Meet Your Tutor
Money and Banking is easiest when every definition is tied to one practical question: what changes the amount banks can lend? I will help you move from functions of money to credit creation and RBI tools without relying on current policy rates, using small numerical checks and plain-English cause-and-effect at every step.
Take a ten-rupee note out of your pocket and look at it honestly. It is a rectangle of printed paper. You cannot eat it, wear it or build with it. And yet the shopkeeper downstairs will hand you real biscuits for it without a second thought. That small everyday miracle is the whole of this chapter. Money and Banking is worth only six marks in the Class 12 board paper, but it is six of the friendliest marks on the whole question paper — the ideas are short, the numericals repeat the same two formulas, and the theory answers are almost always four clean points. If the chapter has felt slippery so far, that is usually because it is taught as a list of definitions to swallow. We are going to do it differently.
Everything here follows the NCERT Introductory Macroeconomics textbook for Class 12 (the current CBSE-prescribed edition), and the scope matches the CBSE 2026-27 Economics syllabus (subject code 030). Whether you are hunting for money and banking class 12 important questions, credit creation numericals with solutions class 12, or just want the money multiplier formula class 12 explained slowly enough to actually stick, work through this page from the top and do not skip the worked examples. They are where the marks live.
- The One Question: The Lendable Rupees Test
- Barter and Its Problems
- Meaning and Functions of Money
- Forms of Money
- Money Supply: Board Focus on M1
- High-Powered Money (Reserve Money)
- Commercial Banks and Their Functions
- Credit Creation and the Money Multiplier
- The Central Bank (RBI) and Its Functions
- Instruments of Monetary Policy
Your Game Plan
- Read the Lendable Rupees Test first. It is one sentence, and it quietly answers about half the chapter.
- Do barter, functions of money and forms of money in one sitting — they are pure recall and they go fast.
- Slow right down for money supply and high-powered money. For the CBSE board, learn M1 exactly as the official syllabus defines it; treat M3 and the other RBI aggregates only as optional context.
- Spend your best hour on credit creation. Draw the cascade yourself, then do every numerical example on this page without looking at the answer.
- Finish with the RBI’s functions and the policy instruments, sorting each instrument with the one question rather than memorising it.
- Close the notes and attempt all ten worksheet questions in one go, timed. Only then open the answers.
Study Notes: Money and Banking Class 12 Important Questions, Explained Slowly
The One Question: The Lendable Rupees Test
Most students meet this chapter as a pile of unrelated facts: eight policy instruments, four money measures, a formula with a fraction in it, and a long list of RBI functions. That pile is exhausting to memorise and very easy to mix up in the exam hall. So here is a single lens that we will use again and again, and I want you to write it on the inside cover of your notebook.
Notice how much work that one sentence does. The money multiplier is nothing more than a measure of how far one lendable rupee can travel before it runs out. Credit creation is the story of a rupee travelling. The Cash Reserve Ratio is a rule about how many rupees a bank is not allowed to lend. Open market operations are the RBI physically pushing rupees into banks or pulling them out. Same lens, every time.
Suppose an examiner invents an instrument you have never heard of: “the RBI raises the minimum balance banks must park with it overnight.” You have not memorised this. Apply the test.
Step 1. Where do those rupees come from? Out of the bank’s own cash.
Step 2. Can the bank lend the parked rupees? No, they are locked at the RBI.
Step 3. So the bank has fewer lendable rupees.
∴ Loans fall, deposit creation falls, money supply falls. This is a tight or contractionary measure.
You just answered correctly without knowing the instrument. That is the whole point.
Barter and Its Problems
Before money existed, people swapped goods directly for goods. That is barter, and an economy that runs on it is called a C-C economy (commodity for commodity). It sounds charming until you actually try it.
Imagine you are a potter with a stack of clay pots and you badly want a pair of shoes. You must find a cobbler who happens to want pots today, in the quantity you have, and who is willing to trade shoes for them. If the cobbler wants rice instead, the deal collapses. That requirement — that both people must want exactly what the other is offering, at the same moment — is called the double coincidence of wants, and it is the central problem of barter.
- Lack of double coincidence of wants. Both parties must want each other’s goods simultaneously. Most of the time they do not, so the exchange simply never happens.
- Lack of a common measure of value. With no single yardstick, every pair of goods needs its own exchange rate. Ten goods need forty-five separate rates; a hundred goods need 4,950. Nobody can hold that in their head.
- Lack of a store of value. You cannot save wealth as tomatoes or milk. They rot. Saving becomes almost impossible, which means investment becomes almost impossible too.
- Difficulty in making deferred payments. If you borrow twenty kilos of wheat and promise to repay in wheat next year, whose wheat — the good grain or the poor grain? Contracts over time become quarrels.
- Lack of divisibility. Some goods cannot be split without destroying them. If a cow is worth forty kilos of rice and you only want ten kilos, you cannot hand over a quarter of a living cow.
Question: In a barter economy with 8 goods, how many exchange ratios must traders keep track of? What does your answer tell you about the need for money?
Answer: Every pair of goods needs one ratio, so the number of ratios is n(n − 1) ÷ 2.
