NCERT
Every NCERT book that matters for UPSC — open a book, then a chapter. Learn each chapter's concepts, then how UPSC tests them — with diagrams, flowcharts and the past questions to attempt.
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← Introductory Macroeconomics — all chaptersMoney and Banking
Start here: why this chapter matters
In simple wordsMoney is a promise everyone agrees to accept. Banks take that promise, lend it out, and — because people do not all withdraw at once — end up creating more money than the central bank printed. The RBI's job is to make sure there is neither too much (inflation) nor too little (slump). This chapter explains how all three — money, banks and the RBI — fit together.
Monetary policy is in the news after every RBI policy meeting: ‘repo rate unchanged’, ‘CRR cut’, ‘liquidity tight’, ‘inflation within the target band’. UPSC Prelims asks about this almost every year — the RBI's instruments, the money multiplier, measures of money, legal tender, the Monetary Policy Committee, and recently the digital rupee. This chapter gives the theory; the Beyond-NCERT notes give India's current framework (without quoting policy-rate levels, which change often).
- Builds on Chapter 2: money makes the circular flow possible; the ‘stock vs flow’ idea applies to money (a stock) and transactions (a flow); the GDP deflator reappears in money demand (P).
- Leads into: Chapter 4 (interest rates affect investment, hence income), Chapter 5 (borrowing from the RBI and deficit financing) and Chapter 6 (foreign exchange reserves, sterilisation, exchange rates).
- Class 10 Economics: Money and Credit — double coincidence, formal vs informal credit, SHGs, the RBI's supervision of banks.
- Indian Economic Development: Chapter 3 (1991 financial-sector reforms, RBI from regulator to facilitator) and Chapter 5 (rural credit, NABARD, SHGs, Jan Dhan) — the institutional side of banking.
- UPSC: GS3 ‘mobilisation of resources’, ‘inflation’, ‘monetary policy’; Prelims economy — instruments, multiplier, money measures, MPC, legal tender, CBDC.
| Word | What it means here |
|---|---|
| Barter / double coincidence of wants | Direct exchange of goods / each party must want exactly what the other has |
| Liquidity | How easily an asset can be turned into goods without loss; money is the most liquid |
| High-powered (reserve) money | Currency issued by the central bank held by the public and by banks, plus banks' deposits with it — the base for credit creation |
| Cash reserve ratio (CRR) | Share of deposits banks must keep as cash balances with the RBI |
| Statutory liquidity ratio (SLR) | Share of deposits banks must hold in liquid assets — cash, gold, approved government securities |
| Money multiplier | Total deposits (or money) created per rupee of reserves; = 1 ÷ CRR in NCERT's model |
| Repo / reverse repo | RBI lends to banks against securities with a repurchase agreement / RBI absorbs money from banks the same way |
| Open market operations | RBI buying (injects money) or selling (absorbs money) government securities |
| Bank rate | Rate at which the RBI lends to (or rediscounts bills of) commercial banks |
| Lender of last resort | The central bank stands ready to lend to banks in a liquidity crisis |
| Fiat money / legal tender | Money with no intrinsic value, backed by the issuer's guarantee / money no one may refuse in settlement |
| Narrow / broad money | M1, M2 / M3, M4 — in decreasing order of liquidity |
Reading the chapter-opening illustration (page 36)A man sits at a laptop holding a smartphone, with a coin marked with the rupee symbol floating above — money as digital information. The point: money today is mostly bank deposits and digital transfers, not paper; the chapter's ‘cashless’ paragraph (Jan Dhan, Aadhaar-enabled payments, e-wallets, National Financial Switch) develops this.
At a glance — the six ideas to carry away
- Barter fails without a double coincidence of wants; money is a medium of exchange, unit of account, store of value.
- Transaction demand = k·P·Y (rises with income and prices); speculative demand falls as interest rises; at rmin → liquidity trap.
- Bond prices move opposite to interest rates: a 10% bond is worth ≈ ₹109.30 at 5%, ≈ ₹107.33 at 6%.
- Banks create money: with CRR 20%, ₹100 reserves → ₹500 deposits, ₹400 loans. Money multiplier = 1 ÷ CRR (= 5).
- RBI tools: CRR, SLR, OMOs, repo/reverse repo, bank rate (+ SDF, MSF †) and qualitative tools; RBI is lender of last resort.
- M1 = CU + DD; M3 = M1 + time deposits (broad money, most used). Notes and coins are fiat money and legal tender; demonetisation: Nov 2016.
1. Barter, and what money does
In simple wordsYou have rice and want a shirt. The tailor has shirts but wants shoes, not rice. Without money you must hunt for someone who has shirts and wants rice. With money, you sell rice to anyone who wants it and buy a shirt from anyone who sells one.
