Revising Money and Banking for Class 12 Economics? These money and banking class 12 notes compress NCERT Introductory Macroeconomics chapter 3 into revision-ready form — the barter problem, the demand and supply of money, credit creation by banks, the money multiplier, and every RBI policy tool, each with the textbook page where it appears. The notes follow the 2026-27 session and the rationalised NCERT edition.
Use the jump links below to go straight to the section that is troubling you — the definitions table, formula sheet and solved numericals are the fastest stops the night before.
Every formula and fact here sits on the chapter’s actual pages, and the full text is open at the official NCERT textbook page for Class 12 Introductory Macroeconomics, chapter 3 if you want to verify a point against the book.
Chapter Map: From Barter to the RBI’s Tools
This chapter answers three questions in order: why money exists, how banks create it, and how the central bank controls it. The table below maps the whole argument with its textbook pages.
| Theme | What it explains | Textbook pages |
|---|---|---|
| Barter and functions of money | Why money replaced direct exchange, and the three jobs money does | pp. 36–37 |
| Demand for money — transaction and speculative motives | Why people hold cash: for spending (tied to income) and for waiting (scared of interest) | pp. 37, 43–47 |
| Supply of money and its measures M1–M4 | Who issues currency, which deposits count as money, how the total is measured | pp. 38, 47–48 |
| Credit creation by commercial banks | How a bank loan becomes a new deposit and the money stock multiplies | pp. 38–41 |
| Money multiplier and its CRR limit | Why expansion stops: reserves cap deposits at (1/CRR) × reserves | pp. 40–42, 51 |
| RBI’s policy tools | CRR, bank rate, open market operations, repo and reverse repo rates | pp. 42–43 |
| Cashless economy and demonetisation | India’s digital-payments drive and the 2016 note ban | pp. 37, 49 |
One teaching note: NCERT keeps the detailed demand-for-money discussion in the main text late in the chapter, but this page teaches it early. The build-up then flows naturally — need → demand → supply → credit creation → central-bank control. The Class 12 Economics notes hub collects the other chapters of the book if you are revising the whole subject at once.
Why Money Exists: Barter and the Three Functions of Money
Money is the commonly accepted medium of exchange (p. 36). With only one person there is no exchange and no role for money; money becomes necessary once many agents trade through a market.
Direct exchange without money is barter exchange. It demands the improbable double coincidence of wants: each trader must hold exactly what the other wants. A baker wants vegetables; a farmer has vegetables but wants shoes — no trade happens, because the baker offers nothing the farmer wants.
As the number of traders grows, the search for someone with the exact opposite surplus drives search costs up, and barter becomes impractical (p. 36). Money cuts through this — traders sell their produce for money and buy with money, so nobody needs a double coincidence.
Beyond mediating exchange, money does three jobs (pp. 36–37):
- Medium of exchange — universally accepted in payment, so no double coincidence of wants is needed (p. 36).
- Unit of account — all values are expressed in one monetary unit, which makes relative prices easy to see. With a notebook at Rs 30 and a pen at Rs 10, one notebook is worth 3 pens; one rupee is worth 1/30 of a notebook or 1/10 of a pen. When the general price level rises, each rupee buys less — the purchasing power of money falls (p. 37).
- Store of value — money carries purchasing power into the future. Unlike surplus rice, money is not perishable and costs little to store (p. 37).
Be honest about the third function: money is not the only store of value. Gold, landed property, houses and bonds also store wealth. Money’s edge is universal acceptability and low storage cost; its weakness is inflation, which erodes what money will buy. So money stores value well only while prices stay stable (p. 37).
Real-life application — the cashless economy. A cashless society settles transactions through the transfer of digital information instead of physical notes and coins. India’s push — Jan Dhan accounts, Aadhaar-enabled payment systems, e-wallets and the National Financial Switch (NFS) — has made financial inclusion a realistic goal (p. 37).
The 2016 demonetisation, covered under supply of money below, is the same story from the policy side.
Demand for Money: Why People Hold Cash
Why hold money at all when a bank deposit pays interest? Holding cash means the interest is foregone — the opportunity cost of liquidity. The demand for money (also called liquidity preference) is the trade-off between the convenience of liquidity and the interest lost (p. 43). The chapter splits this demand into two motives (pp. 43–47).
