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Money and Banking

NCERT Class 12 · Economics Based on NCERT Class 12 Economics textbook · Free CBSE study kit

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Chapter Notes

Overview
This chapter explains the concept of money, its functions, and how it facilitates economic exchanges by overcoming the drawbacks of the barter system. It delves into the demand for money (transaction and speculative motives) and the supply of money, focusing on the role of the central bank (RBI) and commercial banks in money creation. The one big idea a student must walk away with is that commercial banks create money through the process of credit creation, which is limited by the reserve ratio set by the central bank, and that the central bank uses various policy tools to control the money supply in the economy.
Key Concepts (28)
Money
Money is the commonly accepted medium of exchange.
e.g. Using a ₹500 note to buy groceries from a shop.
Barter Exchange
Economic exchanges without the mediation of money are referred to as barter exchanges.
e.g. A farmer exchanging a sack of rice directly for a pair of shoes from a cobbler.
Double Coincidence of Wants
The improbable situation where a person who has a surplus of a good finds another person who has a surplus of the good he wants and also wants the good he has to offer.
e.g. A person with surplus rice wanting clothes must find someone who has surplus clothes and wants rice.
Medium of Exchange
The first and foremost role of money, acting as an intermediate good acceptable to both parties in a transaction.
e.g. A seller accepts money for goods, and the buyer uses that same money to purchase other goods.
Unit of Account
Money acts as a convenient unit of account, where the value of all goods and services can be expressed in monetary units.
e.g. The price of a wristwatch is ₹500, and the price of a pencil is ₹2, allowing us to calculate relative prices.
Store of Value
Money can act as a store of value for individuals, allowing wealth to be stored for future use as it is not perishable and has low storage costs.
e.g. Selling surplus rice for money and storing that money to buy other commodities later.
Demand for Money
The demand for money tells us what makes people desire a certain amount of money, primarily for transactions and as a store of value.
e.g. A person keeps cash to buy daily necessities (transaction motive) and also holds cash as a precaution against future uncertainty.
Supply of Money
In a modern economy, money comprises cash and bank deposits, created by the central bank and the commercial banking system.
e.g. The total money supply includes currency notes, coins, and demand deposits held by the public in commercial banks.
Central Bank
A very important institution in a modern economy that issues currency, controls money supply, acts as a banker to the government, and is the custodian of foreign exchange reserves.
e.g. The Reserve Bank of India (RBI) is the central bank of India.
Commercial Banks
Institutions that accept deposits from the public and lend out part of these funds to those who want to borrow, earning profit from the 'spread' between interest rates.
e.g. State Bank of India (SBI) accepts deposits and gives home loans, crop loans, etc.
High-Powered Money (Monetary Base)
Currency issued by the central bank that can be held by the public or by commercial banks, acting as a basis for credit creation.
e.g. The ₹100 note issued by the RBI is part of high-powered money.
Reserves
Deposits which commercial banks keep with the Central bank (RBI) and its cash, kept partly as cash and partly in the form of financial instruments.
e.g. A commercial bank keeps 20% of its deposits as reserves with the RBI.
Cash Reserve Ratio (CRR)
The percentage of deposits which a bank must keep as cash reserves with the bank, as decided by the Central bank.
e.g. If CRR is 20%, a bank with deposits of ₹100 must keep ₹20 as cash reserves.
Statutory Liquidity Ratio (SLR)
The ratio of deposits which banks are required to keep in liquid form in the short term.
e.g. Banks must maintain a certain percentage of their deposits in gold, cash, or government-approved securities.
Money Multiplier
The ratio of the total money supply created by the banking system to the initial amount of reserves, calculated as 1 divided by the reserve ratio.
e.g. With a CRR of 20%, the money multiplier is 5, meaning reserves of ₹100 can create deposits of ₹500.
Open Market Operations
The buying and selling of bonds issued by the Government in the open market, entrusted to the Central bank on behalf of the Government.
e.g. When RBI buys a government bond, it pays by cheque, increasing reserves and money supply.
Bank Rate
The rate at which the Central bank gives loans to the commercial banks.
e.g. If RBI increases the bank rate, loans taken by commercial banks become more expensive, reducing money supply.
Repo Rate
The interest rate at which the central bank lends money to commercial banks through repurchase agreements (repo).
e.g. RBI conducts repo operations at various maturities like overnight, 7-day, etc.
Reverse Repo Rate
The rate at which the central bank borrows money from commercial banks through reverse repurchase agreements (reverse repo).
e.g. RBI sells securities with an agreement to repurchase them at a specified date and price.
Lender of Last Resort
The role of the Central bank of being ready to lend to banks at all times when they need funds.
e.g. When commercial banks face a shortage of funds, they can borrow from the RBI.
Fiat Money