Exchange without money is barter, which needs a double coincidence of wants; as the number of traders grows, search costs become prohibitive. An intermediate good acceptable to all — money — solves this. On a solitary island or in a self-sufficient family, money has no role; it matters as soon as several agents trade through markets.
Medium of exchange is the first and foremost function. As a unit of account, money lets us compare values: a pen at ₹10 and a pencil at ₹2 means 1 pen = 10 ÷ 2 = 5 pencils; a rupee is worth 1 ÷ 2 = 0.5 pencil or 1 ÷ 10 = 0.1 pen. If all prices rise, each rupee buys less — the purchasing power of money falls. As a store of value, money is non-perishable, cheap to store and universally acceptable — unlike rice — but works well only if prices are stable. Gold, land, houses and bonds also store value but are less liquid.
Towards cashless: NCERT notes India's push for financial inclusion and digital payments — Jan Dhan accounts, Aadhaar-enabled payment systems, e-wallets, the National Financial Switch — helped by mobile-phone spread.
Beyond NCERT
- Standard of deferred payment: loans, salaries and contracts are written in money — often listed as the fourth function.
- UPI (Unified Payments Interface, launched in 2016 by the National Payments Corporation of India) is the backbone of India's digital retail payments; UPI moves bank deposits, not new money.
- The digital rupee (e₹), India's central bank digital currency, began pilots in 2022 (wholesale in November, retail in December). It is a direct liability of the RBI, like a currency note — unlike a UPI payment, which moves a claim on a commercial bank (UPSC 2024, 2026; Mains 2026).
- Cryptocurrencies such as bitcoin are not issued by any central bank and are not legal tender in India.
Exam traps
- The first function is medium of exchange; store of value is weakened by inflation.
- Money is the most liquid asset, but it has an opportunity cost — the interest forgone.
- UPI is a payment system, not a currency; the e-rupee is a currency.
2. The demand for money
In simple wordsYou keep some cash in your wallet to pay for things through the month — the more you spend, the more you keep. You might also keep extra cash if you think it is a bad time to buy shares or bonds and want to wait. Those are the two motives: transactions and speculation.
Demand for money rises with income (more transactions) and falls with the interest rate (holding money means giving up interest). Box 3.1 develops two motives:
Transaction motive. Earn ₹100 on day 1 and spend it evenly: average balance = (100 + 0) ÷ 2 = ₹50 for ₹100 of monthly transactions. In NCERT's two-person economy (firm pays a worker ₹100; worker buys the firm's output), each holds ₹50 on average, total ₹100, while monthly transactions are ₹200 (₹100 of labour + ₹100 of goods). So MdT = k·T with k = ½; equivalently v·MdT = T, where v = 1/k = 2 is the velocity of circulation — each rupee changes hands twice a month. Since transactions move with nominal GDP, MdT = k·P·Y: transaction demand rises with real income Y and the price level P. (Money demand is a stock; transactions are a flow; velocity has a time dimension.)
Speculative motive. Lump all non-money assets into ‘bonds’. A two-year bond with face value ₹100 and 10% coupon pays ₹10 after one year and ₹110 after two. At a market interest rate of 5%, its present value = 10 ÷ 1.05 + 110 ÷ 1.05² = 9.524 + 99.773 = ₹109.30 (NCERT prints 109.29). Competition pushes the bond's price to its present value. At 6%: 10 ÷ 1.06 + 110 ÷ 1.06² = 9.434 + 97.899 = ₹107.33. So bond prices move inversely to interest rates. If you expect rates to rise, you expect bond prices to fall (a capital loss), so you sell bonds and hold money. Hence speculative demand is high when rates are low and low when rates are high: MdS = (rmax − r) ÷ (r − rmin).
Reading Fig. 3.1 — The Speculative Demand for Money (page 46)
- Interest rate r on the vertical axis, speculative money demand on the horizontal. At rmax demand is zero — everyone expects rates to fall and bond prices to rise, so all hold bonds. As r falls the curve slides right; near rmin it becomes flat and runs off to infinity.
- The flat stretch is the liquidity trap: everyone expects rates to rise, so any extra money is simply held — it cannot push the interest rate below the floor. Money demand is infinitely elastic there.
- Total demand: Md = kPY + (rmax − r) ÷ (r − rmin) (equation 3.5).
Beyond NCERT
- The liquidity trap is Keynes's idea (Chapter 1): in a deep slump, monetary policy can lose its power, so fiscal policy matters more. Near-zero interest rates in Japan and, after 2008, in many rich countries revived the debate.
- UPSC 2021: Indian government bond yields respond to the RBI's actions, the US Federal Reserve's actions, and inflation and short-term rates — all three. Higher yield = lower bond price.
