus with.

2.2 Unit of account

Learn by heartDefinition 4

Money is a convenient unit of account: the value of all goods and services can be expressed in monetary units (the rupee in India). A wristwatch worth ₹500 can be exchanged for 500 units of money.

Worked example 1 (book)

Given: price of a pencil ₹2, price of a pen ₹10
Relative price of a pen: 10 ÷ 2 = 5 pencils
Value of money: ₹1 = 1 ÷ 2 = 0.5 pencil, or ₹1 = 1 ÷ 10 = 0.1 pen
Meaning: if all prices rise (a general increase in the price level), a rupee buys less of every good. This is a deterioration in the purchasing power of money.

2.3 Store of value

Learn by heartDefinition 5

Money acts as a store of value: wealth can be stored in the form of money for future use. To do this well, the value of money must be sufficiently stable.

Under barter a stock of rice is an asset, but rice is perishable, needs a lot of space, and selling it later means searching for buyers again
Money is not perishable, its storage cost is low, and it is acceptable to anyone at any time
A rising price level erodes the purchasing power of money, so it weakens this function
Gold, land, houses and bonds can also store value, but they are not easily converted into other goods and lack universal acceptability

2.4 Standard of deferred payments

Learn by heartDefinition 6

Payments contracted to be made at a future date are deferred payments. Money serves as their standard. This function made borrowing and lending easy and led to financial institutions (CBSE Supplementary Reading Material).

Exam tip

For “How does money overcome the shortcomings of barter?”, write each drawback against the function of money that removes it (as in the table above). A bare list of functions leaves the answer incomplete.

2.5 Cashless society and financial inclusion

A cashless society is one where financial transactions are made not with physical notes or coins but through the transfer of digital information (an electronic representation of money) between the parties
The Government of India has been investing steadily in reforms for greater financial inclusion
Initiatives: Jan Dhan accounts, Aadhaar enabled payment systems, e-wallets, the National Financial Switch (NFS)
With mobile and smartphone penetration across the country, financial inclusion is seen as a realistic dream

3 Demand for money (Not in CBSE 2026-27 syllabus)

The demand for money explains why people want to hold a certain amount of money. Read this part for the UP, Bihar, Rajasthan and MP boards; the detail is in section 8.

Factor	Effect on demand for money	Reason
Income rises	Demand rises	More income means more transactions, which need more money
Rate of interest rises	Demand falls	Holding cash means holding less in interest-earning deposits, so more interest is given up

4 Supply of money: the central bank and commercial banks

In a modern economy money consists of cash (currency) and bank deposits. Depending on which deposits are counted there are several measures of money (section 9). Money is created by two kinds of institutions: the central bank and the commercial banking system.

4.1 The central bank

Learn by heartDefinition 7

The central bank is the apex institution of a country’s monetary system; it issues the currency and controls the money supply and credit. India got its central bank in 1935; it is the Reserve Bank of India (RBI).

Bank of issue

Sole authority to issue the country’s currency (notes); brings uniformity and direct control over money supply

Government’s bank

Banker to the central and state governments: keeps their accounts, receives and makes payments, gives short-term credit, manages public debt, advises

Bankers’ bank

Holds banks’ cash reserves (CRR), lends to them when needed (lender of last resort), provides clearing, supervises and regulates banks

Controller of credit

Controls money supply and credit through bank rate, CRR, SLR, repo, reverse repo, open market operations and margin requirement

Custodian of foreign exchange reserves

Holds the economy’s foreign exchange reserves

The first four headings are exactly the ones in the CBSE syllabus (the tools from bank rate to margin requirement are in section 7). The fifth is given in the book.

Learn by heartDefinition 8

Currency issued by the central bank, whether held by the public or by commercial banks, is called high powered money. It is also called reserve money or monetary base, because it acts as the basis for credit creation.

4.2 Commercial banks

Learn by heartDefinition 9

Commercial banks accept deposits from the public and lend part of these funds to those who want to borrow. They mediate between those with excess funds and those who need funds.

Learn by heartDefinition 10

The interest rate a bank pays depositors is lower than the rate it charges borrowers. The difference between the two rates is called the spread; it is the bank’s profit.

