NCERT Solutions for Class 12 Economics Chapter 3: Money and Banking
These Class 12 Economics Chapter 3 solutions cover Money and Banking from the NCERT textbook Introductory Macroeconomics (updated for the 2026–27 session). The chapter explains the functions of money, the demand for and supply of money, how the commercial banking system creates money through the money multiplier, the role of high-powered money and the central bank (RBI), the legal measures of money supply (M1–M4), and the policy tools the RBI uses to control money supply. Below you get every end-of-chapter Exercise question answered step by step — with the money-multiplier numerical worked out in full — plus key terms and formulas, extra practice, MCQs, Assertion–Reason questions and FAQs.
Chapter 3, Money and Banking, begins by explaining why money replaced the inefficient barter system, which suffered from a lack of double coincidence of wants. Money performs four key functions — it is a medium of exchange, a unit of account (measure of value), a store of value and a standard for deferred payments. People demand money for the transaction motive (positively related to income/GDP and the price level) and the speculative motive (inversely related to the rate of interest). The supply of money consists of currency and bank deposits, measured by RBI as M1, M2, M3 and M4 in decreasing order of liquidity. Currency issued by the central bank and held by the public or banks is high-powered money, the base for credit creation. Commercial banks create money by keeping only a fraction of deposits as reserves (the Cash Reserve Ratio) and lending the rest; total deposits expand by the money multiplier = 1 ÷ reserve ratio. Finally, the RBI controls money supply using quantitative tools (CRR, bank rate, open market operations, repo/reverse-repo) and qualitative tools (moral suasion, margin requirements), and acts as the lender of last resort.
Key Terms, Concepts & Formulas
Barter exchange: the direct exchange of one commodity for another without the mediation of money. It requires a double coincidence of wants — both parties must want exactly what the other offers — which makes it difficult and costly in a large economy.
Money: the commonly accepted medium of exchange. It overcomes the drawbacks of barter and also serves as a unit of account, a store of value and a standard of deferred payments.
Demand for money (liquidity preference): the desire to hold wealth in the form of cash. It has a transaction component (k·PY, rising with real income Y and price level P) and a speculative component (inversely related to the interest rate r).
Supply of money: the total stock of money held by the public at a point of time — currency notes and coins plus demand deposits with banks. It is a stock variable.
High-powered money (reserve money / monetary base): currency issued by the central bank, held either by the public or by commercial banks as reserves. It acts as the basis for credit creation: H = Currency held by public + Reserves of banks.
Fiat money: currency notes and coins that are money by government order and carry the issuing authority’s guarantee; they have no intrinsic value. Being legal tender, they cannot be refused for any payment.
Legal tender: money that must legally be accepted for settling debts and transactions. Currency notes and coins are legal tender; cheques (drawn on demand deposits) are not.
Cash Reserve Ratio (CRR): the percentage of deposits that a commercial bank must keep as cash reserves with the RBI. SLR (Statutory Liquidity Ratio): the proportion of deposits banks must keep in liquid form in the short term.
Narrow & broad money: M1 and M2 are narrow money; M3 and M4 are broad money. M3 is the most commonly used measure (aggregate monetary resources). They are listed in decreasing order of liquidity (M1 most liquid, M4 least).
Lender of last resort: the central bank’s role of lending to commercial banks at all times when they need funds, ensuring the banking system never collapses for want of liquidity.
Formulas used in this chapter
Measures of money supply:
M1 = CU + DD (currency with public + net demand deposits)
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 NSCs)
Money multiplier = 1 ÷ Reserve Ratio (CRR)
Total deposits created = Initial deposit (reserves) × Money multiplier
Cash reserves required = Reserve Ratio × Total Deposits
Velocity of circulation: v = 1 ÷ k, where k is the fraction of transactions held as money
NCERT “Exercises” — Full Solutions
All questions below are reproduced verbatim from the NCERT textbook’s end-of-chapter Exercises. Answers are original, written in exam-ready style; numericals are shown with full working.
