The main difficulty of a barter system that money removes is:

The lack of a double coincidence of wants

The existence of interest on loans

Which of the following is NOT a component of M1?

Savings deposits with post office savings banks

Net demand deposits with commercial banks

Other deposits with the Reserve Bank

Savings deposits with post office savings banks

To control inflation through open market operations, the Reserve Bank will:

Sell government securities in the open market

Buy government securities from banks and the public

Sell government securities in the open market

The repo rate is the rate at which:

The RBI lends to banks for the short term

Commercial banks lend to the public

The RBI borrows from commercial banks

The RBI lends to banks for the short term

The government borrows from foreign countries

The Reserve Bank is called the "lender of last resort" because it:

Lends to a bank in crisis when no one else will

Lends to individuals who are refused by every commercial bank

Is the last institution to set its interest rates each year

Lends to a bank in crisis when no one else will

If the legal reserve ratio is raised from 10% to 20%, the maximum total deposits that an initial deposit of ₹1,000 can support:

Fall from ₹10,000 to ₹5,000

Rise from ₹5,000 to ₹10,000

Stay at ₹10,000, because the deposit is unchanged

Money and Banking — Money Supply, Credit Creation and the Reserve Bank

Money is whatever is generally accepted in exchange, and an economy without it — a barter economy — runs into problems that money exists to solve. This chapter has three parts and each produces its own kind of question. What money does and how the stock of it is measured (definitions). How commercial banks create money out of deposits (the one computation, credit creation). How the Reserve Bank of India controls the money supply (directions — which way each tool moves to fight inflation or to revive demand). The arithmetic is short; the marks are lost by confusing CRR with SLR, repo with reverse repo, or total deposits with credit created.

Barter and the Functions of Money

Under barter, goods are exchanged directly for goods. Its central difficulty is the double coincidence of wants: a weaver who wants rice must find a farmer who has rice and wants cloth at the same time. Barter also lacks a common measure of value, makes saving awkward because most goods perish or lose value, and gives no way to settle a payment due in the future. Money removes each problem, and its functions are usually listed in two groups.

The four functions, and the barter problem each one solves
Function	Type	What it solves
Medium of exchange	Primary	Removes the need for a double coincidence of wants
Unit of account (measure of value)	Primary	Every good gets a price in one common unit
Store of value	Secondary	Purchasing power can be kept for later use
Standard of deferred payment	Secondary	Loans and future payments can be stated and settled in money

In India, currency notes and coins are fiat money — they have value because the government declares them legal tender, not because of the metal or paper in them — and nobody may refuse them in settlement of a debt. One-rupee notes and all coins are issued by the Government of India; all other currency notes are issued by the Reserve Bank. Demand deposits (current and savings accounts payable on demand, usable by cheque) are money too, because they are generally accepted, but they are not legal tender — a seller may refuse a cheque.

Measuring the Money Supply — M1 to M4

The money supply is the total stock of money held by the public at a point of time. "Public" excludes the producers of money — the government and the banking system — so currency lying in bank vaults is not part of the money supply until it is withdrawn. It is a stock, measured on a date. The textbook teaches four measures, each adding a less liquid component to the one before:

The four measures — liquidity falls from M1 to M4
Measure	Definition	Note
M1	CU + DD + OD — currency held by the public, net demand deposits with banks, other deposits with the RBI	Narrow money; the most liquid
M2	M1 + savings deposits with post office savings banks	Post office savings are less liquid than bank demand deposits
M3	M1 + net time deposits of commercial banks	Broad money, also called aggregate monetary resources
M4	M3 + total deposits with post office savings organisations (excluding National Savings Certificates)	The least liquid

⚠️ M2 and M3 are both built on M1, not on each other

The commonest error is to write M3 = M2 + time deposits. It is M3 = M1 + net time deposits of commercial banks; M2 adds post office savings to M1, and M4 adds post office deposits to M3. Savings deposits with a commercial bank are already inside demand deposits in M1 — only the post office's savings deposits are added at M2.

The money that the Reserve Bank itself creates is high-powered money (reserve money, H): currency held by the public plus the reserves of commercial banks, which are their cash in vaults and their deposits with the RBI. It is called high-powered because each rupee of bank reserves supports several rupees of deposits — the process the next section works through.