Function of a commercial bank	Detail
1. Accepting deposits	Demand deposits (savings and current accounts, payable on demand) and time (fixed) deposits; deposits earn interest
2. Giving loans	Home loans, crop loans and so on; higher interest on loans, the gap being the spread
3. Payment services	Cheques and debit cards make transactions convenient and safe (imagine paying for a house in cash)
4. Credit (money) creation	A loan opens a new deposit in the borrower’s name, so the money supply rises (section 6)

People keep money in banks because (i) deposits earn interest, (ii) it is safer than at home, (iii) demand deposits make payments easy through cheques and debit cards, even when they earn no interest
A bank knows that all depositors will not withdraw at the same time, so it keeps part of the deposits and lends the rest
Repaying depositors on demand is crucial to a bank’s survival, so it must balance its wish to lend the maximum against keeping enough funds

5 Lala the goldsmith: money “out of thin air”

Step 1In a village, gold and other precious metals served as money; people kept their gold with the goldsmith Lala for safe-keeping and got paper receipts for a small fee

↓

Step 2Over time the receipts began to circulate as money; people paid for wheat or shoes with Lala’s receipts instead of gold

↓

Step 3Lala holds 100 kg of deposited gold and has issued receipts for 100 kg; Ramu asks for a loan of 25 kg

↓

Step 4Lala reckons that all depositors will not come for their gold at the same time, so he lends 25 kg to Ramu and charges him for it

↓

Step 5Ramu pays the gold to Ali, who deposits it with Lala for a receipt. The receipts acting as money now total 125 kg

Lala seems to have created money out of thin air. The modern banking system works precisely this way.

6 Money creation by the banking system

Banks can lend because they do not expect all depositors to withdraw at the same time. When a bank lends to a person, a new deposit is opened in that person’s name. So money supply rises to old deposits + new deposit (+ currency).

6.1 The bank balance sheet

Learn by heartDefinition 11

A balance sheet is a record of the assets and liabilities of a firm. By convention assets are written on the left and liabilities on the right, and the two sides must be equal.

Assets: what a firm owns or can claim from others. A bank’s assets are, besides buildings and furniture, its loans to the public (a ₹100 loan is the bank’s claim of ₹100 on the borrower) and its reserves
Reserves: deposits that commercial banks keep with the central bank (RBI) and their cash; kept partly as cash and partly as financial instruments (bonds and treasury bills) issued by the RBI. Just as our deposits are our assets, the deposits of banks such as SBI with the RBI are their assets
Liabilities: a firm’s debts, what it owes to others; a bank’s main liability is the deposits people keep with it

Balance sheet formulas

\text{Assets} = \text{Reserves} + \text{Loans}

\text{Liabilities} = \text{Deposits}

\text{Net Worth} = \text{Assets} – \text{Liabilities}

If assets exceed liabilities, the difference is recorded on the right as net worth, so that both sides balance.

Table 3.1: Balance sheet of a bank (start)

Ms Fernandes deposits ₹100 and the bank keeps the whole amount with the RBI as reserves.

Assets		Liabilities
Reserves	₹100	Deposits	₹100
		Net worth	₹0
Total	₹100	Total	₹100

With no currency in circulation: M1 = Currency + Deposits = 0 + 100 = ₹100.

6.2 The limit to credit creation: CRR and SLR

Suppose Mr Mathew asks for a loan of ₹500 and deposits it in the same bank; deposits and money supply would rise. It seems banks could create as much money as they like. But there is a limit, set by the central bank (RBI).

Learn by heartDefinition 12

The Cash Reserve Ratio (CRR), also called the Required Reserve Ratio or Reserve Ratio, is the minimum percentage of deposits that every bank must keep as cash reserves (with the central bank). The RBI fixes it; it is a legal requirement binding on banks, meant to ensure that no bank is “over-lending”.

Learn by heartDefinition 13

The Statutory Liquidity Ratio (SLR) is the percentage of deposits that banks must keep, in addition to the CRR, in liquid form (in specified liquid assets) with themselves in the short term (the book and the CBSE supplementary material).