1. What is a barter system? What are its drawbacks?
ANSWERA barter system is an economic system in which goods and services are exchanged directly for other goods and services, without the use of money as a medium of exchange — for example, exchanging surplus rice directly for cloth.Drawbacks of the barter system:(i) Lack of double coincidence of wants: an exchange is possible only if each party wants exactly what the other has to offer. Finding such a match is difficult and the search costs rise sharply as the number of individuals increases.(ii) Lack of a common measure of value: there is no single unit in which the value of all goods can be expressed, so working out exchange ratios for every pair of goods is cumbersome.(iii) Difficulty in storing wealth: wealth has to be stored as commodities (e.g. rice), which may be perishable, costly to store and require a lot of space.(iv) Difficulty in deferred (future) payments: contracts involving future payment are hard to settle when there is no common unit of value.(v) Indivisibility of certain goods: some goods (such as cattle) cannot be divided to make small exchanges. Money removes all these difficulties.
2. What are the main functions of money? How does money overcome the shortcomings of a barter system?
ANSWERMain functions of money:(i) Medium of exchange: money is universally acceptable, so people can sell their produce for money and use it to buy what they need. This removes the need for a double coincidence of wants.(ii) Unit of account (measure of value): the value of all goods and services can be expressed in monetary units, giving a common standard to measure and compare values and to fix relative prices.(iii) Store of value: money is not perishable, has low storage cost and is acceptable to everyone, so wealth can be conveniently stored in the form of money for future use.(iv) Standard of deferred payments: money provides a stable unit for borrowing and lending, so future payments and contracts can be expressed conveniently.How money overcomes barter shortcomings: as a medium of exchange it removes the lack of double coincidence of wants; as a unit of account it provides a common measure of value; as a store of value it solves the problem of storing wealth; and as a standard of deferred payments it makes future contracts possible.
3. What is transaction demand for money? How is it related to the value of transactions over a specified period of time?
ANSWERTransaction demand for money is the demand for money to carry out day-to-day transactions, because people earn income at discrete points in time but spend it continuously. Money held for this purpose bridges the gap between receipts and payments.The transaction demand for money is directly (positively) related to the total value of transactions in the economy. It can be written as:MdT = k·T, where T is the total value of (nominal) transactions over the period and k is a positive fraction.Since the value of transactions is closely linked to nominal income, this can be expressed as MdT = k·PY, where Y is real GDP and P is the price level. Thus the larger the value of transactions (or the higher the income/price level), the greater the transaction demand for money. The inverse of k is the velocity of circulation (v = 1/k).
4. What are the alternative definitions of money supply in India?
ANSWERIn India, the RBI publishes four alternative measures of money supply — M1, M2, M3 and M4 — in decreasing order of liquidity:M1 = CU + DD (currency notes and coins held by the public + net demand deposits held by commercial banks).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).M1 and M2 are called narrow money; M3 and M4 are called broad money. M3 is the most commonly used measure and is also known as aggregate monetary resources.
5. What is a ‘legal tender’? What is ‘fiat money’?
ANSWERLegal tender: money that the law requires to be accepted as a means of payment for settling any transaction or debt — it cannot be refused by any citizen of the country. Currency notes and coins are legal tender; cheques drawn on savings or current accounts are not legal tender, since they can be refused.Fiat money: currency notes and coins that are accepted as money because of the order (fiat) and guarantee of the issuing authority, not because of any intrinsic value of the paper or metal. The value of a hundred-rupee note comes from the promise of the RBI Governor printed on it, not from the paper itself. Fiat money is also legal tender.
6. What is High Powered Money?
ANSWERHigh-powered money (also called reserve money or monetary base) is the currency issued by the central bank (RBI). It is held either by the public or by the commercial banks as reserves.H = Currency held by the public + Reserves of commercial banks.It is called ‘high-powered’ because it forms the basis for credit creation by the banking system: a given amount of high-powered money supports a multiple of deposits through the money multiplier. The central bank controls money supply largely by controlling the stock of high-powered money.
7. Explain the functions of a commercial bank.
ANSWERA commercial bank is a financial institution that mediates between people who have surplus funds and those who need funds. Its main functions are:(i) Accepting deposits: banks accept deposits from the public — demand deposits (savings and current accounts, withdrawable on demand) and time deposits (fixed deposits with a maturity period) — and pay interest on them.(ii) Advancing loans: banks lend out the funds they do not need to keep as reserves, in the form of home loans, crop loans and other credit, charging a higher rate of interest than they pay depositors. The difference between the two rates, called the spread, is the bank’s profit.(iii) Credit (money) creation: by keeping only a fraction of deposits as reserves and lending the rest, banks create credit and expand the money supply through the money multiplier.(iv) Other functions: providing means of payment such as cheques and debit cards, transfer of funds, and other agency and utility services that make transactions safer and more convenient.