- Keynes listed a third, precautionary motive (money kept for emergencies); NCERT folds it into the two.
Exam traps
- Transaction demand depends on income and prices; speculative demand on the interest rate.
- Interest rate up → bond prices down.
- In a liquidity trap, more money does not lower interest rates further.
3. The central bank and commercial banks
In simple wordsThink of the RBI as the banks' own bank and the government's bank. It prints the notes, keeps the government's account, holds the country's foreign currency, and lends to banks when they run short — just as a bank lends to you.
Money is created by two kinds of institutions. India's central bank, the Reserve Bank of India, came in 1935. Its functions (NCERT): it issues currency; controls money supply (bank rate, open market operations, reserve ratios); is banker to the government; is custodian of foreign exchange reserves; and is banker to banks. Currency it issues, held by the public or by banks, is high-powered money (reserve money, monetary base) — the base for credit creation.
Commercial banks accept deposits and lend part of them. They pay depositors less than they charge borrowers; the difference — the spread — is their profit. People keep deposits for interest, safety and convenience (cheques, debit cards). A bank keeps enough to repay depositors on demand and lends the rest; confidence that deposits can be withdrawn is what keeps the system alive.
Beyond NCERT
- RBI: established 1 April 1935 under the RBI Act, 1934; nationalised 1 January 1949 (UPSC 2004 — not 26 January 1950). Its Governor is appointed by the Central Government and draws powers from the RBI Act; the government's power to give it directions comes from the RBI Act, not the Constitution (UPSC 2021).
- Notes carry the RBI Governor's signed promise (UPSC 1980); coins and the ₹1 note are issued by the Government of India.
- Other roles: debt manager and banker to Central and State governments (handles their borrowing — UPSC 2001), regulator and supervisor of banks (liquidity, branch expansion, mergers — UPSC 2013), and payment-system overseer.
- A scheduled bank is one listed in the Second Schedule of the RBI Act (UPSC 1979).
- The RBI's accounting year was July–June (UPSC 1998's key) until it moved to April–March from 2020–21 — that key is now dated.
- Its main income comes from interest on government securities and foreign-currency assets (UPSC 2025).
Exam traps
- RBI was established in 1935 but nationalised in 1949.
- Coins are issued by the Government, notes (except ₹1) by the RBI.
- ‘Banker's bank’ = banks keep deposits with RBI, borrow from it, and are guided by it (UPSC 2012: all three).
4. Money creation and the money multiplier
In simple wordsLeela deposits ₹100. The bank keeps ₹20 and lends ₹80 to Jaspal, who pays a shopkeeper, who deposits it back. Now the bank keeps 20% of that and lends again. Each round is smaller, but together they add up — and ₹100 of real cash ends up supporting ₹500 of deposits.
A bank's balance sheet: assets = reserves + loans; liabilities = deposits; net worth = assets − liabilities. Reserves are the bank's cash and its deposits with the RBI. When a bank lends, it opens a new deposit in the borrower's name — so money supply = currency + old deposits + new deposits.
Reading Tables 3.1–3.3 — the fictional bank and the multiplier process (pages 40–41)
- Table 3.1: Ms Fernandes deposits ₹100; the bank holds it all as reserves. Assets: reserves 100; liabilities: deposits 100; net worth 0. With no currency, M1 = 0 + 100 = 100.
- Table 3.2 (CRR 20%): round 1 — deposits 100, required reserve 20, loan 80; round 2 — deposits 180, required reserve 36, loan 64 (= 100 − 36); … last — deposits 500, required reserve 100, loans 400. Our extension: round 3 — 244, 48.8, 51.2; round 4 — 295.2, 59.04, 40.96; round 5 — 336.16, 67.23, 32.77 …
- Small inconsistency: in rounds 1–2 column 4 shows the new loan of that round (80, 64), but in the last row it shows total loans (400). Read the last row as the cumulative position.
- Table 3.3: reserves 100 + loans 400 = assets 500; deposits 500 (100 + 400). M1 = 0 + 500 = 500.
⤵ Worked: the multiplier as a geometric series (NCERT Appendix 3.1)
Deposits created100 + 80 + 64 + 51.2 + … = 100 × (1 + 0.8 + 0.8² + 0.8³ + …)
Sum of an infinite geometric seriesa ÷ (1 − r) with a = 1 and r = 0.8 (the share lent each round) → 1 ÷ 0.2 = 5
Total deposits100 × 5 = ₹500; reserves ₹100 (20% of 500); loans ₹400
Money multiplier = 1 ÷ CRRCRR 20% → 5; CRR 25% → 4 (deposits ₹400, loans ₹300; the bank must call back ₹100 of loans)
NCERT's slips in this section
- CRR definition (page 40): ‘percentage of deposits which a bank must keep as cash reserves with the bank’. CRR balances are kept with the RBI, as the book itself says elsewhere.