6.3 The process of credit creation (book example, CRR = 20%)

Leela deposits ₹100. With a CRR of 20%, the bank keeps ₹20 as reserves and can lend ₹80
The bank lends ₹80 to Jaspal Kaur; it shows up in the next round as deposits (liabilities), total ₹180
Now required reserves = 20% of 180 = ₹36. The bank started with ₹100 of cash, so it can lend 100 − 36 = ₹64 again
The bank lends ₹64 to Junaid, which again becomes a deposit; the process repeats until required reserves become the whole ₹100
Required reserves are ₹100 only when total deposits are ₹500 (20% of 500 = 100)

Figure 1: The credit creation cycle. Each round the bank keeps 20% of deposits as reserves and lends 80%; the loan is spent and comes back to the bank as a new deposit — **Figure 1**: The credit creation cycle. Each round the bank keeps 20% of deposits as reserves and lends 80%; the loan is spent and comes back to the bank as a new deposit

Table 3.2: Money multiplier process (₹)

Round	Deposits in bank (total at start)	Required reserve (20%)	Loan made by bank
1	100.00	20.00	80.00
2	180.00	36.00	64.00
…	…	…	…
Last	500.00	100.00	400.00

Column 2 shows total deposits at the start of each round, column 3 the 20% to be kept with the RBI as required reserves, and column 4 the loans made. What the bank lends in each round is added to the deposits of the next round.

Figure 2: Total deposits after each round at a CRR of 20%: 100, 180, 244, 295.2 … and finally ₹500. Each round's new deposit is 80% of the last, so the increase keeps shrinking — **Figure 2**: Total deposits after each round at a CRR of 20%: 100, 180, 244, 295.2 … and finally ₹500. Each round’s new deposit is 80% of the last, so the increase keeps shrinking

Table 3.3: Balance sheet of the bank at the end

Assets		Liabilities
Reserves	₹100	Deposits (100 + 400)	₹500
Loans	₹400
Total	₹500	Total	₹500

M1 = Currency + Deposits = 0 + 500 = ₹500; money supply rises from ₹100 to ₹500
With a CRR of 20% the bank cannot lend beyond ₹400; the reserve requirement is the limit to money creation

6.4 The money multiplier

Learn by heartDefinition 14

The money multiplier tells us how many times the initial deposit (reserves) the banking system can create as total deposits (money). In the book, money multiplier = 1 ÷ Cash Reserve Ratio.

Learn by heartDefinition 15

Legal Reserve Ratio (LRR): the minimum fraction of deposits banks must by law keep as reserves; one part is kept with the central bank (CRR) and the other with the banks themselves (SLR). The CBSE supplementary material writes the multiplier as 1 ÷ LRR; if a question gives “LRR” or “required reserve ratio”, use it in place of the CRR.

The book’s Key Concepts also list two more terms: currency deposit ratio = currency held by the public ÷ its bank deposits; reserve deposit ratio = total reserves of banks ÷ their deposits.

\text{Money Multiplier} = \frac{1}{\text{CRR}} = \frac{1}{20\%} = \frac{1}{0.2} = 5

…(3.A)

Credit creation formulas

Total deposits (total money created) = initial deposit × $\frac{1}{CRR}$
Total loans (credit) = total deposits − initial deposit
Required reserves = total deposits × CRR (at the end this equals the initial deposit)
So reserves of ₹100 create deposits of 5 × 100 = ₹500.

Exam tip

The CRR and the money multiplier are inversely related: a lower CRR raises the multiplier and credit creation; a higher CRR lowers them. With an LRR of 0.1 the multiplier is 10; with 0.4 it is 2.5 (CBSE supplementary material). Always write all three: the multiplier, total deposits and total loans.

Given

Initial deposit ₹1,000; CRR 10%

To find

Money multiplier, total deposits, total credit (loans)

Worked example 2

Formula: money multiplier = 1 ÷ CRR (½)
Substituting: 1 ÷ 0.10 = 10 (½)
Total deposits: 1,000 × 10 = ₹10,000 (1)
Total credit (loans): 10,000 − 1,000 = ₹9,000 (1)
Meaning: an initial deposit of ₹1,000 lets the banking system give ₹9,000 of new loans and create ₹10,000 of deposits in all.

Worked example 3 (working backwards)

Question: an initial deposit of ₹2,000 created total deposits of ₹10,000. Find the CRR.
Formula: multiplier = total deposits ÷ initial deposit = 10,000 ÷ 2,000 = 5
CRR = 1 ÷ multiplier = 1 ÷ 5 = 0.2 = 20%
Question: at a CRR of 20%, banks gave total loans of ₹8,000. What was the initial deposit?
Solution: total loans = initial deposit × (multiplier − 1), so initial deposit = 8,000 ÷ (5 − 1) = ₹2,000 (total deposits ₹10,000).

