Money and Banking class 12 Notes studies the various concepts about the

money used in the Indian economy and the role of commercial and central
banks in supply of money and credit creation.
Money is an important discovery of modern times. It is the basic requirement
of all economies in today’s time.
Before money was invented, the world used to trade as per the barter system
of exchange in which the commodity was exchanged for another commodity.

Money and Banking is an important concept as one cannot imagine his life
without money. Banks also plays an important role as they are considered a
better place to store money or take advances and loans.

Money and Banking Class 12 Notes

Economics: Overview
What is MONEY?
Money is anything which is generally used as a medium of exchange,
measure of value, store of value and means of standard deferred payment.
It covers all types of money: coins, paper notes, cheques, digital money,
plastic money etc…. It can be used to buy anything as it is legally accepted by
everyone. It removes the problem of double coincidence of wants as anyone
can buy anything he needs.

FUNCTIONS OF MONEY
The functions of money are broadly classified as:

1. Primary Functions
2. Secondary Functions
TYPES OF MONEY
1. Legal Tender Money: Money which can be legally used to make
payments for some obliged debt is known as legal tender money. It is of
two types-
•
• Limited legal tender money: It is that form of legal money which is
used to make payments for the debts up to a certain amount. For
example; coins.
• Unlimited legal tender money: It is that form of legal money which
can be used to make payment of debts up to any amount. There is
no limit fixed. For example; paper/ currency notes.
2. Full Bodied Money: It is that form of money in which face value is
equal to intrinsic value of money. It means commodity value= money
value. For example: gold and silver coins.
3. Representative Full Bodied Money: It is that form of full bodied money
in which intrinsic value is less than face value of money. It means
commodity value< money value. For example: paper notes.
4. Credit Money: It is that form of money whose intrinsic value is lower
than its face value. It means that money value> commodity value. For
example: credit cards, bank deposits etc….
MONETARY SYSTEM IN INDIA
• In India, monetary authority is ‘Reserve Bank of India’.
• Paper currency standard is followed in India.
• Coins are regarded as limited legal tender money.
• RBI has sole monopoly to issue currency in India.
• Ministry of Finance issues 1 rupee coins and notes in India.
• India follows Minimum Reserve System for issuing notes. It means that
RBI has to keep a minimum of Rs. 200 crores as gold and foreign
exchange with the World Bank for issuing coins and notes.
MONEY SUPPLY
Money supply refers to the total money held by public at a particular point of
time in an economy.

It includes money only held by the “public” not the government or banking
system. Money supply is a “Stock” concept.

There are 4 measures of money supply. As per money and banking class 12
we need to cover only M1 measure of money supply.
MEASURES OF MONEY SUPPLY
(i) M1: It is the first and basic measure of money supply. It includes currency
held by the public, demand deposits of commercial banks and other deposits
with the RBI.
M1= Currency and coins with public+ Demand deposits with commercial
banks+ Other deposits with RBI
(ii) M2: It is a broader concept of money supply as compared to M1. It also
includes savings deposits with the post office saving bank.
M2 = M1 + Savings deposit with Post office saving bank
(iii) M3: It also includes net time deposits in addition to M1 measure of money
supply.
M3 = M1 + Net time deposits with banks
(iv) M4: It includes total deposits with post office savings bank in addition to
M3 measure of money supply.
M4 = M3 + Total deposits with post office saving bank
• M1 is the most liquid form of money supply while M4 is the least liquid.
• M1 and M2 are considered the narrow concept of money supply while
M3 and M4 are the broader concept of money supply.
HIGH POWERED MONEY
• High powered money is the money produced by RBI and the
government.
• It includes currency held by the public and the cash reserves held by the
banks.
 • It is denoted by symbol (H).
• It is different from money because money consists of demand deposits
while it includes cash reserves which act as a base for generating
demand deposits.
BANKING
There are mainly 2 types of banks, Commercial Banks and Central Banks. In
money and banking class 12 we will study about the functions of both banks
and the credit creation process of commercial banks.

COMMERCIAL BANKS
A commercial bank is a bank which accepts deposits and advance loans for
the purpose of earning profits. For example: SBI, PNB, Canara Bank, Kotak
Mahindra Bank etc….

CREDIT CREATION PROCESS

This is an important activity of commercial bank. Through this process,
commercial banks create credit, which is created through excess reserves of
the initial deposits.

There are two main assumptions

1. The entire banking system is one unit known as “BANK”.

2. All the receipts and payments in the economy is done through the Banks.
For the credit creation, commercial banks are legally required to keep a
certain fraction of deposits with RBI and themselves. This fraction is
called Legal Reserve Ratio (LRR).
The bank knows that all the customers will not come in one go to withdraw
their money and that there is a constant flow of money with the bank. That’s
why only a fraction of deposits are kept as reserve.

• Money creation is an important aspect of money and banking class 12.