Transaction Motive: Money for Day-to-Day Spending
Incomes arrive at discrete points — salary on the 1st of the month — but spending runs continuously through the month. You bridge the gap with a cash balance that is high right after payday and empty just before the next one (p. 43).
With a monthly salary of Rs 18,000 spent evenly, the balance runs from Rs 18,000 down to Rs 0, so the average holding is half of monthly income:
\[ \frac{18000 + 0}{2} = \text{Rs } 9{,}000 \]
Paid fortnightly instead, the average balance falls to Rs 4,500. The rule is general: average transaction balance = half the income over the pay period (p. 43).
For the whole economy, transaction demand is a positive fraction of the total value of transactions in the period:
\[ M_T^d = kT \qquad \text{(3.1)} \]
where \(T\) is the total value of nominal transactions over a unit period and \(k\) is a positive fraction (p. 44).
Rewrite (3.1) using velocity of circulation \(v = 1/k\) — the number of times a unit of money changes hands in the unit period:
\[ v \cdot M_T^d = T \qquad \text{(3.2)} \]
One note, several jobs: a single Rs 100 note spent five times in a month does Rs 500 of work — that is what velocity 5 means. In (3.2), the right-hand side \(T\) is a flow, money demand \(M_T^d\) is a stock (a balance held at a point of time), and \(v\) carries a time dimension — times per month or per year (p. 44).
Since the value of all transactions moves with nominal GDP, the aggregate form is:
\[ M_T^d = kPY \qquad \text{(3.3)} \]
where \(Y\) is real GDP and \(P\) is the general price level. So transaction demand rises with real income and with the price level (pp. 44–45). Nominal GDP — the \(PY\) product — is defined in the national income accounting notes.
Speculative Motive: Money for Waiting
Wealth can be held as property, bullion, bonds or money. For this chapter, group every non-money asset under one heading — bonds: papers promising a future stream of monetary returns, issued by governments or firms and traded in the market (p. 45). A typical bond carries:
- Face value — the printed principal (for example Rs 100).
- Coupon rate — the fixed annual return (for example 10 per cent of face value).
- Maturity — the period after which the principal is repaid.
Present value is the comparison tool. Before buying a bond you ask: how much, kept in a savings account, would grow into the bond’s payments? That amount is the present value of the payment discounted at the market rate of interest.
In a competitive assets market, a bond’s price settles at the present value of all its future payments — coupons plus the final repayment of face value (p. 45).
Now raise the market rate of interest: future payments are discounted more heavily, their present value falls, and the bond price falls with it. Bond price is inversely related to the market rate of interest (p. 46).
Expectations build on this. At high rates, everyone expects rates to fall and bond prices to rise, so they buy bonds and anticipate capital gains — speculative money demand is low. At low rates, everyone expects rates to rise and bond prices to fall, so they sell bonds and hold money to avoid capital losses — speculative demand is high.
Hence speculative demand is inversely related to the rate of interest (p. 46). The chapter assumes the simple form:
\[ M_n^d = \frac{r_{\max} – r}{r – r_{\min}} \qquad \text{(3.4)} \]
where \(r\) is the market rate and \(r_{\max}, r_{\min}\) are its upper and lower limits. As \(r\) falls from \(r_{\max}\) towards \(r_{\min}\), \(M_n^d\) rises from 0 towards infinity (p. 46).
At the floor \(r_{\min}\) the economy enters the liquidity trap: everyone is sure rates will rise and bond prices fall, nobody buys bonds, extra money is simply hoarded, and the interest rate refuses to fall further. The speculative demand curve is infinitely elastic here (p. 47).
The textbook’s Fig 3.1 pictures this: the rate of interest on the vertical axis against speculative money demand on the horizontal axis. The curve meets the vertical axis at \(r_{\max}\) — demand is zero because everyone is in bonds — and turns horizontal at \(r_{\min}\), the liquidity trap (p. 47).
Total money demand adds the two motives (3.5, p. 47):
\[ M^d = M_T^d + M_S^d = kPY + \frac{r_{\max} – r}{r – r_{\min}} \]
| Point of comparison | Transaction motive | Speculative motive |
|---|---|---|
| What drives it | Volume of transactions — incomes and spending | Expectations about future interest rates and bond prices |
| Direction with income and price level | Positive — more income or higher prices mean more money held | No direct link |
| Direction with interest rate | No interest term in \(M_T^d = kPY\) — the inverse relation belongs to the speculative motive | Inverse — low rates point to future capital losses |
| Key equation | \( M_T^d = kPY \) (3.3) | \( M_n^d = (r_{\max}-r)/(r-r_{\min}) \) (3.4) |
| Textbook pages | pp. 43–45 | pp. 45–47 |
Memory device: T-I — Transaction demand is Tied to Income; S-I — Speculative demand is Scared of Interest.