Worked example 4 (change in CRR)

Working: if the CRR is raised from 20% to 25%, the multiplier = 1 ÷ 0.25 = 4; reserves of ₹100 now support only ₹400 of deposits and ₹300 of loans (book: “the banking system would now be able to loan Rs 300 only”). Loans were ₹400, so banks must call back some loans and the money supply falls.
The other way: on a new deposit of ₹1,000, a CRR cut from 5% to 4% raises the multiplier from 20 to 25; total deposits rise from ₹20,000 to ₹25,000, i.e. ₹5,000 more money created.

Common mistakes (credit creation)

Leaving the CRR as a percentage: not 1 ÷ 20 but 1 ÷ 0.20 = 5
Treating “total deposits” and “total loans” as the same: at ₹100 and 20% CRR, deposits ₹500, loans ₹400
Writing that a higher CRR raises the multiplier: the relation is inverse
Taking the second-round loan as (180 − 36) instead of (100 − 36): the bank’s cash is only the original ₹100

Credit creation as a series (Appendix 3.1)

Infinite geometric series: $S = a + ar + ar^2 + \dots$ , with $0 \lt r \lt 1$ . Multiplying by r and subtracting gives $S – rS = a$ , so

S = \frac{a}{1-r}

In credit creation each round’s new deposit is 80% of the last: 100 + 80 + 64 + 51.2 + … , with a = 100 and r = 1 − CRR = 0.8, so S = 100 ÷ (1 − 0.8) = ₹500. (The appendix’s own example takes a = 1, r = 0.4 and gets 1 ÷ 0.6 = 5/3.)

7 Policy tools to control money supply (monetary policy)

The RBI regulates money supply by controlling the stock of high powered money, the bank rate and the reserve requirements of commercial banks, and it also sterilises (sterilisation) the money supply in the economy against external shocks (the book’s summary). The Reserve Bank is the only institution that can issue currency. When commercial banks need more funds to create more credit, they may go to the market or to the central bank.

Learn by heartDefinition 16

The RBI’s role of being ready to lend to banks at all times makes it the lender of last resort. Even when a bank can get funds nowhere else, the central bank provides them.

RBI’s tools to control money supply

Quantitative toolsChange the extent of money supply: CRR, SLR, bank rate, repo and reverse repo rates, open market operations

Qualitative toolsMake banks encourage or discourage lending: moral suasion, margin requirement, etc.

7.1 Changing the Cash Reserve Ratio (CRR)

A higher CRR makes banks keep more reserves; the lendable amount and the multiplier fall; money supply falls
A lower CRR does the opposite: the multiplier and credit creation rise
Book example: from 20% to 25%, loans fall from ₹400 to ₹300 (Worked example 4)

7.2 Statutory Liquidity Ratio (SLR)

A higher SLR makes banks hold a larger share of deposits in liquid assets, leaving less to lend; credit falls
A lower SLR frees more funds for lending

7.3 Bank rate

Learn by heartDefinition 17

The rate at which the RBI gives loans to commercial banks is called the bank rate in India.

Bank rate upBorrowing from the RBI costlier

→

Bank reserves fallBanks also raise their lending rates

→

Less borrowingCredit falls

→

Money supply fallsThe reverse if the bank rate falls

7.4 Open market operations (OMO)

Learn by heartDefinition 18

Open market operations are the buying and selling of bonds issued by the government in the open market. The central bank carries them out on behalf of the government.

RBI buys bonds

Pays by cheque
The cheque raises the total reserves in the economy
Banks can lend more
Money supply rises

RBI sells bonds

Buyers (individuals or institutions) pay the RBI
Reserves fall
Banks can lend less
Money supply falls

Outright and repo operations

Basis	Outright open market operation	Repo (repurchase agreement)
Later reversal	No promise to sell later what is bought (or buy back what is sold)	The purchase agreement itself fixes the date and price of resale
Effect	Injection or absorption of money is permanent	Money for a fixed period (overnight, 7-day, 14-day, etc.)
Importance	Not the main tool	Repo and reverse repo are now the main tool of RBI monetary policy

Learn by heartDefinition 19

When the central bank buys a security with an agreement specifying the date and price at which it will resell it, the agreement is a repurchase agreement or repo. The interest rate at which money is lent this way is the repo rate. Simply put, it is the rate at which the RBI lends to banks for the short term.