= 8 × 7 ÷ 2 = 28 exchange ratios.
With money, each of the 8 goods needs only one price expressed in rupees — just 8 numbers instead of 28. Money therefore acts as a common measure of value and cuts the information burden of exchange dramatically. (1 mark formula, 1 mark computation, 1 mark interpretation.)
Situation: A farmer wants to send his daughter to a school that charges fees. He has only paddy. The school does not want paddy.
Which barter problem is this? Primarily the lack of double coincidence of wants — the farmer wants schooling, but the school does not want what he has.
A second problem hiding underneath: even if the school accepted paddy, the fees are due every month while the harvest comes once a year. Paddy cannot be stored indefinitely without loss, so the farmer also faces the store-of-value problem. Money solves both at once: he sells paddy for rupees at harvest, holds the rupees safely, and pays the fees month by month.
Meaning and Functions of Money
Money is anything that is generally accepted as a means of payment and as a way of settling debts. Read that definition again and notice what it does not say. It does not say money must be issued by a government, and it does not say money must have value of its own. What makes something money is general acceptability — the ordinary confidence that the next person will take it from you too.
Economists sort the jobs money does into two primary functions and two secondary ones. Learn them as four, and always give a one-line example with each; that is usually where the second mark comes from.
| Function | What it means | Everyday example |
|---|---|---|
| Medium of exchange (primary) | Money sits in the middle of every trade, so goods no longer have to be swapped directly. Barter’s double coincidence problem disappears. | You sell your labour for a salary, then buy vegetables with it. The vegetable seller never had to want your labour. |
| Measure of value / unit of account (primary) | All goods and services are priced in the same unit, so values can be compared and added up. | A shirt at ₹600 and a bag at ₹900 can be compared instantly — and national income can be totalled at all. |
| Store of value (secondary) | Purchasing power can be carried forward into the future because money does not perish. | Saving ₹2,000 a month for a year to buy a cycle. |
| Standard of deferred payment (secondary) | Debts and future payments can be written in a stable, agreed unit. | A loan repaid in twelve monthly instalments of a fixed rupee amount. |
Question: Explain any two primary functions of money. (4 marks)
Model answer:
(i) Medium of exchange. Money is generally accepted as a means of payment, so a buyer can pay in money instead of offering goods. This removes the need for a double coincidence of wants, splits a single barter transaction into a separate sale and a separate purchase, and thereby allows specialisation and large-scale trade. Example: a teacher earns a salary and uses it to buy food from a farmer who has no use for teaching. (2 marks)
(ii) Measure of value. Money provides a common unit in which the value of every good and service is expressed. This makes values comparable, makes accounting possible, and makes it possible to add unlike goods into aggregates such as national income. Example: without a rupee price, you could not add cloth output and cement output into one figure. (2 marks)
Marking note: 1 mark for the statement of each function, 1 mark for the explanation or example. Naming without explaining scores half.
Decide for each item whether it is money in the economic sense, and say why.
- A ₹500 note — Yes. Generally accepted, legal tender, settles debts finally.
- Balance in your savings bank account — Yes. It is a demand deposit; you can convert it to a final payment on demand, so it counts in the money supply.
- A credit card — No. The card is a device for obtaining credit. Nothing is settled until the bill is paid from an actual deposit. Credit cards are sometimes called “plastic money”, but they are not part of the money supply.
- A five-year fixed deposit — It is a time deposit, so it is not part of narrow money (M1), but it does enter broad money (M3).
- Gold jewellery — No. It stores value beautifully, but the shopkeeper will not accept a bangle at the counter, so it fails general acceptability.
Forms of Money
Money has changed shape many times, and each change was a solution to a problem with the shape before it. Reading the story as a chain of fixes makes it far easier to remember than a bare list.
- Commodity money. Ordinary goods with their own use-value became the medium of exchange — cattle, grain, salt, shells. Problem: bulky, perishable, hard to divide, and its value swung with the harvest.
- Metallic money. Gold and silver coins. Durable, divisible, valuable in small bulk. Problem: heavy to carry in quantity, risky to transport, and the supply depended on how much metal was mined.
- Paper money. Notes issued and guaranteed by the state. Light, cheap to produce, easy to standardise. Today it is fiat money (from the Latin for “let it be done”) — it has value because the government declares it so, not because the paper is worth anything.
- Bank money / deposit money. Demand deposits held at commercial banks, moved around by cheque, transfer or app. Most of the money in a modern economy exists only as entries in bank records.
- Digital and electronic money. UPI transfers, NEFT, mobile wallets, and the RBI’s own central bank digital currency (the e-rupee). These change how money moves; the underlying rupee is still fiat money.
Full-bodied money vs credit money. In full-bodied money the value of the material equals the face value (an old gold coin). In credit money the value of the material is far below the face value (a ₹500 note is worth a few paise as paper). All modern money is credit money.
Question: Distinguish between limited legal tender and unlimited legal tender with one example each.
Answer:
Unlimited legal tender must be accepted in payment up to any amount whatsoever; refusing it is not permitted. Currency notes in India are unlimited legal tender — a seller cannot refuse payment of ₹50,000 in notes on grounds of amount.
