Money and Banking Class 12: Money Supply, Credit Creation and the RBI

What Money and Banking is about

Weightage: This chapter is Unit 2, Money and Banking (Part A Introductory Macroeconomics), which carries 6 of the 80 theory marks.Source: CBSE Economics (030) syllabus 2026-27, Unit 2 Money and Banking

In real board papers: asked in 2 of the 2 board papers we hold (2026 to 2026), on average 10 marks per paper. See the questions

Key concepts

Barter and its problems

NCERT section Chapter 3 (introduction), 3.1

Barter is the direct exchange of goods for goods. Its problems:

• Lack of double coincidence of wants: you must find someone who has what you want and wants what you have; search costs rise as the economy grows.
• No common measure of value: the value of each good must be stated in terms of every other good.
• Difficulty of storing wealth: goods like rice perish and need storage space.
• Indivisibility and difficulty of deferred payments.

Money removes these problems.

Worked example

Suppose a potter wants rice, but the rice farmer wants cloth, not pots. Which problem of barter is this, and how does money solve it? [3 marks]

Try it first, then show the solutionSolution

1. Each party must want what the other offers: double coincidence of wants is missing.
2. With money, the potter sells pots to anyone for money and buys rice with it.
3. The farmer uses the money to buy cloth.

Answer: Lack of double coincidence of wants; money as a medium of exchange separates buying from selling.

Functions of money

NCERT section 3.1

• Medium of exchange (primary function): accepted in payment for goods and services.
• Unit of account (measure of value): all values can be expressed in rupees, so relative prices are easy (if a pen is ₹10 and a pencil ₹2, a pen is worth 5 pencils).
• Store of value: money does not perish and is cheap to store; it works well only if its value (purchasing power) is stable. A rising price level erodes it.
• Standard of deferred payments: future payments, like loans, can be stated in money.

Worked example

Suppose prices of all goods double. What happens to the purchasing power of money, and which function is weakened most? [3 marks]

Try it first, then show the solutionSolution

1. Each rupee buys half as much: purchasing power halves.
2. Money held as savings loses value.
3. The store-of-value function is weakened.

Answer: Purchasing power halves; money becomes a poor store of value.

Money supply

NCERT section 3.2 (money supply)

Money supply is a stock: the total money held by the public at a point of time. As per the syllabus:

Money supply = currency held by the public (notes and coins) + net demand deposits held by commercial banks. NCERT writes $M1=CU+DD$.

"Net" means only the public's deposits; interbank deposits are excluded. Money held by the government and by banks themselves is not part of money supply held by the public.

NCERT also lists M2, M3 (most commonly used, "aggregate monetary resources") and M4: M1 and M2 are narrow money, M3 and M4 broad money, in decreasing order of liquidity.

Currency notes and coins are fiat money (no intrinsic value; value comes from government authority) and legal tender (cannot be refused). Cheques on demand deposits can be refused, so demand deposits are not legal tender.

Worked example

Suppose currency with the public is ₹3,500 crore, demand deposits of the public with banks ₹2,800 crore, and deposits of banks with other banks ₹300 crore. Find money supply (M1). [1 mark]

Try it first, then show the solutionSolution

1. Interbank deposits are excluded.
2. M1 = 3,500 + 2,800 = ₹6,300 crore.

Answer: ₹6,300 crore

Money creation (credit creation) by commercial banks

NCERT section 3.3, 3.3.1, 3.3.2

Banks know that depositors do not withdraw all deposits at once, so they keep a fraction as reserves (the legal reserve ratio, LRR, set by the RBI as CRR and SLR) and lend the rest. Borrowers spend the loans; the receivers deposit the money in banks; banks lend again. Each round deposits rise by a smaller amount.

Total deposits created = initial deposit × money multiplier, where money multiplier = 1 ÷ LRR. Credit created (loans) = total deposits − initial deposit.

Assumptions: all transactions go through banks (no cash leakage), banks lend everything above the required reserve, and borrowers are available.

