Money and Banking – AHSEC Class 12 Economics Chapter 3 Part – A

Introductory Macroeconomics”
Chapter 3: Money and Banking

Money and Banking

Chapter Summary

What is Money?
Money is anything that is generally accepted as a medium of exchange. In an economy without money, transactions occur through a Barter System, which involves the direct exchange of goods for goods. This system suffers from a major drawback: the double coincidence of wants, where two individuals must have a reciprocal demand for each other’s goods for an exchange to take place. Money solves this problem.

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Functions of Money:
The primary functions of money are:

1. Medium of Exchange: It facilitates the buying and selling of goods and services, eliminating the need for a double coincidence of wants.
2. Unit of Account: It provides a common measure of value, allowing the value of all goods and services to be expressed and compared in a single unit (e.g., Rupees, Dollars).
3. Store of Value: Money can be held and stored for future use. Unlike perishable goods, it does not lose its value quickly (though inflation can erode its purchasing power).
4. Standard of Deferred Payment: It allows for borrowing and lending, as future payments (debts) can be expressed and settled in terms of money.

Demand for Money:
People desire to hold money for two main reasons, as theorized by John Maynard Keynes:

1. The Transaction Motive: People hold money to carry out their day-to-day transactions (buying goods and services). The amount of money demanded for this purpose depends on the volume of transactions, which in turn depends on the level of income. Higher income leads to a higher transaction demand for money.
2. The Speculative Motive: People hold money as an asset with the hope of making a profit from future changes in the interest rate. There is an inverse relationship between the market rate of interest and the price of bonds. When the interest rate is high, people expect it to fall in the future (causing bond prices to rise), so they buy bonds and hold less money. When the interest rate is low, they expect it to rise, so they sell bonds to avoid a capital loss and prefer to hold cash. Thus, the speculative demand for money is inversely related to the rate of interest.

Supply of Money:
The supply of money refers to the total stock of money in circulation among the public at a particular point in time. The Reserve Bank of India (RBI) publishes four alternative measures of money supply:

• M1 (Narrow Money): Currency with the Public (CU) + Demand Deposits with the banking system (DD). It is the most liquid measure.
• M2: M1 + Savings deposits with Post Office savings banks.
• M3 (Broad Money): M1 + Net Time Deposits of the commercial banks. This is the most commonly used measure of money supply.
• M4: M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates).

Money Creation by the Banking System:
Commercial banks are creators of money. They create credit (and thus, money) based on the initial deposits they receive. They are required to keep a certain fraction of their deposits as reserves (determined by the Cash Reserve Ratio, CRR, and Statutory Liquidity Ratio, SLR) and can lend out the rest. This loan creates a new deposit in the banking system, and the process continues. This is known as the Money Multiplier process.
Money Multiplier = 1 / Reserve Ratio

Policy Tools to Control Money Supply:
The Reserve Bank of India (RBI), as the central bank, uses several monetary policy instruments to control the money supply:

1. Bank Rate: The rate at which the RBI lends long-term funds to commercial banks.
2. Open Market Operations (OMO): The buying and selling of government securities by the RBI in the open market to inject or absorb liquidity.
3. Varying Reserve Requirements: Changing the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
4. Repo Rate and Reverse Repo Rate: The rates for short-term borrowing and lending between the RBI and commercial banks.

Demonetisation:
On November 8, 2016, the Government of India announced the demonetisation of all ₹500 and ₹1,000 banknotes. The stated objectives were to curb black money, counterfeit currency, and terror financing. While it caused short-term disruptions, it led to increased tax compliance and a push towards digital transactions.

Textual Question Answers (Exercise)

1. What is a barter system? What are its drawbacks?
Answer: A barter system is a system of exchange where goods and services are directly exchanged for other goods and services without the use of money.
Drawbacks:

• Lack of Double Coincidence of Wants: For an exchange to occur, two individuals must have a reciprocal demand for each other’s goods, which is rare.
• Lack of a Common Measure of Value: It is difficult to determine the value of goods in terms of other goods.
• Difficulty in Storing Value: Perishable goods cannot be stored for future exchange.
• Difficulty in Making Deferred Payments: It is hard to make contracts and future payments in terms of goods.

2. What are the main functions of money? How does money overcome the shortcomings of a barter system?
Answer: The main functions of money are: (i) Medium of Exchange, (ii) Unit of Account, (iii) Store of Value, and (iv) Standard of Deferred Payment.
Money overcomes the shortcomings of barter by:

• Acting as a medium of exchange, it solves the problem of double coincidence of wants.
• Acting as a unit of account, it provides a common measure of value.
• Acting as a store of value, it makes saving possible.

