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CBSE Class 12 Economics★ 6-10 marks · CBSE Class 12 Economics (Introductory Macroeconomics) Chapter 3

Money and Banking

What is MONEY — and who CREATES it? This chapter explains the functions of money, the money supply measures (M1, M2, M3, M4), the role of the RBI in controlling money supply, and how COMMERCIAL BANKS CREATE money through the credit multiplier. CBSE Class 12 Economics (Introductory Macroeconomics) Chapter 3.

⏱ 20 min readMedium difficulty✓ Free · NCERT-aligned

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By the end of this chapter you'll be able to…

1Explain the four functions of money and how money evolved from barter (overcoming the double coincidence of wants problem)
2Distinguish between M1, M2, M3, and M4 measures of money supply
3Describe the functions of the Reserve Bank of India (RBI) as the central bank
4Explain how the RBI controls money supply using repo rate, CRR, SLR, and open market operations
5Explain the process of credit creation by commercial banks and calculate the money multiplier

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Why this chapter matters

Money and Banking generates some of the most reliable exam questions in Class 12 Economics: the credit multiplier formula (1/CRR), money supply measures (M1 vs M3), and RBI's monetary policy tools (repo rate, CRR, SLR, OMO). Numericals on the credit multiplier appear almost every year.

Before you start — revise these

A 5-minute refresher here will save you 30 minutes of confusion below.

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Money and Banking

"Money is a matter of functions four: a medium, a measure, a standard, a store."

1. Chapter Overview

Money is the LIFEBLOOD of an economy. This chapter covers: what money IS (its functions), how it's MEASURED (money supply: M1, M2, M3, M4), the role of the CENTRAL BANK (RBI) in controlling money supply through repo rate, CRR, SLR, and open market operations, and how COMMERCIAL BANKS CREATE MONEY through the credit multiplier process.

2. Money — Definition and Functions

Functions of Money

Function	Meaning
Medium of Exchange	Money is ACCEPTED as payment for goods and services. Solves the 'double coincidence of wants' problem of barter.
Measure of Value / Unit of Account	All goods and services are PRICED in money. 'What is a haircut worth in terms of bread? Money answers this.'
Store of Value	Money can be SAVED and used LATER. (NOT perfect — inflation erodes value.)
Standard of Deferred Payment	Debts and future payments are denominated in money.

3. Money Supply — How Much Money Is There?

The RBI publishes FOUR measures of money supply:

Measure	What It Includes
M1	Currency with the public + Demand deposits (current/savings accounts) + Other deposits with RBI. 'NARROW MONEY.'
M2	M1 + Savings deposits with Post Office savings banks
M3	M1 + Net TIME DEPOSITS with commercial banks. 'BROAD MONEY.' The MOST commonly used measure.
M4	M3 + Total deposits with Post Office savings organisations

4. The Central Bank — Reserve Bank of India (RBI)

Functions

Issues currency (except one-rupee note — Ministry of Finance)
Banker to the government: Manages government's accounts. Handles borrowing.
Bankers' bank: Commercial banks hold accounts with RBI.
Controller of money supply and credit: Uses MONETARY POLICY tools.
Custodian of foreign exchange reserves.

Monetary Policy Tools (Quantitative)

Tool	What It Is	How It Works
Repo Rate	Rate at which RBI LENDS to commercial banks	INCREASE repo rate → costlier for banks to borrow → banks lend LESS → money supply CONTRACTS. DECREASE → opposite.
Reverse Repo Rate	Rate at which RBI BORROWS from commercial banks
CRR (Cash Reserve Ratio)	% of deposits banks MUST keep with RBI	INCREASE CRR → less money for banks to lend → money supply CONTRACTS
SLR (Statutory Liquidity Ratio)	% of deposits banks MUST keep in liquid assets (cash, gold, govt securities)
Open Market Operations (OMO)	RBI BUYS or SELLS government securities	RBI BUYS securities → releases money into the banking system → money supply EXPANDS

5. How Commercial Banks Create Money — The Credit Multiplier

Banks don't just LEND depositors' money. They CREATE money through the lending process.
Suppose: CRR = 10%. Someone deposits ₹1,000. Bank keeps ₹100 (CRR). Lends ₹900. The ₹900 is deposited in another bank → ₹81 kept, ₹810 lent. The process CONTINUES.
Money Multiplier = 1 / CRR. With CRR = 10%: multiplier = 10. Initial deposit of ₹1,000 → total money created = ₹10,000.
'Banks create money by lending. The central bank controls how MUCH they create — through CRR, repo rate, and OMO.'