- Reserves ‘in the form of bonds and treasury bills issued by the RBI’ (page 39): CRR reserves are cash balances with the RBI; government securities and treasury bills (issued for the government) count toward SLR, not CRR.
- Page 42: ‘Rs 100 in reserves could support deposits of Rs 400’ — it supports loans of ₹400 (deposits of ₹500).
- Appendix 3.1: it says the derivation uses a = 1 and r = 0.4, giving 1 ÷ 0.6 = 5/3. That is left over from an older edition; for this chapter's example r = 0.8, giving 5.
- Key Concepts list ‘currency deposit ratio’ and ‘reserve deposit ratio’, which the current text never defines (see Beyond NCERT).
Beyond NCERT — the multiplier with cash leakage
- If the public holds currency equal to a fraction c of deposits (currency-deposit ratio) and banks hold reserves r of deposits, then money multiplier = (1 + c) ÷ (c + r), money supply = multiplier × high-powered money.
- Example: c = 0.25, r = 0.10 → (1.25) ÷ (0.35) ≈ 3.57. If people use banks more (c falls to 0.10): 1.10 ÷ 0.20 = 5.5. Hence UPSC 2019 and 2021: the multiplier rises with the banking habit of the people, and falls with higher CRR or SLR.
- UPSC 2020: withdrawing ₹1,00,000 in cash from your account leaves money supply unchanged at once (deposits fall, currency with the public rises equally).
- Real-world money creation is limited also by banks' willingness to lend, borrowers' demand, capital requirements and SLR.
5. RBI's instruments of monetary policy
In simple wordsThe RBI controls money a bit like a water engineer controls a canal: it can change how much water must stay behind each gate (reserve ratios), pour water in or pump it out (buying or selling bonds), or change the price of borrowing water for a night (repo rate).
Because the RBI alone issues currency and lends to banks at all times, it is the lender of last resort. Its tools are quantitative (CRR, bank rate, open market operations — control the volume of money) and qualitative (moral suasion, margin requirements — steer lending to or away from particular uses).
- Reserve ratios: raising CRR cuts the multiplier and lending (UPSC 2010: banks have less to lend). SLR requires liquid assets (cash, gold, approved government securities) — it also makes banks lend to the government by holding its bonds (UPSC 2010 key). Cutting SLR frees funds, so banks may cut lending rates (UPSC 2015).
- Open market operations: the RBI buys government bonds → pays with a cheque → banks' reserves rise → money supply rises; selling does the reverse (UPSC 2013). Outright OMOs are permanent; repo deals are temporary: the RBI buys securities with an agreement to resell at a set date and price — the interest charged is the repo rate; reverse repo absorbs money the same way. Repo operations at overnight, 7-day, 14-day and other tenors are now the main tool.
- Bank rate: the rate at which the RBI lends to (or discounts bills of) banks; raising it makes borrowing dearer, cuts reserves and money supply (UPSC 1995, 2011, 2013: a higher bank rate signals tight money).
- Qualitative: margin requirements (how much of an asset's value can be borrowed against), moral suasion, selective credit control, rationing (UPSC 1995: variable reserve ratios are not selective — they are quantitative).
⤵ How a repo-rate rise is meant to cool inflation (transmission)
MPC raises the repo ratebanks' cost of borrowing from the RBI rises; the call money rate follows within the corridor
Banks raise lending and deposit ratesvia external benchmarks such as the repo rate; earlier the MCLR (2016) and base rate
Borrowing and spending slowhome, car and business loans dearer; saving more attractive; bond prices fall
Aggregate demand coolsless pressure on prices (Chapter 4)
Rupee may firmhigher yields can draw capital inflows (Chapter 6)
Inflation moves towards target — with a lagweak against supply shocks such as vegetable prices (Mains 2024)
Beyond NCERT — India's framework
- Monetary Policy Committee (RBI Act amended in 2016): six members — the Governor (chair, with a casting vote), a Deputy Governor, one RBI officer, and three external members appointed by the government for four years. It sets the repo rate; it is not chaired by the Finance Minister and not reconstituted annually (UPSC 2017).
- Inflation target: CPI (Combined) inflation of 4% with a band of ±2%, first notified in 2016 for 2016–21 and retained for 2021–26; whether and how it was re-notified for the period after March 2026 should be checked in the latest official notification. If inflation stays outside the band for three consecutive quarters, the RBI must report the reasons to the government.
- LAF (from 2000) sets short-term rates: MSF (from 2011) is the ceiling, and the Standing Deposit Facility (from April 2022) replaced the fixed-rate reverse repo as the floor; the bank rate is kept aligned with the MSF rate. NBFCs cannot use the LAF window (UPSC 2024).