Let us take a hypothetical example to understand this concept.
• Let us assume that LRR= 10% and Initial deposits= Rs. 100.
• Now, the banks will keep 10% of Rs. 100 as reserve and give the rest
Rs.90 as loan to the public in round 1.
• In round 2, banks will keep 10% of Rs. 90 as reserve and give Rs. 81 as
loan to public.
• This process goes on and on till the reserves are exhausted. In this
way, commercial banks create multiple credits with just the initial
deposit.
• This gives rise to the concept of “Money Multiplier”.
• “Money Multiplier” or deposit multiplier measures the amount of deposits
the commercial banks are able to create through the deposits of public
kept with them as reserves.
Money Multiplier = 1/LRR
• In this case, money multiplier is 1/10% = 10.

Total Deposits= = 100*10= Rs. 1000

CENTRAL BANKS

Central bank is the ‘apex’ body that controls, regulates and operates the entire
banking system in the country. In India, the central bank is RBI.

FUNCTIONS OF CENTRAL BANK

1. Bank of issue: Central bank has the sole authority to issue currency
notes and coins (except one rupee notes and coins). The central bank is
obliged to keep the reserves in terms of gold equal to the amount of
currency issued with the World Bank. It leads to uniformity in note
circulation. It gives the power to Central Bank to enhance the money
supply. It also helps in maintaining stability in value of money.
2. Bankers to Government: The RBI acts as a banker, agent and a
financial advisor to the central and state government. As a banker, it
carries out all the banking business of the government. As an agent, it
manages the public debt. As a financial advisor, it advices the
government from time to time in financial and monetary matters.
3. Banker’s Bank: Being the apex bank, central bank acts as a banker to
all other banks. Other banks in the economy keep their reserves with
the RBI. It has same relationship with other banks as the commercial
banks have with the public. It obliges the commercial banks to keep
CRR with them during the credit creation process.
4. Custodian of Foreign Exchange: Central banks keep the reserves of
foreign currency with themselves so that there is no excess increase or
decrease in price of foreign currency. Central bank does this so that
foreign reserves are available to the public.
5. Lender of Last Resort: When commercial banks fail to meet the needs
of the public, then RBI helps the commercial banks and the public by
advancing loans to them and acts as a lender of last resort.
6. Clearing House: Central bank has the reserves of commercial banks
with themselves. All commercial banks have their accounts with the
RBI. Therefore, RBI can make settlement of claims of various banks
against each other by editing the entries in their accounts.
7. Supervisor: Central bank regulates and controls the commercial banks.
It exercises regular inspection and of banks and entries passed by
them.

CONTROL OF CREDIT AND MONEY SUPPLY

There are TWO ways of controlling the credit creation in the market:
Quantitative measure and Qualitative measures.

QUANTITATIVE MEASURES

1. Repo Rate: It is the rate at which central bank gives money to

commercial banks for short- term purpose without any
collateral. An increase in repo rate reduces the capability of commercial
banks to lend money and thus decreases money supply in the
economy. A decrease in repo rate increases the money supply in the
economy.
2. Bank Rate: It is the rate at which central bank lends money to
commercial banks for long- term purpose by keeping something as
collateral. An increase in bank rate will decrease the lending capacity of
commercial banks and thus reduces money supply in the economy.
A decrease in bank rate increases the money supply in the economy.
3. Reverse Repo Rate: It is the rate at which commercial banks keep their
reserves with central bank in order to earn interest
willfully. An increase in reverse repo rate induces commercial banks to
keep reserves with central bank rather than giving to public. So, money
supply decreases in the economy. A decrease in reverse repo rate
increases the money supply in the economy.
4. Legal Reserve Ratio (LRR): It is the amount of deposits which the
commercial banks are obliged to keep with themselves and the central
bank for credit creation process. There are two parts of LRR: CRR and
SLR.
•
• Cash Reserve Ratio (CRR): It is the amount of deposits which the
commercial banks are obliged to keep with the central bank for
creating credit in the economy. An increase in CRR decreases
money supply in economy and decrease in CRR increases money
supply in the economy.
• Statutory Liquidity Ratio (SLR): It is the amount of deposits which the
commercial banks are obliged to keep with themselves for the credit
creation process. An increase in SLR decreases money supply in
economy and decrease in SLR increases money supply in the
economy.
QUALITATIVE MEASURES
1. Open Market Operations: It refers to the sale and purchase of
securities in the open market by the central bank to/from commercial
banks or public. Purchase of securities by central bank increases the
bank capacity to give credit as it receives money and thus it increases
the money supply in the economy. Sale of securities by commercial
banks soaks the excess money from the economy and thus reduces the
money supply in the market.
2. Margin Requirement: It refers to the difference between the amount of
loan and the market value of the securities offered against the
loan. An increase in margin reduces the borrowing capacity and
reduces the money supply in the economy. A decrease in margin
increases the borrowing capacity and increases the money supply in the
economy.
DIFFERENCE BETWEEN COMMERCIAL BANK AND CENTRAL
BANK