Money and Banking Class 12 NCERT: Concepts, Examples and Practice

Chapter Overview: Why Money and Banks Matter

Money solves the main difficulty of barter: double coincidence of wants. In a barter system, a person who has wheat and wants cloth must find someone who has cloth and wants wheat at the same time. Money removes this problem because it is generally accepted as a medium of exchange. Banking builds on this trust. Commercial banks accept deposits and give loans, so idle savings become productive investment. The central bank, the RBI in India, supervises the banking system and controls credit so that growth, price stability and financial confidence are maintained.

Key Definitions for NCERT Money and Banking

Money

Anything that is generally accepted as a medium of exchange, measure of value, store of value and standard of deferred payments.

Fiat money

Money issued by the government or central bank and accepted because it has legal authority, not because of its intrinsic value.

Commercial bank

A financial institution that accepts deposits from the public, gives loans and creates credit through demand deposits.

Central bank

The apex monetary institution of a country. In India, the Reserve Bank of India issues currency, acts as banker to the government and controls money supply.

Money multiplier

The ratio of total deposit creation to the initial deposit. It is equal to 1 divided by the legal reserve ratio.

How Commercial Banks Create Credit

1. Step 1: Bank receives a primary deposit — Suppose a customer deposits Rs 1,000 in a bank. This is a liability for the bank because it must return the money when demanded, but it is also the base for lending.
2. Step 2: Bank keeps required reserves — If the legal reserve ratio is 20 percent, the bank must keep Rs 200 as cash reserve. It does not keep the entire deposit idle because all depositors do not withdraw money at the same time.
3. Step 3: Bank lends the excess reserve — The remaining Rs 800 is given as a loan. When the borrower spends it, the amount usually returns to the banking system as another deposit in some bank.
4. Step 4: Repeated deposits expand money supply — Each new bank keeps 20 percent reserve and lends the rest. The process continues until total deposits become Initial Deposit x Money Multiplier. Here, multiplier = 1/0.20 = 5, so total deposits = Rs 5,000.

Worked Examples: Calculations and Concepts

• Example 1: Calculate money multiplier and total deposits.
  Given: Initial deposit = Rs 2,000, legal reserve ratio = 10 percent.
  Step 1: Convert reserve ratio to decimal: 10 percent = 0.10.
  Step 2: Money multiplier = 1/LRR = 1/0.10 = 10.
  Step 3: Total deposits created = Initial deposit x Multiplier = 2,000 x 10 = Rs 20,000.
  Final answer: Money multiplier is 10 and total deposit creation is Rs 20,000.

• Example 2: Find M1 money supply.
  Given: Currency with public = Rs 8,000 crore, demand deposits with banks = Rs 12,000 crore, other deposits with RBI = Rs 500 crore, inter-bank deposits = Rs 700 crore.
  Step 1: Use M1 = Currency with public + Demand deposits + Other deposits with RBI.
  Step 2: Exclude inter-bank deposits because they are not held by the public.
  Step 3: M1 = 8,000 + 12,000 + 500 = Rs 20,500 crore.
  Final answer: M1 money supply is Rs 20,500 crore.

• Example 3: Explain effect of a rise in repo rate.
  Step 1: Repo rate is the rate at which RBI lends short-term funds to commercial banks.
  Step 2: If repo rate rises, borrowing from RBI becomes costlier for banks.
  Step 3: Banks may increase lending rates for households and firms.
  Step 4: Demand for loans and credit expansion may fall, reducing money supply growth.
  Final answer: A rise in repo rate is a contractionary monetary policy measure.

Board Exam Tips and Common Mistakes

• Do not write that banks create physical currency. Commercial banks create credit or deposit money; only the central bank issues currency notes, except one-rupee notes issued by the Government of India.
• In money supply numericals, use currency held by the public, not total currency issued. Cash held by banks is excluded because it is not with the public.
• Remember that money multiplier is inversely related to the legal reserve ratio. If LRR increases, the multiplier decreases.
• For 3-mark answers, define the term first, then explain with one clear point or formula. For 4 or 6 marks, add mechanism, effect and an example.
• Do not confuse repo rate with reverse repo rate. Repo rate is for RBI lending to banks; reverse repo rate is for RBI borrowing from banks.

Practice Questions with Solutions

• Q: State any four functions of money.
  A: Step 1: The first function is medium of exchange because money is accepted for buying and selling goods.
  Step 2: The second function is measure of value because prices of goods are expressed in money terms.
  Step 3: The third function is store of value because purchasing power can be saved for future use.
  Step 4: The fourth function is standard of deferred payments because future payments like loans can be fixed in money.
  Final answer: Money acts as medium of exchange, measure of value, store of value and standard of deferred payments.

• Q: If the initial deposit is Rs 5,000 and LRR is 25 percent, calculate money multiplier and total deposits.
  A: Step 1: Convert LRR into decimal: 25 percent = 0.25.
  Step 2: Money multiplier = 1/LRR = 1/0.25 = 4.
  Step 3: Total deposits = Initial deposit x Multiplier = 5,000 x 4 = Rs 20,000.
  Final answer: Money multiplier is 4 and total deposits created are Rs 20,000.

• Q: Calculate M1 from the following: currency with public Rs 15,000 crore, demand deposits Rs 30,000 crore, other deposits with RBI Rs 1,000 crore, government deposits with RBI Rs 2,000 crore.
  A: Step 1: Formula: M1 = Currency with public + Demand deposits + Other deposits with RBI.
  Step 2: Government deposits with RBI are not included in M1.
  Step 3: M1 = 15,000 + 30,000 + 1,000 = Rs 46,000 crore.
  Final answer: M1 money supply is Rs 46,000 crore.

• Q: Explain how open market operations can control inflation.
  A: Step 1: Open market operations mean buying and selling of government securities by the central bank.
  Step 2: During inflation, RBI can sell government securities to commercial banks and the public.
  Step 3: Buyers pay money to RBI, so liquidity in the banking system falls.
  Step 4: With lower liquidity, banks create less credit and aggregate demand may reduce.
  Final answer: Selling government securities is a contractionary measure used to control inflation.

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