(Introductory Macro Economics) Chapter 3-Money and Banking (NCERT Class-XII)


  • commonly accepted medium of exchange. 
  • Economic exchanges without the mediation of money are referred to as barter exchanges. However, they presume the rather improbable double coincidence of wants.
  • To smoothen the transaction, an intermediate good is necessary which is acceptable to both parties. Such a good is called money.


  • acts as a medium of exchange.
  • acts as a convenient unit of account.
  • A barter system has other deficiencies. It is difficult to carry forward one‟s wealth under the barter system.
  • act as a store of value for individuals. Wealth can be stored in the form of money for future use.


  • Money is the most liquid of all assets in the sense that it is universally acceptable and hence can be exchanged for other commodities very easily.
  • On the other hand, it has an opportunity cost. If, instead of holding on to a certain cash balance, you put the money in a fixed deposits in some bank you can earn interest on that money.

The Transaction Motive

  • The principal motive for holding money is to carry out transactions.
  • The number of times a unit of money changes hands during the unit period is called the velocity of circulation of money.
  • We are ultimately interested in learning the relationship between the aggregate transaction demand for money of an economy and the (nominal) GDP in a given year.
  • The total value of annual transactions in an economy includes transactions in all intermediate goods and services and is clearly much greater than the nominal GDP. 
  • However, normally, there exists a stable, positive relationship between value of transactions and the nominal GDP.  An increase in nominal GDP implies an increase in the total value of transactions and hence a greater transaction demand for money from equation. 
  • that transaction demand for money is positively related to the real income of an economy and also to its average price level.

The Speculative Motive

  • An individual may hold her wealth in the form of landed property, bullion, bonds, money etc.
  • For simplicity, let us club all forms of assets other than money together into a single category called „bonds‟. Typically, bonds are papers bearing the promise of a future stream of monetary returns over a certain period of time. These papers are issued by governments or firms for borrowing money from the public and they are tradable in the market. 
  • Different people have different expectations regarding the future movements in the market rate of interest based on their private information regarding the economy. If you think that the market rate of interest should eventually settle down to 8 per cent per annum, then you may consider the current rate of 5 per cent too low to be sustainable over time. You expect interest rate to rise and consequently bond prices to fall. If you are a bond holder a decrease in bond price means a loss to you – similar to a loss you would suffer if the value of a property held by you suddenly depreciates in the market. Such a loss occurring from a falling bond price is called a capital loss to the bond holder. Under such circumstances, you will try to sell your bond and hold money instead. Thus speculations regarding future movements in interest rate and bond prices give rise to the speculative demand for money.
  • When the interest rate is very high everyone expects it to fall in future and hence anticipates capital gains from bond-holding. Hence people convert their money into bonds. Thus, speculative demand for money is low. When interest rate comes down, more and more people expect it to rise in the future and anticipate capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money.
  • Speculative demand for money is inversely related to the rate of interest.


  • In a modern economy money consists mainly of currency notes and coins issued by the monetary authority of the country. In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India. 
  • However, coins are issued by the Government of India.
  • Apart from currency notes and coins, the balance in savings, or current account deposits, held by the public in commercial banks is also considered money since chequeens drawn on these accounts are used to settle transactions. 
  • Such deposits are called demand deposits as they are payable by the bank on demand from the accountholder. Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits.

Legal Definitions: Narrow and Broad Money 

  • Money supply, like money demand, is a stock variable.
  • The total stock of money in circulation among the public at a particular point of time is called money supply.
  • RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows;

M1 = CU + 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 (excluding National Savings Certificates)

  • CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks.
  • The word „net‟ implies that only deposits of the public held by the banks are to be included in money supply. 
  • The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of money supply.
  • M1 and M2 are known as narrow money. 
  • M3 and M4 are known as broad money. 
  • M1 is most liquid and easiest for transactions whereas M4 is least liquid of all. M3 is the most commonly used measure of money supply. 
  • It is also known as aggregate monetary resources.