Currency notes and coins that do not have intrinsic value like gold or silver coins, but are accepted as money because of the guarantee provided by the issuing authority.
e.g. A ₹100 note has negligible paper value but is accepted because the RBI guarantees its purchasing power.
Legal Tender
Currency notes and coins that cannot be refused by any citizen of the country for settlement of any kind of transaction.
e.g. A shopkeeper cannot refuse to accept a ₹500 note as payment for goods.
Demand Deposits
Deposits in savings or current accounts that are payable by the bank on demand from the account-holder, and cheques drawn on these are used to settle transactions.
e.g. A person can write a cheque from their savings account to pay for a house purchase.
Narrow Money (M1 and M2)
Measures of money supply that are most liquid and easiest for transactions, including currency and demand deposits.
e.g. M1 = CU (currency) + DD (net demand deposits).
Broad Money (M3 and M4)
Measures of money supply that are less liquid than narrow money, including time deposits of commercial banks.
e.g. M3 = M1 + Net time deposits of commercial banks, also known as aggregate monetary resources.
Liquidity Trap
A situation where the market rate of interest is so low that everyone expects it to rise in future, causing capital losses, so nobody wishes to hold bonds and everyone holds wealth in money balance.
e.g. When the interest rate is at rmin, the speculative demand for money becomes infinitely elastic.
Velocity of Circulation of Money
The number of times a unit of money changes hands during the unit period.
e.g. In a two-person economy, if money worth ₹100 is used for transactions worth ₹200 per month, the velocity is 2.
Demonetisation
A government initiative where old currency notes of certain denominations are no longer legal tender, aimed at tackling corruption, black money, and fake currency.
e.g. In November 2016, old ₹500 and ₹1000 notes were demonetised in India.
Formulas & Equations (8)
Money Multiplier = 1 / Reserve Ratio (CRR)
Reads as: Money multiplier equals one divided by the reserve ratio.
Variables: Reserve Ratio (CRR) is the percentage of deposits a bank must keep as cash reserves (e.g., 0.2 for 20%).
Use when: Use this to calculate the maximum amount of deposits that can be created from a given amount of reserves.
⚠ Students often forget that the reserve ratio must be expressed as a decimal (e.g., 20% as 0.2) and not as a whole number (20).
Total Deposits Created = Initial Reserves × Money Multiplier
Reads as: Total deposits created equals initial reserves multiplied by the money multiplier.
Variables: Initial Reserves is the amount of high-powered money (e.g., ₹100), Money Multiplier is 1/CRR.
Use when: Use this to find the total money supply after the credit creation process.
⚠ Students sometimes add the initial reserves to the deposits created instead of multiplying.
Md_T = k.T
Reads as: Transaction demand for money equals k times total value of nominal transactions.
Variables: Md_T is transaction demand for money, k is a positive fraction, T is total value of nominal transactions over unit period.
Use when: Use this to express the transaction demand for money as a fraction of total transactions.
⚠ Students confuse T with real GDP instead of nominal value of all transactions.
v.Md_T = T
Reads as: Velocity times money demand equals total value of transactions.
Variables: v is velocity of circulation (number of times money changes hands), Md_T is transaction demand for money, T is total value of transactions.
Use when: Use this to relate the stock of money to the flow of transactions.
⚠ Students forget that v = 1/k and treat v as a constant without understanding its derivation.
Md_T = kPY
Reads as: Transaction demand for money equals k times price level times real GDP.
Variables: k is a positive fraction, P is general price level (GDP deflator), Y is real GDP.
Use when: Use this to show that transaction demand for money is positively related to nominal GDP.
⚠ Students often omit P and write Md_T = kY, forgetting that it is nominal income that matters.
Md_S = (r_max - r) / (r - r_min)
Reads as: Speculative demand for money equals r_max minus r divided by r minus r_min.
Variables: r is market rate of interest, r_max and r_min are upper and lower limits of r (positive constants).
Use when: Use this to show the inverse relationship between speculative demand for money and the rate of interest.
⚠ Students incorrectly write the formula as (r - r_min)/(r_max - r), which would give a positive relationship.
S = a / (1 - r) (Sum of Infinite Geometric Series)
Reads as: Sum S equals a divided by one minus r.
Variables: a is the first term, r is the common ratio (0 < r < 1).
Use when: Use this to derive the money multiplier, where a = 1 and r = 0.4 (for CRR 20%, r = 0.2? Actually, in the text, a = 1 and r = 0.4 for the example, but the derivation uses r as the common ratio, not the reserve ratio. The text says: 'In the example used for the derivation of the money multiplier, a = 1 and r = 0.4. Hence the value of the infinite series is 1/(1-0.4) = 5/3.' Wait, the text says 'a = 1 and r = 0.4' but the money multiplier example uses CRR = 20%, giving multiplier 5. There is a discrepancy. The text uses r = 0.4 for the series, but the money multiplier is 1/0.2 = 5. The series sum formula is used to derive the multiplier, but the numbers don't match. I will report as given in the text.
⚠ Students confuse the common ratio 'r' in the geometric series with the reserve ratio 'r' in the money multiplier context.
Present Value (PV) = X + Y = 10/(1 + 5/100) + (10 + 100)/(1 + 5/100)^2
Reads as: Present value equals the sum of discounted future returns.
