Four functions of money
- Medium of exchange — eliminates the double coincidence of wants;
- Unit of account — common measure of value (rupees, dollars);
- Store of value — can be saved for the future;
- Standard of deferred payment — basis for loans and credit.
In India, the rupee is legal tender. Currency notes are issued by the RBI under the RBI Act 1934 (except ₹1 coin/notes issued by Government of India).
Demand for money — three motives (Keynes)
Keynes identified three motives for holding money rather than other assets:
| Motive | What drives it |
|---|---|
| Transaction | Day-to-day expenses; depends on income level and frequency of receipt |
| Precautionary | Unforeseen needs (illness, emergencies); depends on income and risk perception |
| Speculative | Hold cash to buy bonds/stocks when their price falls; depends inversely on interest rate |
Total demand for money = Transaction + Precautionary + Speculative demand.
The liquidity trap
When interest rates are very low, people prefer to hold cash rather than buy low-yielding bonds. Money supply expansion fails to lower rates further. Keynes argued this was the situation during the Great Depression — monetary policy becomes ineffective; fiscal policy needed.
Money supply — M1, M2, M3, M4
RBI's official money supply measures:
| Measure | Composition | Use |
|---|---|---|
| M1 (Narrow Money) | Currency with public + Demand deposits with banks + Other deposits with RBI | Most liquid; for transactions |
| M2 | M1 + Savings deposits with Post Office Savings Banks | Slightly broader |
| M3 (Broad Money) | M1 + Time deposits with banks | Most-tracked; broad money supply |
| M4 | M3 + Total deposits with Post Office Savings Banks (excluding NSCs) | Most inclusive |
RBI primarily tracks M3 as the key indicator of money supply in India.
High-powered money
High-powered money (H) = Currency in circulation + Bankers' deposits with RBI + Other deposits with RBI.
Also called "monetary base" or "M0". This is what RBI directly controls. From this base, the banking system creates a multiple amount of broad money through credit creation.
Money multiplier
The money multiplier is the ratio between the broad money supply and the high-powered money. m = M / H.
For example, if H = ₹50 lakh crore and M3 = ₹260 lakh crore, money multiplier = 5.2. This means every ₹1 of high-powered money generates ₹5.2 of broad money in the system.
The multiplier depends on:
- Cash-deposit ratio (how much public holds as cash);
- Cash Reserve Ratio (CRR);
- Statutory Liquidity Ratio (SLR);
- Behaviour of banks.
Credit creation by commercial banks
Banks create credit through fractional reserve banking. Process:
- Person A deposits ₹1,000 in Bank 1;
- Bank 1 keeps ₹100 as required reserve (10% CRR for illustration) and lends ₹900 to Person B;
- Person B spends ₹900 with Person C; Person C deposits ₹900 in Bank 2;
- Bank 2 keeps ₹90 as reserve and lends ₹810 to Person D;
- And so on...
Total deposits created = ₹1,000 / 0.10 = ₹10,000. The original ₹1,000 has become ₹10,000 in the banking system. This is the simple money multiplier (1/CRR).
RBI — functions and tools
Established 1 April 1935; nationalised 1 January 1949. India's central bank.
Functions
- Sole authority to issue currency (except ₹1 coin);
- Banker to government;
- Banker to banks;
- Credit control through monetary policy;
- Foreign exchange management (under FEMA 1999);
- Bank regulation (Banking Regulation Act 1949);
- Payment systems (UPI, RTGS, NEFT);
- Lender of last resort.
Quantitative tools
| Tool | What it does |
|---|---|
| Cash Reserve Ratio (CRR) | % of bank deposits kept with RBI as cash; currently ~4.5% |
| Statutory Liquidity Ratio (SLR) | % of deposits kept in govt securities/gold; currently ~18% |
| Repo rate | Rate RBI lends to banks; currently 6.5% |
| Reverse repo rate | Rate RBI borrows from banks |
| Marginal Standing Facility (MSF) | Emergency lending to banks |
| Bank rate | Rate at which RBI lends long-term; now largely symbolic |
| Open Market Operations (OMO) | Buying/selling g-securities to inject/absorb liquidity |
| Liquidity Adjustment Facility (LAF) | Daily liquidity management — repo + reverse repo |
Qualitative tools
- Margin requirements;
- Consumer credit regulation;
- Moral suasion;
- Direct credit allocation (priority sector lending — 40% mandate, of which 18% agriculture).