Learn by heartDefinition 20

When the central bank sells a security with an agreement specifying the date and price at which it will buy it back, the agreement is a reverse repurchase agreement or reverse repo. The rate at which money is withdrawn this way is the reverse repo rate; simply put, the rate the RBI pays banks for parking their surplus funds with it.

Tool	To reduce money supply (contract credit)	To raise money supply (expand credit)
CRR	Raise	Lower
SLR	Raise	Lower
Bank rate	Raise	Lower
Repo rate	Raise (bank borrowing costlier)	Lower
Reverse repo rate	Raise (banks prefer to park funds with the RBI)	Lower
Open market operations	Sell bonds	Buy bonds
Margin requirement	Raise	Lower
Moral suasion	Ask banks to lend less	Encourage banks to lend more

7.5 Qualitative tools: margin requirement and moral suasion

Learn by heartDefinition 21

Margin requirement: the margin is the difference between the amount of the loan and the market value of the security the borrower offers against it (gold, shares, goods). The central bank fixes it. If the margin is 40%, a bank can lend only up to 60% of the value of the security (CBSE supplementary material).

Formula

Maximum loan = market value of the security × (1 − margin)

Worked example 5

Given: security worth ₹10,00,000; margin 40%
Maximum loan: 10,00,000 × (1 − 0.40) = ₹6,00,000
At a 50% margin: 10,00,000 × 0.50 = ₹5,00,000
Meaning: raising the margin cut the loan on the same security by ₹1,00,000, so credit contracts; lowering it expands credit. The book places it with moral suasion among the qualitative tools.

Learn by heartDefinition 22

Moral suasion is persuasion by the central bank to make commercial banks encourage or discourage lending.

Common mistakes (monetary policy)

Treating the repo rate and the bank rate as the same: a repo carries an agreement to sell back a security; the bank rate is the rate on ordinary loans
Writing reverse repo as “RBI lends to banks”: in a reverse repo banks give funds to the RBI (it absorbs money)
Saying the RBI’s sale of bonds raises the money supply: the money goes to the RBI, so supply falls
Calling the margin requirement a quantitative tool: it is qualitative

8 Demand for money: a detailed discussion (Box 3.1) (Not in CBSE 2026-27 syllabus)

This box is for the state boards. Money is the most liquid asset: universally acceptable and easily exchanged for other goods. But it has an opportunity cost: a fixed deposit would have earned interest.

Learn by heartDefinition 23

How much money to hold is decided by weighing the advantage of liquidity against the disadvantage of the interest forgone. So the demand for money balance is called liquidity preference. People hold money broadly from two motives: the transaction motive and the speculative motive.

8.1 The transaction motive

The principal motive is to carry out transactions, since income arrives at discrete dates but spending goes on continuously
Book example: ₹100 earned on the first day of each month and run down evenly; balance ₹100 at the start, ₹0 at the end; average cash = (100 + 0) ÷ 2 = ₹50, half the monthly transactions
Two-person economy (a firm and a worker): the firm pays a salary of ₹100 at the start of the month, the worker spends it on the firm’s output over the month; each holds ₹50 on average, total transaction demand ₹100, while monthly transactions are ₹200 (₹100 of output and ₹100 of services)

M^d_T = k \cdot T

…(3.1)

\frac{1}{k} \cdot M^d_T = T \quad \text{or} \quad v \cdot M^d_T = T

…(3.2)

M^d_T = kPY

…(3.3)

M^d_T

transaction demand for money (a stock)₹

T

total (nominal) value of transactions in the unit period (a flow)₹ per period

k

a positive fractionnumber

v

velocity of circulation = 1/ktimes per period

P

Y

general price level (GDP deflator) and real GDP

Learn by heartDefinition 24

The number of times a unit of money changes hands during the unit period is the velocity of circulation of money. In the two-person example each rupee changes hands twice a month, so v = 2 (the inverse of k = 1/2).

Annual transactions include intermediate goods, so they far exceed nominal GDP, but the two are related in a stable, positive way
Hence (3.3): transaction demand is positively related to real income (Y) and the price level (P)

Worked example 6

Given: k = 0.25, P = 1.2, real GDP Y = ₹5,000 crore
Formula: $M^d_T = kPY$
Substituting: 0.25 × 1.2 × 5,000 = ₹1,500 crore
Meaning: ₹1,500 crore of money is demanded for transactions; it rises in proportion if Y or P rises.