Variables: X is present value of first year return, Y is present value of second year return, 5/100 is the market rate of interest (5%).
Use when: Use this to calculate the price of a bond in equilibrium.
⚠ Students forget to discount the principal amount along with the interest in the final year.
How It Works
Money Creation by Commercial Banks (Credit Creation)
  1. Step 1: A person deposits ₹100 in a bank. The bank now has liabilities of ₹100 (deposits) and assets of ₹100 (reserves).
  2. Step 2: The central bank sets a Cash Reserve Ratio (CRR) of 20%. The bank must keep 20% of deposits (₹20) as reserves.
  3. Step 3: The bank can lend the excess reserves of ₹80 (100 - 20) to a borrower. The borrower takes the loan and deposits it back into the bank (or pays someone who deposits it).
  4. Step 4: The bank now has total deposits of ₹180 (original ₹100 + new ₹80). It must keep 20% of ₹180 (₹36) as reserves.
  5. Step 5: The bank can lend again the excess reserves of ₹64 (100 - 36). This process repeats until total deposits reach ₹500, with reserves of ₹100.
  6. Step 6: The total money supply increases from ₹100 to ₹500, creating a money multiplier of 5.
💡 Students often forget that the initial deposit of ₹100 is also part of the money supply, and the process stops when the required reserves equal the initial reserves (₹100).
Open Market Operations (OMO)
  1. Step 1: The central bank (RBI) decides to increase or decrease money supply.
  2. Step 2: To increase money supply, RBI buys government bonds from the open market (from banks or the public).
  3. Step 3: RBI pays for the bonds by issuing a cheque, which increases the reserves of the commercial banks.
  4. Step 4: With higher reserves, banks can create more credit, increasing the overall money supply.
  5. Step 5: To decrease money supply, RBI sells government bonds in the open market. Buyers pay RBI, reducing reserves in the banking system.
  6. Step 6: With lower reserves, banks' ability to create credit is reduced, decreasing the money supply.
💡 Students often confuse buying and selling: buying bonds injects money (increases supply), selling bonds absorbs money (decreases supply).
Repo and Reverse Repo Operations
  1. Step 1: The central bank conducts repo operations to inject money into the system. It buys securities from commercial banks with an agreement to sell them back at a specified future date and price.
  2. Step 2: The interest rate at which money is lent in this way is called the repo rate.
  3. Step 3: To absorb money from the system, the central bank conducts reverse repo operations. It sells securities to commercial banks with an agreement to buy them back.
  4. Step 4: The rate at which money is withdrawn in this manner is called the reverse repo rate.
  5. Step 5: These operations are conducted at various maturities (overnight, 7-day, 14-day) and have become the main tool of monetary policy.
💡 Students often mix up repo and reverse repo: repo is when RBI lends (injects money), reverse repo is when RBI borrows (absorbs money).
Determination of Bond Price and Speculative Demand for Money
  1. Step 1: A bond promises a future stream of monetary returns (e.g., ₹10 at end of year 1, ₹110 at end of year 2).
  2. Step 2: The present value (PV) of these returns is calculated by discounting at the current market rate of interest.
  3. Step 3: In equilibrium, the price of the bond equals its present value.
  4. Step 4: If the market rate of interest rises, the present value (and hence bond price) falls. If the interest rate falls, bond price rises.
  5. Step 5: People speculate on future interest rate movements. If they expect interest rates to rise (bond prices to fall), they sell bonds and hold money (speculative demand for money increases).
  6. Step 6: If they expect interest rates to fall (bond prices to rise), they buy bonds and reduce their money holdings (speculative demand decreases).
💡 Students often think that higher interest rates make bonds more attractive, but they forget that higher rates mean lower bond prices, leading to capital losses for existing bondholders.
Liquidity Trap
  1. Step 1: The market rate of interest falls to a very low level (rmin).
  2. Step 2: Everyone expects the interest rate to rise in the future, which would cause bond prices to fall (capital losses).
  3. Step 3: No one wants to hold bonds; everyone prefers to hold money.
  4. Step 4: The speculative demand for money becomes infinitely elastic (horizontal at rmin).
  5. Step 5: Any additional money injected into the economy is held as idle cash balances, not used to buy bonds.
  6. Step 6: The interest rate cannot fall further, and monetary policy becomes ineffective in stimulating the economy.
💡 Students often think a liquidity trap means there is no money demand, but it actually means demand is infinite at that interest rate.
Exam Traps — Don't Make These Mistakes
⚠ Confusing Barter with Money Transactions
✗ In a barter system, money is used as a medium of exchange.
→ Barter exchange is defined as economic exchanges without the mediation of money. Using money contradicts the definition of barter.
✓ Barter exchange refers to economic exchanges without the mediation of money, where goods are directly exchanged for goods.
⚠ Misstating the Money Multiplier Formula
✗ Money multiplier = 1 / (1 - CRR).
→ The correct formula is Money Multiplier = 1 / CRR (where CRR is expressed as a decimal). The formula 1/(1-CRR) is for the sum of an infinite geometric series, not the money multiplier.
✓ Money multiplier = 1 / CRR. For example, if CRR is 20%, the money multiplier is 1 / 0.2 = 5.
⚠ Confusing Repo and Reverse Repo
✗ Repo rate is the rate at which RBI borrows from commercial banks.