- UPSC 2020: an expansionary RBI would cut SLR, bank rate and repo — it would not raise the MSF rate.
- UPSC 2022: price stability is the RBI's responsibility; to fight high inflation it would sell, not buy, government securities.
Exam traps
- RBI buying bonds = injecting money; selling = absorbing.
- Repo = RBI lends to banks; reverse repo / SDF = RBI borrows from (absorbs from) banks.
- CRR earns banks no interest from the RBI; SLR securities do earn interest.
- Lender of last resort = lending to banks in temporary liquidity trouble — not to industry or to finance budget deficits (UPSC 2021).
6. Measures of money supply; fiat money and legal tender
In simple wordsWhich counts as ‘money’ — only the notes in your wallet? The balance in your savings account that you can spend by UPI? Your fixed deposit that you can break with a small penalty? Each answer gives a different measure, from the narrowest (most spendable) to the broadest.
Money supply is a stock: the total money held by the public at a point of time. It consists of currency (notes from the RBI, coins from the government) and bank deposits. Demand deposits (savings and current accounts) are payable on demand; time deposits (fixed deposits) have a maturity. NCERT's RBI definitions:
| Measure | Definition (NCERT) | Type |
|---|---|---|
| M1 | CU (currency with the public) + DD (net demand deposits of banks) | Narrow money — most liquid |
| M2 | M1 + savings deposits with post office savings banks | Narrow money |
| M3 | M1 + net time deposits of commercial banks | Broad money — most used; ‘aggregate monetary resources’ |
| M4 | M3 + total post office savings deposits (excluding National Savings Certificates) | Broad money — least liquid |
‘Net’ means only the public's deposits; inter-bank deposits are excluded. Notes and coins are fiat money — their value comes from the issuer's guarantee, not the paper or metal — and legal tender: no one may refuse them in settlement. Cheques on demand deposits can be refused, so deposits are not legal tender.
Reading Table 3.4 — M1 and M3, 1999–2000 to 2024–25 (page 51)
- ₹ crore: M1 3,41,796 → 65,84,081; M3 11,24,174 → 2,72,86,589 — both up about 19–24 times in 25 years. The gap is time deposits.
- M3 is about 3.3× M1 in 1999–2000 and about 4.1× in 2024–25 — Indians hold proportionally more in fixed deposits.
- 2016–17 (demonetisation): M1 grew only 3.1% (26,02,538 → 26,81,957) against 13.5% the year before, as currency was withdrawn; M3 still grew because old notes were deposited in banks.
- The title ‘(in crore) (2023-24)’ is confusing — the series runs to 2024–25.
Reading Table 3.5 — Sources of change in monetary base (page 52)
- Columns: currency in circulation = cash with banks + currency with the public (checked for every year); other deposits with the RBI; bankers' deposits with the RBI. These are the parts of reserve money.
- Slips: 2016–17 ‘currency with the public’ is printed 124124 — it must be 12,64,124 (13,35,266 − 71,142); 2024–25 ‘cash with banks’ is printed 9396 — it must be about 93,697 (37,24,448 − 36,30,751).
- The point: demonetisation cut currency in circulation from ₹16.63 to ₹13.35 lakh crore (−19.7%) and currency with the public by about 21% in a year; it recovered by 2017–18 and kept rising.
- Note that ‘other deposits with the RBI’ appears here, though NCERT's M1 definition omits it.
Beyond NCERT
- RBI's standard M1 also includes ‘other deposits with the RBI’ (OD) — which is why UPSC 1997's broad money = currency + demand deposits + time deposits + other deposits with RBI (all four). UPSC 2002: M3 includes currency, demand and time deposits.
- Reserve money (M0) = currency in circulation + bankers' deposits with the RBI + other deposits with the RBI.
- Following its 1998 Working Group, the RBI also compiles NM0–NM3 and liquidity aggregates L1–L3; M3 remains the headline broad-money figure.
- Liquidity order (UPSC 2013): currency → demand deposits → savings deposits → time deposits.
- UPSC 2018: legal tender is money a creditor is compelled to accept.
Exam traps
- M2 adds post-office savings deposits, M3 adds bank time deposits — both build on M1, not on each other.
- M1 and M2 are narrow; M3 and M4 broad. Liquidity decreases from M1 to M4.
- Cheques and UPI balances are not legal tender; notes and coins are.
7. Demonetisation, 2016
In simple wordsImagine the school announces at night that all old canteen tokens stop working tomorrow; you must exchange them at the office within seven weeks. Hidden stockpiles of tokens are exposed — but the canteen also nearly stops for a while because there are not enough new tokens. That, in miniature, was demonetisation.