8.2 The speculative motive

Wealth can be held as land, bullion, bonds, money and so on; for simplicity all assets other than money are called bonds
Bonds: papers issued by governments or firms to borrow from the public, promising a stream of money returns over a period; they are tradable in the market
The book’s bond: a firm borrows ₹100, pays ₹10 at the end of year 1 and ₹10 + the principal ₹100 at the end of year 2. Face value ₹100, maturity period 2 years, coupon rate 10%

PV = \frac{10}{(1+\frac{5}{100})} + \frac{10+100}{(1+\frac{5}{100})^2} \approx 9.524 + 99.773 = 109.297

(at 5% interest)

With 5% interest on a savings account, the bond’s present value is about ₹109.30 (the book prints “Rs 109.29 (approx.)”): ₹109.30 in the savings account would earn the same return as the bond
But the bond sells at its face value of ₹100, so people rush to buy it; competitive bidding raises its price to the present value. If the price goes above PV, excess supply pushes it back. In equilibrium bond price = present value
If the interest rate rises from 5% to 6%, the same bond is worth about ₹107.33; so the price of a bond is inversely related to the market rate of interest

Figure 3: As the interest rate rises, the price of the same bond (face value ₹100, 10% coupon, 2 years) falls: ≈ ₹111.32 at 4%, ≈ ₹109.30 at 5%, ≈ ₹107.33 at 6%, ≈ ₹103.57 at 8% — **Figure 3**: As the interest rate rises, the price of the same bond (face value ₹100, 10% coupon, 2 years) falls: ≈ ₹111.32 at 4%, ≈ ₹109.30 at 5%, ≈ ₹107.33 at 6%, ≈ ₹103.57 at 8%

A loss from a falling bond price is a capital loss to the bond holder; a gain from a rising price is a capital gain
Someone who expects interest rates to rise (bond prices to fall) sells bonds and holds money; this is the speculative demand for money
Interest rate very high: everyone expects it to fall and anticipates capital gains, converts money into bonds; speculative demand low
Interest rate low: more people expect it to rise and fear capital losses, convert bonds into money; speculative demand high. So speculative demand is inversely related to the rate of interest

M^d_S = \frac{r_{max} – r}{r – r_{min}}

…(3.4)

r is the market rate of interest; $r_{max}$ and $r_{min}$ are its upper and lower limits (positive constants). As r falls from $r_{max}$ to $r_{min}$ , $M^d_S$ rises from 0 to infinity.

Learn by heartDefinition 25

When the interest rate is already so low ( $r_{min}$ ) that everyone expects it to rise (and bond prices to fall), nobody wishes to hold bonds; any extra money is simply held as money balance and the interest rate falls no further. This is a liquidity trap. Here the speculative money demand function is infinitely elastic.

Figure 4 (like the book's Fig. 3.1): speculative demand on the horizontal axis, rate of interest on the vertical. At r = rmax (here 10%) demand is zero; as r falls demand rises; at r = rmin (here 2%) the curve becomes flat, which is the liquidity trap — **Figure 4** (like the book’s Fig. 3.1): speculative demand on the horizontal axis, rate of interest on the vertical. At r = rmax (here 10%) demand is zero; as r falls demand rises; at r = rmin (here 2%) the curve becomes flat, which is the liquidity trap

M^d = M^d_T + M^d_S = kPY + \frac{r_{max} – r}{r – r_{min}}

…(3.5)

Total demand for money = transaction demand (directly proportional to real GDP and the price level) + speculative demand (inversely related to the rate of interest).

9 The supply of money: various measures

In India currency notes are issued by the Reserve Bank of India (the monetary authority), but coins are issued by the Government of India
Balances in savings and current accounts are also money, because cheques drawn on them settle transactions

Demand deposits

Savings and current accounts
Payable by the bank on demand
Usable by cheque; part of M1

Time deposits

Fixed deposits and the like
Fixed period to maturity
Part of M3, not M1

9.1 Fiat money and legal tender

The paper of a ₹100 note is worth far less than ₹100, and the metal in a ₹5 coin is probably not worth ₹5. People still accept them because their value comes from the guarantee of the issuing authority: every currency note bears a promise from the Governor of RBI that RBI will be responsible for giving the holder purchasing power equal to the value printed on it.

Learn by heartDefinition 26

Currency notes and coins are fiat money: they have no intrinsic value like a gold or silver coin; their value comes from the guarantee of the issuing authority.