Credit creation, LRR 20% (₹)

Round	Deposits	Reserves (20%)	Loans (80%)
Round 1	1,000	200	800
Round 2	800	160	640
Round 3	640	128	512
…	…	…	…
Total	5,000	1,000	4,000

Worked example

Suppose an initial deposit of ₹1,000 is made and the legal reserve ratio is 20%. Calculate the money multiplier, total deposits and total credit created. Verify with the first three rounds. [4 marks]

Try it first, then show the solutionSolution

1. Money multiplier = 1 ÷ 0.2 = 5.
2. Total deposits = 1,000 × 5 = ₹5,000; credit = 5,000 − 1,000 = ₹4,000.
3. Credit creation, LRR 20% (₹)

   Round	Deposits	Reserves (20%)	Loans (80%)
   Round 1	1,000	200	800
   Round 2	800	160	640
   Round 3	640	128	512
   …	…	…	…
   Total	5,000	1,000	4,000

4. Deposits form 1,000 + 800 + 640 + ... = 1,000 ÷ (1 − 0.8) = 5,000: the same answer.

Answer: Multiplier 5; deposits ₹5,000; credit ₹4,000.

Central bank and its functions (RBI)

NCERT section 3.4 (and CBSE syllabus)

• Bank of issue: the RBI alone issues currency notes (coins and one-rupee notes are issued by the Government of India through the RBI). This gives uniformity and public confidence and lets the RBI regulate currency.
• Banker to the government: keeps the government's accounts, makes and receives payments for it, manages public debt, gives short-term loans and advises on financial matters.
• Banker's bank and supervisor: holds part of commercial banks' cash reserves, lends to them and supervises them. As lender of last resort, it is ready to lend to banks at all times when they cannot get funds elsewhere.
• Controller of credit: regulates money supply and credit through quantitative and qualitative tools.

Worked example

Suppose a sound commercial bank faces a sudden rush of withdrawals and cannot borrow from other banks. Which function of the RBI helps, and how? [3 marks]

Try it first, then show the solutionSolution

1. The RBI acts as banker's bank.
2. As lender of last resort it lends to the bank against securities.
3. This protects depositors' confidence and prevents a banking crisis.

Answer: Lender of last resort (banker's bank function).

Instruments of credit control

NCERT section 3.4

Quantitative tools affect the total volume of credit:

RBI's instruments of credit control

Instrument	What it is	To reduce money supply (inflation)	To raise money supply (deflation)
Repo rate	Rate at which RBI lends to banks against securities for short periods	Raise	Lower
Reverse repo rate	Rate at which RBI borrows from (absorbs funds of) banks	Raise	Lower
Bank rate	Rate at which RBI lends to banks (longer term, without repurchase)	Raise	Lower
Cash Reserve Ratio (CRR)	Share of deposits banks must keep as cash with RBI	Raise	Lower
Statutory Liquidity Ratio (SLR)	Share of deposits banks must keep in liquid assets (cash, gold, approved securities) with themselves	Raise	Lower
Open market operations	RBI buys or sells government securities in the market	Sell securities	Buy securities
Margin requirement (qualitative)	Difference between the value of a security and the loan given against it	Raise the margin	Lower the margin

Repo and reverse repo are repurchase agreements at various maturities (overnight, 7-day, 14-day); NCERT notes they have become the main tool of the RBI's monetary policy. In an outright open market operation, the RBI buys or sells securities with no promise to reverse the deal, so the effect is permanent.

Qualitative tools direct credit to or away from particular uses: margin requirement and moral suasion (persuading banks through advice and pressure).

Worked example

Suppose inflation is high. State how the RBI would use (i) repo rate, (ii) CRR, (iii) open market operations, and explain one of them. [4 marks]

Try it first, then show the solutionSolution

1. (i) Raise the repo rate: borrowing from RBI costs more, banks raise lending rates, credit falls.
2. (ii) Raise the CRR: banks keep more reserves, the multiplier falls, lending falls.
3. (iii) Sell government securities: buyers pay from bank deposits, reserves fall, credit falls.

Answer: Raise repo rate, raise CRR, sell securities: all reduce money supply and aggregate demand.

Effect of a change in reserve ratio on money creation

NCERT section 3.3.2, 3.4

Since the multiplier is $1/LRR$, a higher reserve ratio reduces the multiplier and the deposits the banking system can create; a lower ratio increases them. With reserves of ₹100, LRR 20% supports deposits of ₹500; LRR 25% supports only ₹400, so banks must call back loans and money supply falls.

Worked example

Suppose banks have reserves of ₹100 crore. Compare total deposits possible when the reserve ratio is 20% and 25%. [3 marks]

Try it first, then show the solutionSolution

1. At 20%: multiplier 5; deposits ₹500 crore.
2. At 25%: multiplier 4; deposits ₹400 crore.
3. A rise in the ratio cuts possible deposits by ₹100 crore.