→ Repo rate is the rate at which RBI lends to commercial banks (injects money). Reverse repo rate is the rate at which RBI borrows from commercial banks (absorbs money).
✓ Repo rate is the interest rate at which the central bank lends money to commercial banks through repurchase agreements.
⚠ Ignoring the Role of Initial Deposit in Credit Creation
✗ The bank creates money only from the loans it gives, and the initial deposit is not part of the money supply.
→ The initial deposit (e.g., ₹100) is part of the money supply (M1 = Currency + Deposits). The credit creation process increases total deposits from ₹100 to ₹500, but the initial ₹100 is included.
✓ The initial deposit of ₹100 is part of the money supply. Through the credit creation process, total deposits increase to ₹500, meaning the bank has created an additional ₹400 of money.
⚠ Misunderstanding the Speculative Demand for Money
✗ Speculative demand for money is directly related to the rate of interest.
→ Speculative demand for money is inversely related to the rate of interest. When interest rates are high, people expect them to fall, so they buy bonds (low speculative demand). When rates are low, people expect them to rise, so they hold money (high speculative demand).
✓ Speculative demand for money is inversely related to the rate of interest. As the interest rate falls, speculative demand for money increases.
⚠ Confusing Narrow Money and Broad Money
✗ M3 is narrow money and M1 is broad money.
→ M1 and M2 are narrow money (most liquid), while M3 and M4 are broad money (less liquid). M3 is the most commonly used measure of money supply.
✓ M1 and M2 are known as narrow money, while M3 and M4 are known as broad money. M3 is also known as aggregate monetary resources.
Compare & Contrast
Primary Function
Central Bank
Commercial Bank
The central bank (RBI) issues currency, controls money supply, and acts as a banker to the government and the banking system. Commercial banks accept deposits from the public and lend out funds to borrowers.
Direction of Transaction
Repo Rate
Reverse Repo Rate
Repo rate is the rate at which the central bank lends money to commercial banks (injects liquidity). Reverse repo rate is the rate at which the central bank borrows money from commercial banks (absorbs liquidity).
Motive for Holding Money
Transaction Demand for Money
Speculative Demand for Money
Transaction demand is for carrying out day-to-day transactions and is positively related to income. Speculative demand is for holding wealth in liquid form to avoid capital losses from bonds and is inversely related to the rate of interest.
Components and Liquidity
Narrow Money (M1)
Broad Money (M3)
M1 (narrow money) includes currency and demand deposits, making it the most liquid. M3 (broad money) includes M1 plus net time deposits of commercial banks, making it less liquid but a more comprehensive measure of money supply.
Exam Focus
Marks pattern: This chapter typically appears in board exams with 2-3 MCQs (1 mark each), 1 short answer question (3 marks), and 1 long answer question (5-6 marks), totaling approximately 10-12 marks.
Most asked: Functions of money · Drawbacks of barter system · Money creation by commercial banks (credit creation process) · Money multiplier · Cash Reserve Ratio (CRR) and its impact on money supply · Open Market Operations · Repo Rate and Reverse Repo Rate · Demand for money (transaction and speculative motives) · Liquidity trap
Don't skip: Explain the process of money creation by commercial banks with the help of a numerical example.; What is the money multiplier? Derive it using the reserve ratio.; Explain the various instruments of monetary policy used by the RBI to control money supply.; Distinguish between transaction demand and speculative demand for money.; Explain the concept of liquidity trap.
One-Line Revision (read aloud before the exam)
  1. Money is the commonly accepted medium of exchange that facilitates transactions by overcoming the double coincidence of wants in a barter system.
  2. The three main functions of money are medium of exchange, unit of account, and store of value.
  3. Barter exchange is the direct exchange of goods for goods without the use of money.
  4. The demand for money arises from the transaction motive and the speculative motive.
  5. Transaction demand for money is positively related to income, while speculative demand is inversely related to the rate of interest.
  6. The supply of money in India is measured as M1 (narrow money) and M3 (broad money), among others.
  7. The central bank (RBI) issues currency and controls money supply using tools like CRR, bank rate, and open market operations.
  8. Commercial banks create money through the process of credit creation, limited by the Cash Reserve Ratio (CRR).
  9. The money multiplier is the ratio of total deposits created to initial reserves, calculated as 1/CRR.
  10. Open Market Operations involve the buying and selling of government bonds by the central bank to influence money supply.
  11. Repo rate is the rate at which RBI lends to commercial banks; reverse repo rate is the rate at which RBI borrows from them.
  12. A liquidity trap occurs when the interest rate is so low that everyone expects it to rise, making the speculative demand for money infinitely elastic.
  13. Fiat money has no intrinsic value but is accepted as legal tender due to government guarantee.
  14. Demonetisation in 2016 involved the withdrawal of old ₹500 and ₹1000 notes as legal tender to curb black money.
  15. The velocity of circulation of money is the number of times a unit of money changes hands during a unit period.