Supply of Money: Currency, Deposits and the M1–M4 Ladder
Who Supplies Money: RBI and Commercial Banks
Modern money is cash plus bank deposits (p. 38), created by two institutions:
- Reserve Bank of India (RBI) — India’s central bank, established in 1935. It issues the currency, controls money supply through the bank rate, open market operations and variations in reserve ratios, acts as banker to the government, and is the custodian of the foreign exchange reserves (p. 38).
- Commercial banks — they accept deposits from the public and lend a large part of them out. The rate they charge borrowers is higher than the rate they pay depositors; the difference, the spread, is the bank’s profit (p. 38).
Currency issued by the RBI — whether held by the public or by banks — is called high-powered money (also reserve money or the monetary base), because it acts as the basis on which credit is created (p. 38).
Narrow and Broad Money: M1 to M4
Fiat money and legal tender. The paper of a hundred-rupee note is worth almost nothing, and the metal in a five-rupee coin is worth less than Rs 5. Their value comes from the guarantee of the issuing authority, so they are fiat money — currency without intrinsic value.
Because the guarantee is legally binding, they are also legal tender: no citizen can refuse them in settlement of any transaction. Cheques, by contrast, can be refused — demand deposits are money but not legal tender (pp. 47–48).
Demand vs time deposits. Savings and current account balances are payable on demand and transferable by cheque — demand deposits. Fixed deposits have a fixed period to maturity — time deposits (p. 47).
The four measures. Money supply is a stock — the total stock of money in circulation among the public at a point of time. The RBI publishes four measures (p. 48):
\[ M_1 = CU + DD \]
\[ M_2 = M_1 + \text{savings deposits with Post Office savings banks} \]
\[ M_3 = M_1 + \text{net time deposits of commercial banks} \]
\[ M_4 = M_3 + \text{total deposits with Post Office savings organisations (excluding National Savings Certificates)} \]
where \(CU\) is currency (notes plus coins) held by the public and \(DD\) is net demand deposits of commercial banks — “net” excludes interbank deposits. M1 and M2 are narrow money; M3 and M4 are broad money. The ladder runs in decreasing order of liquidity: M1 is the most liquid and easiest for transactions, M4 the least.
M3, also called aggregate monetary resources, is the most commonly used measure (p. 48).
The appendix tables put numbers to this: Table 3.4 (p. 51) tracks M1 and M3 across more than two decades, and the widening gap between the two columns is exactly the net time deposits of commercial banks. Table 3.5 (p. 52) splits the monetary base into currency with the public, cash with banks, and deposits with the RBI.
For revision, the concept you need is the gap definition, not the rows.
Demonetisation 2016: Legal Tender in Action
Demonetisation is fiat money and legal tender working in reverse. In November 2016 the government declared that old Rs 500 and Rs 1,000 notes would no longer be legal tender, and new notes were launched. Old notes could be deposited in bank accounts up to 31 December 2016 without declaration, and with the RBI up to 31 March 2017 with declaration (p. 49).
The costs were immediate — cash shortages, long queues outside banks and ATMs, and an adverse effect on economic activity. The gains were structural: improved tax compliance, household savings channelled into the formal financial system (so banks gained more funds to lend), and a lasting shift of households and firms from cash to electronic payments (p. 49).
Money Creation by Banks: The Goldsmith’s Story and the Balance Sheet
The Lala story, compressed. In a village, gold acted as money and people stored their gold with the goldsmith Lala, who issued paper receipts against it. Over time the receipts — not the gold — circulated as payment. When Ramu asked for a loan of 25 kg of gold, Lala reasoned that not all depositors would withdraw at once, and lent it.
Ramu paid Ali; Ali re-deposited the gold and took a receipt. Receipts in circulation had risen from 100 kg to 125 kg — as the textbook puts it, Lala “created money out of thin air” (p. 39).
Modern banks work exactly this way. They expect that not all depositors will withdraw at once, so they lend most deposits out. When a bank lends, it opens a new deposit in the borrower’s name — the loan becomes a deposit, and money supply rises to old deposits plus the new one (p. 39).