Answer: ₹500 crore and ₹400 crore.

Money and Banking in real life

Each concept, met in an everyday situation. Read the situation, answer the question in your own words, then compare with the model answer. The one-line hook is what to remember.

Topics in this chapter

• Central Bank Functions and Instruments of Monetary Policy
• Money Creation by Commercial Banks
• Money: Meaning, Functions and Supply

Money and Banking: key facts

Money supply (syllabus)

Currency held by the public + net demand deposits held by commercial banks ($M1=CU+DD$)

Money multiplier

$\frac{1}{LRR}$

Total deposits created

Initial deposit × $\frac{1}{LRR}$

Credit created

Total deposits − initial deposit

Initial deposit from given total

Total deposits × LRR

Other measures (NCERT)

M2 = M1 + post office savings deposits; M3 = M1 + net time deposits of banks; M4 = M3 + total post office deposits (excluding NSC)

How the board asks Money and Banking

The question patterns to expect, and the method that works for each.

Tricks to remember Money and Banking

Short memory aids. Say each one aloud once, then use it on a question the same day.

• Medium, Measure, Store, Standard

  Four functions of money.

  Use it when: Functions questions.

• Inflation: Raise and Sell

  Raise repo, reverse repo, bank rate, CRR, SLR, margins; sell securities.

  Use it when: Choosing tools.

• One over LRR

  Multiplier = 1/LRR; deposits = initial × multiplier.

  Use it when: Credit creation.

• Issue, Government, Banks, Credit

  RBI functions in order: bank of issue, banker to government, banker's bank, controller of credit.

  Use it when: RBI functions.

Money and Banking: board-level solved questions

Ordered from board level to HOTS. Cover the solution, write your own, then compare step by step.

Case-study practice (Section E style)

Read the situation, then answer every part. In the board paper this is a 4-mark question split into 1 + 1 + 2 marks.

Where the marks are

How a typical answer is split into step marks. Show every step: a right final answer alone rarely earns full marks.

Where students lose marks in Money and Banking

The slips examiners see most often, and what to write instead.

• ✗Mistake: Including interbank deposits or bank cash in money supply

  They are deposits too.

  ✓Do this: Only currency with the public and net demand deposits of the public.

  Usually costs: 1 mark.

• ✗Mistake: Saying demand deposits are legal tender

  They are money.

  ✓Do this: They are money but not legal tender.

  Usually costs: 1 mark.

• ✗Mistake: Using total deposits − reserves as credit created

  Mixing items.

  ✓Do this: Credit created = total deposits − initial deposit.

  Usually costs: 1 mark.

• ✗Mistake: Getting the direction of OMO wrong

  Thinking selling gives money.

  ✓Do this: RBI sells securities → absorbs money; buys → injects money.

  Usually costs: 1-2 marks.

• ✗Mistake: Writing about demand for money motives

  It is in NCERT.

  ✓Do this: Demand for money is not in the 2026-27 syllabus; focus on supply, creation and RBI.

  Usually costs: Time lost.

NCERT exercise guide: Money and Banking

What each exercise in the NCERT chapter tests, how to approach it, and a question of the same kind solved step by step. Questions here are written in our own words.

Money and Banking: previous year questions

• Asked in 2 of the 2 board papers we hold (2026 to 2026), on average 10 marks per paper; 11 questions in all, counting OR alternatives. In 4 of 4 sample papers.

Counted from the real papers on our previous year papers page, not estimated. Average marks are over every board paper we hold, with an OR pair counted once. Chapter tags are ours.

Solved board questions from Money and Banking

Real questions from recent papers. Try each one first, then open our step-by-step solution with marks per step.

Every Money and Banking question, by year

Practice questions on Money and Banking

Write each answer on paper first. Open the hint only if you are stuck, and the answer only when you have finished.

1. Q1 · 1 mark · MCQBoard level

   Which of these is legal tender?
   (a) Cheque
   (b) Demand draft
   (c) Currency note
   (d) Credit card

   Hint

   Cannot be refused.

   Answer

   (c)

2. Q2 · 1 mark · MCQBoard level

   If LRR is 25%, the money multiplier is:
   (a) 2.5
   (b) 4
   (c) 25
   (d) 0.25

   Hint

   1/LRR.

   Answer

   (b) 4

3. Q3 · 3 marks · Short answerBoard level

   Explain three functions of money.