Learn by heartDefinition 27

Currency notes and coins are legal tender: no citizen of the country can refuse them in settlement of any transaction. A cheque on a savings or current account can be refused by anyone, so demand deposits are not legal tender.

9.2 Narrow and broad money: M1, M2, M3, M4

Like the demand for money, the supply of money is a stock variable: the total stock of money in circulation among the public at a point of time. The RBI publishes four alternative measures.

Learn by heartDefinition 28 (CBSE syllabus)

M1 = CU + DD, where CU = currency (notes and coins) held by the public and DD = net demand deposits held by commercial banks. “Net” means only the public’s deposits are counted; interbank deposits one bank holds in another are not part of money supply.

M1CU + DD (most liquid; narrow money)

↓

M2M1 + savings deposits with post office savings banks (narrow money) (Not in CBSE 2026-27 syllabus)

↓

M3M1 + net time deposits of commercial banks (broad money; most commonly used, “aggregate monetary resources”) (Not in CBSE 2026-27 syllabus)

↓

M4M3 + total deposits with post office savings organisations (excluding National Savings Certificates) (broad money; least liquid) (Not in CBSE 2026-27 syllabus)

M1 and M2 are narrow money; M3 and M4 are broad money
The measures are in decreasing order of liquidity: M1 most liquid and easiest for transactions, M4 least liquid
M3 is the most commonly used measure; it is also called aggregate monetary resources

Given (₹ crore)

Currency with the public 400; net demand deposits of banks 600; savings deposits with post office savings banks 50; net time deposits of banks 1,500; total deposits with post office savings organisations (excluding NSC) 120

To find

M1, M2, M3, M4

Worked example 7

M1 = CU + DD = 400 + 600 = ₹1,000 crore
M2 = M1 + post office savings deposits = 1,000 + 50 = ₹1,050 crore
M3 = M1 + net time deposits = 1,000 + 1,500 = ₹2,500 crore
M4 = M3 + total post office deposits = 2,500 + 120 = ₹2,620 crore
Note: M3 adds to M1, not to M2.

9.3 M1 and M3 in India (Appendix 3.2, not in CBSE syllabus)

Figure 5: M1 and M3 in India, ₹ lakh crore (the book's Table 3.4, source: RBI Handbook of Statistics on Indian Economy 2024-25). In 2024-25 M1 was ₹65.84 lakh crore and M3 ₹272.87 lakh crore — **Figure 5**: M1 and M3 in India, ₹ lakh crore (the book’s Table 3.4, source: RBI Handbook of Statistics on Indian Economy 2024-25). In 2024-25 M1 was ₹65.84 lakh crore and M3 ₹272.87 lakh crore

The gap between the two columns is due to the time deposits of commercial banks: in 2024-25, 2,72,86,589 − 65,84,081 = ₹2,07,02,508 crore
In 2024-25 M3 was about 4.14 times M1, so most of the public’s money is in time deposits

10 Demonetisation (Box 3.2)

Learn by heartDefinition 29

Demonetisation is the withdrawal of the legal tender status of a series of currency notes in circulation. The Government of India took this new initiative in November 2016.

Corruption

To tackle the problem of corruption

Black money

To tackle the problem of black money

Terrorism

To tackle the problem of terrorism

Fake currency

To tackle the circulation of fake currency

November 2016Old ₹500 and ₹1000 notes ceased to be legal tender; new ₹500 and ₹2000 notes launched

Till 12 December 2016Old notes accepted at petrol pumps, government hospitals and for government dues (taxes, power bills, etc.)

Till 31 December 2016Old notes could be deposited in bank accounts without any declaration

Till 31 March 2017Old notes could be deposited with the RBI with a declaration

To avoid a complete breakdown and cash crunch, the government allowed exchange of old notes for new currency up to ₹4000 per person per day.

Criticism (negative effects)

Long queues outside banks and ATM booths
Shortage of currency in circulation hurt economic activity
Things improved with time and normalcy returned

Positive effects

Better tax compliance; a large number of people brought into the tax net
Savings channelised into the formal financial system; banks have more resources to lend at lower interest rates
A signal that tax evasion will no longer be tolerated; it will bring financial penalty and social condemnation; corruption will decrease
Transactions shifted out of cash into the formal payment system; households and firms moving to electronic payments

Read the data (Appendix 3.3)

The book’s Table 3.5 shows currency in circulation of ₹16,63,463 crore in 2015-16, falling to ₹13,35,266 crore in 2016-17 (the demonetisation year), a drop of ₹3,28,197 crore (about 19.7%). In 2017-18 it rose again to ₹18,29,348 crore. Demonetisation is also examined under “Indian Economic Development” in the syllabus.

