Money and Banking

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Economics Class XII (Introductory Macroeconomics), Chapter 3.

The goldsmith who created money out of nothing

In a village, people left their gold with a goldsmith called Lala for safe keeping, and he gave them paper receipts. Soon the receipts themselves began to be used to buy wheat and shoes. Lala had 100 kg of gold and had issued receipts for 100 kg. Then Ramu asked for a loan of 25 kg. Lala reasoned that depositors would not all come for their gold on the same day, so he lent it. Ramu paid Ali with the gold, and Ali left it with Lala for a receipt. Now receipts worth 125 kg were circulating against 100 kg of gold. Lala had created money.

Modern banks work exactly like Lala, with one big difference: a rule limits how far they can go. This chapter explains what money is, how people demand it, how banks and the RBI supply it, and where the limit comes from.

Why money exists: the problem with barter

Exchange without money is barter. It needs a double coincidence of wants: if you have surplus rice and want clothing, you must find someone who has surplus clothing and wants rice. As the number of people grows, the cost of searching becomes prohibitive. An intermediate good that everybody accepts solves this, and that good is money.

Purchasing power. If the price level rises, a unit of money buys less of every commodity. This is a fall in the purchasing power of money. It also means money is a good store of value only when its value is reasonably stable. Other assets (gold, land, houses, bonds) can also store value, but they are not as easily converted into commodities and are not universally accepted.

The move to less cash. A cashless society is one where transactions use digital information instead of notes and coins. India has promoted financial inclusion through measures such as Jan Dhan accounts, Aadhaar enabled payment systems, e-wallets and the National Financial Switch.

Demand for money: why do people hold cash?

Money is the most liquid asset, meaning it can be exchanged for anything immediately. But holding it has a cost: the interest you could have earned by putting it in a fixed deposit. People balance liquidity against forgone interest, which is why demand for money is also called liquidity preference. Two things drive it. A rise in income raises the transactions people make, so it raises the money they want. A rise in the interest rate raises the cost of holding idle money, so it reduces the demand.

The transaction motive. Incomes arrive at intervals but spending is continuous. Suppose you receive ₹100 on the first day of the month and spend evenly. Your balance starts at ₹100 and ends at ₹0, so the average is $(100 + 0)/2 = 50$, that is ₹50. You make transactions worth ₹100 with an average of ₹50. In general, transaction demand is a fraction $k$ of the value of transactions $T$:

$$M^d_T = kT, \qquad \text{or} \qquad v \cdot M^d_T = T, \quad v = \dfrac{1}{k}$$

The number of times a unit of money changes hands in a period is the velocity of circulation $v$. The text's two person economy uses ₹100 of money to carry out ₹200 of monthly transactions, so each rupee changes hands twice and $v = 2$. Transactions are a flow, money demand is a stock, and velocity has a time dimension that links them. Because transactions move with nominal GDP, the demand becomes:

$$M^d_T = kPY$$

where $Y$ is real GDP and $P$ is the price level or GDP deflator. Transaction demand rises with real income and with the price level.

The speculative motive. Imagine all assets other than money as "bonds". A bond promises a stream of payments. Take a two year bond with face value ₹100 and a coupon rate of 10 per cent. It pays ₹10 after one year and ₹110 (₹10 plus the principal) after two. If the market interest rate is 5 per cent, its present value is what you would have to put in a savings account to receive the same payments:

$$PV = \dfrac{10}{1.05} + \dfrac{110}{(1.05)^2} \approx 109.3$$

(in rupees)

Since the bond sells for only ₹100, everyone wants it, bidding the price up until it equals present value. At a market rate of 6 per cent, the same calculation gives about ₹107.33. So the price of a bond is inversely related to the market interest rate. If you expect the interest rate to rise, you expect bond prices to fall and a capital loss, so you sell bonds and hold money. When the rate is very high, people expect it to fall, expect capital gains and hold bonds, so speculative money demand is low. When it is low, they expect it to rise, hold money and speculative demand is high. Speculative demand is inversely related to the interest rate:

$$M^d_S = \dfrac{r_{\max} - r}{r - r_{\min}}$$

At $r = r_{\max}$ it is zero; as $r$ falls to $r_{\min}$ it rises without limit. At $r_{\min}$ the economy is in a liquidity trap: everybody expects the rate to rise, so any extra money is simply held, bond demand does not rise and the interest rate cannot fall further. Speculative demand is then infinitely elastic. Total demand for money is the sum of the two:

$$M^d = kPY + \dfrac{r_{\max} - r}{r - r_{\min}}$$

Pause and predict: the market interest rate rises from 5% to 6%. What happens to the price of an existing bond, and to speculative demand for money?