The bank’s balancing act between lending and safety is the whole story of credit creation.
The accounting basis (pp. 39–40):
- Assets = Reserves + Loans — what the bank owns. Reserves are the bank’s cash plus its deposits with the RBI (p. 39).
- Liabilities = Deposits — what the bank owes its depositors.
- Net Worth = Assets − Liabilities — the balancing item (p. 40).
The book’s Table 3.1 (p. 40) shows the simplest case: Ms Fernandes deposits Rs 100, the bank keeps all of it as reserves, and both sides of the balance sheet stand at Rs 100. With no currency in circulation, total money supply = Rs 100. But if a bank can relend, where does it stop? That question opens the money multiplier.
The Money Multiplier: Why Credit Creation Stops
CRR and SLR. The RBI fixes the percentage of deposits every bank must hold as cash reserves — the Cash Reserve Ratio (CRR). It is a legal, binding requirement whose purpose is to stop banks from over-lending. In addition, banks hold Statutory Liquidity Ratio (SLR) reserves — liquid assets held short-term (p. 40).
The textbook’s illustration walks the process round by round. Leela deposits Rs 100; CRR is 20 per cent (pp. 40–41):
- Round 1: the bank keeps Rs 20 (20 per cent of 100) as reserves and lends Rs 80 to Jaspal Kaur. The loan shows up again as a deposit — total deposits rise to Rs 180.
- Round 2: required reserves become 20 per cent of 180 = Rs 36, so the bank lends Rs 64 to Junaid (its starting cash of Rs 100 minus the Rs 36 now locked away).
- And so on: every round locks more cash into reserves, until required reserves reach Rs 100 — which happens only when total deposits reach Rs 500 (20 per cent of 500 = 100). Table 3.2 (p. 41) shows the rounds; Table 3.3 (p. 41) shows the stop: reserves Rs 100, loans Rs 400, deposits Rs 500.
Reserves of Rs 100 support deposits of Rs 500 because of the multiplier:
\[ \text{Money Multiplier} = \frac{1}{\text{CRR}} = \frac{1}{0.2} = 5 \]
So at 20 per cent CRR, reserves of Rs 100 create deposits of 5 × 100 = Rs 500 (p. 42), and with no currency in circulation \(M_1 = \text{Currency} + \text{Deposits} = 0 + 500 = 500\). The CRR is the ceiling: reserves limit credit, and that limit is why money creation is not infinite (p. 42).
Now let the RBI raise the CRR to 25 per cent (p. 42): the multiplier falls to 4, the same Rs 100 of reserves backs only Rs 400 of deposits, the system can lend only Rs 300, and banks must call back loans — money supply falls.
That single mechanism is the bridge from credit creation to monetary policy, and it is worked with original numbers in Example 2 below.
Appendix 3.1 (p. 51) shows the repeated rounds are an infinite geometric series, whose sum is \(S = \frac{a}{1-r}\) for \(0 \lt r \lt 1\). Recognise it as the maths of the rounds; you do not need the derivation in a written answer.
Also keep the rounds logic in mind — you will reuse it when you revise the determination of income and employment notes.
(An original-number worked version of the whole process is Example 1 under Solved Numericals below.)
RBI’s Policy Tools: CRR, Bank Rate, OMO and Repo Rates
Because the RBI stands ready to lend funds to commercial banks at all times, it is called the lender of last resort (p. 42). This readiness, plus the tools below, is how the central bank steers money supply.
The tools divide into two families (p. 42):
- Quantitative tools — they change the size of money supply: changing the reserve ratio, the bank rate, and open market operations.
- Qualitative tools — they steer the direction of lending: moral suasion and margin requirements.
Changing the Reserve Ratio
Raise the CRR: banks must hold back a larger share of every deposit, so lendable funds shrink, and with them deposits and money supply (p. 42).
Open Market Operations
Open market operations (OMO) are the buying and selling of government bonds in the open market, conducted by the RBI on behalf of the government. When the RBI buys a bond, it pays with a cheque that raises the reserves of the banking system — money supply rises. When it sells, reserves drain out — money supply falls (p. 42).
Government bonds originate in government borrowing, which is the subject of the government budget and the economy notes.
OMO comes in two forms (pp. 42–43):
- Outright operations are permanent — a purchase is not tied to any promise to sell back later, and a sale is not tied to a promise to buy back.