How Banks Create Money — Credit Creation and the Multiplier

A bank knows that depositors do not all withdraw at once, so it keeps only a fraction of deposits as reserves — the legal reserve ratio (LRR), set by the RBI — and lends the rest. The loan is spent, the money is deposited in some bank, that bank keeps its fraction and lends the rest, and so on. Each round is smaller than the last, and the rounds add up to a fixed multiple of the first deposit.

Worked example — initial deposit ₹1,000, LRR 20%
Round	Deposits (₹)	Reserves kept, 20% (₹)	Loans made, 80% (₹)
1	1,000	200	800
2	800	160	640
3	640	128	512
… and so on	…	…	…
Total	5,000	1,000	4,000

The totals follow from one formula. Deposit (money) multiplier = 1 ÷ LRR, so with LRR = 20% the multiplier is 1 ÷ 0.2 = 5, and total deposits = initial deposit × multiplier = 1,000 × 5 = ₹5,000. The credit created is the loans, which is total deposits minus the initial deposit: 5,000 − 1,000 = ₹4,000. The process stops when the whole of the initial deposit has been absorbed as reserves (₹1,000 = 20% of ₹5,000). A higher LRR means a smaller multiplier: at 25% it is 4, at 10% it is 10.

⚠️ Total deposits or credit created? Read the last word of the question

With ₹1,000 and LRR 20%, both ₹5,000 and ₹4,000 will be among the options, and each is right for a different question. "Total deposits" or "total money created by the banking system" is ₹5,000; "credit created", "loans" or "derivative deposits" is ₹4,000. In practice credit creation is smaller still, because the public holds some cash rather than redepositing all of it, and banks may not find enough creditworthy borrowers.

The Reserve Bank — Functions and the Tools of Monetary Control

Issuer of currency — the sole authority for issuing currency notes other than the one-rupee note.
Banker to the government — keeps the government's accounts, makes and receives payments for it, and manages its borrowing.
Banker's bank and lender of last resort — holds banks' reserves and lends to a bank in difficulty when no one else will, so that a run on one bank does not become a collapse of the system.
Controller of credit — regulates the volume and cost of bank credit, using the instruments below.
Custodian of foreign exchange reserves — holds the country's reserves and intervenes in the foreign exchange market.

The quantitative tools, and which way each moves to fight inflation
Tool	What it is	To curb inflation
Cash reserve ratio (CRR)	Share of deposits a bank must keep with the RBI as cash	Raise it
Statutory liquidity ratio (SLR)	Share of deposits a bank must keep with itself in liquid assets — cash, gold, approved government securities	Raise it
Repo rate	Rate at which the RBI lends to banks for the short term against government securities	Raise it
Reverse repo rate	Rate at which the RBI borrows from banks, absorbing their surplus funds	Raise it
Bank rate	Rate at which the RBI lends to banks for the longer term	Raise it
Open market operations	RBI buying or selling government securities in the market	Sell securities — money flows out of banks into the RBI

To revive demand in a slowdown, every direction reverses: lower the ratios and rates, and buy securities so that money flows from the RBI into banks. Alongside these, the RBI uses qualitative (selective) tools that steer credit to or away from particular uses — margin requirements on loans against goods or shares, moral suasion (persuading banks through advice and pressure), and selective credit controls. When large foreign exchange inflows threaten to swell the money supply, the RBI can offset them by selling government securities — an operation called sterilisation.

🧠 Repo: the RBI lends. Reverse repo: the RBI borrows.

Name it from the bank's side: in a repo the bank sells securities to the RBI today and repurchases them later, so the bank receives cash — the RBI is lending. Reverse the deal and the bank parks cash with the RBI. And CRR is kept with the RBI, SLR is kept with the bank itself — the letter L in SLR is for liquid assets the bank holds.

Key takeaways

Barter fails mainly for want of a double coincidence of wants; money serves as medium of exchange, unit of account, store of value and standard of deferred payment.
Money supply is a stock held by the public; money held by the government and banks is excluded.
M1 = CU + DD + OD; M3 = M1 + net time deposits of banks; liquidity falls from M1 to M4.
Deposit multiplier = 1 ÷ LRR; total deposits = initial deposit × multiplier; credit created = total deposits − initial deposit.
CRR is kept with the RBI, SLR with the bank itself; repo is the RBI lending, reverse repo the RBI borrowing.
To curb inflation the RBI raises CRR, SLR and its rates and sells securities; to revive demand it does the opposite.
As lender of last resort the RBI rescues a bank in difficulty so that a run on one bank does not bring down the system.

