Chap 2 PDF

b
 Money – meaning and supply of money –

Currency held by the public and net demand
deposits held by commercial banks
 Money creation by the commercial banking
system
 Central bank and its functions (example of the
Reserve Bank of India) : Bank of issue, Govt.
Bank, Banker’s Bank, Controller of Credit
2.1 Money and Supply of Money
Money — Its Meaning
Anything which is commonly accepted as a medium
of exchange is called money.
It is usable for undertaking transactions, i.e., receipts
and payments. In a modern economy, money comprises
cash and bank deposits. Currency notes and coins can be
used for settlement of any economic transactions. Bank
deposits, e.g. the balance in savings and current account
deposits with commercial banks, are also used to settle
transactions through cheques, debit cards, etc.
Supply of Money
Meaning
Money supply refers to the total quantity of money
in circulation in the economy at a given point of
time.
 Top Tip
Money supply is a stock variable since the total stock of
money in circulation among the public is measured at a
particular point of time.
Components
The basic measure of money supply (M1) has two
components–Currency with public and demand deposits
in commercial banks.
1. Currency held by the public (CU): Money supply
consists of currency notes and coins held by the public
outside the banks. The Reserve Bank of India (RBI) is
the only institution which can issue currency in India.
Currency notes are issued by the RBI. However, coins
are issued by the Government of India.
 The currency issued by the central bank (Reserve
Bank of India in India) can be held by the public or
by the commercial banks, and is called the
high-powered money or 'reserve money' or
'monetary base' as it acts as a basis for credit creation.
 Currency notes and coins are called legal tenders
as they cannot be refused by any citizen of the
country for settlement of any transaction.
 Currency notes and coins are called fiat money
because every currency note bears on its face a
promise from the Governor of RBI that if someone
produces the note to RBI ,or any other commercial
bank, RBI will be responsible for giving the person
purchasing power equal to the value printed on
the note. The same is also true of coins.
2. Net demand deposits held by commercial banks
(DD): Demand deposits are the deposits which can
be withdrawn on demand by the depositors from
banks, example, current account and savings account
deposits.
 Demand deposits are created by the commercial
banks and are called bank money.
 The word 'net' implies that only deposits of the
public held by the banks are to be included in
money supply. The inter-bank deposits, which a
commercial bank holds in other commercial
banks,are not to be regarded as part of money
supply.
 Top Tip
Commercial banks also hold time deposits of the public.
Time deposits are those deposits in banks which have a
fixed period of maturity, e.g., Fixed Deposits (FD).
However, the basic measure of money supply (M1)
includes only demand deposits, not time deposits.
Key Term
Money — Anything which is commonly accepted as a medium
of exchange is called money.
Money supply — Money supply refers to the total quantity of
money in circulation in the economy at a given point of time.
High powered money — The currency issued by the central
bank (Reserve Bank of India in India) can be held by the public
or by the commercial banks, and is called the high-powered
money.
Demand deposits — Demand deposits are the deposits which
can be withdrawn on demand by the depositors from banks, e.g.
current account and savings account deposits.
Time deposits — Those deposits in banks which have a fixed
period of maturity, e.g., Fixed Deposits (FD).
Bank money — Demand deposits are created by the commercial
banks and are called bank money.
RECAP
Money and Supply of Money

Anything which is commonly accepted as a medium of exchange is
called money.
Money supply refers to the total quantity of money in circulation
in the economy at a given point of time. Thus, it is a stock variable.
It has two components:
(i) Currency held by the public (CU): The currency issued by the
central bank (Reserve Bank of India) can be held by the public
or by the commercial banks, and is called the high-powered
money.
(ii) Net demand deposits held by commercial banks (DD): Demand
deposits are the deposits which can be withdrawn on demand
by the depositors from banks, e.g. current account and savings
account deposits. Demand deposits are created by the
commercial banks and are called bank money. The word ‘net’
implies that money supply includes only deposits of the public
held by the banks, not inter-bank deposits).
Question 1
Demand deposits created by the commercial banks are
called _________.
(Choose the correct alternative)
(a) High powered money
(b) Money
(c) Bank money
(d) Time deposits
Objective Type Questions 2.1