3. What is the transaction demand for money? How is it related to the value of transactions over a specified period of time?
Answer: The transaction demand for money is the money held by people to carry out their daily transactions. It is directly related to the value of transactions. If the total value of transactions (T) in an economy is high, the demand for money (M^d) to facilitate these transactions will also be high. The relationship is expressed as M^d = kT, where ‘k’ is a positive fraction, meaning money demand is a fraction of the total transaction value.

4. Suppose a bond promises Rs 500 at the end of two years with no intermediate return. If the rate of interest is 5 per cent per annum, what is the price of the bond?
Answer: The price of the bond is its Present Value (PV).
Formula: PV = R / (1 + i)ⁿ
Given:

• Future Value (R) = Rs 500
• Rate of interest (i) = 5% = 0.05
• Number of years (n) = 2
  PV = 500 / (1 + 0.05)²
  PV = 500 / (1.05)²
  PV = 500 / 1.1025
  PV ≈ Rs 453.51
  So, the price of the bond is approximately Rs 453.51.

5. Why is the speculative demand for money inversely related to the rate of interest?
Answer: The speculative demand for money is the money held to make profits from future changes in the interest rate. The price of bonds is inversely related to the market rate of interest.

• When the interest rate is high, bond prices are low. People expect the interest rate to fall in the future, which would increase bond prices. To make a capital gain, they buy bonds and hold less cash. Thus, speculative demand for money is low.
• When the interest rate is low, bond prices are high. People expect the interest rate to rise, which would decrease bond prices. To avoid a capital loss, they sell their bonds and prefer to hold cash. Thus, speculative demand for money is high.
  Therefore, the speculative demand for money is inversely related to the rate of interest.

6. What is a ‘liquidity trap’?
Answer: A liquidity trap is a situation, typically during a severe recession, where the market rate of interest is extremely low, and people expect it to only rise in the future. In this scenario, everyone prefers to hold cash rather than bonds because a future rise in the interest rate would cause a capital loss on bonds. At this point, the speculative demand for money becomes perfectly elastic, and monetary policy becomes ineffective.

7. What are the alternative definitions of money supply in India?
Answer: The four alternative definitions of money supply in India are:

• M1 = Currency with Public (CU) + Demand Deposits (DD)
• M2 = M1 + Savings deposits with Post Office savings banks
• M3 = M1 + Net time deposits of commercial banks
• M4 = M3 + Total deposits with Post Office savings organisations

8. What is ‘legal tender’? What is ‘fiat money’?
Answer:

• Legal Tender: It is a form of money that courts of law are bound to recognize as satisfactory payment for any monetary debt. In India, coins and currency notes are legal tender.
• Fiat Money: It is money that has no intrinsic value (like gold or silver) but is declared by a government to be legal tender. Its value comes from the “fiat” or order of the government. All modern paper currencies are fiat money.

9. What is High-Powered Money?
Answer: High-Powered Money (or Monetary Base) is the total liability of the monetary authority of the country (the RBI in India). It consists of currency held by the public and commercial banks, and the deposits held by the Government of India and commercial banks with the RBI.

10. Explain the functions of a commercial bank.
Answer: The main functions of a commercial bank are:

• Accepting Deposits: Accepting money from the public in the form of savings, current, and fixed deposits.
• Advancing Loans: Providing loans and advances to individuals and businesses for various purposes.
• Credit Creation: Creating credit (money) through the process of lending, based on the deposits they hold.
• Agency Functions: Acting as an agent for customers by collecting cheques, paying bills, etc.
• General Utility Functions: Providing services like lockers, foreign exchange, and letters of credit.

11. What is the money multiplier? How will you determine its value? What ratios play an important role in the determination of the money multiplier?
Answer: The money multiplier is the number by which the change in the high-powered money is multiplied to find the resulting change in the money supply. It shows the capacity of the banking system to create credit.
Its value is determined by the formula:
Money Multiplier = 1 / Reserve Ratio
The ratios that play an important role are:

• The Currency Deposit Ratio (cdr): The ratio of money held by the public in currency to that they hold in bank deposits.
• The Reserve Deposit Ratio (rdr): The fraction of total deposits that commercial banks keep as reserves. This is influenced by the CRR and SLR.