- Repo is a purchase with a specified resale date and price; reverse repo is a sale with a specified repurchase date.
The repo rate is the rate at which the RBI lends money through repo — it injects liquidity into the system. The reverse repo rate is the rate at which money is withdrawn — it absorbs liquidity. Repo and reverse repo operations at overnight, 7-day and 14-day maturities have become the RBI’s main monetary-policy tool (p. 43).
Bank Rate
The bank rate is the rate at which the RBI lends to commercial banks. Raise it: bank borrowing becomes more expensive, reserves shrink, and money supply falls. Lower it: the reverse (p. 43).
| Policy tool | RBI’s action | Effect on money supply |
|---|---|---|
| CRR | Raised | Falls — more of every deposit is locked away as reserves |
| Open market operations | RBI buys government bonds | Rises — payment by cheque swells bank reserves |
| Open market operations | RBI sells government bonds | Falls — reserves drain out of the system |
| Repo rate | Raised | Falls — borrowing from the RBI becomes costlier |
| Bank rate | Raised | Falls — bank borrowing costlier, reserves shrink |
Definitions at a Glance: Every Term in One Place
The two tables below carry a one-line meaning for many of the terms the chapter uses — including several items from the Key Concepts list (p. 49) — plus spread and reserves, which it defines in passing.
| Term | Meaning | Page |
|---|---|---|
| Money | The commonly accepted medium of exchange | p. 36 |
| Barter exchange | Direct exchange of goods without money | p. 36 |
| Double coincidence of wants | Each trader holds exactly what the other wants | p. 36 |
| Medium of exchange | A good commonly accepted in payment | p. 36 |
| Unit of account | Common monetary measure for expressing all prices | p. 37 |
| Store of value | Means of carrying purchasing power into the future | p. 37 |
| Liquidity preference | Demand for money, viewed as a trade-off between liquidity and foregone interest | p. 43 |
| Transaction motive | Holding money for day-to-day spending | p. 43 |
| Speculative motive | Holding money to avoid capital losses or to wait for gains | p. 46 |
| Velocity of circulation | Number of times a unit of money changes hands in a period | p. 44 |
| Demand deposits | Deposits payable on demand, transferable by cheque | p. 47 |
| Time deposits | Deposits with a fixed maturity, like fixed deposits | p. 47 |
| Spread | Difference between the lending rate and the deposit rate | p. 38 |
| Reserves | A bank’s cash plus its deposits with the RBI | p. 39 |
| High-powered money | Currency issued by the RBI, held by the public or by banks; also reserve money or monetary base | p. 38 |
| Term | Meaning | Page |
|---|---|---|
| Fiat money | Currency whose value rests on the issuer’s guarantee, with no intrinsic value | p. 47 |
| Legal tender | Money that cannot be refused in settlement of any transaction | p. 48 |
| Narrow money | M1 and M2 | p. 48 |
| Broad money | M3 and M4 | p. 48 |
| Aggregate monetary resources | Another name for M3, the most commonly used money measure | p. 48 |
| CRR (Cash Reserve Ratio) | Percentage of deposits a bank must keep as cash reserves; legal and binding | p. 40 |
| SLR (Statutory Liquidity Ratio) | Short-term liquid reserves that banks must hold | p. 40 |
| Money multiplier | The number by which reserves multiply into deposits: 1/CRR | p. 42 |
| Lender of last resort | RBI’s readiness to lend to commercial banks at all times | p. 42 |
| Bank rate | Rate at which the RBI lends to commercial banks | p. 43 |
| Open market operations | RBI’s buying and selling of government bonds in the open market | p. 42 |
| Repo rate | Rate at which the RBI lends by buying securities with a resale agreement | p. 43 |
| Reverse repo rate | Rate at which the RBI withdraws money by selling with a repurchase agreement | p. 43 |
| Liquidity trap | Situation at \(r_{\min}\) where extra money is hoarded and the interest rate cannot fall further | p. 47 |
Formula Sheet: Every Equation, Symbol by Symbol
All the chapter’s formulas in one table. Rupee values carry rupee units, interest is per cent per annum, velocity is times per period, and the multiplier is a pure number.