8. What is money multiplier? What determines the value of this multiplier?
ANSWERThe money multiplier is the number of times the total deposits (and hence the money supply) increase as a result of an initial increase in the reserves (high-powered money) of the banking system. It measures how a small amount of reserves can support a much larger volume of deposits.It is determined by the Reserve Ratio (CRR) — the fraction of deposits that banks must keep as cash reserves:Money multiplier = 1 ÷ Reserve Ratio.Worked example (from the textbook): if the reserve ratio (CRR) = 20% = 0.20, then Money multiplier = 1 ÷ 0.20 = 5. So reserves of Rs 100 can support deposits of 5 × Rs 100 = Rs 500, and the bank can give a loan of Rs 400 (since reserves required = 20% of 500 = Rs 100). The money supply rises from Rs 100 to Rs 500.The value of the multiplier is therefore inversely related to the reserve ratio: the lower the reserve ratio, the larger the multiplier. (For example, if the RBI raises the reserve ratio to 25% = 0.25, the multiplier falls to 1 ÷ 0.25 = 4, so Rs 100 of reserves supports only Rs 400 of deposits.)
9. What are the instruments of monetary policy of RBI?
ANSWERThe RBI controls money supply using quantitative and qualitative instruments.Quantitative tools (control the overall volume of credit):(i) Cash Reserve Ratio (CRR): the share of deposits banks must keep as reserves with the RBI. Raising the CRR reduces lendable funds and money supply; lowering it increases them.(ii) Bank Rate: the rate at which the RBI lends to commercial banks. A higher bank rate makes borrowing costlier, reduces reserves and lowers money supply; a fall in the bank rate raises money supply.(iii) Open Market Operations (OMO): the buying and selling of government bonds in the open market. When the RBI buys bonds it injects reserves and raises money supply; selling bonds withdraws reserves and reduces money supply. These include repo and reverse repo operations, now the main tools of monetary policy.Qualitative tools (regulate the direction/use of credit): moral suasion (persuasion by the RBI), margin requirements on loans, and selective credit controls to encourage or discourage lending for particular purposes.
10. Do you consider a commercial bank ‘creator of money’ in the economy?
ANSWERYes, a commercial bank is a creator of money. Banks can create money (credit) because they do not expect all depositors to withdraw their deposits at the same time, so they keep only a fraction as reserves and lend out the rest.When a bank gives a loan, it opens a new deposit in the borrower’s name; this new deposit becomes a part of the money supply. The borrower may spend it, and it returns to the banking system as a fresh deposit, against which the bank again keeps a fraction as reserves and lends out the rest. This process repeats, multiplying the original deposit.Illustration: with a reserve ratio of 20%, an initial deposit of Rs 100 ultimately supports total deposits of Rs 500 (money multiplier = 1 ÷ 0.20 = 5). Thus banks create deposits several times the original reserves — making them ‘creators of money’ — though credit creation is limited by the reserve ratio fixed by the RBI.
11. What role of RBI is known as ‘lender of last resort’?
ANSWERThe RBI is the lender of last resort because it stands ready to lend to commercial banks at all times whenever they are short of funds and cannot raise money from any other source.When commercial banks need more funds to meet their reserve requirements or to repay depositors, and ordinary market sources are unavailable, they can borrow from the RBI against approved securities. By providing this support, the RBI ensures that no sound bank fails merely for want of liquidity, thereby maintaining public confidence and the stability of the entire banking system.
Extra Practice Questions
Short Answer Type Questions
Q1. Define money supply. Is it a stock or a flow?
ANSWERMoney supply is the total stock of money (currency held by the public plus demand deposits with banks) in circulation among the public at a particular point of time. It is a stock variable, because it is measured at a point of time, not over a period.
Q2. Distinguish between demand deposits and time deposits.
ANSWERDemand deposits (savings and current accounts) are payable by the bank on demand and can be withdrawn anytime by cheque; they are part of M1. Time deposits (fixed deposits) have a fixed maturity period, generally earn higher interest, and cannot be withdrawn on demand; they are included in M3, not M1.
Q3. What is the Cash Reserve Ratio (CRR)?
ANSWERThe CRR is the minimum percentage of its total deposits that a commercial bank is legally required to keep as cash reserves with the RBI. It is a legal, binding requirement that prevents over-lending and acts as a limit on credit creation. Raising the CRR reduces the money supply; lowering it increases the money supply.
Q4. State two differences between repo rate and reverse repo rate.