Answer 1
(c) Bank money

Question 2
_________ are called legal tenders.
(a) Demand deposits
(b) Time deposits
(c) Inter-bank deposits
(d) Currency notes and coins

Answer 2
(d) Currency notes and coins

Question 3
Which of the following is not included in money supply?
(a) High powered money
(b) Bank money
(c) Time deposits
(d) Inter-bank deposits

Answer 3
(d) Inter-bank deposits

Question 4
Supply of money refers to quantity of money ________.
(CBSE 2017) (Choose the correct alternative)
(a) as on 31st March
(b) during any specified period of time
(c) as on any point of time
(d) during a fiscal year

Answer 4
(c) as on any point of time

Question 5
Demand deposits include __________.
(a) Saving account deposits and fixed deposits
(b) Saving account deposits and current account deposits
(c) Current account deposits and fixed deposits
(d) All types of deposits

Answer 5
(b) Saving account deposits and current account deposits

Question 6
_____________ is the main source of money in an
economy.
(a) Central bank of the economy
(b) Commercial banking system
(c) Both (a) and (b)
(d) Government

Answer 6
(c) Both (a) and (b)

Question 7
Currency issued by the central bank is called:
(a) Fiat money
(b) Legal tenders
(c) High powered money
(d) All of the above

Answer 7
(d) All of the above

Question 8
Apart from currency notes and coins, the balance in
(i) ___________, held by the public in commercial banks
is also considered money since the amount in these
accounts can be used to settle transactions. Such deposits
are called demand deposits because (ii) ___________.
(Fill in the blanks)

Answer 8
(i) savings, or current account deposits
(ii) they are payable by the bank on demand from the
account-holder.

Question 9
Demand deposits created by commercial banks are
called ________.
(Fill in the blank)

Answer 9
bank money

Question 10
Demand deposits are not _______ since cheques drawn
on these accounts can be refused by anyone as a mode of
payment.
(Fill in the blank)

Answer 10
legal tenders

Question 11
Bank deposits which have fixed period to maturity, e.g.
fixed deposits are referred to as _______.
(Fill in the blank)

Answer 11
Time deposits

Question 12
M1 measure of money supply is defined as follows:
M1 = CU +DD
where, CU is Currency (notes plus coins) held by
the public and DD is ‘net’ demand deposits held by
commercial banks. The word ‘net’ here implies that
_____________.
(Fill in the blank)

Answer 12
Only deposits of the public held by the banks are to be
included in money supply. The interbank deposits, which
a commercial bank holds in other commercial banks, are
not to be regarded as part of money supply.

Question 13
In a modern economy, money comprises _______.
(Fill up the blank with correct answer)

Answer 13
Cash and bank deposits

Question 14
The currency issued by the central bank can be held by
the public or by the commercial bank, and is called the
‘___________’ or ‘reserve money’ or ‘monetary base’
as it acts as basis for credit creation.
(Fill up the blank with correct answer)

Answer 14
high powered money

Question 15
Besides central bank, ________ are the other type of
institutions which are a part of the money-creating system
of the economy.

Answer 15
commercial banks

Question 16
__________ accept deposits from the public and lend
out part of these funds to those who want to borrow.

Answer 16
Commercial banks

Question 17
_______ is the only institution which can issue currency
notes. However, coins are issued by the _______.

Answer 17
The Reserve Bank of India (RBI): Government of India.

Question 18
Which of the following is not a function of the Reserve
Bank of India?
(a) It issues the currency of the country.
(b) It acts as a bank to the banking system.
(c) It is the custodian of the foreign exchange reserves
of the economy.
(d) None of the above

Answer 18
(d) None of the above

Question 19
Central Bank is a very important institution in a modern
economy. Almost every country has one central bank.
India got its central bank in 1935. Its name is ________.
(Fill up the blanks with correct answer)

Answer 19
The Reserve Bank of India (RBI)

Question 20
Currency notes and coins are called fiat money.
True/False? Give reason.

Answer 20
True: RBI is responsible for giving the bearer of the
currency equal purchasing power.