On 8 November 2016 the Government of India announced that the existing ₹500 and ₹1,000 notes would cease to be legal tender; new ₹500 and ₹2,000 notes were issued. Stated aims (NCERT): curb corruption, black money, terror financing and counterfeit notes. Old notes could be deposited in bank accounts for about seven weeks, and later with the RBI with a declaration; limited exchange and temporary acceptance at petrol pumps, government hospitals and for government dues eased the transition.
⤵ Demonetisation in sequence
8 Nov 2016: ₹500 and ₹1,000 notes cease to be legal tenderabout 86% of currency by value withdrawn at once †
Deposit and exchange windowold notes deposited in banks till end-December 2016; limited exchanges; queues at banks and ATMs
Short-run costscash shortage hit informal trade, farm sales and daily-wage work; currency with the public fell about 21% in 2016–17 (Table 3.5)
Claimed gainsmore tax filers, deposits into the formal system, a push to digital payments (NCERT)
Outcome debatedRBI later reported that almost all withdrawn notes came back (≈ 99% †); currency in circulation recovered by 2017–18
Reading Box 3.2 — Demonetisation (page 49)
- Describes the November 2016 move, the replacement notes, deposit deadlines (to ‘31 December 2016’ in banks; to 31 March 2017 with the RBI with a declaration), exchange of ₹4,000 per person, and temporary acceptance of old notes for essential payments.
- Notes the long queues and the adverse effect on economic activity, then lists benefits: better tax compliance, savings moved into banks (so more lending at lower rates), a signal against tax evasion, and a shift to electronic payments.
- The box mentions criticism in one paragraph but argues mainly for the measure. For exams, present both sides with evidence (see below).
- Dates in the box are simplified: the bank deposit window closed on 30 December 2016, and exchange limits and acceptance deadlines changed several times — check RBI notifications for exact dates.
Why the verdict is still debated
- Supporters point to the jump in digital payments (UPI grew rapidly from 2016–17), wider tax filing, data on cash deposits that helped tax authorities, and a one-time hit to counterfeit notes.
- Critics point to the RBI's finding that about 99% of the withdrawn notes (≈ ₹15.3 of ₹15.4 lakh crore †) returned — suggesting little black money was held in cash — to the short-run output and job losses in the informal sector, and to currency in circulation soon exceeding pre-2016 levels.
- A balanced answer separates the stated aims, the evidence on each, and the costs borne by the cash-dependent poor.
Beyond NCERT
- Demonetisation was legally done by notification under the RBI Act and later backed by the Specified Bank Notes (Cessation of Liabilities) Act, 2017.
- In May 2023 the RBI withdrew the ₹2,000 note from circulation; it remains legal tender.
- India had demonetised high-value notes before, in 1946 and 1978.
8. Inflation, sterilisation and the limits of monetary policy
In simple wordsIf lots of dollars flow into India and the RBI buys them to stop the rupee rising too fast, it pays with newly created rupees — more money in the economy. To stop that extra money pushing up prices, the RBI sells government bonds and soaks the rupees back up. That mopping-up is ‘sterilisation’.
NCERT's summary says the RBI regulates money supply by controlling high-powered money, the bank rate and reserve requirements, and that it ‘sterilises’ money supply against external shocks — a term the chapter does not explain. In practice: foreign-exchange purchases add to reserve money; the RBI offsets them with OMO sales (UPSC 2023: sterilisation = open market operations) or other absorption tools.
- Excess money → inflation: if money grows much faster than output, prices tend to rise (UPSC 2015: decreased money circulation helps control inflation). Central banks worldwide raised rates after the pandemic, believing monetary policy can counter rising prices (UPSC 2023, statement II explains statement I).
- Limits: monetary policy works through demand; it is slow and weak against supply shocks (vegetables, pulses, oil). Mains GS3 2024 asked about persistent food inflation and the effectiveness of RBI's policy — argue both its role in anchoring expectations and the need for supply-side measures (storage, trade policy, buffer stocks).
- Liquidity trap (section 2): at very low rates more money may not lower rates or raise spending — fiscal policy (Chapter 5) then matters more.
Beyond NCERT
- India used a Market Stabilisation Scheme (from 2004) to issue special government securities for sterilisation; the SDF (2022) now gives the RBI a tool to absorb liquidity without collateral.
- Debate: inflation targeting vs a broader mandate. Supporters credit the framework with lower, more stable inflation since 2016; critics say a CPI target with a high food weight makes policy react to supply shocks it cannot fix, and that growth and employment deserve more weight.
NCERT's in-text question — short answer
In the fictional bank example, what would the money multiplier be if the RBI increases the reserve ratio to 25 per cent? (page 42)
Multiplier = 1 ÷ 0.25 = 4. ₹100 of reserves now supports deposits of 100 × 4 = ₹400 and loans of 400 − 100 = ₹300. Since loans were ₹400 at 20%, the bank must call back ₹100 of loans; deposits fall from ₹500 to ₹400, so money supply falls.