MCQs — 10 Questions with Answers

Q1. In a barter system, why does the 'double coincidence of wants' problem become more severe as the economy grows larger?

  • A. Because there are fewer traders in larger economies
  • B. Because search costs increase exponentially when finding matching trading partners becomes harder ✓
  • C. Because prices cannot be calculated in a barter system
  • D. Because money supply decreases with economic growth

Answer: B — As economy size increases, the probability of finding someone with exactly what you want and who wants exactly what you have decreases dramatically, raising search costs.

Q2. If the general price level in an economy increases by 20%, what happens to the purchasing power of money?

  • A. It increases by 20%
  • B. It remains unchanged
  • C. It decreases by approximately 16.67% ✓
  • D. It decreases by exactly 20%

Answer: C — Purchasing power is inversely related to price level; if prices rise 20%, money buys 1/1.2 = 0.833 of what it did before, a loss of 16.67% of purchasing power.

Q3. Which of the following is NOT a function of money in a modern economy?

  • A. Medium of exchange
  • B. Unit of account for measuring all commodity values
  • C. Determination of production technology ✓
  • D. Store of value for preserving wealth

Answer: C — Money does not determine production technology; this is decided by firms based on input availability and costs, while money only facilitates exchange and stores value.

Q4. Why is money superior to gold jewellery as a store of value for daily use?

  • A. Because gold has no intrinsic value
  • B. Because money is non-perishable and has universal acceptability without melting costs ✓
  • C. Because gold cannot be stored safely
  • D. Because gold is only accepted in some countries

Answer: B — Money is non-perishable, has low storage costs, and is universally accepted, whereas gold requires authentication, melting, and purity verification for transactions.

Q5. The Reserve Bank of India issues currency called high-powered money. This is also known as:

  • A. Real money because it has intrinsic value
  • B. Reserve money or monetary base that forms the foundation for credit creation ✓
  • C. M3 money because it is the broadest measure
  • D. Digital money because it is stored electronically

Answer: B — High-powered money (reserve money) issued by RBI serves as the basis or foundation upon which commercial banks create credit through the money multiplier process.

Q6. When interest rates in the economy increase from 5% to 8%, how does this affect the demand for money?

  • A. Demand for money increases because people need more cash
  • B. Demand for money decreases because holding money has higher opportunity cost compared to interest-earning deposits ✓
  • C. Demand for money remains unchanged
  • D. Demand for money increases because money becomes more valuable

Answer: B — Higher interest rates increase the opportunity cost of holding non-interest-bearing money, so people shift to interest-earning bank deposits, reducing money demand.

Q7. An individual's income rises from Rs 40,000 to Rs 50,000 per month. Based on the demand for money theory, what would be the expected change?