12. What are the instruments of monetary policy of the RBI? How does the RBI stabilize the money supply against exogenous shocks?
Answer: The main instruments of monetary policy of the RBI are:

• Quantitative Instruments: Bank Rate, Open Market Operations (OMO), Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Repo Rate, and Reverse Repo Rate.
• Qualitative Instruments: Margin requirements, moral suasion, etc.

The RBI stabilizes the money supply against exogenous shocks (like a large inflow of foreign currency) through a process called sterilisation. For example, if there is a large inflow of foreign currency which increases the high-powered money, the RBI will sell government securities in the open market to absorb the excess liquidity, thus keeping the overall money supply stable.

13. ‘Commercial banks are creators of money in the economy’. Do you agree with this statement?
Answer: Yes, I agree with this statement. While the central bank prints currency, the bulk of the money supply in a modern economy is created by commercial banks through the process of credit creation. They accept deposits, keep a fraction as reserves, and lend out the rest. These loans become new deposits, which are again used for lending. This process, known as the money multiplier effect, allows the banking system to create a total money supply that is several times larger than the initial deposits.

14. Why is the RBI called the ‘lender of last resort’?
Answer: The RBI is called the ‘lender of last resort’ because if a commercial bank faces a financial crisis and is unable to get funds from any other source, the RBI comes to its rescue by providing loans against approved securities. This function is crucial for maintaining the stability of the banking system and protecting the interests of depositors.

Previous Years’ AHSEC Question Answers (2015-2025)

1. Question: Explain the working of the investment multiplier with an example. What is the backward working of the investment multiplier? (AHSEC 2025)
Answer:
Working of Investment Multiplier: The investment multiplier shows that an initial increase in investment leads to a multiple increase in national income. This is because one person’s expenditure is another person’s income.
Example: Assume MPC = 0.8 and there is a new investment of Rs 100 crore.

• Round 1: The investment of Rs 100 crore will generate an income of Rs 100 crore.
• Round 2: Out of this Rs 100 crore income, 80% (the MPC) i.e., Rs 80 crore will be spent on consumption, which will generate an income of Rs 80 crore for others.
• Round 3: Out of this Rs 80 crore income, 80% i.e., Rs 64 crore will be spent again.
  This process continues. The total increase in income will be:
  Total Increase in Income = Initial Investment × (1 / (1-MPC))
  = 100 crore × (1 / (1-0.8)) = 100 × 5 = Rs 500 crore.
  Backward Working: When investment decreases, income decreases by a multiple amount. This is known as the backward working of the multiplier.

2. Question: What are the sources of supply of foreign currency in an economy? (AHSEC 2025)
Answer: The main sources of supply of foreign currency in an economy are:

1. Exports: When a country sells goods and services abroad, it earns foreign currency.
2. Foreign Investment: When foreign citizens or companies invest in the country (through FDI or FII).
3. Unilateral Transfers: Remittances sent by citizens working abroad and grants received from foreign countries.

3. Question: Write two functions of the Reserve Bank of India. (AHSEC 2023)
Answer:

1. Issue of Currency: The RBI has the sole authority to issue currency notes in India.
2. Banker to the Government: It acts as a banker, agent, and financial advisor to the central and state governments.

4. Question: Differentiate between a commercial bank and a central bank. (AHSEC 2022)
Answer:

• Central Bank: It is the apex financial institution of a country. It issues currency and its primary objective is not profit-making but economic stability.
• Commercial Bank: It operates under the control of the central bank. It cannot issue currency and its primary objective is to earn profits.

5. Question: What do you understand by devaluation of domestic currency? Write with an example. (AHSEC 2020, 2025)
Answer: Devaluation is the deliberate reduction in the value of a country’s currency in relation to another currency, under a fixed exchange rate system, by the government.
Example: If the exchange rate was previously fixed at $1 = ₹70, and the government decides to change it to $1 = ₹75, this is a devaluation of the rupee.

Long Questions:

1. Discuss the functions of the Reserve Bank of India. (AHSEC 2015, 2017, 2019, 2023)
   Answer: The main functions of the RBI are:
   1. Issuer of Currency: It has the sole authority to issue currency notes in India.
   1. Banker to the Government: It acts as a banker, agent, and financial advisor to the Central and State Governments.
   1. Bankers’ Bank and Supervisor: It holds the cash reserves of commercial banks, provides them with loans, and supervises their functioning.
   1. Lender of Last Resort: It provides financial assistance to commercial banks during a crisis.
   1. Custodian of Foreign Exchange Reserves: It manages the country’s foreign exchange reserves.
   1. Controller of Credit: It controls the supply of money and credit in the economy through its monetary policy.
2. Explain the process of credit creation by commercial banks. (AHSEC 2016, 2018, 2022)
   Answer: (The answer is the same as explained under the “Money Creation by the Banking System” section in the summary above).