NCERT exercise — answer outlines
Try each question yourself first. The exercise has no numericals; the multiplier and bond examples above are fully worked.
1. What is a barter system? What are its drawbacks?
Direct exchange of goods without money. Drawbacks: needs a double coincidence of wants (high search costs); no common unit of account (every good priced in every other); poor store of value (perishable, bulky goods); indivisibility; no standard for deferred payments.
2. What are the main functions of money? How does money overcome the shortcomings of a barter system?
Medium of exchange (removes the double coincidence: sell to anyone, buy from anyone); unit of account (one yardstick: pen ₹10, pencil ₹2 → 1 pen = 5 pencils); store of value (non-perishable, cheap to store, universally acceptable, if prices are stable); also standard of deferred payment.
3. What is transaction demand for money? How is it related to the value of transactions over a specified period of time?
Money held to carry out transactions. It is a fraction k of the value of transactions T per period: MdT = k·T, or v·MdT = T where v = 1/k is velocity. Example: two-person economy, transactions ₹200 a month, money held ₹100 → k = ½, v = 2. Since T moves with nominal GDP, MdT = k·P·Y.
4. What are the alternative definitions of money supply in India?
M1 = CU + DD (+ other deposits with RBI); M2 = M1 + post office savings bank deposits; M3 = M1 + net time deposits of banks; M4 = M3 + total post office savings deposits (excluding NSCs). M1, M2 narrow; M3, M4 broad; liquidity falls M1 → M4; M3 is most used. (Beyond: RBI's NM0–NM3 and L1–L3.)
5. What is a ‘legal tender’? What is ‘fiat money’?
Legal tender: money that cannot be refused in settlement of a debt — notes and coins (cheques can be refused). Fiat money: money with no intrinsic value, accepted because of the issuer's guarantee (the RBI Governor's promise on a note), unlike a gold coin.
6. What is High Powered Money?
Currency issued by the central bank, held by the public and by commercial banks (as cash and as deposits with the RBI) — also called reserve money or monetary base. It is the base on which banks create deposits; money supply = money multiplier × high-powered money.
7. Explain the functions of a commercial bank.
Accept deposits (demand and time); lend (loans, overdrafts, cash credit, discounting bills) and earn the spread; create credit (deposits through lending); payments (cheques, cards, transfers, UPI); agency and utility services (lockers, remittances, collecting bills, foreign exchange).
8. What is money multiplier? What determines the value of this multiplier?
The ratio of money supply (or total deposits) to reserves / high-powered money. In NCERT's model = 1 ÷ CRR (20% → 5). More generally (1 + c) ÷ (c + r): it falls with a higher reserve ratio r (CRR, SLR, excess reserves) and a higher currency-deposit ratio c, and rises with the banking habit.
9. What are the instruments of monetary policy of RBI?
Quantitative: CRR, SLR, open market operations (outright), repo and reverse repo under the LAF (with SDF and MSF today), bank rate. Qualitative: margin requirements, moral suasion, selective credit controls, credit rationing, priority-sector norms. Explain the direction of each for easy vs tight money.
10. Do you consider a commercial bank ‘creator of money’ in the economy?
Yes: when a bank lends, it creates a new deposit, which is money; through repeated lending and redepositing, ₹100 of reserves can support ₹500 of deposits at CRR 20% (Lala's story; Tables 3.2–3.3). But the system is limited by reserve requirements, the public's cash holding, borrowers' demand and the RBI's supply of reserves — banks cannot create high-powered money.
11. What role of RBI is known as ‘lender of last resort’?
Its readiness to lend to commercial banks at all times, especially when they face a temporary liquidity shortage and cannot borrow elsewhere — preventing bank runs and panics. Today this is done through the LAF, MSF and special facilities (UPSC 2021: providing liquidity to banks in temporary crisis).
What to remember
Numbers
RBI established1935 (nationalised 1949 †)
Money multiplier (NCERT)1 ÷ CRR: 20% → 5; 25% → 4
Fictional bank at CRR 20%reserves 100 → deposits 500, loans 400
Table 3.2 roundsdeposits 100, 180, 244, 295.2 … → 500
Bond PV at 5% / 6%≈ ₹109.30 / ≈ ₹107.33
Two-person economymoney ₹100, transactions ₹200, velocity 2
Pen and pencil1 pen = 5 pencils; ₹1 = 0.5 pencil = 0.1 pen
M3 / M1, 1999–2000 → 2024–25≈ 3.3 → ≈ 4.1
M3, 2024–25≈ ₹272.9 lakh crore
M1 growth in 2016–173.1% (13.5% the year before)
Currency with the public, 2016–17−21% (₹15.97 → ₹12.64 lakh crore)
Demonetisation8 Nov 2016; ₹500 and ₹1,000 notes
MPC † (2016)6 members, Governor chairs
Inflation target †CPI 4% ± 2%
LAF / MSF / SDF †2000 / 2011 / April 2022
e-rupee pilot †2022; ₹2,000 note withdrawn 2023 †
One-liners
- Money removes the double coincidence of wants.