   Hint

   Exchange, account, store.

   Answer

   Medium of exchange (accepted for payments, solving double coincidence); unit of account (common measure of value); store of value (wealth kept for the future, if prices are stable).

4. Q4 · 3 marks · Short answerBoard level

   Explain the "banker to the government" and "bank of issue" functions of the RBI.

   Hint

   Accounts, debt; currency.

   Answer

   Banker to government: keeps its accounts, receives and makes payments, manages public debt, lends and advises. Bank of issue: sole authority to issue currency notes, ensuring uniformity and confidence and control over currency.

5. Q5 · 3 marks · Short answerHarder board level

   Suppose total deposits created are ₹12,000 crore and the initial deposit is ₹2,400 crore. Find the LRR and the credit created.

   Hint

   Multiplier first.

   Answer

   Multiplier = 5; LRR = 20%; credit = ₹9,600 crore.

6. Q6 · 4 marks · Short answerHarder board level

   Explain with a numerical example how commercial banks create money.

   Hint

   Rounds.

   Answer

   With LRR 20% and a deposit of ₹1,000, the bank keeps ₹200 and lends ₹800; it returns as a deposit; ₹640 is lent next; and so on. Total deposits = 1,000 × 5 = ₹5,000; credit = ₹4,000.

7. Q7 · 3 marks · Short answerHarder board level

   Distinguish between bank rate and repo rate.

   Hint

   Term and security.

   Answer

   Both are rates at which the RBI lends to banks. Repo is lending through short-term repurchase agreements against securities (overnight to a few days) and is the main policy rate; the bank rate is the rate on loans or rediscounting without repurchase agreements, generally for a longer term.

8. Q8 · 4 marks · Short answerHOTS / competency

   Suppose the RBI raises CRR from 4% to 5% while lowering the repo rate. What conflicting signals does this send, and what is the likely net effect on credit?

   Hint

   Quantity vs price of funds.

   Answer

   Higher CRR reduces lendable funds (tightening); a lower repo rate cheapens borrowing (easing). The net effect depends on magnitudes: banks have less to lend but cheaper refinance; the RBI might be reshaping liquidity rather than changing overall stance.

9. Q9 · 1 mark · Assertion-reasonHOTS / competency

   Assertion (A): An increase in margin requirement reduces credit for the purpose concerned.
   Reason (R): Borrowers get smaller loans against the same security.
   (a) Both true and R explains A (b) Both true, R does not explain A (c) A true, R false (d) A false, R true

   Hint

   Margin is the uncovered part.

   Answer

   (a)

10. Q10 · 1 mark · Very short answerHarder board level

    Money supply is a stock or a flow? Explain.

    Hint

    Point of time.

    Answer

    A stock: it is measured at a point of time.

Test your recall

Answer in your head or on paper first, then open the card. Pulling an answer out of memory makes it stick far better than re-reading.

1. 1.What is fiat money?Show answer

   Money with no intrinsic value, accepted because of government authority (notes and coins).

2. 2.What are the components of money supply in the syllabus?Show answer

   Currency held by the public and net demand deposits held by commercial banks.

3. 3.What is the money multiplier with LRR 10%?Show answer

   10.

4. 4.What is the reverse repo rate?Show answer

   The rate at which the RBI absorbs funds from (borrows from) banks.

5. 5.What does "lender of last resort" mean?Show answer

   The RBI lends to banks when they cannot get funds elsewhere.

6. 6.What is SLR?Show answer

   The share of deposits banks must keep in liquid assets such as cash, gold and approved securities.

7. 7.Which measure of money is most commonly used (NCERT)?Show answer

   M3 (aggregate monetary resources).

8. 8.How does buying securities by the RBI affect money supply?Show answer

   It increases money supply.

Quick revision checklist

The night before the exam: can you do each of these without looking?

• ☐Can you explain double coincidence of wants?
• ☐Can you list four functions of money?
• ☐Can you state money supply as per the syllabus?
• ☐Can you say what is excluded from money supply?
• ☐Can you compute multiplier, deposits and credit?
• ☐Can you work back the LRR from deposits?
• ☐Can you explain the RBI's four functions?
• ☐Can you use repo, reverse repo, bank rate, CRR, SLR and OMO for inflation?
• ☐Can you explain margin requirement?
• ☐Can you explain lender of last resort?

Money and Banking: frequently asked questions