Question 21
Currency notes and coins are called legal tenders.

Answer 21
True: They cannot be refused by any citizen of the
country for settlement of any kind of transaction.

Question 22
Demand deposits are called legal tenders.

Answer 22
False: Cheques drawn on savings or current accounts
can be refused by anyone as a mode of payment. Hence,
demand deposits are not legal tenders.

Question 23
Money supply is a stock variable.

Answer 23
True: Money supply is the total stock of money in
circulation among the public at a particular point of time.

Question 24
Currency created by the Central Bank is called bank
money.

Answer 24
False: The currency created by the Central bank
(Reserve Bank of India in India) is called High Powered
Money.

Question 25
Who regulates money supply in India?
(a) Government of India
(b) Reserve Bank of India
(c) Commercial Banks
(d) Planning Commission

Answer 25
(b) Reserve Bank of India

Question 26
The components of money supply are:
(a) Currency held by the public
(b) demand deposits of the public in commercial banks
(c) other deposits with the RBI
(d) currency held by the public and demand deposit of
the public in commercial banks

Answer 26
(d) currency held by the public and demand deposit of
the public in commercial banks

Question 27
Fixed deposit is also termed as:
(a) Chequeable deposits
(b) Demand deposit
(c) Time deposit
(d) Non-chequeable deposits

Answer 27
(c) Time deposit

Money Creation by Commercial
2.2 Banking System: Working of Money
Multiplier/ Lending Process of Banks
Process of Money Creation by
Commercial Banks
Commercial banks receive deposits from the public.
The depositors are free to withdraw, in part or in
full,their deposit amounts by writing cheques. The
banks use the money in these deposits to give loans.
These functions of the commercial banking system are
the basis of money creation. Note that money creation
is also called 'deposit creation' or 'credit creation‘.
Commercial banks cannot use the total deposits for
giving loans. It is legally compulsory for the banks to
keep a certain minimum fraction of net total demand
and time deposits as legal reserves. The fraction is
called the Legal Reserve Ratio (LRR).
LRR is the minimum reserve that a commercial
bank must maintain as per the instructions of the
central bank.
 Top Tip
Legal Reserve Ratio is also called Reserve Ratio or Required
Reserve Ratio or Reserve Deposit Ratio or Legal Reserve
Deposit Ratio.
The LRR is fixed by the Central Bank. It has two
components:
(i) Cash reserve ratio (CRR): It is the fraction of net
total demand and time deposits that commercial
banks must keep as cash reserves with the Central
Bank.
(ii) Statutory liquidity ratio (SLR): It is the fraction
of net total demand and time deposits that
commercial banks must keep with themselves in
the form of specified liquid assets.
How much are the deposits created is determined by
primary deposits and Legal Reserve Ratio (LRR). Primary
deposits refer to initial deposits with the commercial banks.
Given the amount of primary deposits (or initial deposits)
and the legal reserve ratio (LRR), total deposits creation
(or credit creation or money creation) will be:
Total credit creation (or money creation)
= Initial deposits × 1/Legal Reserve Ratio
Money creation (or deposits creation or credit creation) is
a process by which a commercial bank creates total
deposits number of times the primary deposits.
Process of money creation (or deposits creation or credit
creation) is based on the following assumptions:
(i) There is single banking system in the economy.
(ii) All transactions are routed through banks. One who
makes payment does it by writing cheque. The one who
receives payment deposits the same in his deposit account.
Numerical Example
Suppose customer deposits `10,000 in bank and the
legal reserve ratio (LRR) proposed by the Central Bank
is 20%. Bank has to pay interest on this amount for
which bank should lend this money to someone. A part
of the amount is to be retained with bank to meet its
customers' obligations. Since LRR is 20%,the bank will
keep 20% of deposits as reserves, i.e., `2,000 and will
lend the remaining 80%, i.e. `8,000. Those who borrow
will spend this money and same `8,000 will come back
to bank in the form of deposits. This raises the total
deposits to `18,000 now. Bank again keeps 20% of
`8,000,i.e. `1,600 as reserves and lend `6,400 to those
who needs. This will further raise the deposits with
bank. In this way deposits will go on increasing @ 80%
of the last deposit.
 Top Tip
The deposits creation comes to an end when total reserves
become equal to the initial deposit, i.e. `10,000.
Deposits creation by commercial bank