Limited legal tender must be accepted only up to a specified limit; beyond that the receiver may lawfully refuse. Small coins are the standard example — nobody is obliged to accept a payment of ₹5,000 entirely in fifty-paise coins.
1 mark for each definition, 1 mark for the two examples.
Students often ask: if a note is only paper, why does anyone take it? Three reasons, and an exam-ready sentence for each.
1. Legal backing. The state declares it legal tender, so it must be accepted in settlement of debts.
2. General acceptability. Everyone takes it because everyone expects everyone else to take it — confidence feeds on itself.
3. Controlled supply. The RBI has a monopoly on issue and manages the quantity, so the note keeps its purchasing power reasonably stable.
Remove any one of the three — especially the third — and the currency does start to fail. That is exactly what a hyperinflation is.
Money Supply: Board Focus on M1
The money supply is the total stock of money held by the public at a point in time. Two words in that sentence do a lot of work, and both are examined.
- Stock, not flow. Money supply is measured at a moment, like the water in a tank — not over a period, like water flowing through a pipe. If you have already met stocks and flows in National Income and Related Aggregates, this is the same distinction.
- Held by the public. Cash lying in a bank’s own vault, or with the RBI, or with the government, is not counted. Counting it would be double counting, because the same rupee also backs the deposits already counted.
The CBSE syllabus defines the supply of money as currency held by the public plus net demand deposits held by commercial banks. Use that definition in a board answer. The broader RBI aggregates shown next are enrichment to help you understand liquidity, not a second list you must memorise for the CBSE exam.
| Measure | Formula | What it adds | Liquidity |
|---|---|---|---|
| M1 | C + DD + OD | Currency with the public (C), net demand deposits with commercial banks (DD), and other deposits with the RBI (OD). | Highest — spendable this second |
| M2 | M1 + savings deposits with post office savings banks | Post office savings balances, which can be withdrawn fairly easily. | High |
| M3 | M1 + net time deposits with commercial banks | Fixed and recurring deposits, which are locked for a period. | Lower |
| M4 | M3 + total post office savings deposits (excluding National Savings Certificates) | All remaining post office deposits. | Lowest |
Given (₹ crore): Currency with the public 4,200; Net demand deposits with commercial banks 9,500; Other deposits with the RBI 300; Net time deposits with commercial banks 22,000; Inter-bank deposits 1,800; Government deposits with the RBI 700.
Step 1 — discard the traps. Inter-bank deposits (1,800) and government deposits with the RBI (700) are both excluded by definition.
Step 2 — M1 = C + DD + OD = 4,200 + 9,500 + 300 = ₹14,000 crore.
Step 3 — M3 = M1 + net time deposits = 14,000 + 22,000 = ₹36,000 crore.
Check: M3 must always exceed M1, and it does. If your M3 ever comes out smaller than your M1, you have added something into M1 that belongs in M3.
Question: A household shifts ₹50,000 from its savings account at a commercial bank into a two-year fixed deposit at the same bank. What happens to M1 and to M3? Give reasons.
Answer: The savings balance was part of demand deposits, so M1 falls by ₹50,000. The fixed deposit is a time deposit, which is included in M3 but not in M1. Since M3 = M1 + net time deposits, M3 loses ₹50,000 from the M1 component and gains ₹50,000 in the time-deposit component, so M3 is unchanged.
The pattern to remember: money moving between M1 and time deposits changes the narrow measure but leaves the broad measure alone.
Question: You withdraw ₹3,000 in cash from your savings account. What happens to the money supply?
Answer: Currency with the public rises by ₹3,000 and demand deposits fall by ₹3,000. M1 = C + DD + OD, so the two changes cancel exactly and M1 is unchanged. M3 is unchanged too.
But watch the second-round effect. The bank has lost ₹3,000 of cash, so it now holds fewer lendable rupees. Its ability to create fresh credit falls. Applying the Lendable Rupees Test, a public-wide rush to hold cash is a contractionary force on the money supply even though the first-round arithmetic nets to zero.
High-Powered Money (Reserve Money)
High-powered money, written H and also called reserve money or the monetary base, is the money the RBI itself creates. It is the raw material of the whole banking system, and it comes in only two forms.
Why “high-powered”? Because one rupee of H does not sit still. Handed to a bank, it becomes the reserve base on which several rupees of deposits are built. The ratio between the money supply it ends up supporting and H itself is the money multiplier, which we build carefully in the next section.
| High-Powered Money (H) | Money Supply (M) | |
|---|---|---|
| Who creates it | The RBI alone | The RBI (currency) plus commercial banks (deposits) |
| Components | Currency with the public + bank reserves | Currency with the public + deposits of the public |
| Bank reserves | Included | Excluded — reserves are not held by the public |
| Size | Smaller | Larger, by a factor of the money multiplier |
| Relationship | The base | M = money multiplier × H |
Given: Currency with the public = ₹800 crore. Cash reserves of commercial banks = ₹200 crore. Demand deposits of the public = ₹3,200 crore.
H = C + R = 800 + 200 = ₹1,000 crore.
