Money and Banking

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Money is any generally accepted medium of exchange that simultaneously performs the role of unit of account and store of value. The RBI measures it through four aggregates — M0 (reserve money), M1 (narrow money), M3 (broad money), and M4 — based on liquidity and the type of deposit included. High-powered money (H) equals currency with the public plus bank reserves with the RBI (M0). The money multiplier formula to memorise is:

m = (1 + c) / (c + rd), where c is the currency–deposit ratio and rd is the reserve–deposit ratio.

The RBI conducts monetary policy through the policy repo rate (now 5.50% w.e.f. June 2025), the LAF corridor (MSF ceiling, SDF floor), CRR (4%) and SLR (18%), and Open Market Operations (OMO). High-yield pointers: (1) distinguish narrow money (M1) from broad money (M3); (2) fractional reserve banking is the engine of credit creation; (3) RBI is the lender of last resort and the issuer of banknotes above ₹2.

🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Definitions and Functions of Money

Money is defined by what it does, not by what it is made of. Its primary functions are: medium of exchange (eliminates the double coincidence of wants), unit of account (numerical pricing of all goods), store of value (wealth held over time), and standard of deferred payment (settlement of future obligations). Qualities that make a good money item are durability, portability, divisibility, homogeneity, acceptability, and controlled scarcity. Modern money is overwhelmingly fiat money — inconvertible paper currency made legal tender by statute. Near-money assets (e.g., savings deposits, small savings schemes) are highly liquid but not directly usable as a means of payment.

Monetary Aggregates in India

The RBI publishes four stock measures:

Aggregate	Components	Interpretation
M0	Currency with public + Bankers’ deposits with RBI + Other deposits with RBI	Reserve / high-powered money (H)
M1	M0 + Demand deposits of banks + Other deposits with RBI	Narrow money
M2	M1 + Savings deposits of post offices	—
M3	M1 + Time deposits with banks	Broad money (most-cited)
M4	M3 + Total deposits with post offices (excluding NSS)	—

Fractional Reserve Banking and Credit Creation

Banks keep only a fraction (rd) of deposits as reserves and lend out the rest. The act of lending creates a new deposit of equal size in the borrower’s account — this is credit creation. A single bank can only create credit equal to Initial deposit / rd, but the banking system as a whole can expand deposits by the multiple m = 1/rd (ignoring cash leakages). With both leakage parameters, m = (1 + c) / (c + rd). Hence money supply M = m × H.

Monetary Policy Instruments (RBI)

The RBI uses quantitative tools — CRR (4%), SLR (18%), OMO, and open market borrowings of the government — and qualitative tools — moral suasion, credit rationing, and priority-sector directives. The LAF corridor is anchored by the policy repo rate (5.50%), with MSF at repo + 25 bps (lending window) and the SDF at repo – 25 bps (absorption window, introduced April 2022). The Bank Rate equals the MSF rate.

Exam Question Patterns

RBI Grade B Phase II (ESI) typically asks: (i) a 10-mark descriptive on the difference between narrow and broad money, (ii) a numerical on the money multiplier, (iii) a short note on CRR vs SLR, and (iv) a current-affairs hook on the latest Monetary Policy Committee (MPC) decision.

🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Mechanism: From Reserve Money to Broad Money

Start from the RBI’s balance sheet. When the RBI purchases government securities under OMO, it credits the reserve account of the selling bank. Bank reserves (R) rise, currency with public (C) is unchanged, so M0 (= C + R) rises by the same amount. If the entire H injection is held as reserves, broad money does not change. But once banks lend, the deposit multiplier takes over. Suppose c = 0.4 (public holds ₹0.40 as cash per ₹1 of deposit) and rd = 0.2. Then m = (1 + 0.4) / (0.4 + 0.2) = 2.33. A ₹1,000 cr injection of H therefore raises M3 by roughly ₹2,333 cr.

This is exactly why the RBI watches the currency–deposit ratio carefully — it is endogenous. During demonetisation (Nov 2016) c spiked and the multiplier collapsed, sterilising part of the intended monetary expansion. During COVID-19 (2020–21), c surged again as households hoarded cash, weakening transmission of rate cuts.

LAF Corridor and Rate Transmission

The corridor system (SDF floor, MSF ceiling) is engineered so that overnight rates hover near the policy repo rate. The Standing Deposit Facility (April 2022) replaced the uncollateralised reverse repo as the floor, eliminating the asymmetric incentive that had pushed overnight rates persistently below the repo rate. Banks now have a hard floor at SDF (5.25%) and can borrow overnight from RBI at MSF (5.75%). The width of ±25 bps constrains volatility without taxing banks’ parking decisions.

Credit Creation: A Worked Illustration

A fresh primary deposit of ₹1,000 enters Bank A. With rd = 0.10, Bank A keeps ₹100 and lends ₹900, which is redeposited in Bank B. Bank B keeps ₹90 and lends ₹810. Total deposits created = 1,000 + 900 + 810 + 729 + … = ₹10,000 = 1/rd. The same logic holds for cheque clearing, RTGS, and NEFT — these are settlement systems, not creators of money. NEFT operates in half-hourly batches; RTGS is real-time and gross (minimum ₹2 lakh). The NEFT/IMPS/UPI stack has dramatically reduced the velocity cost of retail payments.

Edge Cases, Reforms, and Pitfalls

Base rate (2010) was replaced by MCLR (2015) and further by the external benchmark regime (April 2019), under which floating-rate loans must be linked to repo, T-bill, or any other published benchmark. This was RBI’s response to weak rate transmission (2015–18).
NPA classification changed under the Feb 2015 RBI circular and the 4R framework (Recognition, Resolution, Recapitalisation, Reform). NPAs are now aged 90 days overdue; the CAMELS supervisory model and Basel III CRAR (15% including capital conservation buffer, 11.5% in India) frame prudential soundness.
Priority Sector Lending (PSL) mandates 40% of ANBC to agriculture, MSMEs, education, housing — banks falling short must contribute to the RIDF.
Liquidity vs solvency: a bank is illiquid if it cannot meet cash obligations today but is solvent if its assets exceed liabilities at market value. The RBI, as lender of last resort, addresses liquidity crises; solvency crises trigger PCA (Prompt Corrective Action) or amalgamation under the Banking Regulation Act, 1949.

Common Mistakes

Confusing M0 with M1 — M0 excludes demand deposits of banks with the public.
Treating CRR as payable on total liabilities — it is calculated on demand and time liabilities.
Forgetting that SLR includes cash, gold, and unencumbered government securities, not just government bonds.
Believing reverse repo is still the floor — SDF replaced it.
Computing credit creation as 1/CRR — the legal reserve ratio and the behavioural rd differ; the multiplier uses rd.

Practice Prompts

If CRR is raised from 4% to 5% with c = 0.5 and rd = 0.25, compute the change in the money multiplier and explain the policy intent.
“Demonetisation was a monetary policy operation.” Critically evaluate this statement using the money multiplier identity and RBI data on currency in circulation.

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Money and Banking