Class 12 Economics Notes

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Money and Banking Class 12 Notes

This unit introduces the medium through which the whole economy transacts. It defines money by its functions, measure of value, store of value and standard of deferred payment, then the supply of money, then the commercial banks as the creators of credit through the deposit multiplier, and finally the central bank, the lender of last resort, whose instruments control the credit created.

Class:12Subject:EconomicsUnit:2Covers:CBSE · CUET

6 Key Formulas

DWritten byDeep Narayan

UpdatedSeptember 2026

Key Concept Summary

How do commercial banks create credit?

A bank keeps only a fraction, the legal reserve ratio, of its deposits and lends the rest. A deposit of Rs. 1,000 at a 20 per cent reserve ratio lets the bank lend Rs. 800, which is deposited again and re-lent, so the same Rs. 1,000 ultimately supports deposits of Rs. 5,000, the initial deposit times the money multiplier 1 ÷ LRR. Credit is created by repeated lending of the same initial reserve.

Money — the Meaning and the Functions

Money is anything that is generally accepted as a medium of exchange. The barter exchange of goods for goods failed because it required a double coincidence of wants, a matching of needs on both sides, and the absence of a common measure of value. Money removes both problems by acting as the universal medium and the common measure.The four functions of money, three primary and one secondary, are the standard one-mark list of the unit.

Medium of exchange: accepted by everyone, it removes the double coincidence of wants of the barter system.
Measure of value: a common unit in which the value of every good is expressed, making comparison and accounting possible.
Store of value: money holds purchasing power over time, unlike perishable goods, so saving becomes possible.
Standard of deferred payment: debts and contracts are fixed in money, making borrowing and lending clean and certain.
The absence of money, barter, failed on the double coincidence of wants, the lack of a common measure, the difficulty of storing value and the indivisibility of goods.

The three-mark question is the function list with one line each

'State any three functions of money' is a guaranteed question, and the marks fall to the phrase. Medium of exchange, measure of value and store of value, each with its one-line meaning, is a complete answer. The secondary function, standard of deferred payment, upgrades the same list to a four-function answer when the question asks for all.

The Supply of Money

The money supply is the stock of money in circulation in the country at a point in time. In India the measures M1 and M3 are the standard aggregates: M1, the narrow money, and M3, the broad money, which adds time deposits with the banks.The supply of high-powered money, currency and bank reserves, is issued by the central bank; the commercial banks multiply it into the deposits of the public.

Narrow money: currency with the public plus demand deposits and other deposits

M_{1} = C + D D + O D

Broad money: narrow money plus time deposits with the banks

M_{3} = M_{1} + Time deposits

Bank money is money too

Demand deposits, the balances on which cheques are drawn, are money in the economic sense. The supply of money in M1 counts currency plus these deposits, because both are accepted as a medium of exchange. The student who answers 'money is currency' alone has missed half the measure.

The Commercial Banks

Commercial banks accept deposits from the public and advance loans. Their twin functions are the deposit function, accepting savings on demand, and the lending function, advancing loans against security. The banks earn by the margin between the interest on loans and the interest on deposits.The deposit and loan functions combine in credit creation: a deposit becomes a loan, a loan becomes a deposit elsewhere, and the same initial reserve supports a multiple of deposits, under the reserve ratio fixed by the central bank.

The primary and derivative deposit

The primary deposit is the cash first deposited; the derivative deposits are those created by the loans as they are spent and re-deposited. The exam question hands over one primary deposit and the reserve ratio, and the entire credit-multiplication answer follows from the multiplier.

Credit Creation by the Commercial Banks

A bank need not hold the whole of its deposits; it keeps the legal reserve ratio and lends the rest. The loan is spent by the borrower, and the receiver deposits the proceeds in a bank, which again keeps the reserve and lends onward. The chain multiplies the initial deposit into a total of deposits equal to the initial deposit times the reciprocal of the reserve ratio.