M1 = C + DD = 800 + 3,200 = ₹4,000 crore (taking other deposits with the RBI as nil).
Money multiplier = M ÷ H = 4,000 ÷ 1,000 = 4.
Read that last line in plain English: every rupee the RBI put into the system is currently supporting four rupees of money supply.
Question: What is high-powered money? Explain why it is described as ‘high-powered’. (4 marks)
Model answer: High-powered money is the total money produced by the monetary authority, the RBI. It consists of currency held by the public and the cash reserves held by commercial banks, so H = C + R. It is the monetary base of the economy and every unit of it is a liability of the central bank. (2 marks)
It is called high-powered because a unit of it does not merely circulate once. When it reaches a commercial bank as a deposit, the bank keeps only a fraction as a legal reserve and lends the rest. The loan returns to the banking system as a fresh deposit, part of which is lent again, and so on. A single rupee of reserve money therefore supports a multiple of itself in total deposits, the multiple being the money multiplier 1 ÷ LRR. Its effect on the money supply is thus magnified, or ‘high-powered’. (2 marks)
Commercial Banks and Their Functions
A commercial bank is an institution that accepts deposits from the public, repayable on demand or after a fixed period, and lends that money out to earn a profit. Strip away the marble and the queue tokens and a bank is doing one simple thing: it stands between people who have money they are not using and people who need money they do not have.
Its functions are examined as two groups, and the grouping itself is worth a mark.
| Primary functions | Secondary functions |
|---|---|
| Accepting deposits — demand deposits (current and savings, withdrawable on demand) and time deposits (fixed and recurring, locked for a period and paying higher interest). | Agency functions — collecting cheques and bills, paying insurance premiums and utility bills by standing instruction, buying and selling securities, transferring funds, acting as trustee or executor. |
| Advancing loans — cash credit, overdrafts, term loans, and discounting bills of exchange. Interest charged on loans exceeds interest paid on deposits, and that spread is the bank’s income. | General utility functions — locker facilities, issuing drafts and letters of credit, dealing in foreign exchange, underwriting, and providing debit cards and digital payment rails. |
| Credit creation — the function that makes banks unique, and the whole of the next section. | Note: Credit creation is sometimes listed separately as a third primary function. Either presentation is accepted, provided you explain it. |
Question: Distinguish between demand deposits and time deposits on any three bases.
Answer:
- Withdrawal: demand deposits are withdrawable at any time without notice; time deposits are repayable only after the agreed maturity period.
- Interest: demand deposits earn little or no interest; time deposits earn a higher rate as compensation for the lock-in.
- Money supply: demand deposits are counted in M1 (narrow money); time deposits are excluded from M1 and enter only M3 (broad money).
1 mark per correctly stated basis with both sides given.
If banks kept every rupee deposited, they would earn nothing and you would pay them a storage fee. They do not, because of one steady observation: on any ordinary day, only a small fraction of depositors come to withdraw, and much of what goes out is replaced by fresh deposits coming in.
So a bank keeps a fraction of deposits as cash — the Legal Reserve Ratio (LRR) — and lends the rest. The LRR itself has two legally required parts: the Cash Reserve Ratio (CRR), kept with the RBI, and the Statutory Liquidity Ratio (SLR), kept by the bank itself in cash, gold or approved securities.
Apply the Lendable Rupees Test right here: everything inside the LRR is money the bank is forbidden to lend. Everything outside it is lendable. The entire credit-creation story is about the size of that second pile.
Credit Creation and the Money Multiplier
This is the heart of the chapter and the source of most of its numericals. It is also the single idea students find hardest to believe, so let us build it slowly and honestly.
Start with one fact and one assumption. The fact is that a bank keeps only a fraction of deposits as reserves. The assumption, which the textbook makes explicitly, is that whatever a bank lends does not leak out of the banking system — the borrower spends it, and whoever receives it deposits it back into some bank. With those two, watch what happens.
- Somebody deposits ₹1,000 in Bank A. The reserve ratio is 20%.
- Bank A keeps ₹200 in reserve and lends ₹800. Total deposits so far: ₹1,000.
- The borrower pays a supplier ₹800. The supplier deposits it in Bank B. Total deposits now: ₹1,800.
- Bank B keeps ₹160 and lends ₹640. That ₹640 comes back as a deposit somewhere. Total deposits: ₹2,440.
- Bank C keeps ₹128, lends ₹512, which returns as a deposit. Total deposits: ₹2,952.
- Each round is exactly 80% of the round before it, so the rounds shrink towards zero — but the running total climbs towards a definite ceiling.
That ceiling is not a guess. The deposits form a geometric series 1,000 + 800 + 640 + 512 + …, whose sum is the first term divided by (1 − 0.80), that is 1,000 ÷ 0.20 = 5,000. Notice that 1 ÷ 0.20 is just 1 ÷ LRR.
Total deposits created = Initial deposit × (1 ÷ LRR)
And two derived lines the examiner often wants:
Total credit (loans) created = Total deposits − Initial deposit
Total reserves finally held = Total deposits × LRR = Initial deposit
That last identity is a beautiful self-check: when the cascade finishes, the reserves sitting across the whole banking system add up to exactly the original deposit. Nothing was conjured from nowhere — the deposits were, but the cash was not.