  • A. Demand for money decreases because income increase causes inflation
  • B. Demand for money remains constant as income changes
  • C. Demand for money increases because higher income requires more cash for increased transactions ✓
  • D. Demand for money becomes negative

Answer: C — As income increases, the volume of transactions increases, necessitating a larger quantity of money to conduct these expanded economic activities.

Q8. Which statement correctly describes the relationship between commercial banks and the money supply system? (Both statements below)

  • A. Commercial banks only hold deposits and cannot create money; only central bank creates money
  • B. Both central bank and commercial banks create money — RBI through currency issue and banks through credit creation from deposits ✓
  • C. Commercial banks create money but central bank only controls inflation
  • D. Money is created only by commercial banks; RBI merely supervises them

Answer: B — In modern economies, both institutions participate in money creation: RBI issues high-powered money, and commercial banks create credit by lending deposits, expanding money supply.

Q9. Assertion: Money serves as a unit of account. Reason: This allows all commodity values to be expressed in a common metric, making price comparisons easy. Which is correct?

  • A. Assertion is true, Reason is false
  • B. Assertion is false, Reason is true
  • C. Both Assertion and Reason are true, and Reason correctly explains Assertion ✓
  • D. Both Assertion and Reason are true, but Reason does not explain Assertion

Answer: C — Money's unit of account function means all values are measured in monetary units (rupees), which directly enables easy price comparisons like pen = 5 pencils.

Q10. HOTS: If the RBI decides to increase the quantity of high-powered money in circulation, and the reserve requirement ratio is 10%, by how much would the total money supply potentially increase if all created credit is fully utilized?

  • A. By exactly 10% of the increase in high-powered money
  • B. By 1 times the increase (same as high-powered money increase)
  • C. By 10 times the increase in high-powered money through the money multiplier effect ✓
  • D. By an unpredictable amount because commercial banks may not lend all deposits

Answer: C — Money multiplier = 1/CRR = 1/0.10 = 10; therefore, if high-powered money increases by X, total money supply increases by 10X, assuming full credit utilization.

Flashcards

What is the primary function of money in an economy?

Money acts as a medium of exchange, allowing people to avoid the inefficiencies of barter by providing a universally acceptable means of transaction.

Define the double coincidence of wants problem.

In barter, both parties must want exactly what the other has to offer at the same time, which becomes increasingly difficult and costly in a large economy.

How does money function as a unit of account?

Money provides a common standard for expressing the value of all goods and services, allowing relative prices to be calculated easily (e.g., one pen = 5 pencils).

What is the relationship between price level and purchasing power of money?

When general price levels rise, the purchasing power of money deteriorates because each unit of money can buy fewer goods and services.

Why is money superior to rice as a store of value?

Money is non-perishable, has low storage costs, and is universally acceptable at any time, whereas rice spoils, requires space, and has limited acceptability.

What is 'high-powered money' issued by the central bank?

High-powered money (reserve money) is currency issued by the central bank that serves as the basis for credit creation by commercial banks.

What are the two main institutions that create money in a modern economy?

The central bank (RBI in India) issues currency, and commercial banks create credit through accepting deposits and lending.

How do interest rates affect the demand for money?

When interest rates rise, the opportunity cost of holding money increases, so people prefer to keep savings in interest-earning deposits rather than hold cash.

Why does income influence the demand for money?

Higher income leads to more transactions, so people need larger quantities of money to conduct their increased economic activity.

What is a cashless economy and which government initiative supports it in India?

A cashless economy relies on digital transactions instead of physical cash; initiatives like Jan Dhan, Aadhaar-enabled payments, and e-wallets promote this in India.

Important Board Questions

Define money and explain why the barter system becomes inefficient in a large economy. Give one reason. [2 marks]

Define money as universally accepted medium of exchange. Explain double coincidence of wants and rising search costs as economy grows. One reason is sufficient (e.g., difficulty finding matching trading partners).

Explain the four functions of money with one example for each function. Which function makes money superior to commodities like rice or gold as a store of value? [5 marks]

List four functions: (1) Medium of exchange — transactions, (2) Unit of account — price comparison, (3) Store of value — preserve wealth, (4) Standard of deferred payment — future payments. For each give one concrete example (e.g., buying groceries, comparing pen and pencil prices, saving for future, paying loan next month). For superiority: money is non-perishable, low storage cost, universally accepted compared to rice (perishable, space-consuming) or gold (needs authentication, melting costs).

Analyse how income and interest rates jointly determine the demand for money in an economy. Use a numerical example to show the combined effect of these two factors on money demand. [6 marks]

Demand for money depends on: (1) Income — higher income means more transactions, more money needed; (2) Interest rate — higher rates increase opportunity cost of holding non-interest-bearing money, so demand falls. Example: If monthly income Rs 50,000 (demands more money for Rs 5,000 in transactions) but interest rates rise from 5% to 10%, person shifts savings to deposits, reducing money holdings. Show both factors moving in opposite directions and their net effect on quantity of money an individual would want to hold.

