CUET UG Economics: Macroeconomics - Money Functions, Money Supply, Credit Creation by Banks

Must-Know (15–20 detailed bullets)

• Money serves four primary functions: medium of exchange, unit of account, store of value, and standard of deferred payment. Example: Using ?500 to buy groceries illustrates medium of exchange.
• Barter system suffered from lack of double coincidence of wants. Example: A farmer needing clothes must find a tailor who wants food.
• Full-bodied money is when the intrinsic value equals face value, e.g., gold coins (verify from NCERT).
• Fiat money has no intrinsic value but is authorized by the government, e.g., Indian rupee notes.
• Legal tender money cannot be refused in settlement of debts; in India, coins up to ?1 are unlimited legal tender, while ?2 and above are limited legal tender (verify from NCERT).
• Narrow money is defined as M1 = Currency with public (C) + Demand deposits with banks (DD) + Other deposits with RBI (OD). Example: M1 includes cash in hand and savings account balances.
• Broad money is M3 = M1 + Time deposits with banks. M3 is most commonly used to measure money supply in India.
• M2 = M1 + Post office savings deposits; M4 = M3 + Total post office deposits (verify from NCERT).
• High-powered money (H) = Currency in circulation (C) + Reserves of commercial banks with RBI (R). Also called monetary base.
• The Reserve Ratio (RR) is the fraction of deposits banks must keep as reserves. In India, it includes CRR and SLR (though SLR is not part of the simple credit multiplier model in NCERT).
• Credit creation by banks is inversely related to the Legal Reserve Ratio (LRR). Formula: Total credit created = Initial deposits × (1/LRR).
• If LRR is 10%, the money multiplier is 1/0.10 = 10. So, ?1,000 initial deposit can create ?10,000 total deposits.
• The actual money multiplier is less than the theoretical one due to cash leakage and excess reserves (verify from NCERT).
• Central bank (RBI) controls money supply via quantitative tools: Bank Rate, Repo Rate, Reverse Repo Rate, Open Market Operations (OMO).
• Qualitative tools include Margin Requirements, Rationing of Credit, and Moral Suasion (verify from NCERT).
• Repo Rate is the rate at which RBI lends to commercial banks against securities; as of 2023, it was 6.5% (verify from NCERT).
• Reverse Repo Rate is the rate at which RBI borrows from banks; it is usually 0.25–0.50 percentage points below Repo Rate.
• Open Market Operations involve buying/selling government securities to control money supply. Buying-increases money supply.
• When RBI sells government bonds, commercial banks pay money, reducing their reserves and credit creation capacity.
• Demonetization in 2016 involved withdrawal of ?500 and ?1,000 notes as legal tender (8 November 2016) to curb black money and counterfeiting.

Difficulty Level

Intermediate — because it combines conceptual understanding (functions of money) with numerical application (credit multiplier) and current institutional knowledge (RBI tools).

Common CUET Traps

• Trap: Confusing M1 and M3 as interchangeable terms for money supply.
  Avoid: M1 is narrow money (most liquid); M3 is broad money and includes time deposits.

• Trap: Assuming all deposits create unlimited credit regardless of reserve ratio.
  Avoid: Credit creation is limited by LRR and follows the formula: Total credit = Initial deposit × (1/LRR).

• Trap: Thinking that coins of all denominations are unlimited legal tender.
  Avoid: Only coins up to ?1 are unlimited legal tender in India; higher denominations are limited legal tender.

Practice MCQs

Q1. Which of the following is included in M1 measure of money supply?
A. Fixed deposits
B. Public Provident Fund
C. Demand deposits
D. National Savings Certificate

Answer: C
Explanation: M1 includes currency with public, demand deposits, and other deposits with RBI.
Why others fail: Fixed deposits are part of M3, not M1; PPF and NSC are not included in any money supply measure.

Q2. What is the primary function of money as a 'unit of account'?
A. Holding wealth for future use
B. Facilitating deferred payments
C. Measuring the value of goods and services
D. Exchanging goods without barter

Answer: C
Explanation: Unit of account allows prices to be quoted in a common denomination.
Why others fail: Storing wealth refers to store of value; exchange without barter is medium of exchange.

Q3. If the Legal Reserve Ratio is 20%, what is the credit multiplier?
A. 4
B. 5
C. 10
D. 20

Answer: B
Explanation: Credit multiplier = 1 / LRR = 1 / 0.20 = 5.
Why others fail: Students often divide 100 by 20 incorrectly or confuse it with percentage.

Q4. Which of the following is an example of fiat money?
A. Gold coins
B. Silver ornaments
C. ?100 note issued by RBI
D. US dollars held in India

Answer: C
Explanation: Fiat money has no intrinsic value and is issued by government authority; Indian currency notes are fiat money.
Why others fail: Gold and silver have intrinsic value; foreign currency is not fiat in domestic context.

Q5. Suppose a bank receives a fresh deposit of ?20,000 and LRR is 25%. What is the total credit creation in the banking system?
A. ?20,000
B. ?40,000
C. ?60,000
D. ?80,000

Answer: D
Explanation: Total credit = Initial deposit × (1/LRR) = 20,000 × (1/0.25) = ?80,000.
Why others fail: Many forget to apply the multiplier and choose ?20,000 or miscalculate 1/0.25 as 4 instead of using it correctly.

Last?Minute Revision (15–20 one?liners)

• M1 = C + DD + OD; M3 = M1 + Time deposits.
• Money multiplier = 1 / LRR; higher LRR-lower multiplier.
• Demonetization date: 8 November 2016.
• RBI regulates money supply in India.
• Full-bodied money: intrinsic value = face value (e.g., gold coin).
• Fiat money: authorized by government, no intrinsic value.
• Legal tender: cannot be refused in payment of debt.
• Coins up to ?1: unlimited legal tender; above ?1: limited legal tender.
• High-powered money (H) = C + R (currency + reserves).
• Credit creation requires surplus reserves and loan demand.
• Repo Rate > Reverse Repo Rate.
• OMO: RBI buys/sells government securities to control money supply.
• Bank Rate: rate at which RBI lends to banks for long term.
• Marginal Requirement: difference between loan amount and collateral value.
• Barter system requires double coincidence of wants.
• Store of value function allows money to be saved and used later.
• Standard of deferred payment enables future debt settlement.
• M2 = M1 + Post office savings; M4 = M3 + Post office deposits (verify from NCERT).
• Cash leakage reduces actual credit creation below theoretical maximum.
• Mnemonic: "M1 is Most Liquid" – think "Money in hand and demand accounts".