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Money and Banking — Class 12 Economics Notes & Practice

July 31, 2026
Money and Banking — Class 12 Economics Notes & Practice

Money and Banking explains what money really is, how banks actually “create” money, and how the RBI steers the economy. It is conceptual and scoring once the ideas click. This page teaches the whole chapter in plain language, with a plan and an original practice set (with answers you can reveal) at the end.

What This Chapter Covers

Your Game Plan for This Chapter

  1. First — Learn the functions of money and why it beats barter.
  2. Next — Understand money supply and how banks create credit.
  3. Last — Learn the central bank’s functions and its tools of credit control, then attempt the practice set.

Study Notes

1. Money: Meaning and Functions

Money is anything generally accepted as a means of payment. It performs four functions: a medium of exchange (you buy and sell with it), a measure of value (prices are stated in it), a store of value (you can save it), and a standard of deferred payment (loans and future payments are fixed in it).

Key Idea
Money solves the “double coincidence of wants” problem of barter — you no longer need to find someone who both has what you want and wants what you have. That is the core reason money exists.

2. Supply of Money

The money supply is the total money held by the public at a point in time. It is measured in stages: M1 = currency with the public + demand deposits + other deposits with the RBI. Broader measures M2, M3 and M4 add various savings and time deposits, so M1 < M2 < M3 < M4. High-powered money is the currency issued by the RBI plus the cash reserves of banks — the base on which credit is built.

3. Money Creation by Commercial Banks

Banks do not keep all deposits idle. They hold a fraction as reserves (the Legal Reserve Ratio, LRR) and lend the rest; that loan is spent and returns to the banking system as a fresh deposit, which is again partly lent — and so on. The total credit created is the initial deposit multiplied by the money multiplier = 1 / LRR.

Staircase diagram showing three rounds of credit creation with a legal reserve ratio of twenty percent, where an initial deposit of 1000 keeps a reserve of 200 and lends 800, the 800 returns as a deposit that keeps 160 and lends 640, and so on, giving total deposits of 5000 from a money multiplier of five.
Figure: How an initial deposit multiplies into total credit · चित्र: साख निर्माण और मुद्रा गुणक
Key Rule
Money multiplier = 1 / LRR. So with an LRR of 20% (0.20), an initial deposit of ₹1,000 can create total credit of 1,000 × (1/0.20) = ₹5,000.

4. The Central Bank and Control of Credit

The central bank (in India, the RBI) is the bank of issue (it prints currency), the government’s bank, the bankers’ bank, and the controller of credit. To control the money supply it uses quantitative tools — Bank Rate, Repo and Reverse Repo rates, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and Open Market Operations — and qualitative tools such as margin requirements.

Chart showing the four roles of the central bank of India as bank of issue that prints the currency, government bank that acts as banker to the government, bankers bank that lends to commercial banks, and controller of credit that sets the repo rate and cash reserve ratio.
Figure: The four main functions of the central bank · चित्र: केंद्रीय बैंक के चार कार्य
To REDUCE money supply, the RBI…Action
Repo rateIncreases it (borrowing costlier)
Cash Reserve Ratio (CRR)Increases it (banks keep more)
Statutory Liquidity Ratio (SLR)Increases it
Open Market OperationsSells government securities
Exam Tip
Expect a question on how a change in CRR, SLR or the repo rate affects the money supply. Rule of thumb: raising any of these reduces the money supply; lowering them increases it.

Practice Worksheet

Try each question fully on your own first, then click Show Answer to check yourself.

Q1. State the four functions of money.

Show Answer
(i) Medium of exchange; (ii) Measure (unit) of value; (iii) Store of value; (iv) Standard of deferred payment.

Q2. What is high-powered money?

Show Answer
High-powered money is the money produced by the RBI and the government — the currency held by the public plus the cash reserves of the commercial banks. It is the base on which the banking system creates additional money.

Q3. A bank receives a deposit of ₹1,000 and the Legal Reserve Ratio is 20%. How much total credit can the banking system create?

Show Answer
Money multiplier = 1 / LRR = 1 / 0.20 = 5. Total credit = initial deposit × multiplier = 1,000 × 5 = ₹5,000.

Q4. How does an increase in the CRR affect the money supply?

Show Answer
A higher CRR means banks must keep a larger share of their deposits as reserves with the RBI, leaving less to lend. This lowers credit creation and therefore reduces the money supply.

Q5. Name any two quantitative instruments the central bank uses to control credit.

Show Answer
Any two of: Bank Rate, Repo Rate, Reverse Repo Rate, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Open Market Operations.

Once these feel easy, you have genuinely finished this chapter. Do not aim for perfect on the first try — aim for one more correct answer than yesterday.

Written & reviewed by Team Principal Saab — Meet the team →