MPC and inflation targeting
Since 2016, India follows a flexible inflation targeting framework under the amended RBI Act 1934.
- Target — 4% CPI inflation with ±2% band;
- Set by — Government in consultation with RBI;
- Reviewed — Every five years;
- Monetary Policy Committee (MPC) — 6 members; 3 RBI (Governor as Chair, Deputy Governor, RBI nominee) + 3 government appointees; meets every 2 months; sets repo rate by majority vote; Governor has casting vote in case of tie.
Current Governor: Sanjay Malhotra (since December 2024).
Modern Indian money — UPI and digital revolution
- UPI (Unified Payments Interface) — launched April 2016 by NPCI; ~14 billion transactions/month; world's largest real-time payments system;
- Demonetisation — 8 November 2016; ₹500 and ₹1,000 notes withdrawn; ~₹15.4 lakh crore demonetised; accelerated digital payments;
- Central Bank Digital Currency (CBDC) — Digital Rupee; piloted by RBI from December 2022 in wholesale and retail formats;
- ₹2,000 note withdrawal — initiated May 2023;
- India Stack — Aadhaar + UPI + DigiLocker → foundation for digital financial inclusion.
NCERT exercise solutions — selected answers
Q1. What is a barter system? What are its drawbacks?
BARTER SYSTEM is the DIRECT EXCHANGE of GOODS for GOODS without using money. EXAMPLE: A wheat farmer exchanges wheat for cloth with a weaver. DRAWBACKS: (1) DOUBLE COINCIDENCE OF WANTS — Both parties must want what the other has; if shoemaker needs grain but grain seller doesn't want shoes, no trade. (2) LACK OF COMMON MEASURE OF VALUE — How many shoes equal one cow? No standard. (3) DIVISIBILITY problem — Can't trade half a horse for a sack of wheat. (4) STORE OF VALUE — Perishable goods can't store value over time; food rots. (5) DEFERRED PAYMENT — Loans and contracts difficult without a stable medium. (6) SEARCH COSTS — Finding compatible barter partners takes time. (7) INDIVISIBILITY of HUMAN SERVICES — Doctor's services for shoemaker's services — how to value? (8) LIMITED TRADE — Only nearby, infrequent exchanges. MONEY SOLVES these problems by being: (1) Universally accepted; (2) Standardised unit of account; (3) Divisible; (4) Storable; (5) Standard of deferred payment. INDIAN HISTORY: Pre-monetary economies in pre-Mauryan India had barter; first metal coins began in 6th century BCE (Mahajanapadas). UPI, Aadhaar, India Stack are MODERN digital money infrastructure.
Q2. What are the functions of money?
FOUR functions of MONEY: (1) MEDIUM OF EXCHANGE — Money is universally accepted; eliminates double coincidence of wants; allows multilateral exchange. (2) UNIT OF ACCOUNT — Common measure of VALUE; prices, debts, accounts denominated in single unit (rupees, dollars); makes COMPARISON possible. (3) STORE OF VALUE — Money holds purchasing power over time; CAN BE SAVED for future consumption; better than perishable barter goods. (4) STANDARD OF DEFERRED PAYMENT — BASIS for LOANS and CREDIT; allows debt contracts denominated in money; FUTURE PAYMENTS specified in money. ADDITIONAL functions: (5) TRANSFER OF VALUE — Easy international transfers; (6) LIQUIDITY — Money is most liquid asset. INDIAN CONTEXT: (1) RUPEE is legal tender — must be accepted for payment of debt; (2) RBI issues notes; Government mints coins; (3) UPI/digital payments increasingly substituting cash; (4) Cryptocurrencies are NOT legal tender in India — government has tried to restrict (Cryptocurrency Bill 2021); (5) Digital Rupee (CBDC) piloted from Dec 2022. Modern money is BANK MONEY (deposits) plus DIGITAL — not just paper currency. The functions remain the same — what changes is the FORM.