Assertion-Reason Questions for Money and Banking

Q1. Assertion (A):

Money is necessary in an economy where multiple economic agents engage in market transactions.

Reason (R):

Without money, barter exchanges would face the problem of double coincidence of wants, making transactions extremely costly and difficult.

Answer: A — Both A and R are true, and R is the correct explanation of A — Both the assertion and reason are true, and the reason correctly explains why money is necessary. The double coincidence of wants problem and search costs in barter directly justify the need for money as a medium of exchange in multi-agent economies.

Q2. Assertion (A):

The purchasing power of money decreases when the general price level in the economy rises.

Reason (R):

A rise in price level means each unit of money can purchase fewer goods and services than before.

Answer: A — Both A and R are true, and R is the correct explanation of A — Both assertion and reason are true, and the reason correctly explains the assertion. If all prices double, the same amount of money buys half as much, demonstrating the inverse relationship between price level and money's purchasing power. No misconception here.

Q3. Assertion (A):

Commercial banks create money through the process of accepting deposits and advancing loans.

Reason (R):

When a bank lends to a borrower, the borrower receives cash drawn entirely from the bank's vault, thereby reducing the bank's money supply.

Answer: C — A is true but R is false — The assertion is true—commercial banks do create money through deposit and lending. However, the reason is false. Banks don't simply hand over existing cash from vaults. Instead, they create new money by advancing loans against deposits, expanding the monetary base through credit creation (money multiplier effect). The reason presents a barter-like misconception.

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Case-Based Questions (CBQ) for Money and Banking

Case Study:

Rajesh, a vegetable vendor in Delhi, traditionally conducted all transactions in cash. In 2023, he adopted a digital payment system using a QR code. His daily transactions increased from Rs 5,000 to Rs 8,000 because customers found digital payments convenient. However, on days with internet outages, his sales dropped significantly. Over six months, Rajesh accumulated Rs 50,000 in his Jan Dhan account. He used this accumulated amount to purchase a better vegetable cart from a supplier who also accepts digital payments.

Q1. Which function of money did Rajesh's Jan Dhan account primarily enable over the six-month period?

  • A. Medium of exchange, as digital payments allowed faster transactions
  • B. Store of value, as accumulated deposits in the account preserved purchasing power for future investment ✓
  • C. Unit of account, as the bank recorded all transactions in rupees
  • D. Standard of deferred payment, since the supplier extended credit to Rajesh

Answer: B

Q2. Why did Rajesh's sales increase when he adopted digital payments, according to the passage?

  • A. Digital payments reduce the purchasing power of money
  • B. Customers perceived digital transactions as more convenient, reducing transaction friction and increasing demand ✓
  • C. The RBI mandated all transactions to be digital
  • D. Digital payments increased the interest rate Rajesh received from his bank

Answer: B

Q3. The passage mentions that sales dropped on days with internet outages. What does this reveal about digital money's limitations?

  • A. Digital money has eliminated the need for physical currency entirely
  • B. Digital money's store of value function fails during outages
  • C. Digital money as a medium of exchange requires reliable infrastructure; without it, universal acceptability is compromised ✓
  • D. Internet outages increase the purchasing power of money

Answer: C

Q4. Rajesh's ability to purchase a vegetable cart using accumulated digital deposits demonstrates which aspect of the money supply system?

  • A. Commercial banks facilitate wealth accumulation and enable consumers to convert savings into real investments through credit and deposits ✓
  • B. The Reserve Bank must approve all purchases made by vendors
  • C. Only the government can authorize purchase of equipment
  • D. Digital money has no connection to real economic transactions

Answer: A

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Previous Year Questions (PYQ) for Money and Banking

Real CBSE board exam questions from past papers — free to attempt.

CBSE 2026 · Set 58/1/1 · 1 mark

Read the following statements: Assertion (A) and Reason (R). Assertion (A): Money is of perishable nature and is generally accepted by all at any point of time. Reason (R): Money serves as a store of value, facilitating individuals to transfer purchasing power from the present to the future. Which option is correct?

  • Both Assertion (A) and Reason (R) are true, and Reason (R) is the correct explanation of Assertion (A).
  • Both Assertion (A) and Reason (R) are true, but Reason (R) is not the correct explanation of Assertion (A).
  • Assertion (A) is true, but Reason (R) is false.
  • Assertion (A) is false, but Reason (R) is true.

