Key takeaways
- Money is a medium of exchange, unit of account and store of value; it solves barter's need for a double coincidence of wants.
- Transaction demand for money rises with nominal income (kPY); speculative demand falls as the interest rate rises.
- Bond prices and interest rates move in opposite directions; at a very low rate the economy can fall into a liquidity trap.
- Banks create money: money supply = money multiplier × high powered money, with multiplier (1 + cdr) ÷ (cdr + rdr).
- The RBI controls money through open market operations, the bank rate and reserve requirements (CRR, SLR), and acts as lender of last resort.
This page is part of the Introductory Macroeconomics chapter list for Class 12 Economics. It uses real GDP and the price level from national income accounting.
3.1Functions of Money
Money's main job is to act as a medium of exchange, so goods can be bought and sold without barter. It also serves as a common unit of account for measuring value, and as a store of value that lets people carry purchasing power into the future. Barter fails because it needs a double coincidence of wants.
Why barter breaks down
In a barter exchange, goods are traded directly for goods. A potter who wants rice must find a rice farmer who, at the same moment, wants pots. This need for a double coincidence of wants makes trade slow and uncertain. Barter also has no common measure of value, and many goods cannot be stored or divided without losing worth.
| Function | What it means | Barter problem removed |
|---|---|---|
| Medium of exchange | Accepted by everyone in return for goods and services | No need for a double coincidence of wants |
| Unit of account | Values of all goods are stated in one unit, the rupee | No common measure of value |
| Store of value | Purchasing power can be kept for later use | Many goods perish or lose value when stored |
Money is not a perfect store of value: when the general price level rises, the same note buys less. Assets such as land, gold or bonds can also store value, but money is the most liquid, because it can be spent immediately without loss.
3.2Demand for Money
People choose to hold part of their wealth as money for two main reasons. The transaction motive is the need for money to pay for day-to-day purchases, and it rises with income and prices. The speculative motive is holding money instead of bonds when people expect bond prices to fall, and it falls as interest rates rise.
The transaction motive
Income usually arrives at intervals, such as a monthly salary, while spending happens every day. People therefore keep money to bridge the gap. The amount needed depends on the value of transactions in the economy, which is measured by nominal GDP:
P = general price level · Y = real GDP · k = fraction of nominal income held for transactions (0 < k < 1)
If prices or real income rise, people need more money to carry out the same pattern of spending, so transaction demand rises.
The speculative motive and bond prices
Wealth can be kept as money, which earns nothing, or as bonds, which pay a fixed stream of returns. The price of a bond equals the present value of what it will pay, discounted at the market rate of interest. When the market interest rate rises, each future payment is worth less today, so the bond's price falls. Bond prices and interest rates always move in opposite directions.
Each person has a view of the “normal” interest rate. If the current rate is high, people expect it to fall, which means bond prices will rise. They buy bonds now to make a capital gain and hold little speculative money. If the current rate is low, people expect it to rise and bond prices to fall, so they sell bonds and hold money to avoid a capital loss. Speculative demand for money is therefore inversely related to the rate of interest:
In a liquidity trap, the interest rate is so low that everyone expects it to rise. People hold any additional money instead of buying bonds, so pumping more money into the economy cannot push the interest rate lower.
3.3The Supply of Money
Money supply is the total stock of money held by the public at a point of time: currency notes and coins plus bank deposits. Currency is fiat money and legal tender; deposits count as money because cheques and transfers on them settle payments. Banks multiply the RBI's high powered money into a larger money supply.
Legal definitions: narrow and broad money
In India, currency notes are issued by the RBI and coins by the Government of India. A note has almost no value as paper; it is accepted because the issuing authority promises to honour it. Such money is fiat money, and because it cannot be refused in settling a payment it is legal tender. Cheques on bank deposits are widely accepted but can be refused, so deposits are not legal tender.
| Measure | Definition | Type |
|---|---|---|
| M1 | CU + DD (currency with the public + net demand deposits of commercial banks) | Narrow money, most liquid |
| M2 | M1 + savings deposits with post office savings banks | Narrow money |
| M3 | M1 + net time deposits of commercial banks | Broad money, “aggregate monetary resources” |
| M4 | M3 + total deposits with post office savings organisations (excluding National Savings Certificates) | Broad money, least liquid |
“Net” means only deposits held by the public count; deposits that one bank keeps with another are excluded. M3 is the most commonly used measure.