6. Exam Focus

Functions of money — 4 (medium, measure, store, standard of deferred payment)
Money supply measures — M1, M2, M3, M4. M3 = 'Broad Money.'
RBI functions — 5. Monetary policy tools: repo rate, reverse repo, CRR, SLR, OMO.
Money/credit multiplier — 1/CRR. How banks create money.

7. Conclusion

Money is what makes modern economies POSSIBLE:

FUNCTIONS: Medium of exchange. Measure of value. Store. Standard.
SUPPLY: M1 (narrow) to M4 (broad). RBI publishes.
RBI: Controls the quantity and cost of money through repo, CRR, OMO. 'The RBI's most important job: keep inflation low while supporting growth.'
BANKS: Create money through lending. The multiplier amplifies — and the central bank controls the amplification.

'Money is a social convention. It works because we ALL agree it works. The central bank's job is to make sure that agreement holds.'

Key formulas & results

Everything you need to memorise, in one card. Screenshot this for revision.

Four Functions of Money

1. MEDIUM OF EXCHANGE: Money is universally accepted in exchange for goods/services. Solves the barter problem of DOUBLE COINCIDENCE OF WANTS (under barter, you need someone who wants what you have AND has what you want). 2. MEASURE OF VALUE / UNIT OF ACCOUNT: All goods priced in money. Enables price comparison. 3. STORE OF VALUE: Money can be saved and used later. (Limitation: inflation erodes real value.) 4. STANDARD OF DEFERRED PAYMENT: Future payments (loans, EMIs) denominated in money.

Classic MCQ: 'Solving the double coincidence of wants' is the MEDIUM OF EXCHANGE function — not 'store of value.' Also tested: 'Money is an imperfect store of value because…' (Answer: inflation erodes its purchasing power).

Money Supply Measures (M1 to M4)

M1 (NARROW MONEY) = Currency with the public + Demand deposits with commercial banks (savings/current accounts) + Other deposits with RBI. M2 = M1 + Savings deposits with Post Office savings banks. M3 (BROAD MONEY) = M1 + Net time deposits (fixed deposits) with commercial banks. M4 = M3 + Total deposits with Post Office savings organisations (excluding NSCs). LIQUIDITY ORDER: M1 > M2 > M3 > M4 (M1 is most liquid; M4 is least).

M3 is the most important for the exam — it is called BROAD MONEY and is the measure RBI focuses on for policy. M1 = most liquid (can be used immediately). Fixed deposits (time deposits) are less liquid — hence M3 > M1.

RBI's Monetary Policy Tools

REPO RATE: Rate at which RBI lends to commercial banks (short-term, overnight, against collateral). INCREASE repo → costlier for banks to borrow → banks lend LESS → money supply FALLS (contractionary). DECREASE repo → cheaper → banks lend MORE → money supply RISES (expansionary). REVERSE REPO RATE: Rate at which RBI BORROWS from commercial banks. Higher reverse repo → banks prefer to park funds with RBI → money supply CONTRACTS. CRR (Cash Reserve Ratio): % of NET DEMAND AND TIME LIABILITIES (NDTL) that banks must keep with RBI in CASH. SLR (Statutory Liquidity Ratio): % of NDTL banks must keep in LIQUID ASSETS (cash, gold, approved govt securities). OPEN MARKET OPERATIONS (OMO): RBI BUYS govt securities from banks → pays banks → bank reserves increase → money supply EXPANDS. RBI SELLS → withdraws money → money supply CONTRACTS.

Repo rate as of 2026: ~6.5% (varies). India's CRR: ~4.5%. SLR: ~18%. Knowing current approximate values can score extra marks in 'apply to current scenario' questions.