Question: The legal reserve ratio is 20% and the initial deposit is ₹1,000. Calculate the total deposits created and the total credit created.
Money multiplier = 1 ÷ 0.20 = 5
Total deposits = 1,000 × 5 = ₹5,000
Total credit created = 5,000 − 1,000 = ₹4,000
Check: total reserves = 5,000 × 0.20 = ₹1,000, which equals the initial deposit. Correct.
Question: Initial deposit ₹2,000, legal reserve ratio 10%. Find the multiplier, total deposits and total credit.
Multiplier = 1 ÷ 0.10 = 10
Total deposits = 2,000 × 10 = ₹20,000
Total credit = 20,000 − 2,000 = ₹18,000
Check: 20,000 × 0.10 = ₹2,000 = the initial deposit. Correct.
Question: Initial deposit ₹1,500, legal reserve ratio 25%. Find the total deposits and total credit created.
Multiplier = 1 ÷ 0.25 = 4
Total deposits = 1,500 × 4 = ₹6,000
Total credit = 6,000 − 1,500 = ₹4,500
Check: 6,000 × 0.25 = ₹1,500. Correct. Compare with Example 16: raising the reserve ratio from 10% to 25% cuts the multiplier from 10 to 4. Fewer lendable rupees per deposit, less credit — the test again.
Question: An initial deposit of ₹900 finally produces total deposits of ₹4,500. What is the legal reserve ratio, and how much credit was created?
Step 1. Multiplier = Total deposits ÷ Initial deposit = 4,500 ÷ 900 = 5.
Step 2. Multiplier = 1 ÷ LRR, so LRR = 1 ÷ 5 = 0.20 = 20%.
Step 3. Credit created = 4,500 − 900 = ₹3,600.
Check: 4,500 × 0.20 = ₹900 = the initial deposit. Correct.
Question: Initially the LRR is 20% and total deposits in the system stand at ₹5,000 on an initial deposit of ₹1,000. The RBI now cuts the reserve requirement to 12.5%. Calculate the new total deposits and comment on the direction of the effect.
New multiplier = 1 ÷ 0.125 = 8
New total deposits = 1,000 × 8 = ₹8,000
Change = 8,000 − 5,000 = an increase of ₹3,000, a rise of 60%.
Comment: a lower reserve ratio means banks must hold back a smaller fraction of every deposit, so they are left with more lendable rupees. Each round of the cascade passes on more, the multiplier rises, and total deposit creation expands. This is an expansionary (easy-money) move.
Question: Explain why the actual expansion of deposits in a real economy is usually smaller than the value predicted by 1 ÷ LRR.
Answer: The formula rests on assumptions that reality only partly honours.
- Cash drain. Borrowers keep part of the loan as cash instead of depositing all of it. Every rupee held as currency leaves the banking system and cannot be re-lent, so the cascade weakens at every round.
- Excess reserves. Banks may hold more than the legally required reserve when they are nervous about repayment or when good borrowers are scarce. The effective reserve ratio is then higher than the legal one, so the effective multiplier is lower.
- Demand for loans. Credit creation needs willing borrowers. In a downturn firms do not want to borrow, however cheap credit becomes, so the deposits are simply never created.
- Access to the banking system. Where transactions settle outside banks in cash, the leakage is permanent.
All four are the same idea wearing different clothes: they each reduce the number of lendable rupees that survive to the next round. Hence the textbook multiplier is a maximum, not a prediction. This ceiling on credit expansion is one reason monetary policy alone cannot always revive demand — a point you will meet again in Determination of Income and Employment.
The Central Bank (RBI) and Its Functions
The Reserve Bank of India, established in 1935, sits at the apex of the financial system. It is not a bank for you and me — you cannot open an account there. It is the bank for banks and for the government, and it is the only body allowed to create the country’s legal tender.
- Bank of issue. The RBI has the sole right to issue currency notes in India (the government issues one-rupee notes and all coins). A single issuing authority keeps the currency uniform, keeps public confidence in it, and lets the money supply be controlled from one place.
- Banker to the government. It keeps the accounts of the central and state governments, receives and pays out money on their behalf, manages the public debt, and advises on financial matters. Government borrowing, taxation and spending — the material of Government Budget and the Economy — all flow through these accounts.
- Bankers’ bank and supervisor. Commercial banks keep their cash reserves with the RBI, obtain licences from it, and are inspected by it. It sets prudential rules and can act against a bank in trouble.
- Lender of last resort. A basically sound bank that runs short of cash in a crisis can borrow from the RBI when nobody else will lend. This is the promise that stops an ordinary shortage of cash from becoming a panic and a bank run.
- Custodian of foreign exchange reserves. The RBI holds the country’s reserves of foreign currency and gold and buys or sells foreign exchange to keep the external value of the rupee orderly — the machinery behind managed floating in Balance of Payments.
- Controller of credit. The function this whole chapter has been building towards. Using the instruments in the next section, the RBI expands or contracts the volume of credit in the economy. Its scope widened considerably after the reforms you study in Liberalisation, Privatisation and Globalisation.