| Formula | What the symbols mean | Units | Page |
|---|---|---|---|
| \( \text{Assets} = \text{Reserves} + \text{Loans} \) | What the bank owns and can claim | rupees | p. 39 |
| \( \text{Liabilities} = \text{Deposits} \) | What the bank owes its depositors | rupees | p. 39 |
| \( \text{Net Worth} = \text{Assets} – \text{Liabilities} \) | The balancing item of the balance sheet | rupees | p. 40 |
| \( \text{Money Multiplier} = \frac{1}{\text{CRR}} \) | CRR written as a decimal | pure number | p. 42 |
| \( M_1 = CU + DD \) | CU = currency (notes plus coins) with the public; DD = net demand deposits of commercial banks | rupees | p. 48 |
| \( M_2 = M_1 + \text{savings deposits with Post Office savings banks} \) | — | rupees | p. 48 |
| \( M_3 = M_1 + \text{net time deposits of commercial banks} \) | — | rupees | p. 48 |
| \( M_4 = M_3 + \text{total deposits with Post Office savings organisations (excluding NSC)} \) | — | rupees | p. 48 |
| \( M_T^d = kT \) (3.1) | T = total value of nominal transactions over the unit period; k = a positive fraction | rupees for T; k dimensionless | p. 44 |
| \( v \cdot M_T^d = T \), \( v = 1/k \) (3.2) | v = velocity of circulation of money | v in times per period | p. 44 |
| \( M_T^d = kPY \) (3.3) | Y = real GDP; P = general price level (GDP deflator) | rupees | pp. 44–45 |
| \( M_n^d = \frac{r_{\max} – r}{r – r_{\min}} \) (3.4) | r = market rate of interest; rmax and rmin its upper and lower limits | interest in per cent | p. 46 |
| \( M^d = M_T^d + M_S^d = kPY + \frac{r_{\max} – r}{r – r_{\min}} \) (3.5) | Total money demand = transaction + speculative demand | rupees | p. 47 |
| \( PV = \frac{R_1}{1+i} + \frac{R_2 + F}{(1+i)^2} \) | R1, R2 = coupon payments; F = face value; i = market rate of interest | rupees | p. 45 |
| \( S = \frac{a}{1-r} \) | a = first term of the series; r = common ratio, with \( 0 \lt r \lt 1 \) | same units as a | p. 51 |
Check the nature of each variable: money demand, money supply and a bond’s price are stocks; the value of transactions \(T\) and the product \(v \cdot M_T^d\) are flows; velocity \(v\) carries the time dimension (p. 44).
Solved Numericals: Step-by-Step Worked Examples
Three worked examples with original numbers — none of them repeat the book’s own figures.
Example 1 — Credit creation through the money multiplier (method: multiplier = 1/CRR; NCERT pp. 40–42)
Given: opening deposit Rs 20,000; CRR = 10 per cent.
Step 1 — run the first two rounds to see the pattern.
In each round the bank keeps 10 per cent of current deposits as reserves and lends the rest, which returns as a new deposit:
\[ \text{Round 1: } 20{,}000 \rightarrow \text{reserve } 2{,}000 \rightarrow \text{loan } 18{,}000 \rightarrow \text{total deposits } 38{,}000 \]
\[ \text{Round 2: } 38{,}000 \rightarrow \text{reserve } 3{,}800 \rightarrow \text{loan } 16{,}200 \rightarrow \text{total deposits } 54{,}200 \]
Step 2 — the shortcut (money multiplier): \( \frac{1}{0.10} = 10 \).
Step 3 — total deposits the system can support:
\[ 20{,}000 \times 10 = \text{Rs } 2{,}00{,}000 \]
Step 4 — credit created: total deposits − initial deposit:
\[ 2{,}00{,}000 – 20{,}000 = \text{Rs } 1{,}80{,}000 \]
Step 5 — the stopping rule: final required reserves = 10 per cent of total deposits:
\[ 10\% \times 2{,}00{,}000 = \text{Rs } 20{,}000 \]
That equals the opening deposit exactly, so the chain must stop there.
Final answer: total deposits Rs 2,00,000; credit created Rs 1,80,000; final reserves Rs 20,000 (equal to the opening deposit).
Example 2 — RBI raises the CRR from 10 to 20 per cent (method: recompute the multiplier; NCERT p. 42)
Step 1 — new multiplier: \( \frac{1}{0.20} = 5 \).
Step 2 — deposits the same reserves now support:
\[ 20{,}000 \times 5 = \text{Rs } 1{,}00{,}000 \]
Step 3 — change in money supply:
\[ 2{,}00{,}000 – 1{,}00{,}000 = \text{Rs } 1{,}00{,}000 \text{ fall} \]
Economic meaning: the same reserves now support half the deposits they did before, so banks must call back loans to rebuild reserves — the money supply contracts (p. 42).