ANSWER(i) The repo rate is the rate at which the RBI lends money to commercial banks against securities (with an agreement to repurchase), whereas the reverse repo rate is the rate at which the RBI borrows from / absorbs funds from commercial banks. (ii) A repo injects liquidity into the system, while a reverse repo withdraws liquidity from the system.
Q5. Why is the value of a currency note greater than the value of the paper it is printed on?
ANSWERA currency note is fiat money; its value comes from the guarantee of the issuing authority (the RBI), not from the paper. Every note carries the RBI Governor’s promise to provide purchasing power equal to its face value, and it is legal tender that no one can refuse. This guarantee and universal acceptability give the note a value far above the negligible value of the paper.
Long Answer Type Questions
Q1. Explain, with a numerical example, the process of credit creation by commercial banks.
ANSWERBanks create credit because they keep only a fraction of deposits as reserves and lend out the rest, and because not all depositors withdraw at once. Suppose the reserve ratio (CRR) is 20% and an initial deposit of Rs 100 is made. The bank keeps Rs 20 (20% of 100) as reserves and lends Rs 80. This Rs 80 comes back as a fresh deposit; the bank now keeps Rs 16 (20% of 80) and lends Rs 64, which again returns as a deposit, and so on. The successive deposits form a geometric series — 100 + 80 + 64 + … The total deposits created = Initial deposit × Money multiplier = 100 × (1 ÷ 0.20) = 100 × 5 = Rs 500. The balance sheet finally shows Reserves Rs 100 + Loans Rs 400 = Total assets Rs 500 = Deposits Rs 500. Thus an initial deposit of Rs 100 has created total deposits of Rs 500, i.e. additional money of Rs 400. The process stops when the required reserves (20% of 500 = Rs 100) equal the initial reserves, so the reserve ratio limits credit creation.
Q2. Calculate the total deposits and the loan created if the initial deposit is Rs 2,000 and the reserve ratio is 25%. Show the change if the reserve ratio falls to 10%.
ANSWERCase 1: Reserve ratio (LRR) = 25% = 0.25. Money multiplier = 1 ÷ 0.25 = 4. Total deposits created = Initial deposit × Money multiplier = Rs 2,000 × 4 = Rs 8,000. Loan (credit) created = Total deposits − Initial deposit = 8,000 − 2,000 = Rs 6,000.Case 2: Reserve ratio (LRR) = 10% = 0.10. Money multiplier = 1 ÷ 0.10 = 10. Total deposits created = Rs 2,000 × 10 = Rs 20,000. Loan created = 20,000 − 2,000 = Rs 18,000.Conclusion: a lower reserve ratio raises the money multiplier (from 4 to 10), so the same initial deposit of Rs 2,000 supports much larger total deposits (Rs 8,000 → Rs 20,000) and credit creation (Rs 6,000 → Rs 18,000). The money multiplier and credit creation are inversely related to the reserve ratio.
Item
Reserve ratio = 25%
Reserve ratio = 10%
Money multiplier (1 ÷ r)
4
10
Initial deposit
Rs 2,000
Rs 2,000
Total deposits created
Rs 8,000
Rs 20,000
Loan / credit created
Rs 6,000
Rs 18,000
Q3. Explain how the RBI uses its monetary policy instruments to correct excess demand (inflation) in the economy.
ANSWERDuring excess demand (inflationary gap), aggregate demand exceeds the economy’s capacity at full employment, so the RBI adopts a tight (dear) monetary policy to reduce the money supply and credit. (i) Raise the CRR (and SLR): banks must keep more deposits as reserves, leaving less for lending, which lowers the money multiplier and credit creation. (ii) Raise the bank rate / repo rate: borrowing from the RBI becomes costlier, so banks raise their own lending rates, discouraging loans and reducing demand. (iii) Open market operations — sell government bonds: when the RBI sells bonds, reserves flow from banks to the RBI, reducing the reserves and hence money supply. (iv) Qualitative measures: raise margin requirements and use moral suasion to persuade banks to lend less for non-essential purposes. Together these measures raise interest rates, contract credit, reduce aggregate demand and help control inflation.