The multiplier is the reciprocal of the legal reserve ratio

Money multiplier = \frac{1}{LRR}

Credit created from an initial deposit at the given reserve ratio

Total deposits = Initial deposit \times \frac{1}{LRR}

Example: initial deposit Rs. 10,000, LRR 20 per cent — the bank keeps Rs. 2,000 and lends Rs. 8,000.
The Rs. 8,000 loan returns as a deposit, of which Rs. 1,600 is kept and Rs. 6,400 lent, and so on.
Total deposits converge to 10,000 × (1 ÷ 0.2) = Rs. 50,000; credit created is the deposits born from the loans.
The chain is limited by the reserve requirement: a higher LRR, a smaller multiplier.
The bank must also meet the demand for withdrawals, so the required reserves act as the brake on the whole creation.

The two figures students swap

The credit created is not the initial deposit plus the reserve requirement, but the initial deposit times the multiplier. With Rs. 10,000 and a 20 per cent ratio, the created deposits are Rs. 50,000, of which the bank itself kept Rs. 2,000 per round. Write the chain explicitly in the working, because the formula alone does not show how the loan becomes a deposit.

The Functions of the Central Bank

The central bank, the RBI in India, is the banker of the state and the apex of the banking system. Its three traditional functions are the issue of currency, the banker to the government, and the banker's bank. On these it adds the control of credit, the custodian of foreign exchange reserves and the lender of last resort.

The sole issuer of currency: the monopoly of note issue, which keeps the money supply under one control and gives confidence.
Banker to the government: salary accounts, receipts and payments of the government, and management of the public debt.
Banker's bank and lender of last resort: the commercial banks keep reserves with it and borrow from it in times of difficulty, so a bank under pressure is saved by the central bank rather than allowed to fail.
Custodian of the foreign exchange reserves: the stability of the rupee against other currencies is watched and defended.
Controller of credit: the flow of money and credit is regulated to serve growth with stability, in both inflation and depression.
Clearing house of the banking system: the settlement of inter-bank payments runs through the central bank.

The lender of last resort sentence

The phrase 'lender of last resort' is itself a mark. It means the central bank lends to the commercial banks when no one else will, at whatever rate and against the paper the banks hold, so that a run on a bank does not topple the banking system. Connect it to the reserves the banks keep with the central bank.

Quantitative Instruments of Credit Control

The central bank controls the quantity of credit with the quantitative instruments, which operate on the money supply as a whole, and the qualitative instruments, which redirect credit toward chosen sectors. The quantitative set is examined by name and by effect.

Bank rate (repo rate): the rate at which the central bank lends to the commercial banks; a rise in the bank rate raises the cost of funds and contracts credit.
CRR, cash reserve ratio: the share of deposits the banks must hold with the central bank; a rise drains lendable funds and contracts credit.
SLR, statutory liquidity ratio: the share of deposits the banks must hold in liquid assets like government securities; a rise locks up more funds from lending.
Open market operations: the sale and purchase of government securities by the central bank; the sale of securities absorbs money from the system and contracts credit.
Repo and reverse repo rates: the rates for short-term borrowing and injection of liquidity by the central bank, fine-tuned day to day.
Margin requirements: the share of the loan the borrower must finance himself; raising the margin contracts the credit for a specific purpose.
Moral suasion and selective credit controls: persuasion and the rationing of credit toward productive sectors.

The contraction sentence that sells the answer

Every quantitative instrument reduces to one effect: an increase in the bank rate, the CRR or the SLR, or a sale of securities in the open market, contracts the money supply and checks inflation; their decrease expands credit and revives a depressed economy. Give the direction, give the instrument, and state whether credit is expanded or contracted.

How the Questions Are Asked

The unit is examined through the functions, the money-supply measures, the credit-multiplier numerical and the instruments of the central bank. The numerical question on credit creation is the most dependable mark of the entire macro paper.