Final answer: money supply falls from Rs 2,00,000 to Rs 1,00,000 — a contraction of Rs 1,00,000.
Example 3 — Bond price and the market rate of interest (method: present value; NCERT pp. 45–46)
Given: a 2-year bond, face value Rs 1,000, coupon Rs 60 per year.
Formula: discount each payment at the market rate \(i\):
\[ PV = \frac{60}{1+i} + \frac{1060}{(1+i)^2} \]
where 1060 is the final coupon plus the face value repaid at maturity.
At 6 per cent:
\[ PV = \frac{60}{1.06} + \frac{1060}{(1.06)^2} = 56.60 + 943.40 = \text{Rs } 1{,}000.00 \]
Here the coupon rate (6 per cent) equals the market rate, so the price equals the face value — a useful checkpoint.
At 4 per cent:
\[ PV = \frac{60}{1.04} + \frac{1060}{(1.04)^2} = 57.69 + 980.03 \approx \text{Rs } 1{,}037.72 \]
At 8 per cent:
\[ PV = \frac{60}{1.08} + \frac{1060}{(1.08)^2} = 55.56 + 908.78 \approx \text{Rs } 964.34 \]
Conclusion: as the market rate rises from 4 per cent to 6 per cent to 8 per cent, the bond price falls from Rs 1,037.72 to Rs 1,000 to Rs 964.34 — the inverse relation between bond price and the rate of interest, shown in numbers (p. 46).
Final answer: price = Rs 1,000.00 at 6 per cent; ≈ Rs 1,037.72 at 4 per cent; ≈ Rs 964.34 at 8 per cent. Bond price falls when interest rises.
Common Mistakes in Money and Banking (and the Corrections)
Seven statements students actually write, with the corrected version and the reason. Learn the correction, not just the error.
| Mistake | Correct rule | Why | Page |
|---|---|---|---|
| “Banks lend out all their deposits” | They lend only (1 − CRR) of deposits | CRR is a legal, binding reserve — a set percentage of every deposit must stay as cash reserves | p. 40 |
| “Raising CRR raises money supply” | Raising CRR lowers money supply | A higher CRR locks away more of each deposit, so loans, resulting deposits and money supply all shrink | p. 42 |
| “Cheques are legal tender” | Currency notes and coins are legal tender; cheques are money but can be refused | Demand deposits are not legal tender — anyone can refuse a cheque as payment | p. 48 |
| “Repo rate and reverse repo rate are the same thing” | Repo — RBI lends, money injected; reverse repo — RBI borrows, money absorbed | Test the direction by who holds the securities: repo = RBI buys with a resale promise; reverse repo = RBI sells with a repurchase promise | p. 43 |
| “Speculative demand for money rises when interest rises” | It falls — the relation is inverse | At high rates everyone expects a fall in rates and capital gains, so people buy bonds and hold little money | p. 46 |
| “Money is the only store of value” | Gold, landed property, houses and bonds also store value | Money’s advantage is universal acceptability and low storage cost; inflation erodes its purchasing power | p. 37 |
| “M2 is more liquid than M1 because M2 is larger” | Liquidity decreases from M1 to M4 regardless of size | M1 is the most liquid and easiest for transactions; M4 is the least liquid | p. 48 |
How to Write Answers for the Textbook’s Exercises
The chapter closes with eleven exercises (p. 50). What follows for each is the structure of a complete answer — which concept to define first and which points to list — not the model solution.