Q3. What is transaction demand for money? How is it related to the value of transactions over a specified period of time?
TRANSACTION DEMAND for MONEY is the DEMAND for MONEY to be HELD as CASH for DAY-TO-DAY EXPENSES. People hold money for transactions because: (1) INCOME and EXPENDITURE don't COINCIDE — Income received monthly but expenses are daily; (2) PAYMENT NEEDED in money form; (3) DAILY transactions require cash on hand. RELATIONSHIP with VALUE OF TRANSACTIONS: (1) DIRECTLY PROPORTIONAL — Higher transactions value requires more cash on hand; (2) Mathematically: M^T = k.PT or M^T = k.Y (where T = total transactions or Y = nominal income; k = constant); (3) The Cambridge equation M = kY assumes a constant proportion of income held as money for transactions. (4) PHILLIPS-CURVE-LIKE relationship — As income grows, transaction demand also grows. INVERSE relationship with PAYMENT FREQUENCY: (1) If salary paid daily, less average cash needed; (2) If salary paid monthly, more cash needed on average. INTEREST RATE: Transaction demand is RELATIVELY INELASTIC w.r.t. interest rates (you need cash for shopping regardless). IMPACT OF DIGITAL PAYMENTS: (1) UPI reduces cash holding for transactions; (2) Cards reduce cash needs; (3) Digital wallets allow real-time transfers; (4) BUT may INCREASE total money supply through bank deposits. INDIAN CONTEXT: Demonetisation 2016 disrupted cash-based transaction demand; post-2016 surge in digital payments reduced cash dependence. Currency in circulation has GROWN in absolute terms but FELL as % of GDP.
Q4. Suppose a bond promises ₹500 at the end of two years with no intermediate return. If the rate of interest is 5% per annum, what is the price of the bond?
BOND PRICE = PRESENT VALUE of FUTURE PAYMENTS. Using PV formula: PV = FV / (1+r)^n. Where: FV = ₹500 (future value); r = 5% = 0.05; n = 2 years. PV = 500 / (1.05)^2 = 500 / 1.1025 = ₹453.51. So the bond price is ₹453.51. INTUITION: (1) The bond is WORTH less than ₹500 today because of TIME VALUE of MONEY; (2) ₹453.51 invested today at 5% will grow to ₹500 in 2 years (453.51 × 1.05 × 1.05 = 500); (3) Hence the bond should be priced at ₹453.51 in an EFFICIENT MARKET. IF INTEREST RATE FALLS: Bond price RISES (inverse relationship). EXAMPLE: If r = 3%, PV = 500/1.0609 = ₹471.30 — higher than ₹453.51. INVERSE BOND-INTEREST RATE RELATIONSHIP: (1) When RBI raises repo rate, existing bond prices fall; (2) When RBI cuts rates, bond prices rise; (3) This is why BOND MARKETS care intensely about RBI's MPC decisions. INDIAN MARKET: G-Sec (Government Securities) trading is one of the largest fixed-income markets; G-Sec yields are key indicators of monetary policy expectations; SLR mandate ensures banks hold large G-Sec portfolios.
Q5. What is the speculative demand for money?