- Medium of exchange, unit of account, store of value (+ deferred payment).
- Transaction demand ∝ PY; speculative demand falls with r.
- Bond prices and interest rates move in opposite directions.
- Banks create money by lending; reserves limit it.
- Money multiplier = 1 ÷ CRR (NCERT); (1 + c) ÷ (c + r) generally.
- RBI buys bonds → money up; sells → money down.
- M1 = CU + DD; M3 = M1 + time deposits (broad money).
- Notes and coins: fiat money and legal tender; cheques are not.
Traps to avoid
- CRR is kept with the RBI, not ‘with the bank’ (NCERT's slip).
- ₹100 reserves at 20% supports loans of ₹400, deposits of ₹500 (NCERT says ‘deposits of 400’).
- Appendix 3.1's r = 0.4 → 5/3 is wrong for this example; r = 0.8 → 5.
- Higher CRR or SLR → smaller multiplier; more banking habit → larger.
- Variable reserve ratios are quantitative, not selective, controls.
- Repo: RBI lends; reverse repo/SDF: RBI absorbs. MSF is the ceiling.
- MPC: 6 members, chaired by the RBI Governor — not the Finance Minister.
- RBI nationalised 1 January 1949, not 1950.
- Coins are issued by the Government; notes by the RBI.
- Withdrawing cash from your account leaves money supply unchanged.
- Table 3.5's ‘124124’ (2016–17) is really 12,64,124; ‘9396’ (2024–25) is ≈ 93,697.
- RBI's accounting year is now April–March (since 2020–21), not July–June.
How to strategise
Prelims — what UPSC asks
- Instruments (most frequent): bank rate (1995, 2011, 2013), OMOs (1993, 2013), CRR (2010), SLR (1998, 2010, 2015), statutory reserves' purpose (2014), MSF and NDTL (2014), expansionary policy (2020), selective credit control (1995), interest-rate policy as monetary policy (1989, 1992), components of monetary policy (2015), MCLR (2016), LAF and NBFCs (2024).
- Money and multiplier: broad money and M3 (1997, 2002), liquidity order (2013), multiplier and banking habit (2019, 2021), cash withdrawal and money supply (2020), measures that raise money supply (2012), legal tender (2018), the Governor's signature on notes (1980).
- RBI as an institution: established 1935 (1987), nationalisation date (2004), functions (1991, 2001, 2012, 2013), Governor and RBI Act (2021), lender of last resort (2021), price stability (2015, 2022), accounting year (1998, dated), income (2025), scheduled banks (1979), MPC (2017), sterilisation (2023), global rate hikes (2023), bond yields (2021), and repo (2007).
- New money: CBDC (2023), digital rupee (2024), UPI vs digital rupee (2026).
Mains — where it appears and how to answer
- GS3 2024: persistent food inflation and how effective RBI's monetary policy is against it — causes (supply shocks, weather, storage, input costs), what monetary policy can do (anchor expectations, second-round effects) and cannot (supply), and complementary measures.
- GS3 2026: the digital rupee — what it is (RBI liability, sovereign currency), wholesale and retail pilots since 2022, benefits (cost, programmability, cross-border), concerns (privacy, bank disintermediation, uptake vs UPI).
- Answer frame for monetary policy: objective (price stability with growth; 4% ± 2%) → institution (MPC) → instruments (repo, SDF/MSF, CRR, SLR, OMOs) → transmission → limits (supply shocks, liquidity trap, fiscal dominance) → balanced conclusion.
- For demonetisation, use evidence on both sides: ≈ 99% of notes returned and short-run informal-sector costs vs digital-payment growth and wider tax base.
Self-check
Tap an option. NCERT's own exercise questions come first; the rest test the figures and common confusions.
1. With a cash reserve ratio of 10% and no currency held by the public, ₹200 crore of new reserves can support total deposits of:
2. If the RBI buys government securities in the open market, it will:
3. When the market rate of interest rises, the price of an existing bond:
4. Which of the following will increase the money multiplier?
5. M3 (broad money) in India equals:
6. Which statement about the Monetary Policy Committee is correct?
7. Demand deposits are NOT legal tender because:
8. The ‘lender of last resort’ function of the RBI means:
UPSC questions from this chapter
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