Money Creation by the Banking System

  • Money supply will change if the value of any of its components such as CU, DD or Time Deposits changes.
  • The most liquid definition of money, viz. M1 = CU + DD, as the measure of money supply in the economy. These influences on money supply can be summarised by the following key ratios

The Currency Deposit Ratio : 

  • is the ratio of money held by the public in currency to that they hold in bank deposits. cdr = CU/DD.
  • If a person gets Re 1 she will put Rs 1/(1 + cdr) in her bank account and keep Rs cdr/(1 + cdr) in cash.

The Reserve Deposit Ratio:

  • Banks hold a part of the money people keep in their bank deposits as reserve money and loan out the rest to various investment projects. 
  • Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI.
  • Banks use this reserve to meet the demand for cash by account holders. 
  • Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves.
  • Keeping reserves is costly for banks, as, otherwise, they could lend this balance to interest earning investment projects.
  • However, RBI requires commercial banks to keep reserves in order to ensure that banks have a safe cushion of assets to draw on when account holders want to be paid.
  • RBI uses various policy instruments to bring forth a healthy rdr in commercial banks. 
  • The first instrument is the Cash Reserve Ratio which specifies the fraction of their deposits that banks must keep with RBI. 
  • There is another tool called Statutory Liquidity Ratio which requires the banks to maintain 

High Powered Money: 

  • The total liability of the monetary authority of the country, RBI, is called the monetary base or high powered money.
  • It consists of currency (notes and coins in circulation with the public and vault cash of commercial banks) and deposits held by the Government of India and commercial banks with RBI.
  • By definition, money supply is equal to currency plus deposits

M = CU + DD = (1 + cdr )DD

where, cdr = CU/DD.

  • The Reserve Bank of India plays a crucial role here.
  • In case of a crisis like the above it stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter. 
  • This system of guarantee assures individual account-holders that their banks will be able to pay their money back in case of a crisis and there is no need to panic thus avoiding bank runs. This role of the monetary authority is known as the lender of last resort. 
  • Apart from acting as a banker to the commercial banks, RBI also acts as a banker to the Government of India, and also, to the state governments.
  • It is commonly held that the government, sometimes, „prints money‟ in case of a budget deficit, i.e., when it cannot meet its expenses (e.g. salaries to the government employees, purchase of defense equipment from a manufacturer of such goods etc.) from the tax revenue it has earned.
  • The government, however, has no legal authority to issue currency in this fashion.
  • So it borrows money by selling treasury bills or government securities to RBI, which issues currency to the government in return.
  • Financing of budget deficits by the governments in this fashion is called Deficit Financing through Central Bank Borrowing.
  • However, the most important role of RBI is as the controller of money supply and credit creation in the economy.
  • RBI is the independent authority for conducting monetary policy in the best interests of the economy.

Open Market Operations: 

  • RBI purchases (or sells) government securities to the general public in a bid to increase (or decrease) the stock of high powered money in the economy. Bank Rate Policy:
  • RBI can affect the reserve deposit ratio of commercial banks by adjusting the value of the bank rate – which is the rate of interest commercial banks have to pay RBI – if they borrow money from it in case of shortage of reserves.
  • A low (or high) bank rate encourages banks to keep smaller (or greater) proportion of their deposits as reserves, since borrowing from RBI is now less (or more) costly than before.
  • As a result banks use a greater (or smaller) proportion of their resources for giving out loans to borrowers or investors, thereby enhancing (or depressing) the multiplier process via assisting (or resisting) secondary money creation.
  • In short, a low (or high) bank rate reduces (or increases) rdr and hence increases (or decreases) the value of the money multiplier, which is (1 + cdr)/(cdr + rdr).
  • Thus, for any given amount of high powered money, H, total money supply goes up.

Varying Reserve Requirements:

  • Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) also work through the rdr-route.
  • A high (or low) value of CRR or SLR helps increase (or decrease) the value of reserve deposit ratio, thus diminishing (or increasing) the value of the money multiplier and money supply in the economy in a similar fashion.

Sterilization by RBI :

  • RBI often uses its instruments of money creation for stabilizing the stock of money in the economy from external shocks. 

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