Money, Banking and Monetary Policy
This domain covers the functions of money, the money supply measures, credit creation by commercial banks and the RBI's instruments of control. Numerical questions on the credit multiplier and definitional questions on M1–M4 are frequent.
Core rules
- Functions of money: medium of exchange, measure of value, store of value, standard of deferred payments, and transfer of value.
- Money supply: M1 = currency with the public + demand deposits + other deposits with the RBI (most liquid, narrow money). M2 = M1 + savings deposits with post office banks. M3 = M1 + net time deposits of commercial banks (broad money). M4 = M3 + total post office deposits.
- Credit creation: total deposits = initial deposit × 1/LRR, where LRR = CRR + SLR. Credit created = total deposits − initial deposit.
- Central bank functions: currency issue, banker to government, banker's bank, lender of last resort, custodian of foreign exchange reserves, clearing house, credit control.
- Quantitative tools: bank rate, repo rate (RBI lends), reverse repo (RBI absorbs liquidity), CRR, SLR, open market operations. Qualitative tools: margin requirements, moral suasion, selective credit control, consumer credit regulation.
Worked example
A fresh deposit of ₹1,000 with LRR = 20%. Total deposit creation = 1,000 / 0.20 = ₹5,000, so credit created = ₹4,000. Round by round the bank keeps ₹200 and lends ₹800, then ₹160 and ₹640, and so on; the rounds converge to ₹5,000.
Traps that cost marks
- Using CRR alone as the reserve ratio; legally the leaked reserves are the whole LRR.
- Stating that CRR balances earn interest for banks; they do not.
- Reversing repo and reverse repo.
- Claiming the RBI lends to the general public; it lends to banks and the government.