Check your answer: the bond price falls (from about ₹109.3 to ₹107.33 in the example), and speculative demand for money falls, since a high rate makes people expect it to come down and bond prices to recover, so they hold bonds instead of money.

What counts as money: supply

In a modern economy, money consists of currency (notes and coins) and demand deposits in commercial banks. Notes are issued by the RBI, coins by the Government of India. Deposits that can be withdrawn on demand (savings and current accounts) count as money because cheques on them settle transactions. Time deposits such as fixed deposits have a fixed maturity period.

A hundred rupee note is worth more than its paper. Its value comes from the guarantee on the note. Currency notes and coins are fiat money: they have no intrinsic value, unlike a gold coin. They are also legal tender: nobody can refuse them in settlement of a transaction. Cheques can be refused, so demand deposits are money but not legal tender.

Money supply is a stock: the total amount of money held by the public at a point in time. The RBI publishes four measures.

$CU$ is currency held by the public and $DD$ is net demand deposits of the public with commercial banks. "Net" means deposits that one commercial bank holds in another (interbank deposits) are left out. The measures run from the most liquid (M1) to the least liquid (M4). M3 is the most commonly used and is also called aggregate monetary resources.

Banks and the central bank

The central bank. Almost every country has one. India's central bank, the RBI, was set up in 1935. It issues the country's currency, controls the money supply, acts as banker to the government, is the custodian of the foreign exchange reserves and is the bank to the banking system. Because it is always ready to lend to banks, it is the lender of last resort. Currency issued by the central bank, held by the public or by banks, is high powered money, also called reserve money or the monetary base, because it is the basis of credit creation.

Commercial banks. They accept deposits from the public and lend part of them. They pay depositors a lower interest rate than they charge borrowers, and the difference, the spread, is their profit. A bank cannot lend everything it takes in, because it must be able to repay any depositor on demand. Its survival depends on that confidence.

How banks create money

When a bank lends, it opens a deposit in the borrower's name, and the money supply rises by that new deposit. Banks can do this because not all depositors withdraw at the same time.

The bank's balance sheet. Assets are what a firm owns or can claim from others. For a bank, these are reserves (cash and deposits with the RBI, partly held in RBI bonds and treasury bills) and loans. Liabilities are what it owes, mainly deposits. Net worth is assets minus liabilities.

$$\text{Assets} = \text{Reserves} + \text{Loans}, \qquad \text{Liabilities} = \text{Deposits}$$

Take a bank in an economy with no currency, starting with a deposit of ₹100 that it keeps entirely as reserves. Money supply is $M1 = 0 + 100 = 100$. The RBI makes it hold a minimum share of deposits as reserves, called the Cash Reserve Ratio (CRR), so it can't lend everything. Banks must also keep a share of deposits in liquid form, the Statutory Liquidity Ratio (SLR). With CRR at 20 per cent, ₹20 of the first ₹100 must be kept as reserves, and ₹80 can be lent. That loan comes back as a deposit, so deposits become ₹180, and the bank must now keep ₹36 in reserve. It started with ₹100 in cash, so it can lend ₹64 more. The process repeats.

Each loan is 0.8 times the one before, so the loans form a geometric series that converges. The process stops when required reserves reach the full ₹100, which happens when deposits are ₹500, because 20 per cent of 500 is 100. The final balance sheet shows reserves of ₹100 and loans of ₹400 against deposits of ₹500, so $M1$ rises from ₹100 to ₹500.

The money multiplier. The total deposit created is the original reserve divided by the CRR:

$$\text{Money multiplier} = \dfrac{1}{\text{CRR}} = \dfrac{1}{0.2} = 5$$

The sum of the series $a + ar + ar^2 + \dots$ with $0 < r < 1$ is $\dfrac{a}{1 - r}$. Each new loan is 0.8 times the last, so total deposits are $100 + 80 + 64 + 51.2 + \dots = 100\,(1 + 0.8 + 0.8^2 + \dots) = \dfrac{100}{1 - 0.8} = 500$.

The RBI's tools

The RBI is the only institution that can issue currency, and it uses two groups of tools to control the money supply.

The CRR works through the multiplier. With CRR raised from 20 per cent to 25 per cent, the multiplier falls from 5 to 4: ₹100 of reserves now supports ₹400 of deposits, not ₹500. The banks have to call back loans, and the money supply falls.

