Money and Banking
Money and Banking tests the functions of money, the M1 to M4 measures, credit creation by commercial banks and the RBI's instruments of credit control.
Core rules
- Functions: medium of exchange, unit of account, store of value, standard of deferred payment.
- M1 = currency with the public + demand deposits + other deposits with the RBI (narrow money). M2 = M1 + post office savings deposits. M3 = M1 + net time deposits (broad money). M4 = M3 + total post office deposits.
- Credit creation: total deposits = initial deposit × 1/LRR; money multiplier = 1/LRR.
- Central bank functions: note issue, banker to government, banker's bank, lender of last resort, custodian of reserves, credit control.
- Quantitative tools: repo rate, reverse repo, CRR, SLR, bank rate, open market operations. Qualitative tools: margin requirements, moral suasion, credit rationing.
Worked example
A bank receives a primary deposit of ₹1,000 and keeps LRR = 10%. Total deposit creation = 1,000 × (1/0.10) = ₹10,000. Credit created = 10,000 − 1,000 = ₹9,000. If the RBI raises the reserve ratio to 20%, the multiplier falls to 5 and total deposits fall to ₹5,000, which is why raising CRR is contractionary.
Traps that cost marks
- Counting inter-bank deposits and the RBI's own deposits as part of money supply with the public.
- Mixing up repo and reverse repo: repo is the rate at which the RBI lends to banks; reverse repo is the rate at which it absorbs liquidity.
- Assuming credit creation is unlimited; it is limited by cash reserves and by borrowers' demand for loans.