11 Key formulas

Key formulas

Quantity	Formula
Relative price	price of good A ÷ price of good B (pen = 10 ÷ 2 = 5 pencils)
Balance sheet	Assets = Reserves + Loans; Liabilities = Deposits; Net worth = Assets − Liabilities
Money multiplier	1 ÷ CRR (supplement: 1 ÷ LRR)
Total deposits	initial deposit × 1/CRR
Total loans (credit)	total deposits − initial deposit = initial deposit × (multiplier − 1)
Maximum loan (margin)	value of security × (1 − margin)
M1 / M2 / M3 / M4	CU + DD / M1 + PO savings deposits / M1 + net time deposits / M3 + total PO deposits
Transaction demand (not CBSE)	$M^d_T = kT = kPY$ ; v = 1/k
Present value (not CBSE)	return ÷ (1 + r) + return ÷ (1 + r)² + …
Speculative demand (not CBSE)	$M^d_S = (r_{max} – r)/(r – r_{min})$

12 Differences the exam asks for

Basis	Central bank (RBI)	Commercial bank
Main aim	Control money supply and credit in the interest of the economy	Profit from the spread between loan and deposit rates
Currency	Sole right to issue notes	Cannot issue notes; creates credit (deposits)
Customers	Government and banks	Public and firms
Role	Lender of last resort, controller of credit	Accepting deposits, giving loans

Basis	CRR	SLR
Kept where	With the central bank (RBI)	With the bank itself
In what form	Cash reserves	Specified liquid assets
Effect of a rise	Both cut lendable funds and credit

Basis	Repo rate	Reverse repo rate
Flow of funds	RBI to banks (RBI lends)	Banks to RBI (RBI absorbs)
Agreement	RBI buys securities, will resell	RBI sells securities, will buy back
Effect of a rise	Bank borrowing costlier, credit falls	Banks park funds with RBI, credit falls

Basis	Quantitative tools	Qualitative tools
Purpose	Control the extent of money supply and total credit	Make banks encourage or discourage lending
Examples	CRR, SLR, bank rate, repo, reverse repo, open market operations	Margin requirement, moral suasion

Basis	Narrow money	Broad money
Measures	M1, M2	M3, M4
Liquidity	Higher	Lower
Time deposits	Not included	Included

Basis	Bank rate	Repo rate
Type of lending	Rate on RBI’s ordinary loans to banks	Rate on short-term lending under a repurchase agreement
Security	No repurchase agreement	Repurchase agreement on government securities

Quick revision: read the night before

Barter: exchange without money; main drawback is no double coincidence of wants
Functions of money: medium of exchange, unit of account, store of value, standard of deferred payments
When the price level rises, the purchasing power of money falls
RBI 1935: bank of issue, government’s bank, bankers’ bank, controller of credit, custodian of foreign exchange reserves
High powered money = currency issued by the RBI (held by public + banks)
Spread = loan interest rate − deposit interest rate = bank’s profit
Assets = reserves + loans; liabilities = deposits
Money multiplier = 1/CRR; at 20% CRR, ₹100 creates ₹500 of deposits and ₹400 of loans
Raising CRR, SLR, bank rate, repo, reverse repo or margin, or selling bonds, reduces money supply
Qualitative: moral suasion, margin requirement; a 40% margin allows loans up to 60%
Fiat money: no intrinsic value; legal tender: cannot be refused; cheques are not legal tender
M1 = CU + DD; M3 = M1 + net time deposits; M1, M2 narrow; M3, M4 broad
Demonetisation, November 2016: old ₹500, ₹1000 withdrawn; new ₹500, ₹2000

Check yourself before the exam

Can I write each drawback of barter against the function of money that removes it?
Given a CRR and an initial deposit, can I find the multiplier, total deposits and total loans, and work backwards to the CRR?
Can I draw the credit creation table with the first two rounds and the last row?
For each tool, can I say whether the RBI raises or lowers it to cut money supply?
Can I write the demonetisation dates, aims and both kinds of effects?

More for this chapter

Important Questions MCQ / Objective NCERT Solutions Short Notes