Money creation by the banking system
Two behavioural ratios decide how much money banks can create:
- Currency deposit ratio (cdr) = CU ÷ DD. It shows how much cash the public prefers to hold for every rupee in deposits. It tends to rise during festivals, when people withdraw cash to spend.
- Reserve deposit ratio (rdr): the share of deposits banks keep as reserves, as vault cash and as deposits with the RBI. Reserves earn little, so banks keep them as low as the RBI's rules and safety allow.
The RBI's total liability, currency held by the public plus reserves of banks, is called high powered money (H) or the monetary base. Because banks lend out most of each deposit, and those loans come back as new deposits, total money supply ends up several times larger than H:
Instruments of monetary policy and the Reserve Bank of India
Since deposits far exceed reserves, banks could not repay everyone at once if all depositors panicked, a situation called a bank run. The RBI stands behind commercial banks in such a crisis, lending to keep them solvent. This role is called lender of last resort. The RBI is also banker to the central and state governments. When the government borrows from the RBI by selling it securities, and spends the new currency, this is deficit financing through central bank borrowing.
As controller of money and credit, the RBI uses three main instruments:
- Open market operations (OMO): buying government securities from the public raises high powered money; selling them reduces it.
- Bank rate policy: the bank rate is the rate banks pay to borrow from the RBI. A lower bank rate makes borrowing reserves cheaper, so banks keep a smaller rdr, the multiplier rises and money supply grows.
- Reserve requirements: the Cash Reserve Ratio (CRR) fixes the share of deposits banks must keep with the RBI, and the Statutory Liquidity Ratio (SLR) the share they must hold in specified liquid assets. Raising either raises rdr and shrinks the multiplier.
Sterilisation: when large foreign inflows arrive, banks sell foreign currency to the RBI and their deposits with the RBI rise, increasing high powered money and, through the multiplier, money supply. To stop this from fuelling inflation, the RBI sells an equal value of government securities in the open market. Neutralising the inflow in this way is called sterilisation.
How the RBI works today: the main policy signal is now the policy repo rate, set by the Monetary Policy Committee under a flexible inflation-targeting framework. OMOs, CRR and SLR remain in use, as the chapter describes.
Worked Examples
Example 1: Price of a bond
- Given
- A bond with face value ₹100 pays ₹12 at the end of year 1 and ₹112 (interest plus principal) at the end of year 2. The market rate of interest is 8%.
- Formula
- Price = 12 ÷ (1 + r) + 112 ÷ (1 + r)2
- Steps
- 12 ÷ 1.08 = 11.11. 112 ÷ 1.1664 = 96.02. Price = 11.11 + 96.02 = 107.13. At 10%: 10.91 + 92.56 = 103.47.
- Answer
- ₹107.13 at 8%, falling to ₹103.47 at 10%: a higher interest rate lowers the bond price.
Example 2: Money multiplier and money supply
- Given
- cdr = 0.25; rdr = 0.15; high powered money H = ₹2,000 crore.
- Formula
- Multiplier = (1 + cdr) ÷ (cdr + rdr); M = multiplier × H
- Steps
- Multiplier = 1.25 ÷ 0.40 = 3.125. M = 3.125 × 2,000 = 6,250. Deposits = M ÷ (1 + cdr) = 5,000; currency = 1,250; reserves = 0.15 × 5,000 = 750; check: 1,250 + 750 = 2,000 = H.
- Answer
- Money multiplier = 3.125; money supply = ₹6,250 crore.
Example 3: Transaction demand for money
- Given
- Nominal GDP (P × Y) = ₹48,000 crore; k = 0.25.
- Formula
- MTd = k × P × Y
- Steps
- 0.25 × 48,000 = 12,000.
- Answer
- Transaction demand = ₹12,000 crore. If nominal GDP rises by 10%, it rises to ₹13,200 crore.
Common Mistakes
- Writing that bond prices rise when interest rates rise. They move in opposite directions.
- Treating demand deposits as legal tender. Only currency is legal tender; a cheque can be refused.
- Mixing up M2 and M3: M2 adds post office savings deposits, M3 adds bank time deposits.
- Saying a higher CRR increases money supply. It raises rdr and reduces the multiplier.
- Using 1 ÷ rdr as the multiplier when cdr is given. With cash holding, the multiplier is (1 + cdr) ÷ (cdr + rdr).
10 Important Questions for Class 12 Board and School Examinations
Questions are written in original words. Marks are shown beside each question.
Q1M1 is made up of: (A) currency with the public and time deposits (B) currency with the public and net demand deposits of banks (C) bank reserves and currency (D) post office savings deposits 1 mark · MCQ
(B) Currency with the public and net demand deposits of banks. M1 = CU + DD, the most liquid measure.