(with initial deposits `10,000 and LRR 20%)
Rounds Deposits (`) Loans (`) Reserves (`)
I 10,000 8,000 2,000
II 8,000 6,400 1,600
III 6,400 5,120 1,280
   
Total 50,000 40,000 10,000
Total deposits creation (or credit creation or money
creation) = Initial deposits × 1/LRR
= `10,000 × 1/0.2
= `10,000 × 5
= `50,000
How many times the total deposits would be of the
initial deposit is determined by the LRR. The multiple
called the money multiplier (or deposit multiplier or
credit multiplier) is:
Money multiplier = 1/Legal Reserve Ratio
In our example, Legal Reserve Ratio is 20%, therefore,
money multiplier = 1/0.2 = 5
Thus, the total deposit creation is 5 times the initial
deposit.
Money Multiplier – Its role in determining
credit creation power of banks
Meaning
Money Multiplier (or Credit Multiplier or Deposit
Multiplier) is the number by which total deposits
can increase due to a given change in deposits.
Money Multiplier (or Credit Multiplier or Deposit
Multiplier) is inversely related to legal reserve ratio.
Money multiplier = 1/Legal Reserve Ratio
Money multiplier measures the amount of money that
the banks are able to create in the form of total deposits
with every initial deposit.
Role in determining credit creation power
of banks
The credit creation by commercial banks depends on
money multiplier. There is a direct relationship
between money multiplier and total credit creation by
commercial banks.
Lower the money multiplier, lesser will be total
credit creation by the commercial banking system
and vice-versa.
Total credit creation
= Initial deposits × Money Multiplier (1/LRR)
Numerical Example
Suppose the LRR is 20% and initial deposit is `10,000.
Money multiplier = 1/LRR = 1/0.20 = 5; and Total credit created =
`10,000 × 5 = `50,000
Whereas, suppose LRR is increased by the Central Bank to 50%
and initial deposits remain the same, i.e. `10,000.
Then, Money multiplier = 1/0.50 = 2; and Total credit created =
`10,000 × 2 = `20,000.
Direct relationship between money multiplier and credit creation
Legal Reserve Money multiplier Credit creation = Initial
Ratio (= 1/LRR) deposits × 1/LRR
20% 1/0.20 = 5 `10,000 × 5 = `50,000
50% 1/0.50 = 2 `10,000 × 2 = `20,000
Thus, with the same initial deposit total credit creation decreases
with a decrease in the value of money multiplier.
Legal Reserve Ratio – Its influence in
the process of credit creation by banks
Legal Reserve Ratio (LRR) is the minimum reserves
that a commercial bank must maintain as per the
instructions of the Central Bank.
Credit creation is inversely related to the legal
reserve ratio.
Total credit creation (or money creation) = Initial
deposits × 1/Legal Reserve Ratio
Higher the legal reserve ratio, lesser will be the
credit creation by the commercial banking
system and vice-versa.
Numerical Example
Suppose the LRR is 20% and initial deposit is `10,000.
Total credit creation = Initial Deposits × 1/LRR = 10,000 × 1/0.2 =
10,000 × 5 = `50,000
Now suppose, if the LRR is increased by the Central Bank to
50% and initial deposits remain the same.
Total credit creation = Initial Deposits × 1/ LRR = 10,000 × 1/0.5 =
10,000 × 2 = `20,000.
Inverse relationship between LRR and credit creation
Legal Reserve Ratio Credit creation = Initial deposits × 1/LRR
20% 10,000 × 1/0.2 = `10,000 × 5 = `50,000
50% 10,000 × 1/0.5 = `10,000 × 2 = `20,000
Thus, any increase in LRR will decrease the credit creation power of
the commercial banks (banking system).
Key Term
Legal Reserve Ratio (LRR) – It is the minimum reserve that a commercial
bank must maintain as per the instructions of the central bank.
Cash reserve ratio (CRR) – It is the fraction of net total demand
and time deposits that commercial banks must keep as cash
reserves with the Central Bank.
Statutory liquidity ratio (SLR) – It is the fraction of net total
demand and time deposits that commercial banks must keep with
themselves in the form of specified liquid assets.
Money creation (or deposits creation or credit creation) – It is a
process by which a commercial bankcreates total deposits number
of times the primary deposits.
Primary deposits – It refers to the initial deposits with commercial
banks.
Money Multiplier (or Credit Multiplier or Deposit Multiplier) – It
is the number by which total deposits can increase due to a given
change in deposits.
RECAP
Money creation by commercial banks

