Big picture
Money makes exchange easy, but the economy also needs the right amount of it. Too little money slows down trade and investment; too much pushes up prices. Two institutions decide how much money there is: commercial banks, which create money by lending, and the central bank (the Reserve Bank of India), which controls how much banks can lend.
Exam questions test the functions of money, the measure of money supply, the credit-creation calculation and, above all, how the RBI uses each instrument to fight inflation or deflation.
Learning goals
Explain the drawbacks of barter and the functions of money.
Explain the supply of money and the measure M1.
Explain how commercial banks create credit and calculate the money multiplier.
Explain the functions of the central bank.
Explain how quantitative and qualitative instruments control credit, in inflation and in deflation.
Core ideas
1. Barter and its drawbacks
A barter system exchanges goods directly for goods. It has serious problems:
Lack of double coincidence of wants: a weaver who wants rice must find a rice farmer who wants cloth.
Lack of a common measure of value: how many shirts equal one goat?
Indivisibility of goods: a cow can't be divided to buy a small item.
Difficulty in storing wealth: many goods perish or lose value.
Difficulty in deferred payments: future payments in goods lead to disputes over quality.
2. Functions of money
Function | Meaning | Example |
|---|---|---|
Medium of exchange | Money is accepted in exchange for goods and services; it removes the need for double coincidence | A farmer sells rice for money and uses the money to buy cloth |
Measure of value (unit of account) | The value of all goods is expressed in money | A shirt costs ₹500 and a book ₹250, so one shirt equals two books |
Store of value | Money can be saved and used later | Saving money in a bank account |
Standard of deferred payments | Future payments (loans, salaries) are expressed in money | A loan repayable in five years in rupees |
The first two are the primary functions; the last two are secondary functions.
3. Supply of money
The supply of money is the stock of money held by the public at a point of time. "Public" means households and firms; it excludes the government, the RBI and commercial banks (because money they hold is not in circulation).
M1 (narrow money) = C + DD + OD
C = currency (notes and coins) held by the public;
DD = net demand deposits with commercial banks (deposits withdrawable by cheque on demand);
OD = other deposits with the RBI (deposits of public financial institutions, foreign central banks and governments, international bodies).
M3 (broad money) = M1 + net time deposits of commercial banks. M1 is the most liquid measure; M3 is the most commonly used measure of the money supply.
4. Credit creation by commercial banks
Banks keep only a fraction of deposits as reserves and lend the rest. Borrowers spend the loan, and the money comes back to the banking system as new deposits, which are again partly lent. Each round of lending creates new deposits, so total deposits become a multiple of the initial deposit.
Legal reserve ratio (LRR): the minimum fraction of deposits banks must keep as reserves (CRR and SLR together determine this in practice).
Money multiplier = 1 ÷ LRR.
Total deposits created = Initial deposit × 1 ÷ LRR.
Credit created = Total deposits − Initial deposit.
Worked example. A person deposits ₹10,000 in a bank. The LRR is 20%.
Round | Deposits received | Reserves kept (20%) | Loans given (80%) |
|---|---|---|---|
1 | 10,000 | 2,000 | 8,000 |
2 | 8,000 | 1,600 | 6,400 |
3 | 6,400 | 1,280 | 5,120 |
… | … | … | … |
Total | 50,000 | 10,000 | 40,000 |
Money multiplier = 1 ÷ 0.2 = 5. Total deposits = 10,000 × 5 = ₹50,000. Credit created = 50,000 − 10,000 = ₹40,000.
A lower LRR gives a higher multiplier and more credit creation. If LRR were 10%, the multiplier would be 10 and total deposits ₹1,00,000.
Assumptions: all transactions go through banks (no cash leakage); the LRR is the same for all banks; borrowers are always available.
5. Functions of the central bank
The Reserve Bank of India was set up in 1935. Its functions:
Function | Meaning |
|---|---|
Bank of issue | It has the sole right to issue currency notes (except one-rupee notes and coins, issued by the Government of India). This gives uniformity and public confidence |
Banker to the government | It keeps government accounts, makes and receives payments for the government, manages public debt and advises on financial matters |
Banker's bank and supervisor | Commercial banks keep part of their reserves with it; it supervises, regulates and licenses banks |
Lender of last resort | When banks face a liquidity crisis and can't get funds elsewhere, the RBI lends to them, preventing bank failures |
Custodian of foreign exchange reserves | It holds and manages the country's foreign exchange reserves and helps stabilise the exchange rate |
Controller of credit | It regulates the volume and direction of credit through monetary policy |
6. Instruments of credit control
Quantitative instruments affect the volume of credit in the whole economy.
Instrument | Meaning | To control inflation (excess demand) | To fight deflation (deficient demand) |
|---|---|---|---|
Repo rate | Rate at which the RBI lends short-term funds to commercial banks against government securities | Raise it: borrowing from RBI becomes costlier, banks raise lending rates, credit falls | Lower it |
Reverse repo rate | Rate at which the RBI borrows from (absorbs funds from) commercial banks | Raise it: banks park more funds with RBI and lend less | Lower it |
Bank rate | Rate at which the RBI lends to banks for the long term, without collateral of government securities | Raise it | Lower it |
Open market operations (OMO) | Buying and selling government securities in the open market | Sell securities: money flows from banks and public to RBI, reducing lending capacity | Buy securities: money flows into the system |
Cash reserve ratio (CRR) | Fraction of deposits banks must keep with the RBI as cash | Raise it: less money is available for lending | Lower it |
Statutory liquidity ratio (SLR) | Fraction of deposits banks must keep with themselves in liquid assets (cash, gold, approved securities) | Raise it | Lower it |
Qualitative instruments affect the direction of credit (which sectors get it).
Instrument | Meaning |
|---|---|
Margin requirement | The difference between the value of the security offered and the loan given. Raising the margin reduces the loan available against a security (for example, against stocks of essential goods to discourage hoarding) |
Moral suasion | The RBI persuades banks, through advice, letters and meetings, to follow its policy |
Selective credit control | The RBI directs banks to give or not give credit to particular sectors |
Note. All the instruments work in one direction for inflation (making credit costlier or scarcer) and the opposite direction for deflation. Remember one rule: in inflation, raise rates and ratios and sell securities.
A reliable problem-solving routine
For a credit creation question, write money multiplier = 1 ÷ LRR, then total deposits = initial deposit × multiplier; credit = total deposits − initial deposit.
If the question gives the multiplier or total deposits, work backwards to find the LRR.
For a monetary policy question, decide whether the economy has excess demand (inflation) or deficient demand, then choose the direction for each instrument.
For functions of the RBI, match the case to the role: issuing notes, government accounts, rescuing a bank, holding forex.
Connections that matter
Income and employment determination explains excess and deficient demand, which monetary policy corrects.
Government budget is fiscal policy, the other main tool alongside monetary policy.
Balance of payments: the RBI manages foreign exchange reserves and intervenes in the exchange rate.
Common mistakes
Including deposits held by banks or the government in the money supply. Only money held by the public counts.
Calling money supply a flow. It is a stock at a point of time.
Reversing OMO. To reduce money supply, the RBI sells securities.
Mixing up CRR and SLR. CRR is kept with the RBI as cash; SLR is kept by banks in liquid assets.
Saying a higher LRR increases credit creation. It reduces it.
Revision checklist
I can explain the drawbacks of barter and the four functions of money.
I can define money supply and state the components of M1.
I can calculate the money multiplier, total deposits and credit created.
I can explain the six functions of the RBI.
I can explain each instrument of credit control and how it is used in inflation and deflation.