Credit Multiplier Formula

When a bank receives a deposit, it keeps a fraction (CRR) and lends the rest. The borrower spends → deposited in another bank → that bank keeps CRR fraction and lends the rest → cycle continues. TOTAL DEPOSITS CREATED = Initial Deposit × (1/CRR). MONEY MULTIPLIER = 1/CRR. Example: CRR = 10% = 0.10. Initial deposit = ₹1,000. Total money created = ₹1,000 × (1/0.10) = ₹1,000 × 10 = ₹10,000.

The multiplier assumes: ALL lent money is REDEPOSITED into the banking system (no cash leakage), and banks lend out ALL excess reserves. In reality, the multiplier is smaller. Higher CRR → LOWER multiplier (banks must keep more → lend less). Lower CRR → HIGHER multiplier.

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Common mistakes & fixes

These are the exact errors that cost students marks in board exams. Read them once, save yourself the trouble.

WATCH OUT

✗ Saying the one-rupee note is issued by the RBI

✓ The ONE-RUPEE NOTE (and coins) is issued by the MINISTRY OF FINANCE (Government of India). ALL OTHER CURRENCY NOTES are issued by the RBI. On every note above ₹1, the Governor of the RBI signs. On the one-rupee note, the Finance Secretary signs.

WATCH OUT

✗ Confusing repo rate with reverse repo rate

✓ REPO RATE: RBI LENDS to banks (at the repo rate). Think: 'repo = repurchase — banks sell securities to RBI and repurchase them later.' REVERSE REPO RATE: RBI BORROWS from banks (banks lend to RBI). Repo rate > Reverse repo rate always (otherwise banks would prefer reverse repo over repo). When media says 'RBI raised rates', it means the REPO RATE went up.

WATCH OUT

✗ Saying higher CRR leads to MORE money creation

✓ Higher CRR means banks must KEEP MORE with RBI → they have LESS to lend → LESS money is created → the multiplier FALLS. Money Multiplier = 1/CRR. Higher CRR → smaller multiplier → less money creation. Example: CRR = 10%, multiplier = 10. CRR = 20%, multiplier = 5. The RBI RAISES CRR to REDUCE money supply (contractionary monetary policy).

NCERT exercises (with solutions)

Every NCERT exercise from this chapter — what it covers and how many questions to expect.

Ex s (Ch. 3)

Exercises (Ch. 3)

Questions on: functions of money, money supply measures (which items are in M1 vs M3), RBI functions, monetary policy tool effects, and the credit creation process with numerical

Questions

Practice problems

Try each one yourself before tapping "Show solution". Active recall > rereading.

Q1EASY· credit-multiplier

Suppose the Cash Reserve Ratio (CRR) is 5% and someone deposits ₹2,000 in a bank. Calculate: (i) The total deposit that can be created in the banking system. (ii) The money multiplier.

▶ Show solution

(i) Money Multiplier = 1 / CRR = 1 / 0.05 = 20. Total deposits created = Initial Deposit × Money Multiplier = ₹2,000 × 20 = ₹40,000. (ii) Money Multiplier = 1 / CRR = 1 / 0.05 = 20. INTERPRETATION: An initial deposit of ₹2,000 can lead to ₹40,000 of total deposits through the banking system's process of lending and re-depositing — i.e., the banking system can create ₹38,000 of additional money from the initial ₹2,000 deposit.

Q2MEDIUM· monetary-policy-tools

Explain how the RBI can use (a) the repo rate and (b) open market operations to control inflation.