MCQs & Assertion–Reason
1. The most essential function of money is that it acts as a:
(a) store of value (b) medium of exchange (c) unit of account (d) standard of deferred payment
2. The barter system suffers mainly from the lack of:
3. Which of the following is the most liquid measure of money supply?
(a) M1 (b) M2 (c) M3 (d) M4
4. M1 is equal to:
(a) CU + Time deposits (b) CU + DD (c) M3 + Post Office deposits (d) DD + Savings deposits with Post Office
5. If the Cash Reserve Ratio is 25%, the value of the money multiplier is:
(a) 2.5 (b) 4 (c) 5 (d) 25
6. Currency notes and coins that have no intrinsic value but are accepted because of the issuer’s guarantee are called:
(a) commodity money (b) near money (c) fiat money (d) credit money
7. The central bank’s function of lending to commercial banks whenever they need funds is known as:
(a) banker to the government (b) lender of last resort (c) custodian of foreign exchange (d) issuer of currency
8. The speculative demand for money is:
(a) directly related to income (b) directly related to the rate of interest (c) inversely related to the rate of interest (d) independent of the rate of interest
9. Open market operations refer to the buying and selling of ______ by the RBI.
(a) foreign currency (b) gold (c) government securities/bonds (d) shares of companies
10. To control inflation (excess demand), the RBI should:
(a) reduce the CRR (b) buy government bonds (c) reduce the bank rate (d) raise the bank rate and CRR
For each Assertion–Reason question, choose: (A) Both true and the Reason correctly explains the Assertion; (B) Both true but the Reason is not the correct explanation; (C) Assertion true, Reason false; (D) Assertion false, Reason true.
A-R 1. Assertion: The money multiplier is inversely related to the reserve ratio.
Reason: The money multiplier equals 1 divided by the reserve ratio, so a lower reserve ratio gives a larger multiplier.
A-R 2. Assertion: Cheques are legal tender in India.
Reason: Cheques drawn on demand deposits can be refused as a mode of payment.
A-R 3. Assertion: Commercial banks can create money out of deposits.
Reason: Banks keep only a fraction of deposits as reserves and lend out the rest, which returns to the system as new deposits.
A-R 4. Assertion: High-powered money is called the monetary base.
Reason: It is the currency issued by the central bank, held by the public or as bank reserves, and acts as the basis for credit creation.
A-R 5. Assertion: When the RBI sells government bonds in the open market, the money supply increases.
Reason: Selling bonds withdraws reserves from the banking system.
Answer key: 1-(A), 2-(A), 3-(A), 4-(A), 5-(D).
Exam Tips & Common Mistakes
How to score full marks in this chapter
Memorise the four functions of money and link each to a specific drawback of barter it removes. Learn the exact definitions of M1–M4 and remember that they are in decreasing order of liquidity (M1 most liquid). For numericals, always state the formula Money multiplier = 1 ÷ reserve ratio, then compute Total deposits = initial deposit × multiplier and Loan = total deposits − initial deposit, showing each step. Remember the inverse relationship between the reserve ratio and credit creation, and between bond prices/speculative demand and the interest rate. For policy questions, organise your answer into quantitative (CRR, bank rate, OMO) and qualitative (moral suasion, margin requirements) tools, and state clearly which way each is moved to fight inflation versus deflation.
Common mistakes to avoid
Confusing the store of value function with the standard of deferred payment function.
Writing M1 as currency + time deposits — M1 = currency + demand deposits only.
Calling cheques “legal tender” — only currency notes and coins are legal tender.
Using the reserve ratio as the multiplier — the multiplier is 1 ÷ reserve ratio, not the ratio itself.
Getting the OMO direction wrong — the RBI buys bonds to increase money supply and sells bonds to reduce it.
Treating money supply as a flow — it is a stock variable measured at a point of time.
Frequently Asked Questions
What is Chapter 3 of Class 12 Economics (Introductory Macroeconomics) about?
Chapter 3, Money and Banking, explains the functions of money, the demand for and supply of money, how commercial banks create money through the money multiplier, the role of high-powered money and the RBI, the measures of money supply (M1–M4), and the policy tools the RBI uses to control the money supply.
How do you calculate the money multiplier in Class 12 Economics?
The money multiplier is calculated as 1 ÷ reserve ratio (CRR). For example, if the reserve ratio is 20% (0.20), the multiplier is 1 ÷ 0.20 = 5, so an initial deposit of Rs 100 can support total deposits of Rs 500.
What is the difference between narrow money and broad money?
Narrow money (M1 and M2) includes the most liquid components — currency and demand deposits. Broad money (M3 and M4) adds time deposits and post office deposits, which are less liquid. M3 is the most commonly used measure of money supply in India.