Short Questions:

1. Write one main function of money. (AHSEC 2015, 2019)
   Answer: Medium of Exchange.
2. What is the full form of CRR? (AHSEC 2016, 2020)
   Answer: Cash Reserve Ratio.
3. What is the name of the central bank of India? (AHSEC 2017, 2022)
   Answer: The Reserve Bank of India (RBI).
4. Mention one drawback of the barter system. (AHSEC 2018)
   Answer: Lack of double coincidence of wants.
5. What are the components of M1 money supply?
   Answer: Currency with the public (CU) and Demand Deposits (DD).
6. What is a liquidity trap?
   Answer: A situation where the interest rate is so low that people prefer to hold cash rather than bonds, making monetary policy ineffective.
7. What is the formula for the money multiplier?
   Answer: Money Multiplier = 1 / Reserve Ratio.
8. When did demonetisation take place in India?
   Answer: November 8, 2016.
9. What is Repo Rate?
   Answer: The rate at which the RBI lends short-term funds to commercial banks.
10. Who issues currency in India?
    Answer: The Reserve Bank of India.

Additional Question Answers

Very Short Answer Questions (1 Mark)

1. Question: What is the primary disadvantage of the barter system?
   Answer: The lack of a double coincidence of wants.
2. Question: State one primary function of money.
   Answer: Medium of exchange.
3. Question: What is the name of the central bank of India?
   Answer: The Reserve Bank of India (RBI).
4. Question: What is meant by Narrow Money?
   Answer: M1 (CU + DD) is known as Narrow Money.
5. Question: What is Legal Tender?
   Answer: Money that is legally bound to be accepted as a medium of payment for any transaction is called legal tender.
6. Who introduced the concept of speculative demand for money?
   Answer: John Maynard Keynes.
7. If the CRR is increased, what will be its effect on the money supply?
   Answer: The money supply will decrease because the lending capacity of banks will reduce.
8. Which is more liquid, M1 or M3?
   Answer: M1.
9. What is Fiat Money?
   Answer: Money that has no intrinsic value but is accepted as a medium of exchange because of a government order or “fiat”.
10. When was the Reserve Bank of India established?
    Answer: In 1935.
11. If the RBI sells securities in the open market, will the money supply increase or decrease?
    Answer: It will decrease, as the RBI absorbs money from the market.
12. What is the difference between Bank Rate and Repo Rate?
    Answer: Bank Rate is for long-term loans, while Repo Rate is for short-term loans.
13. What do you mean by ‘liquidity’?
    Answer: Liquidity refers to the ease and speed with which an asset can be converted into cash without loss of value.
14. What is meant by Broad Money?
    Answer: M3 is referred to as Broad Money.
15. What was one of the main objectives of demonetisation?
    Answer: To curb black money and counterfeit currency.

B. Short Answer Questions (2/3 Marks)

1. Question: What is the difference between the M1 and M3 measures of money supply?
   Answer: M1 is the narrow measure of money supply, which includes only the most liquid forms of money: Currency with the public (CU) and Demand Deposits (DD) with commercial banks. M3 is a broad measure of money supply, which includes all components of M1 plus the Net Time Deposits of commercial banks. M1 is more liquid than M3.
2. Question: Why is the central bank called the ‘lender of last resort’?
   Answer: When a commercial bank faces a financial crisis and is unable to get loans from any other source, the central bank comes to its rescue by providing loans. Because of this crucial role in saving banks from failure, it is called the ‘lender of last resort’.
3. Question: What do you understand by Open Market Operations?
   Answer: Open Market Operations (OMO) refer to the buying and selling of government securities (bonds) by the central bank in the open market. When the RBI buys securities, it injects money into the economy, increasing the money supply. When it sells securities, it withdraws money, reducing the money supply.
4. Question: What are the two main motives for the demand for money?
   Answer: The two main motives for the demand for money are:
   1. Transaction Motive: The demand for money to carry out day-to-day transactions and purchases.
   1. Speculative Motive: The demand for money held with the intention of making a profit from future changes in the interest rate or bond prices.
5. Question: What is a Liquidity Trap?
   Answer: A liquidity trap is a situation where the interest rate is extremely low, and people expect it to rise in the future. In this scenario, everyone prefers to hold cash rather than bonds (to avoid capital loss), and any increase in the money supply is simply held as cash without lowering the interest rate further.

