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What money is and why it exists, how much of it there is, how commercial banks create it out of a single deposit, and how the RBI controls the whole machine.
We drew the circular flow and then measured it. But look again at what we measured: every single arrow was a rupee payment. Factor incomes in ₹, consumption expenditure in ₹, GDP in ₹ crore.
We used money as a measuring rod for two whole chapters without ever asking what it is, where it comes from, or who decides how much of it exists. Today we open that box.
Why money had to be invented; its functions; what makes it money.
M1, M2, M3, M4 and high-powered money.
Their functions and the deposit multiplier — worked in full.
Six functions, including lender of last resort.
Quantitative and qualitative instruments.
The bridge into Chapter 4's excess and deficient demand.
Barter system — a system of exchange in which goods and services are exchanged directly for other goods and services, without the use of any medium of exchange.
A weaver with cloth wants rice. He must find a rice farmer who happens to want cloth — and wants it today, and wants roughly as much cloth as the rice is worth.
Every drawback of barter below is really the same drawback wearing different clothes: barter forces two parties to agree on everything at once — what, when, and how much. Money's entire purpose is to split one exchange into two separate half-exchanges, so that each side can be settled independently.
Drawback 1 → medium of exchange. Drawback 2 → unit of account. Drawback 3 → store of value. Drawback 4 → standard of deferred payment. Drawback 5 → divisibility, a property that follows from money being a unit of account.
If a question asks "how does money overcome the shortcomings of barter?", this pairing is the answer. Write it as a pairing, not as two separate lists.
Money — anything that is generally accepted as a medium of exchange, and which also serves as a measure of value, a store of value and a standard of deferred payment.
Note the definition is functional: money is whatever does these jobs. It has never been defined by what it is made of.
Money stores value well only if prices are stable. During high inflation money loses purchasing power steadily, and people flee into gold, land or foreign currency. A store of value is only as good as the price level behind it.
Fiat money — money issued by the order (fiat) of the government, which has no intrinsic value of its own and is not backed by any commodity. A ₹500 note is a piece of paper worth almost nothing as paper.
Legal tender — money that the law says cannot be refused in settlement of a debt. Currency notes and coins in India are legal tender.
Both fiat money and legal tender describe currency. But a cheque is neither: it is money only because the person receiving it chooses to accept it. Nobody is obliged to take your cheque. So cheques and demand deposits are money by general acceptability, not by law.
Money whose value as a commodity equals its value as money — a gold coin worth ₹5,000 containing ₹5,000 of gold. Historical; no country uses it now.
Money whose face value far exceeds its commodity value — every note and coin in your pocket, plus demand deposits created by banks.
Money supply — the total stock of money held by the public at a point of time.
High-powered money (H), also called reserve money or the monetary base — the total money created by the RBI: currency held by the public plus the cash reserves held by commercial banks.
Because every ₹1 of it can support several rupees of deposits once banks lend it out and re-lend it. It is the raw material from which the far larger money supply is manufactured. We will see exactly how in a few slides.
| Measure | Composition | Name |
|---|---|---|
| M1 | Currency with the public (notes + coins) + Demand deposits with commercial banks + Other deposits with the RBI | Narrow money · most liquid |
| M2 | M1 + Savings deposits with post office savings banks | Narrow money |
| M3 | M1 + Net time deposits with commercial banks | Broad money · aggregate monetary resources |
| M4 | M3 + Total deposits with post office savings organisations (excluding National Savings Certificates) | Broad money · least liquid |
From the following, calculate M1 and M3 (₹ crore):
| Currency with the public | 2,000 | Net time deposits with banks | 5,000 |
| Demand deposits with banks | 3,000 | Post office savings deposits | 400 |
| Other deposits with RBI | 100 | Cash held in bank vaults | 800 |
M1 = ₹5,100 crore · M3 = ₹10,100 crore.
Cash held in bank vaults (₹800 crore) is excluded from both. It is not held by the public. Post office savings deposits (₹400 crore) is also excluded — it belongs to M2 and M4, not to M1 or M3.
Commercial bank — a financial institution that accepts deposits from the public which are repayable on demand or otherwise, and lends those funds out for the purpose of earning a profit.
The most important thing a commercial bank does is not "accept deposits" or "give loans". It is creating money — and it does this as a by-product of doing both. That is the next section, and it is the heart of the chapter.
A bank receives a deposit of ₹1,000. Can it lend out ₹1,000? Can it lend more? What stops it from lending everything?
On any given day, only a small fraction of depositors come to withdraw cash. The rest of the money simply sits there. And when the bank lends, the borrower does not walk away with cash — they deposit it in a bank account and pay by cheque. The money never leaves the banking system.
Legal Reserve Ratio (LRR) — the minimum fraction of its total deposits that a commercial bank is legally required to keep as reserves.