Define money, barter, the money supply, the legal reserve ratio and credit creation.
State the functions of money and the difficulties of barter.
Compute total deposits and credit created from an initial deposit and the LRR.
Distinguish M1 from M3, and the bank rate from the repo rate.
Name the functions of the central bank and its quantitative instruments, and state the effect of each on the money supply.
Explain the lender of last resort and the multiplier in the same answer when a question links funds to growth.

Quick Revision

Key formulas at a glance

Memorise these equations — direct application numericals and derivations in CBSE & JEE frequently hinge on these.

Narrow money

M_{1} = C + D D + O D

Currency with the public plus demand deposits and other deposits.

Broad money

M_{3} = M_{1} + Time deposits

Narrow money expanded by the time deposits of the banks.

Money multiplier

MM = \frac{1}{LRR}

The reciprocal of the legal reserve ratio.

Credit created

Total deposits = Initial deposit \times \frac{1}{LRR}

The engine of the commercial banks' credit creation.

Reserve kept by the bank

R = Initial deposit \times LRR

The fraction of each deposit the bank must hold.

Loanable surplus

Loan = Deposit \times (1 - LRR)

The part of a deposit a bank may lend onward.

Exam Strategy

How this chapter is asked

High-yield question patterns observed across CBSE boards, JEE Main & Advanced, and NEET.

Money is defined by its acceptance as a medium of exchange, and barter by its failure on the double coincidence of wants.
The four functions, medium, measure, store and standard, are a fixed list; quote all four when the question allows.
The money supply is a stock (point in time), and M1 narrows to currency plus demand deposits while M3 adds time deposits.
Credit creation always computes by initial deposit times 1 ÷ LRR; a loan becomes a deposit, which is the whole mechanism.
A rise in the bank rate, CRR or SLR contracts credit; their fall expands it — the direction is the evaluated mark.
The central bank is the sole issuer, the government's banker, the banker's bank, the lender of last resort and the controller of credit — the five functions are one question.
Repo versus bank rate: the repo is a short-term instrument on paper, the bank rate the traditional instrument on credit.
Open market operations act on the base money directly, a sale absorbing cash and a purchase injecting it.
The trap in every instrument question: say whether the measure is for inflation (contract) or reviving the economy (expand) before giving the mechanism.

FAQ

Frequently asked questions

What are the functions of money?

The primary functions are the medium of exchange, which removes the double coincidence of wants of barter, the measure of value, in which the worth of every good is expressed, and the store of value, which holds purchasing power over time. The secondary function is the standard of deferred payment, in which debts and contracts are fixed. Together they convert the awkward barter of goods into a smooth flow of exchange.

How do commercial banks create credit?

Banks keep only a fraction of their deposits, the legal reserve ratio, and lend the balance. The loan is spent, and the proceeds are deposited in a bank again, which again keeps the fraction and lends the rest. Each round deposits shrink by the reserve ratio. The initial deposit finally supports total deposits equal to itself times the reciprocal of the ratio, so a Rs. 10,000 deposit at 20 per cent sustains Rs. 50,000 of deposits. This repeated lending is credit creation.

What is the difference between M1 and M3?

M1, the narrow money, is currency with the public plus demand deposits and other deposits with the banks. M3, the broad money, adds the time deposits of the banks to M1. M1 counts the money immediately usable for transactions; M3 captures the whole of the money supply including the idle deposits of the economy. M3 is the broader measure most often quoted for the state of liquidity.

What are the quantitative instruments of credit control?

The bank rate or repo rate at which the central bank lends to banks, the cash reserve ratio and the statutory liquidity ratio that lock up parts of bank deposits, and open market operations in government securities. Each acts on the total volume of credit: raising the rate or the ratios or selling securities contracts credit to check inflation, and lowering them expands credit to revive the economy.

Why is the central bank called the lender of last resort?

Because it stands ready to lend to the commercial banks when no other lender will, against the paper and securities the banks hold. In a crisis, or a run on the deposits, a bank can turn to the central bank, which supplies the funds and prevents the failure of the bank and the panic that would follow. The assurance of this last-resort lending is itself a stabiliser of the whole banking system.

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