Q2Assertion (A): An open market purchase of securities by the RBI increases money supply. Reason (R): It increases high powered money in the economy. Choose: (a) both true, R explains A; (b) both true, R does not explain A; (c) A true, R false; (d) A false, R true. 1 mark · Assertion-reason
(a) Both are true and R correctly explains A. The RBI pays for the securities with new reserves, and the multiplier turns that rise in H into a larger money supply.
Q3What is a barter system? State two of its drawbacks. 3 marks
A barter system is the direct exchange of goods for goods without money.
- It needs a double coincidence of wants, which is rare.
- It has no common unit to measure the value of goods.
- Many goods cannot be stored or divided without losing value.
Example: a weaver wanting wheat must find a farmer who wants cloth at that time.
Money solves these problems.
Q4What is meant by legal tender and fiat money? 3 marks
Fiat money has value because the government declares it money; legal tender is money that cannot be refused in payment.
- Currency notes and coins have little intrinsic value, so they are fiat money.
- Their value rests on the promise of the issuing authority.
- Because the law requires their acceptance in settling debts, they are legal tender.
Example: a ₹500 note is legal tender; a cheque is not.
Q5What is a liquidity trap? 3 marks
A liquidity trap is a situation where the interest rate is so low that people hold any extra money instead of buying bonds.
- At the minimum rate, everyone expects interest rates to rise.
- So everyone expects bond prices to fall and avoids bonds.
- Speculative demand for money becomes unlimited, so more money cannot lower the rate further.
Example: at rmin, the speculative demand curve becomes flat.
Q6Why is the speculative demand for money inversely related to the rate of interest? 4 marks
Because expected changes in bond prices depend on whether the current interest rate looks high or low.
- Bond price and interest: bond prices fall when interest rates rise.
- High rate: people expect it to fall, so they buy bonds for a capital gain and hold less money.
- Low rate: people expect it to rise, so they sell bonds to avoid a capital loss and hold more money.
- Result: as r rises, speculative money demand falls.
Example: at rmax speculative demand is zero.
Q7Explain the role of the RBI as lender of last resort and as banker to the government. 4 marks
The RBI protects depositors by backing banks in a crisis, and manages the government's banking and borrowing.
- Bank runs: deposits exceed reserves, so banks cannot repay everyone at once.
- Lender of last resort: the RBI lends to banks in trouble, so depositors need not panic.
- Banker to government: it holds government accounts and manages its borrowing.
- Deficit financing: government securities sold to the RBI add to the currency in circulation.
Example: RBI support during a run on one bank stops panic withdrawals spreading to others.
Q8Explain how commercial banks create money. What determines the size of the money multiplier? 6 marks
Banks create money by lending out most of their deposits; the loans return as new deposits, so total money supply becomes a multiple of high powered money.
- Banks keep only a fraction of deposits as reserves (rdr).
- They lend the rest; borrowers spend it and recipients redeposit it.
- Each new deposit supports further lending, in diminishing rounds.
- The public also holds some cash, which leaks out of the process (cdr).
- Money multiplier = (1 + cdr) ÷ (cdr + rdr).
- A higher cdr or rdr lowers the multiplier; a lower one raises it.
Thus money supply = multiplier × high powered money.
For example, if a bank receives a deposit of ₹1,000 and must keep 20 per cent as reserves, it lends ₹800; this returns as a deposit, of which ₹640 is lent next, and the process continues until deposits are a multiple of the initial ₹1,000.
Q9Explain the instruments of monetary policy used by the RBI. How does it protect money supply against external shocks? 6 marks
The RBI controls money supply through open market operations, the bank rate and reserve requirements, and uses sterilisation against external shocks.
| Instrument | To raise money supply | Route |
|---|---|---|
| Open market operations | Buy securities | Raises H |
| Bank rate | Lower it | Lowers rdr, raises multiplier |
| CRR and SLR | Lower them | Lowers rdr, raises multiplier |
Sterilisation: foreign inflows raise RBI's foreign assets and H; the RBI sells an equal value of securities to keep money supply unchanged.
Hence the RBI can steer money supply in both normal times and shocks.
Open market operations work directly on high powered money, while the bank rate and reserve requirements act on the deposit ratio and so on the multiplier. The repo rate, the main policy rate in practice, affects the cost of credit. Sterilisation keeps foreign capital inflows from raising money supply and prices.