| Exercise | Build the answer like this |
|---|---|
| 1. Barter system and its drawbacks | Define barter exchange first, then list: double coincidence of wants, rising search costs as traders multiply, and the difficulty of carrying wealth forward (perishable goods, storage needs). |
| 2. Main functions of money | Name all three — medium of exchange, unit of account, store of value — each with an example of the barter problem it solves. |
| 3. Transaction demand for money | Define it as money held for spending, then connect it to transactions with \( M_T^d = kT \): a larger value of transactions needs a larger money balance. |
| 4. Alternative definitions of money supply | Give the full ladder M1–M4; define CU and DD; label narrow money (M1, M2) and broad money (M3, M4). |
| 5. Legal tender and fiat money | Define both; add the no-intrinsic-value point; close with the cheques exception. |
| 6. High-powered money | State it as currency issued by the RBI held by the public or by banks; call it reserve money / monetary base, the base of credit creation. |
| 7. Functions of a commercial bank | Accept deposits, lend most of them out, earn the spread; mention the convenience of demand deposits (cheques, debit cards). |
| 8. Money multiplier and what determines it | Give 1/CRR; explain CRR as the legal limit, and add that the actions of the public and of banks also change money supply — the chapter summary flags these as the currency-deposit and reserve-deposit ratios (p. 49). |
| 9. Instruments of monetary policy | Split into quantitative (CRR, bank rate, open market operations, repo and reverse repo rates) and qualitative (moral suasion, margin requirements); state the direction of effect for each. |
| 10. Commercial bank as creator of money | Use the loans-become-deposits logic round by round, up to the CRR ceiling; close by saying the bank is a creator of money within this limit. |
| 11. Lender of last resort | Define the role — the RBI stands ready to lend to banks at all times — and explain why that role keeps the banking system stable. |
Rapid Revision: Money and Banking in One Page
The chapter’s argument in one flow:
- Barter fails: the double coincidence of wants is improbable and search costs explode (p. 36).
- Money fixes it with three functions: medium of exchange, unit of account, store of value (pp. 36–37).
- Demand for money = transaction demand (tied to income, \( kPY \)) + speculative demand (scared of interest, inverse to \( r \)) (pp. 43–47).
- Supply: RBI currency + bank deposits, measured as M1–M4; narrow (M1, M2) vs broad (M3, M4) (p. 48).
- Banks create credit: loans become deposits, round after round, until the CRR ceiling bites (pp. 39–41).
- Multiplier = 1/CRR: at 20 per cent CRR, Rs 100 of reserves supports Rs 500 of deposits (p. 42).
- RBI steers with CRR, bank rate, open market operations, repo and reverse repo rates (pp. 42–43).
- Cashless push and demonetisation show fiat money, legal tender and e-money in action (pp. 37, 49).
Eight facts that belong in a complete answer:
- Money is a medium of exchange, a unit of account and a store of value (pp. 36–37).
- Legal tender cannot be refused; cheques can be, so demand deposits are not legal tender (p. 48).
- M3 = M1 + net time deposits of commercial banks; the M1–M3 gap is time deposits (p. 48).
- Reserves limit loans: a bank lends (1 − CRR) of its deposits (p. 40).
- Money multiplier = 1/CRR (p. 42).
- Repo rate injects liquidity; reverse repo rate absorbs it (p. 43).
- Bond price and the interest rate move inversely (p. 46).
- In the liquidity trap at \( r_{\min} \), extra money is hoarded and the interest rate cannot fall further — monetary policy loses traction (p. 47).
Pair these with the formula sheet and the definitions tables above and the whole chapter is in front of you. For the rest of the course, the full set of Class 12 notes and the CBSE notes homepage list every subject.
FAQs: Quick Doubts, Straight Answers
Why can banks create money out of thin air?
Because loans come back as new deposits. A bank lends out money it expects will not all be withdrawn at once; a granted loan opens a new deposit in the borrower’s name, so the money supply rises to old deposits plus the new one — the Lala logic (pp. 38–39).
What is the difference between repo rate and reverse repo rate?
Repo is the rate at which the RBI lends to banks — money is injected into the system. Reverse repo is the rate at which the RBI borrows from banks — money is absorbed (p. 43). Test the direction by asking who holds the securities in each case.
What is the difference between CRR and SLR?
CRR is the percentage of deposits a bank must hold as cash reserves; SLR is the additional requirement to hold short-term liquid reserves (p. 40). Both limit how much banks can lend.
Why does a bond’s price fall when the interest rate rises?
Because the bond’s future coupon and principal are discounted more heavily at a higher rate, so their present value — and with it the bond’s price — falls (pp. 45–46).
What is the difference between M1 and M3?
M3 = M1 + net time deposits of commercial banks. M3 is broader and less liquid than M1, and the difference between the two is time deposits (p. 48).
What exactly is a liquidity trap?
The situation at the floor rate \( r_{\min} \) where everyone expects rates to rise and bond prices to fall. Extra money is hoarded instead of buying bonds, so the interest rate will not fall further — speculative money demand is infinitely elastic (pp. 46–47).
Reference: NCERT Class 12 Introductory Macroeconomics textbook, chapter Money and Banking.
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