- Clearing house function. Because every bank holds an account with the RBI, mutual claims between banks are settled by adjusting those accounts rather than by moving cash around.
| Basis | Central Bank (RBI) | Commercial Bank |
|---|---|---|
| Ownership and aim | Publicly owned; works for the welfare of the economy | Usually profit-oriented, whether public or private |
| Dealings with the public | Does not deal with the general public | Deals directly with the public |
| Note issue | Sole authority to issue currency | Cannot issue currency |
| Number | Only one in the country | Many |
| Role in the system | Apex body; regulates and supervises other banks | Operates under the central bank’s regulation |
| Lending | Lender of last resort to banks | Lends to households, firms and government |
| Credit | Controls credit | Creates credit |
Question: Explain the ‘lender of last resort’ function of the central bank.
Model answer: As lender of last resort, the central bank provides funds to commercial banks that are financially sound but face a temporary shortage of cash and are unable to raise it elsewhere. It lends against approved securities or by rediscounting eligible bills. (1½ marks)
The purpose is to protect the stability of the banking system. Knowing that support is available, depositors do not rush to withdraw, so an ordinary liquidity shortage does not turn into a bank run and does not spread to other banks. The central bank thus acts as the ultimate guarantor of confidence in the system. (1½ marks)
Question: Why is the right to issue currency given to a single authority?
Answer: Four reasons, one line each, then a sentence of explanation:
- Uniformity. Notes of one design and one standard circulate everywhere, so nobody has to judge whose note is trustworthy.
- Public confidence. A single issuer with legal backing makes the note universally acceptable.
- Control of the money supply. Currency is the base of high-powered money. If many bodies could issue notes, the quantity of money could not be regulated and over-issue would cause inflation.
- Elasticity with discipline. One authority can expand the issue when the economy genuinely needs more currency and hold back when it does not.
Instruments of Monetary Policy
Here is where most students start memorising, and here is where they do not need to. Every instrument below is in the CBSE 2026-27 syllabus, and every single one of them can be sorted by the Lendable Rupees Test. Read the mechanism, ask the one question, and the direction falls out. These are the instruments of monetary policy class 12 notes you can reason your way through instead of learning by heart.
The instruments split into two families. Quantitative instruments change the total volume of credit in the economy and affect all sectors alike. Qualitative (selective) instruments steer credit towards or away from particular uses without changing the overall volume much.
| Instrument | Family | What it actually is | Raise it → | Lower it → |
|---|---|---|---|---|
| Repo rate | Quantitative | The rate at which the RBI lends short-term funds to commercial banks against securities. | Borrowing from the RBI costs banks more, so they borrow less and lend less, at higher rates. Fewer lendable rupees — tightens | Cheaper for banks to raise funds, so they lend more. More lendable rupees — loosens |
| Reverse repo rate | Quantitative | The rate at which banks park their surplus funds with the RBI. | Parking money at the RBI becomes more attractive than lending it out. Fewer lendable rupees — tightens | Parking pays poorly, so banks prefer to lend. More lendable rupees — loosens |
| Bank rate | Quantitative | The rate at which the RBI lends to banks for the longer term, without a securities repurchase arrangement. | Costlier refinancing pushes lending rates up and lending volume down. Tightens | Cheaper refinancing encourages lending. Loosens |
| Cash Reserve Ratio (CRR) | Quantitative | The percentage of a bank’s total deposits it must keep as cash with the RBI. | A larger slice of every deposit is locked away and cannot be lent. Tightens | A smaller slice is locked, so the multiplier rises. Loosens |
| Statutory Liquidity Ratio (SLR) | Quantitative | The percentage of deposits a bank must itself hold in cash, gold or approved securities. | More of the deposit base is tied up in mandatory holdings. Tightens | Less is tied up, freeing funds for loans. Loosens |
| Open Market Operations (OMO) | Quantitative | The RBI buying or selling government securities in the open market. | Selling securities draws cash out of banks and the public into the RBI. Tightens | Buying securities pushes cash into the system. Loosens |
| Margin requirement | Qualitative | The gap between the value of the security pledged and the loan granted against it. A 40% margin on a ₹1,00,000 asset means a maximum loan of ₹60,000. | A higher margin means a smaller loan for the same collateral. Tightens | A lower margin allows a bigger loan on the same collateral. Loosens |
| Moral suasion & direct action | Qualitative | Persuasion, letters and meetings urging banks to restrain or extend credit; in the last resort, penalties or refusal of rediscounting facilities. | Pressure to restrain lending in chosen sectors. Tightens | Encouragement to lend to chosen sectors. Loosens |
Question: A borrower pledges gold worth ₹2,00,000. The margin requirement is 30%. How much can she borrow? If the RBI raises the margin to 45%, what is the new maximum loan, and by how much does her borrowing capacity fall?
At 30% margin: loan = 2,00,000 × (1 − 0.30) = 2,00,000 × 0.70 = ₹1,40,000
At 45% margin: loan = 2,00,000 × (1 − 0.45) = 2,00,000 × 0.55 = ₹1,10,000
Fall in borrowing capacity = 1,40,000 − 1,10,000 = ₹30,000, a drop of about 21.4%.