SPECULATIVE DEMAND for MONEY is the DEMAND to HOLD MONEY (rather than bonds) in the EXPECTATION of EARNING higher returns from FUTURE BOND PURCHASES. KEYNES' theory of speculative demand: (1) People hold money OR bonds; (2) Bonds pay interest but have CAPITAL RISK (prices fall if interest rates rise); (3) When interest rates are LOW (bond prices HIGH), people EXPECT rates to RISE (prices to FALL), so they HOLD CASH rather than buy expensive bonds; (4) When interest rates are HIGH (bond prices LOW), people EXPECT rates to FALL (prices to RISE), so they BUY BONDS, REDUCING cash demand. INVERSE RELATIONSHIP: Speculative demand for money INVERSELY related to INTEREST RATE. LIQUIDITY TRAP: At very low interest rates, EVERYONE expects rates to RISE — so ALL hold cash, NONE buy bonds; monetary policy becomes ineffective; need fiscal policy (Keynes used this to explain Great Depression). MODERN CRITIQUE: (1) Speculative demand exists but other portfolio choices (stocks, real estate, gold) also relevant; (2) Modern monetary theory emphasises VARIOUS asset substitutes; (3) BEHAVIOURAL FINANCE adds psychological factors. INDIAN CONTEXT: (1) Indians hold significant gold for speculative reasons (~22 trillion stock); (2) Equity markets are alternative; (3) RBI considers various factors in monetary policy. SPECULATIVE DEMAND IS PART OF TOTAL MONEY DEMAND — alongside transaction and precautionary demand. Total demand for money curve slopes DOWNWARD due to speculative component (rates rise, demand falls).
Q6. What do you understand by Open Market Operations (OMOs)?
OPEN MARKET OPERATIONS (OMOs) is the BUYING AND SELLING of GOVERNMENT SECURITIES by the RBI in the SECONDARY MARKET to MANAGE LIQUIDITY in the economy. TWO TYPES: (1) OMO PURCHASE — RBI BUYS g-securities from banks/markets; PAYS in cash; INJECTS liquidity into system; money supply EXPANDS; bond prices RISE; interest rates FALL. Used during economic SLOWDOWNS; (2) OMO SALE — RBI SELLS g-securities to banks/markets; RECEIVES cash; ABSORBS liquidity from system; money supply CONTRACTS; bond prices FALL; interest rates RISE. Used to control INFLATION. MECHANISM (purchase): (1) RBI announces purchase auction; (2) Banks bid to sell securities; (3) RBI buys at competitive prices; (4) Banks receive cash; (5) More liquidity for lending. ADVANTAGES OF OMOs: (1) FLEXIBLE — can be small or large; (2) PRECISE — targeted liquidity injection/absorption; (3) MARKET-FRIENDLY — uses market mechanism; (4) REVERSIBLE — can do opposite operation; (5) NO ADMINISTRATIVE BURDEN unlike CRR changes. INDIAN OMO HISTORY: (1) Pre-2000 — limited use; (2) 2000s — became routine tool; (3) 2008 financial crisis — large OMO purchases; (4) 2020-21 COVID — massive OMO purchases (~₹3 lakh crore+); (5) 2022-23 — OMO sales as RBI tightened. LAF (Liquidity Adjustment Facility) — uses REPO/REVERSE REPO operations daily — closely related to OMOs but more short-term. OPERATION TWIST (US-style) — buying long-term, selling short-term — used occasionally. OMO is COMPLEMENTARY to repo rate; together they shape monetary conditions.
UPSC PYQ tagging
UPSC angle
Money & Banking is core GS-3 vocabulary. Strong answers cite functions of money, Keynes's three motives, RBI tools (CRR/SLR/repo/OMO), credit creation, money multiplier, MPC framework, and the inflation-targeting regime since 2016.
- 2017 GS-3: "Explain the rationale for the Monetary Policy Committee setup in India."
- 2022 GS-3: "Discuss the role of RBI in managing inflation through monetary policy. Examine the effectiveness of inflation targeting framework since 2016."
- 2024 GS-3: "What is Central Bank Digital Currency (CBDC)? Examine its potential to transform India's monetary architecture."
- 2019 GS-3: "Examine the role of UPI in transforming India's payments architecture."
- Likely 2026: "Discuss India's money supply measures (M1, M2, M3, M4). Which is the most appropriate for monetary policy?"