CBSE 2026 · Set 58/1/1 · 1 mark

In the Indian Banking System, the Statutory Liquidity Ratio (SLR) plays a vital role in controlling the credit creation capacity of the Commercial Banks, as it __________.

  • ensures that all the deposits are converted into liquid assets.
  • requires banks to maintain a percentage of deposits in the form of liquid assets.
  • sets the maximum interest rate which the banks can charge on loans.
  • prevent banks from lending beyond a specific proportion of their total reserves.

CBSE 2026 · Set 58/1/1 · 1 mark

In an economy, the currency held by the public, Net Demand Deposits with Commercial Banks and Net Time Deposits with Commercial Banks stand at ` 1,42,000 crore, ` 22,000 crore and ` 86,000 crore respectively. The value of Money Supply (M1) would be ` __________ crore.

  • 2,50,000
  • 86,000
  • 1,64,000
  • 1,42,000

CBSE 2026 · Set 58/1/1 · 3 marks

Under the provisions stated in the Section 20 and Section 21 of the Reserve Bank of India (RBI) Act, 1934, the RBI is mandated to handle the banking operations of the Government of India. In the light of the given statement, elaborate the indicated function of the Reserve Bank of India.

CBSE 2026 · Set 58/1/2 · 1 mark

In an economy, the currency held by the public, Net Demand Deposits with Commercial Banks and Net Time Deposits with Commercial Banks stand at ₹ 1,42,000 crore, ₹ 22,000 crore and ₹ 86,000 crore respectively. The value of Money Supply (M1) would be ₹ __________ crore.

  • 2,50,000
  • 86,000
  • 1,64,000
  • 1,42,000

CBSE 2026 · Set 58/1/2 · 1 mark

Read the following statements: Assertion (A) and Reason (R). Assertion (A): Money is of perishable nature and is generally accepted by all at any point of time. Reason (R): Money serves as a store of value, facilitating individuals to transfer purchasing power from the present to the future.

  • Both Assertion (A) and Reason (R) are true, and Reason (R) is the correct explanation of Assertion (A).
  • Both Assertion (A) and Reason (R) are true, but Reason (R) is not the correct explanation of Assertion (A).
  • Assertion (A) is true, but Reason (R) is false.
  • Assertion (A) is false, but Reason (R) is true.

CBSE 2026 · Set 58/1/3 · 1 mark

Read the following statements: Assertion (A) and Reason (R). Choose the correct option from those given below: Assertion (A): Money is of perishable nature and is generally accepted by all at any point of time. Reason (R): Money serves as a store of value, facilitating individuals to transfer purchasing power from the present to the future.

  • Both Assertion (A) and Reason (R) are true, and Reason (R) is the correct explanation of Assertion (A).
  • Both Assertion (A) and Reason (R) are true, but Reason (R) is not the correct explanation of Assertion (A).
  • Assertion (A) is true, but Reason (R) is false.
  • Assertion (A) is false, but Reason (R) is true.

CBSE 2026 · Set 58/2/1 · 1 mark

Identify, that function of money, which has effectively solved the problem of 'double coincidence of wants' in a transaction.

  • Standard of deferred payments
  • Store of value
  • Measure of value
  • Medium of exchange

CBSE 2026 · Set 58/2/1 · 1 mark

Sumit deposited ` 10 lakh in his savings account. The deposits made by him is a part of ________ in the M1 measure of money supply.

  • Currency held by public
  • Interbank deposits
  • Demand deposits with commercial banks
  • Term deposits with Reserve Bank of India (RBI)

CBSE 2026 · Set 58/2/1 · 1 mark

Identify, which one of the following is not a function of Reserve Bank of India as a bank, agent and advisor to the government.

  • Carries out banking business of the government.
  • Manages national debt.
  • Advises on financial matters.
  • Conducts periodic inspections.

CBSE 2026 · Set 58/2/1 · 3 marks

"When initial deposits in the credit creation process remains same, the total amount of credit created rises as the value of money multiplier increases." Defend or refute the above statement with the help of hypothetical numerical example.

CBSE 2026 · Set 58/2/1 · 1 mark

The Reserve Bank of India (RBI) announced a 50 basis point Repo Rate cut to 5.50% from 6%.

Identify the economic issue indicated in the above text.

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Class 12 Economics Formula Sheet

Every formula from the 5 Macroeconomics chapters on one page, checked against the NCERT textbook and the CBSE 2026-27 syllabus. Free PDF download.

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Class 12 Economics Previous Year Questions, Chapter-wise

All 947 CBSE board questions from 2022–2026, sorted by chapter and question type. Free PDF download.

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