Direction: the same collateral now supports a smaller loan, so credit contracts. Red column.
Question: Banks hold total deposits of ₹40,000 crore. The CRR is 8% and banks hold no excess reserves. The RBI raises the CRR to 10%. By how much must the banking system contract its credit, and what happens to the deposit multiplier?
Reserves required at 8% = 40,000 × 0.08 = ₹3,200 crore
Reserves required at 10% = 40,000 × 0.10 = ₹4,000 crore
Extra reserves to be found = 4,000 − 3,200 = ₹800 crore
Multiplier before = 1 ÷ 0.08 = 12.5
Multiplier after = 1 ÷ 0.10 = 10
With the same reserve base of ₹3,200 crore, deposits the system can support fall from 3,200 × 12.5 = ₹40,000 crore to 3,200 × 10 = ₹32,000 crore — a contraction of ₹8,000 crore. Fewer lendable rupees, exactly as the test predicts.
Question: The economy is facing excess demand. Explain any three monetary measures the central bank can take to correct it. (6 marks)
Model answer: Excess demand means aggregate demand exceeds aggregate supply at full employment, causing an inflationary gap. The central bank must therefore reduce the flow of credit and the money supply. (introductory line)
(i) Raise the repo rate. Borrowing from the central bank becomes dearer, so commercial banks raise their own lending rates and borrow less themselves. Loans become costlier for households and firms, borrowing falls, and consumption and investment demand fall. Aggregate demand contracts. (2 marks)
(ii) Raise the Cash Reserve Ratio. Banks must keep a larger proportion of their deposits as cash with the central bank. Their lendable funds shrink, the money multiplier 1 ÷ LRR falls, credit creation is reduced, and the money supply contracts. (2 marks)
(iii) Sell government securities in the open market. Buyers pay for the securities out of their bank balances, so cash flows out of commercial banks to the central bank. Banks’ reserves fall, their capacity to create credit falls with them, and the money supply contracts. (2 marks)
Marking note: each measure needs the mechanism, not just the name. The words ‘lendable funds fall, so credit contracts’ are what the examiner is looking for.
Practice Worksheet — Credit Creation Numericals with Solutions
Ten original questions, mixing numericals and theory, in roughly rising order of difficulty. Give yourself about forty minutes, keep the notes closed, and open each answer only after you have written something down. Marks are shown so you can judge how much to write.
Q1. An economy trades in 12 goods and uses no money at all. How many exchange ratios must a trader keep track of? What does this show about the role of money? (3M)
Show Answer
Number of ratios = n(n − 1) ÷ 2 = 12 × 11 ÷ 2 = 66 exchange ratios.
With money, only 12 prices are needed — one per good, all expressed in the same unit. This shows that money acts as a common measure of value and drastically reduces the information every trader must carry, which is what makes large-scale, specialised exchange possible.
Q2. From the following data (₹ crore), calculate M1 and M3: Currency with the public 5,600; Net demand deposits with commercial banks 11,200; Other deposits with the RBI 400; Net time deposits with commercial banks 18,000; Inter-bank deposits 2,300; Cash in bank vaults 900. (4M)
Show Answer
Excluded items: inter-bank deposits (₹2,300 crore) are not held by the public, and cash in bank vaults (₹900 crore) is a bank reserve, not money held by the public.
M1 = C + DD + OD = 5,600 + 11,200 + 400 = ₹17,200 crore
M3 = M1 + net time deposits = 17,200 + 18,000 = ₹35,200 crore
Q3. An initial deposit of ₹4,000 enters the banking system. The legal reserve ratio is 25%. Calculate the money multiplier, total deposits created and total credit created. Verify your answer. (4M)
Show Answer
Money multiplier = 1 ÷ 0.25 = 4
Total deposits = 4,000 × 4 = ₹16,000
Total credit created = 16,000 − 4,000 = ₹12,000
Verification: total reserves finally held = 16,000 × 0.25 = ₹4,000, which equals the initial deposit. The answer is consistent.
Q4. The money supply in an economy is ₹6,000 crore and high-powered money is ₹1,200 crore. Find the money multiplier and explain in one sentence what it means. (3M)
Show Answer
Money multiplier = M ÷ H = 6,000 ÷ 1,200 = 5
It means that every one rupee of high-powered money created by the RBI is currently supporting five rupees of money supply in the economy, because commercial banks build deposits on top of the reserves they hold.
Q5. A fresh deposit of ₹2,500 eventually produces total deposits of ₹12,500 in the banking system. Find the legal reserve ratio and the total credit created. (4M)
Show Answer
Step 1. Money multiplier = 12,500 ÷ 2,500 = 5
Step 2. Multiplier = 1 ÷ LRR, so LRR = 1 ÷ 5 = 0.20 = 20%
Step 3. Total credit created = 12,500 − 2,500 = ₹10,000
Check: 12,500 × 0.20 = ₹2,500 = the initial deposit. Correct.