Q10High powered money is ₹3,000 crore, the currency deposit ratio is 0.2 and the reserve deposit ratio is 0.1. Calculate the money multiplier and money supply. 4 marks · Numerical
The money multiplier is 4 and money supply is ₹12,000 crore.
Given: H = 3,000; cdr = 0.2; rdr = 0.1.
Formula: Multiplier = (1 + cdr) ÷ (cdr + rdr); M = multiplier × H.
Steps: (1 + 0.2) ÷ (0.2 + 0.1) = 1.2 ÷ 0.3 = 4. M = 4 × 3,000 = 12,000.
Final answer: multiplier = 4; money supply = ₹12,000 crore.
10 Points for State PSC and UPSC Aspirants
- The RBI began operations on 1 April 1935 under the RBI Act, 1934, and was nationalised in 1949.Why it matters: a standard static fact.Source: Reserve Bank of India, About Us
- The RBI issues currency notes; coins (and the one-rupee note) are issued by the Government of India.Why it matters: the issuer distinction is a frequent prelims trap.Source: Reserve Bank of India
- The RBI's working measures of money are reserve money (M0), narrow money (M1) and broad money (M3).Why it matters: links the textbook's M1–M4 to current data tables.Source: RBI, Handbook of Statistics on the Indian Economy
- The Monetary Policy Committee has six members: three from the RBI including the Governor, who has a casting vote, and three appointed by the central government.Why it matters: composition and voting rules are commonly asked.Source: Reserve Bank of India, monetary policy
- Under flexible inflation targeting, the target is 4% CPI inflation within a band of 2% to 6%.Why it matters: core fact for any monetary policy answer.Source: Reserve Bank of India
- The policy repo rate anchors the liquidity adjustment facility; the standing deposit facility (introduced in 2022) is the floor and the marginal standing facility the ceiling of the corridor.Why it matters: modern successors to the textbook's bank rate.Source: Reserve Bank of India, monetary policy statements
- CRR is kept as a balance with the RBI; SLR is held by banks themselves in cash, gold or approved securities, both as a share of net demand and time liabilities.Why it matters: the CRR–SLR difference is a classic question.Source: Reserve Bank of India
- Bank deposits are insured by the DICGC, an RBI subsidiary, up to ₹5 lakh per depositor per bank (raised from ₹1 lakh in 2020).Why it matters: depositor protection alongside the lender-of-last-resort role.Source: DICGC
- The Market Stabilisation Scheme (2004) lets the RBI issue government securities to absorb surplus liquidity from foreign inflows, a tool of sterilisation.Why it matters: a direct Indian example of sterilisation.Source: Reserve Bank of India
- The RBI launched pilots of the digital rupee (e₹), a central bank digital currency, in 2022.Why it matters: current-affairs extension of fiat money.Source: Reserve Bank of India
These are revision notes, not official predictions of exam content.
Quick Revision
- Functions: medium of exchange, unit of account, store of value.
- Transaction demand = kPY; rises with nominal income.
- Speculative demand falls as r rises; liquidity trap at rmin.
- Bond price and interest rate move inversely.
- M1 = CU + DD; M3 = M1 + net time deposits.
- H = currency + bank reserves (RBI's liability).
- Multiplier = (1 + cdr) ÷ (cdr + rdr).
- Tools: OMO, bank rate, CRR, SLR; plus sterilisation.
Related Glossary Terms and Chapters
Glossary:
Money multiplier High powered money Repo rate
Related chapters: The Government: Functions and Scope, for deficit financing; Open Economy Macroeconomics, for foreign inflows and reserves; Statistics for Economics Chapter 7, Index Numbers, for CPI (page coming soon). From Class 11: Index Numbers, Liberalisation, Privatisation and Globalisation.
Sources
- NCERT textbooks: Introductory Macroeconomics, Class 12, National Council of Educational Research and Training. Syllabus reference. Accessed 23 October 2026.
- About Us, Reserve Bank of India. Accessed 23 October 2026.
- Monetary Policy Statements, Reserve Bank of India. Accessed 23 October 2026.
- Handbook of Statistics on the Indian Economy, Reserve Bank of India. Accessed 23 October 2026.
- Economic Survey, Ministry of Finance, Government of India. Accessed 23 October 2026.
About this page
Drafted with AI assistance from the NCERT chapter structure, in original words. Content is checked and approved by Dr. Anamika Shrivastava, PhD Economics, before publication. Read how this site works or send a correction.
Syllabus year 2026-27 · Last updated