Practice questions (8)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

The main difficulty of a barter system that money removes is:
1. The lack of a double coincidence of wants
2. The absence of a central bank
3. Too many goods being produced
4. The existence of interest on loans
Show answer
Answer: A — The lack of a double coincidence of wants
Under barter a trade needs each party to want exactly what the other has, at the same time; money as a medium of exchange removes that requirement. A central bank is an institution that comes after money exists, not a defect of barter, and neither the volume of goods nor interest on loans is the problem barter has.
Which of the following is NOT a component of M1?
1. Currency held by the public
2. Net demand deposits with commercial banks
3. Other deposits with the Reserve Bank
4. Savings deposits with post office savings banks
Show answer
Answer: D — Savings deposits with post office savings banks
M1 = CU + DD + OD — currency with the public, net demand deposits and other deposits with the RBI. Post office savings deposits are added only at M2 = M1 + those deposits, because they are less liquid than currency and demand deposits. Do not confuse them with savings accounts at commercial banks, which are already counted in demand deposits.
An initial deposit of ₹10,000 is made with a bank and the legal reserve ratio is 25%. The total deposits the banking system can create are:
1. ₹30,000
2. ₹40,000
3. ₹12,500
4. ₹2,500
Show answer
Answer: B — ₹40,000
Multiplier = 1 ÷ 0.25 = 4, so total deposits = 10,000 × 4 = ₹40,000. ₹30,000 is the credit created — total deposits less the initial deposit — which answers a different question. ₹2,500 is the reserve kept on the first deposit alone, and ₹12,500 has no basis in the process.
With an initial deposit of ₹5,000 and a legal reserve ratio of 10%, the credit created by the banking system is:
1. ₹50,000
2. ₹500
3. ₹45,000
4. ₹5,500
Show answer
Answer: C — ₹45,000
Multiplier = 1 ÷ 0.10 = 10, total deposits = 5,000 × 10 = ₹50,000, and credit created = 50,000 − 5,000 = ₹45,000. ₹50,000 is total deposits rather than credit, ₹500 is just the first round's reserve, and ₹5,500 adds the reserve to the deposit.
To control inflation through open market operations, the Reserve Bank will:
1. Buy government securities from banks and the public
2. Sell government securities in the open market
3. Print more currency notes
4. Lower the repo rate
Show answer
Answer: B — Sell government securities in the open market
When the RBI sells securities, buyers pay it with money drawn from bank deposits, so banks' reserves and their capacity to lend shrink. Buying securities does the opposite and injects money, printing currency expands the money supply, and lowering the repo rate makes borrowing cheaper — all three feed inflation rather than curbing it.
The repo rate is the rate at which:
1. Commercial banks lend to the public
2. The RBI borrows from commercial banks
3. The RBI lends to banks for the short term
4. The government borrows from foreign countries
Show answer
Answer: C — The RBI lends to banks for the short term
In a repurchase agreement a bank sells securities to the RBI and agrees to buy them back, so it receives cash — the RBI is lending, and the repo rate is the price. The RBI borrowing from banks is the reverse repo, the definition most often swapped with it; the rate banks charge the public is their own lending rate.
The Reserve Bank is called the "lender of last resort" because it:
1. Lends to individuals who are refused by every commercial bank
2. Is the last institution to set its interest rates each year
3. Lends only to the government
4. Lends to a bank in crisis when no one else will
Show answer
Answer: D — Lends to a bank in crisis when no one else will
The phrase describes the RBI's role as the banks' bank: when a bank faces a sudden withdrawal it cannot meet, the RBI lends to it so that one failure does not spread through the system. The RBI does not lend to individual borrowers at all, and while it is banker to the government, that is a separate function.
If the legal reserve ratio is raised from 10% to 20%, the maximum total deposits that an initial deposit of ₹1,000 can support:
1. Fall from ₹10,000 to ₹5,000
2. Rise from ₹5,000 to ₹10,000
3. Fall from ₹9,000 to ₹4,000
4. Stay at ₹10,000, because the deposit is unchanged
Show answer
Answer: A — Fall from ₹10,000 to ₹5,000
The multiplier is 1 ÷ LRR: 1 ÷ 0.10 = 10 before and 1 ÷ 0.20 = 5 after, so total deposits fall from ₹10,000 to ₹5,000 — a higher reserve ratio means less to lend each round. ₹9,000 to ₹4,000 are the credit-created figures, not total deposits, and a rise from ₹5,000 to ₹10,000 gets the direction backwards.