Q6. A trader pledges stock worth ₹80,000. The margin requirement is 25%. How much can he borrow? The RBI then raises the margin to 40%. Calculate the new loan and the change in his borrowing capacity, and state the direction of the effect on credit. (4M)
Show Answer
At 25% margin: loan = 80,000 × 0.75 = ₹60,000
At 40% margin: loan = 80,000 × 0.60 = ₹48,000
Fall in borrowing capacity = 60,000 − 48,000 = ₹12,000 (a fall of 20%)
Direction: the same collateral now supports a smaller loan, so borrowing against securities is discouraged. Credit contracts — a qualitative, contractionary measure.
Q7. Distinguish between the repo rate and the reverse repo rate, and explain how a rise in each affects the supply of credit. (4M)
Show Answer
Repo rate is the rate at which the RBI lends short-term funds to commercial banks against government securities. Reverse repo rate is the rate at which the RBI borrows from commercial banks, that is, the return banks earn on surplus funds parked with the RBI. (2 marks)
A rise in the repo rate makes borrowing from the RBI dearer. Banks borrow less and pass the higher cost on, so lending rates rise and loan demand falls. Banks are left with fewer lendable rupees and credit contracts. (1 mark)
A rise in the reverse repo rate makes parking funds with the RBI more rewarding than lending them to the public. Banks divert funds to the RBI, their lendable rupees fall, and credit contracts. (1 mark)
Q8. Explain the process of credit creation by commercial banks, using an initial deposit of ₹1,000 and a legal reserve ratio of 20%. State the assumptions on which the result depends. (6M)
Show Answer
The process. A bank keeps only a fraction of its deposits as reserves, because experience shows that only a small share of depositors withdraw on any given day. It lends the rest.
- Round 1: ₹1,000 is deposited. The bank keeps ₹200 (20%) and lends ₹800.
- Round 2: the ₹800 is spent and returns to the banking system as a deposit. The receiving bank keeps ₹160 and lends ₹640.
- Round 3: the ₹640 returns as a deposit; ₹128 is kept and ₹512 lent.
- Each round is 80% of the one before, so the rounds shrink towards zero while the running total rises towards a limit. (3 marks)
The result. Total deposits = Initial deposit × (1 ÷ LRR) = 1,000 × 5 = ₹5,000. Total credit created = 5,000 − 1,000 = ₹4,000. Total reserves finally held = 5,000 × 0.20 = ₹1,000, exactly the original cash. (2 marks)
Assumptions. (i) The whole of every loan returns to the banking system as a deposit — there is no cash drain. (ii) Banks keep no excess reserves beyond the legal minimum. (iii) There is a continuous supply of willing and creditworthy borrowers. If any assumption fails, actual creation is smaller than the formula predicts. (1 mark)
Q9. Commercial banks hold total deposits of ₹25,000 crore and keep no excess reserves. The CRR is raised from 4% to 5%. Calculate the change in the deposit multiplier and the contraction of deposits the system must undergo if the reserve base stays unchanged. (6M)
Show Answer
Step 1 — reserves currently held. 25,000 × 0.04 = ₹1,000 crore
Step 2 — reserves now required against existing deposits. 25,000 × 0.05 = ₹1,250 crore, a shortfall of ₹250 crore.
Step 3 — the multiplier. Before: 1 ÷ 0.04 = 25. After: 1 ÷ 0.05 = 20. The multiplier falls by 5.
Step 4 — deposits the unchanged reserve base can support. 1,000 × 20 = ₹20,000 crore
Contraction required = 25,000 − 20,000 = ₹5,000 crore
Comment. A one percentage point rise in the CRR forces a ₹5,000 crore contraction — twenty times the ₹250 crore reserve shortfall. That leverage is exactly why the CRR is such a powerful instrument, and why the RBI moves it in small steps.
Q10. ‘An increase in the money supply always increases the money supply by more than the amount the central bank injects.’ Do you agree? Support your answer with reasoning. (6M)
Show Answer
Partly agree, with important qualifications.
The case for the statement. Money injected by the central bank is high-powered money. When it reaches commercial banks as reserves, they retain only the legal reserve ratio and lend the rest, which returns as a fresh deposit and is lent again. The total money supply that results is the injection multiplied by 1 ÷ LRR, which exceeds one whenever the reserve ratio is below 100%. So in principle the increase is indeed larger than the injection. (2 marks)
Why it does not always hold.
- Cash drain. If the public keeps part of the money as currency rather than depositing it, those rupees leave the banking system and cannot be re-lent, so the effective multiplier falls.
- Excess reserves. Banks that are nervous about default may hold more than the required reserve, raising the effective reserve ratio and shrinking the multiplier.
- Weak loan demand. Credit creation needs willing borrowers. In a downturn, firms may not borrow at any rate, so deposits are never created and the injection simply sits idle.
(3 marks)
Conclusion. The multiplier gives the maximum possible expansion, not a guarantee. In practice the actual increase lies somewhere between the size of the injection and that maximum. (1 mark)
Where This Chapter Leads Next
You now have a working lens rather than a list of facts. Take it forward: use it on the money-supply measures in National Income and Related Aggregates when you meet stocks and flows again, on the correction of excess and deficient demand in Determination of Income and Employment, and on the fiscal side of demand management in Government Budget and the Economy.