Open market operations are the buying and selling of government bonds by the RBI. They can be outright, which is permanent (no promise to sell back or buy back later), or by agreement to reverse the transaction. In a repurchase agreement (repo), the RBI buys securities and specifies the date and price at which they will be resold. The interest rate at which money is lent this way is the repo rate. In a reverse repo, the RBI sells securities with a promise to repurchase them later, so money is withdrawn from the system. The rate at which the money is withdrawn is the reverse repo rate. The RBI runs repo and reverse repo operations at overnight, 7 day and 14 day maturities, and these have become the main tool of monetary policy.

The bank rate is the rate at which the RBI lends to commercial banks.

Beyond the textbook. For the exam: the money multiplier is $1/\text{CRR}$, so with CRR at 20 per cent each rupee of reserves supports 5 rupees of deposits. In reality: banks often keep reserves above the required minimum, and the public holds part of its money as cash rather than depositing it all, so the actual multiplier is smaller than $1/\text{CRR}$. Why it matters: the formula gives the ceiling, which is what the exam tests, and not what actually happens.

Beyond the textbook. For the exam: currency is issued by the central bank, and banks create deposits by lending. In reality: in India most of the money supply is bank deposits, and currency is only a small part of it. In the RBI's figures for 2024-25, currency in circulation was less than one sixth of M3. Why it matters: it explains why a bank's lending decisions matter as much to the money supply as the RBI's printing.

Pause and predict: the RBI buys government bonds in the open market. What happens to reserves and to the money supply?

Check your answer: both rise. The RBI pays by cheque, which adds to the reserves of banks, and banks can then lend more through the multiplier.

Demonetisation

In November 2016 the Government of India withdrew the legal tender status of the old ₹500 and ₹1,000 notes and launched new ₹500 and ₹2,000 notes. The stated aims were to tackle corruption, black money, terrorism and fake currency. The public could deposit old notes in bank accounts up to 31 December 2016 without a declaration and up to 31 March 2017 at the RBI with a declaration. Exchange of old for new notes was allowed up to a limit of ₹4,000 per person per day, and old notes were accepted at petrol pumps, government hospitals and for government dues until 12 December 2016. The move led to queues at banks and ATMs and a shortage of cash in circulation, which affected economic activity for a time. The move drew both appreciation and criticism. It also moved more savings into the formal financial system and more payments towards electronic methods.

Worked examples

Worked example: how far can the multiplier go? A banking system has no currency in circulation and begins with a deposit of ₹5,000 that it holds entirely as reserves. The CRR is 10 per cent. Find the maximum deposits, loans and the increase in money supply.

Common wrong step. Saying the money supply rises by ₹50,000. The original ₹5,000 was already counted. New money is only what the loans created, ₹45,000.

Worked example: the CRR is raised. In the 20 per cent example above, reserves are ₹100 and deposits are ₹500. The RBI raises the CRR to 25 per cent. What happens to deposits, loans and the money supply?

The banks must call back ₹100 of loans, and the money supply falls by ₹100.

Common wrong step. Thinking the money supply stays at ₹500 because deposits already exist. A binding legal reserve requirement means deposits above the new limit cannot stay, so lending has to shrink.

Worked example: M1 and M3. Currency held by the public is ₹1,000 crore. Demand deposits with commercial banks total ₹3,600 crore, of which ₹600 crore are deposits one bank holds in another. Net time deposits are ₹4,000 crore. Find M1 and M3.

Common wrong step. Using the gross figure of ₹3,600 crore, which gives M1 of 4,600. Interbank deposits are not held by the public and are left out of money supply.

Worked example: transaction demand and velocity. Meera is paid ₹30,000 on the first of each month and spends it at an even rate. Find her average cash holding and the velocity of circulation of her money.

Common wrong step. Taking her average holding to be the full salary of ₹30,000. A balance that runs down evenly averages half of the opening amount.

Worked example: a bond when the interest rate changes. A two year bond has a face value of ₹100 and pays ₹10 after one year and ₹110 after two (coupon rate 10%). Find its fair price when the market interest rate is 10% and when it rises to 20%.

Common wrong step. Expecting the price to stay at ₹100 because the promised payments do not change. The payments are fixed, but their present value falls when the market rate rises, so the price falls. When the market rate equals the coupon rate, the price equals the face value.

Exam traps

Formula sheet

60-second revision

Where this chapter connects

Money is the unit in which every aggregate is counted in National Income Accounting, and the GDP deflator tells you how its purchasing power changes. The RBI and the idea of macro decision makers first appear in Introduction. The multiplier you met here has a twin on the spending side in Determination of Income and Employment. Government borrowing and bonds link to Government Budget and the Economy, and the exchange value of the rupee is in Open Economy Macroeconomics.