It has two parts:
CRR (Cash Reserve Ratio) — the fraction kept as cash with the RBI;
SLR (Statutory Liquidity Ratio) — the fraction kept with itself in cash, gold or
approved government securities.
The bank does not lend out the same rupee many times. It creates a new deposit each time it makes a loan — and a deposit is money. This is why the process is called credit creation or deposit creation, not "lending".
Initial deposit ₹1,000. LRR = 20%. Watch what the banking system as a whole does with it.
| Round | Deposit received | Reserve kept (20%) | Loan given (80%) |
|---|---|---|---|
| 1 | 1,000.00 | 200.00 | 800.00 |
| 2 | 800.00 | 160.00 | 640.00 |
| 3 | 640.00 | 128.00 | 512.00 |
| 4 | 512.00 | 102.40 | 409.60 |
| 5 | 409.60 | 81.92 | 327.68 |
| ⋮ | ⋮ | ⋮ | ⋮ |
| Total | 5,000 | 1,000 | 4,000 |
The deposits form a geometric series:
1,000 + 800 + 640 + 512 + … = 1,000 × (1 + 0.8 + 0.8² + 0.8³ + …)
and the sum of that infinite series is 1 ÷ (1 − 0.8) = 5. So total deposits = 1,000 × 5 = ₹5,000.
Money multiplier — the number of times the total deposits of the banking system exceed the initial deposit; equivalently, the ratio of total money supply to high-powered money.
LRR = 20% = 0.2 ⟹ multiplier = 1 ÷ 0.2 = 5.
Total deposits = 1,000 × 5 = ₹5,000. Credit created = 5,000 − 1,000 = ₹4,000.
A lower LRR. If LRR fell to 10%, the multiplier would be 10 and total deposits ₹10,000 from the same ₹1,000.
A higher LRR. At LRR = 50% the multiplier is only 2. Multiplier and LRR move in opposite directions — this is exactly the lever the RBI pulls with the CRR.
(a) The total deposits of a banking system are ₹8,000 crore and the legal reserve ratio is 25%. Find the initial deposit and the total credit created.
(b) If the RBI now raises the LRR to 40% while the initial deposit is unchanged, find the new total deposits. Comment.
Raising the LRR from 25% to 40% cut the multiplier from 4 to 2.5, and so cut the money supply the same ₹2,000 crore of cash can support from ₹8,000 crore to ₹5,000 crore. The RBI changed the money supply by ₹3,000 crore without printing or destroying a single note.
"Commercial banks create money out of nothing." Is that fair?
Partly. Banks certainly create deposit money — the ₹4,000 crore of new deposits in our example did not exist before. But they cannot do it out of nothing: they need an initial injection of high-powered money from the RBI to start the process, and the LRR caps how far it can go. They multiply money; they do not conjure it. And every new deposit they create is matched by a new loan — an equal liability of somebody else.
Central bank — the apex institution of a country's monetary and banking system, which controls the supply of money and credit and regulates the banking system in the national interest. In India: the Reserve Bank of India, established in 1935.
A commercial bank exists to make a profit. A central bank exists to serve the public interest — and it does not deal with the general public at all.
Lender of last resort — the central bank's role of providing funds to a commercial bank that is solvent but temporarily short of liquidity, when no other lender will.
A bank has ₹1,000 crore of good loans outstanding but only ₹20 crore of cash. A rumour spreads and depositors queue up. The loans are sound but cannot be called back today. Without a lender of last resort the bank fails — even though it was never insolvent — and the panic spreads to healthy banks.
Banking works only because banks lend out most of what is deposited. That is precisely why no bank can ever repay all its depositors at once. The system is therefore stable only if confidence holds — and the lender of last resort exists to make confidence rational.
Monetary policy — the policy of the central bank concerning the supply of money and the cost and availability of credit, used to achieve macroeconomic objectives such as price stability and growth.
Affect the total volume of credit in the economy. General, impersonal, apply to all sectors alike.
Bank rate · Repo rate · Reverse repo rate · CRR · SLR · Open market operations
Affect the direction and use of credit — which sectors get it. Selective and discriminating.
Margin requirement · Moral suasion · Selective credit controls · Rationing of credit
To reduce the money supply (fight inflation / excess demand): make credit
costlier and scarcer → raise every rate and ratio, sell securities.
To increase it (fight deflation / deficient demand): make credit cheaper and more
plentiful → lower every rate and ratio, buy securities.