▶ Show solution

CONTEXT — CONTROLLING INFLATION: Inflation means the general price level is rising, often because too much money is chasing too few goods. The RBI's goal is to REDUCE MONEY SUPPLY (contractionary monetary policy). (a) REPO RATE: The repo rate is the rate at which the RBI lends money to commercial banks. To control inflation, RBI INCREASES the repo rate. Effect: Commercial banks face HIGHER BORROWING COSTS from the RBI. They pass this on by RAISING LENDING RATES for consumers and firms. At higher interest rates: (1) Borrowing becomes MORE EXPENSIVE → households and firms take fewer loans. (2) Consumption and investment FALL. (3) This REDUCES Aggregate Demand → puts downward pressure on prices. Mechanism: ↑ Repo Rate → ↑ Bank Lending Rates → ↓ Borrowing → ↓ AD → ↓ Inflation. (b) OPEN MARKET OPERATIONS (OMO): The RBI SELLS government securities to commercial banks in the open market. Effect: Banks pay the RBI for these securities → money FLOWS OUT of banks and INTO the RBI → banks have LESS MONEY to lend. With less money available, banks must REDUCE lending → money supply CONTRACTS → AD falls → inflation is controlled. Mechanism: RBI sells securities → banks' reserves fall → lending capacity falls → money supply falls → AD falls → ↓ inflation. Both tools work through the SAME channel: reducing the money supply, which reduces aggregate demand, which controls inflation.

Q3HARD· long-answer

Explain the process by which commercial banks create credit. What are the limitations of the credit creation process?

▶ Show solution

THE PROCESS OF CREDIT CREATION: Commercial banks create CREDIT (new deposits) through the process of lending and re-depositing. This is not magic — it is the LOGICAL CONSEQUENCE of banks keeping only a FRACTION of deposits in reserve. STEP-BY-STEP (with CRR = 10%): Suppose an initial deposit of ₹1,000 is made in Bank A. ROUND 1 — Bank A: Keeps ₹100 (10% CRR) with RBI. Lends ₹900 to a borrower. The borrower spends ₹900 on goods → the seller deposits ₹900 in Bank B. ROUND 2 — Bank B: Keeps ₹90 (10% of ₹900). Lends ₹810. The ₹810 is deposited in Bank C. ROUND 3 — Bank C: Keeps ₹81. Lends ₹729. The process continues infinitely, with each round creating smaller and smaller deposits. TOTAL DEPOSITS CREATED: Sum = ₹1,000 + ₹900 + ₹810 + ₹729 + ... = ₹1,000 × (1/0.10) = ₹1,000 × 10 = ₹10,000. Money Multiplier = 1/CRR = 1/0.10 = 10. Of the ₹10,000 total, ₹1,000 was the original deposit — the banks have CREATED ₹9,000 of NEW deposits through lending. HOW BANKS CREATE CREDIT: Note that banks do not physically print money — they create PURCHASING POWER by making loans that become deposits. A bank loan creates a deposit (asset for the borrower, liability for the bank) — which can then be lent again. WHY THE RBI CAN CONTROL THIS: By changing the CRR, the RBI changes the multiplier. CRR 10% → multiplier 10. CRR 20% → multiplier 5. Raising CRR reduces credit creation; lowering CRR increases it. LIMITATIONS OF THE CREDIT CREATION PROCESS: (1) CASH LEAKAGE: The model assumes ALL lent money is redeposited into the banking system. In reality, some people hold CASH — every ₹100 held as cash rather than deposited reduces the multiplier. (2) EXCESS RESERVES: Banks may choose to hold more than the minimum CRR (during recessions, banks become risk-averse and hold excess reserves rather than lending). This reduces the multiplier below the theoretical maximum. (3) DEMAND FOR LOANS: Credit creation requires willing BORROWERS. During a recession, even if banks are willing to lend, firms and consumers may not want to borrow (fear, low confidence). The RBI can make credit AVAILABLE (lower rates) but cannot FORCE banks to lend or people to borrow. (4) RBI CONTROLS: The CRR is set by the RBI — banks cannot exceed the maximum multiplier the CRR implies.

5-minute revision

The whole chapter, distilled. Read this the night before the exam.

•Functions of money: Medium of exchange (solves double coincidence), measure of value, store of value, standard of deferred payment
•Barter's problem: DOUBLE COINCIDENCE OF WANTS. Money solves this.
•M1 (narrow money) = Currency + demand deposits + other deposits with RBI
•M3 (broad money) = M1 + time deposits with commercial banks — the KEY policy measure
•RBI functions: issues currency (not ₹1 coin/note), banker to govt, bankers' bank, monetary policy, forex custodian
•Repo rate: RBI lends to banks. Increase → banks lend less → money supply falls
•CRR: % of deposits kept with RBI as cash. Increase → less lending → money supply falls
•SLR: % of deposits in liquid assets. Increase → less lending → money supply falls
•OMO: RBI buys securities → money supply rises (expansionary). Sells → falls (contractionary)
•Money Multiplier = 1/CRR. Higher CRR → LOWER multiplier → LESS money creation

CBSE marks blueprint

Where the marks come from in this chapter — so you can plan your prep.