C. Long Answer Questions (5/6 Marks)

1. Question: Explain the process of credit creation by commercial banks with the help of an example.
   Answer: Commercial banks create credit based on their initial deposits. The process depends on the Cash Reserve Ratio (CRR), which is the fraction of deposits that banks must keep as reserves.
   Example: Assume the CRR is 20% and there is a fresh deposit of Rs 1,000 in a bank.
   1. Round 1: The bank keeps 20% (Rs 200) as a reserve and lends out the remaining Rs 800.
   1. Round 2: The borrower spends this Rs 800, which eventually gets deposited back into the banking system. The bank now keeps 20% of this Rs 800 (Rs 160) as a reserve and lends out the remaining Rs 640.
   1. Round 3: This Rs 640 is again deposited back into the system, and the process continues.
      This process continues until the initial excess reserves are exhausted. The total money created is determined by the money multiplier.
      Total Money Creation = Initial Deposit × (1 / CRR)
      = Rs 1,000 × (1 / 0.20) = Rs 5,000.
      Here, the money multiplier is 5. Thus, an initial deposit of Rs 1,000 leads to a total money supply of Rs 5,000.
2. Question: What are the quantitative instruments of monetary policy used by the central bank to control the money supply? Explain.
   Answer: The main quantitative instruments used by the central bank (like the RBI) to control the money supply are:
   1. Bank Rate: This is the rate at which the central bank lends money to commercial banks. To control inflation, the RBI increases the bank rate, making borrowing expensive for commercial banks. This, in turn, forces them to increase their lending rates, which reduces the demand for credit and contracts the money supply. The opposite is done during a recession.
   1. Open Market Operations (OMO): This involves the buying and selling of government securities. During inflation, the RBI sells securities, which reduces the cash reserves of commercial banks and their ability to lend. During a recession, the RBI buys securities to increase the money supply.
   1. Cash Reserve Ratio (CRR): This is the percentage of total deposits that commercial banks must keep with the central bank. By increasing the CRR, the RBI reduces the amount of funds available with banks for lending, thereby decreasing the money supply. A decrease in CRR has the opposite effect.
3. Question: What are the main functions of money? How does money overcome the drawbacks of the barter system?
   Answer: The four main functions of money are:
   1. Medium of Exchange: It facilitates the buying and selling of goods and services.
   1. Store of Value: It allows for the storage of wealth for future use.
   1. Unit of Account: It provides a common measure of the value of goods and services.
   1. Standard of Deferred Payment: It simplifies future payments and credit transactions.
      Overcoming Drawbacks of Barter:
   1. Money solves the problem of “double coincidence of wants” because a seller can now accept money and use it to buy whatever they need from someone else.
   1. As a store of value, money makes it easy to save wealth, which was difficult with perishable goods in the barter system.
   1. As a unit of account, money makes it easy to compare the values of different goods.
4. Question: What are the main functions of the Reserve Bank of India?
   Answer: The main functions of the Reserve Bank of India (RBI) are:
   1. Issue of Currency: It has the sole authority to issue currency notes in the country.
   1. Banker to the Government: It manages the banking transactions of the central and state governments and provides them with loans.
   1. Banker’s Bank and Supervisor: It holds the accounts of commercial banks, lends them money, and settles inter-bank transactions. It also supervises their functioning.
   1. Controller of Credit: It controls the supply of money and credit in the economy to achieve price stability and economic growth.
   1. Custodian of Foreign Exchange Reserves: It manages the country’s foreign exchange reserves.
5. Question: Differentiate between the transaction motive and the speculative motive for the demand for money.
   Answer:
   1. Transaction Motive: This refers to the demand for money to conduct day-to-day transactions, i.e., to buy goods and services. This demand is primarily dependent on the level of income; as income rises, the transaction demand for money also rises.
   1. Speculative Motive: This refers to the demand for money held with the intention of making a profit from future changes in the interest rate or the price of bonds. This demand is inversely related to the rate of interest. When the interest rate is low, people hold more money (speculative demand is high), and when the interest rate is high, they hold less money.