You do not need to memorise the direction of each instrument separately. Everything moves together.
| Instrument | What it is | To fight inflation (excess demand) |
|---|---|---|
| Repo rate | The rate at which the RBI lends short-term to commercial banks against government securities | Raise it → banks' borrowing costs rise → they charge more → less borrowing → money supply falls |
| Reverse repo rate | The rate at which the RBI borrows from commercial banks (banks park surplus funds with the RBI) | Raise it → parking money with the RBI becomes more attractive than lending it → less credit |
| Bank rate | The rate at which the RBI lends to commercial banks long-term, without collateral | Raise it → same effect as the repo rate, at longer maturities |
| CRR Cash Reserve Ratio | The % of total deposits banks must keep as cash with the RBI | Raise it → less left to lend, and the money multiplier falls → money supply falls |
| SLR Statutory Liquidity Ratio | The % of deposits banks must keep with themselves in cash, gold or approved securities | Raise it → same effect: less available to lend |
| Open market operations | The RBI's buying and selling of government securities in the open market | Sell securities → the public pays the RBI → cash drains out of the banking system → money supply falls |
The gap between the value of the security pledged and the amount lent against it. If a borrower pledges ₹1,00,000 of shares and the margin is 30%, the bank may lend only ₹70,000.
Raise the margin → less credit against the same collateral. Can be set differently for different sectors — a high margin on speculative commodity lending, a low one on farm loans.
Persuasion, advice and pressure — letters, meetings, informal requests from the RBI to banks to restrain or expand lending in particular directions.
Carries no legal force; it works on the banks' need to stay in the regulator's good books.
Direct instructions to banks to restrict credit to specified uses (hoarding of foodgrains, speculation in shares) or to direct it to priority sectors (agriculture, small industry, exports).
Fixing ceilings on the amount of credit a bank may extend to a particular sector or borrower.
Quantitative tools change how much credit there is and hit all sectors alike. Qualitative tools change who gets it, leaving the total roughly unchanged. An exam answer that says "margin requirement reduces the money supply" has missed the point.
These figures change several times a year and are not examinable. They are here so the concepts have something concrete attached. Always check rbi.org.in before quoting a rate, and always state the date it belongs to.
| Rate / ratio | Level | As at |
|---|---|---|
| Repo rate | 5.50% | RBI Monetary Policy, June 2025 (after cuts from 6.50% during 2025) |
| Cash Reserve Ratio (CRR) | 3% | reduced in phases from 4% during late 2025 |
| Statutory Liquidity Ratio (SLR) | 18% | unchanged since 2020 |
Rates being cut and the CRR being reduced is an easy (expansionary) monetary policy: the RBI is trying to make credit cheaper and more plentiful to support demand and growth. Rates being raised would signal a tight (contractionary) stance aimed at inflation. Read any policy announcement by asking only: which way, and why?
The economy is facing rising inflation. Suggest three monetary measures the RBI could take, and explain the chain of reasoning for each — from the instrument to the price level.
A fourth, qualitative, measure: raise the margin requirement on loans against goods being hoarded, to squeeze speculative demand specifically.
Do not stop at "raise the repo rate". The marks are in the chain: instrument → cost/availability of credit → borrowing → aggregate demand → price level. Write all four links every time.
The RBI creates a small amount of high-powered money; commercial banks multiply it into a much larger money supply; and the RBI controls the size of that multiplication — and hence total spending — through the LRR and the price of credit.
What are the main functions of money? How does money overcome the shortcomings of a barter system?
A fifth function, transfer of value, lets purchasing power be moved easily between people and places.
What is High Powered Money? What is the money multiplier and what determines its value?
High-powered money is the money created by the RBI — currency held by the public plus the cash reserves of commercial banks. It is the base on which the money supply is built, hence "high-powered".
The money multiplier is the ratio of total money supply to high-powered money — the number of times total deposits exceed the initial deposit. It equals 1 ÷ LRR. Its value is therefore determined by the legal reserve ratio: the lower the LRR, the larger the multiplier. In practice it is also reduced by the public's preference for holding cash rather than deposits, and by banks holding excess reserves.
Do you consider a commercial bank a "creator of money" in the economy?
Yes. A commercial bank does not create currency, but it creates deposits, and demand deposits are money. Because only a fraction of deposits (the LRR) needs to be held as reserve, a bank lends out the rest; the borrower's spending returns to the banking system as a fresh deposit; and the process repeats. Starting from an initial deposit of ₹1,000 with an LRR of 20%, the system ends with total deposits of ₹5,000 — ₹4,000 of newly created money — although the cash reserves are still only ₹1,000.
The qualification worth adding: banks can only multiply the high-powered money the RBI supplies, and the RBI caps the multiplication through the LRR.
What role of the RBI is known as "lender of last resort"?
When a commercial bank is solvent — its assets are sound — but faces a temporary shortage of cash, and can raise funds from no other source, the RBI lends to it against approved securities. This prevents an otherwise healthy bank from collapsing merely because it cannot convert its long-term loans into cash quickly, and stops the loss of confidence spreading to other banks. It is called "of last resort" because the RBI is approached only after every other avenue has failed.
We know what the flow is made of. Now: what fixes its size?
You have just seen the RBI raise or lower the money supply to fight inflation or a slump. But why does more credit raise output, and why does an economy sit below full employment in the first place? Chapter 4 is Keynes's answer, in a diagram and a schedule — and it is where every instrument you just learned finally gets its justification.