Typical chapter weightage: 6-10 marks

Question type	Marks each	Typical count	What it tests
Numerical (credit multiplier)	3	1	Given initial deposit and CRR, calculate total money created; or given multiplier, find CRR
Short Answer	3	1	RBI monetary policy tools; functions of money; M1 vs M3; who issues currency
Long Answer	6	occasionally	Credit creation process with example; role of the RBI; monetary policy response to inflation/unemployment

Prep strategy

Memorise: Money Multiplier = 1/CRR; Total Deposits Created = Initial Deposit / CRR. These are the ONLY two formulas you need for the numerical.
Know WHICH DIRECTION each tool pushes money supply: Raise repo/CRR/SLR, or sell securities → REDUCE money supply (contractionary). Lower repo/CRR/SLR, or buy securities → INCREASE money supply (expansionary).
For M1 vs M3: M3 includes TIME DEPOSITS (fixed deposits) in addition to M1. M3 is called 'Broad Money' and is the policy target of the RBI. Know that M3 > M1 because it includes less-liquid deposits.

Where this shows up in the real world

This chapter isn't just an exam topic — it lives in the world around you.

RBI's Monetary Policy Decisions in 2025-26

The RBI's Monetary Policy Committee (MPC) meets every two months and decides whether to raise, hold, or lower the repo rate. In 2024-25, facing post-COVID inflation, the RBI raised the repo rate from 4% to 6.5% over two years — reducing money supply and cooling inflation (exactly the mechanism described in this chapter). Following every MPC meeting, news reports explain the decision in exactly the terms of this chapter: repo rate, CRR, SLR, and their effects on bank lending and money supply.

Exam strategy

Battle-tested tips from teachers and toppers for this chapter.

For 'explain the credit creation process': ALWAYS give a numerical example with a specific CRR (say 10%) and a specific initial deposit (say ₹1,000) — show at least 3 rounds of deposit/lending, then state the final multiplier formula. Verbal explanation without numbers scores poorly.
For monetary policy questions: always state the OBJECTIVE first (inflation → contractionary; unemployment/recession → expansionary), THEN the tool, THEN the mechanism. Structure: Objective → Tool → Effect on banks → Effect on lending → Effect on AD → Effect on prices/output.

Going beyond the textbook

For olympiad aspirants and curious learners — topics that build on this chapter.

Read about India's payment revolution: UPI (Unified Payments Interface, launched 2016) has dramatically changed which liabilities count as 'money' in the M1 sense — digital wallets, BBPS payments, and instant bank transfers have made money MUCH more liquid. Research how the RBI monitors M3 in an era of digital payments
Study the 2016 demonetisation decision: when ₹500 and ₹1,000 notes were withdrawn overnight, M1 collapsed (currency with public fell drastically) — a real-world experiment in what happens when you suddenly remove the 'medium of exchange' function of money from an economy

Where else this chapter is tested

CBSE board isn't the only one — other exams test this chapter too.

CBSE Class 12 Board (Economics)High

CUET (Economics)High

UPSC GS III (Monetary Policy / RBI)High

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Questions students ask

The real ones — pulled from the Q&A community and tutor sessions.

CRR (Cash Reserve Ratio): Banks must keep a specified % of their Net Demand and Time Liabilities (NDTL) with the RBI in the form of CASH BALANCES. This money earns no interest. SLR (Statutory Liquidity Ratio): Banks must maintain a specified % of NDTL in LIQUID ASSETS — which can include cash, gold, or approved government securities. Banks can earn interest on the government securities they hold for SLR. Both tools reduce the money available for lending (contractionary if raised), but SLR is broader in what qualifies as liquid assets.

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