Money creation (or credit creation or deposit creation) is a
process by which a commercial bankcreates total deposits
number of times the primary deposits. Primary deposits refer
to initial deposits with the commercial banks.
Process of credit creation is based on the following
assumptions:
(i) There is single banking system in the economy.
(ii) All transactions are routed through banks.
Total credit creation = Initial deposits
× 1/Legal Reserve Ratio
LRR is the minimum reserve that a commercial bank must
maintain as per the instructions of the central bank.
Initially, customer deposits `10,000 and LRR is 20%. Bank
keeps `2,000 as reserves to meet customers’ obligations and
give loans of `8,000. Those who borrow will spend this
money and same `8,000 will ultimately come back to bank as
fresh deposits. Out of these `8,000, bank keeps 20%, i.e.
`1,600 as reserves and give loans of `6,400. In this way, in
every round 80% of loans are converted into fresh deposits.
Total deposits creation (or credit creation or money creation)
= Initial deposits × 1/LRR
= 10,000 × 1/0.2 = 10,000 × 5 = `50,000
Credit creation is inversely related to the legal
reserve ratio.
For example, suppose LRR is 0.2 and initial deposits are
`10,000.
Total credit creation = Initial Deposits × 1/LRR = 10,000 ×
1/0.2 = 10,000 × 5 = `50,000
Now suppose, if the LRR is increased by the Central Bank to
0.5 and initial deposits remain the same, i.e. `10,000.
Now, total credit creation = Initial Deposits × 1/ LRR = 10,000 ×
1/0.5 = 10,000 × 2 = `20,000.
Thus, any increase in LRR will decrease the credit creation
power of the commercial banks (banking system).
Credit creation is directly related to money multiplier.
Money Multiplier (or Credit Multiplier or Deposit Multiplier)
is the number by which total deposits can increase due to a
given change in deposits. Lower the money multiplier, lesser
will be the total credit created and vice-versa.
Total credit creation = Initial deposits × Money Multipler
(1/LRR)
For example, suppose the LRR is 0.2 and initial deposit is
`10,000. Money multiplier = 1/LRR = 1/0.2 = 5; and Total credit
created = `10,000 × 5 = `50,000.
Whereas, suppose LRR is increased by the Central Bank to 0.5
and initial deposits remain the same, i.e. `10,000.
Then, Money multiplier = 1/0.5 = 2; and Total credit created =
`10,000 × 2 = `20,000.
Thus, with the same initial deposit total credit creation
decreases with a decrease in the value of money multiplier.
Question 1
There is a limit to money or credit creation by banks,
and this is determined by the central bank (RBI). The RBI
decides a certain percentage of (i)_______ which every
bank must keep as reserves, called (ii)_______. This is
done to ensure that no bank is ‘Over lending’

Answer 1
(i) Net total demand and time deposits
(ii) Legal Reserve Ratio/Reserve Ratio

Question 2
Since banks earn interest from loans they make, any
bank would like to land the maximum possible. But
there is a limit to money or credit creation by banks
and this is determined by ___________.
(Fill in the blank)

Answer 2
the central bank (RBI)

Question 3
Apart from the CRR, banks are also required to keep
some reserves in liquid form in the short term. This
ratio is called __________________.
(Fill in the blank)

Answer 3
Statutory Liquidity Ratio (SLR)

Question 4
Deposit creation by banks comes to an end when
__________________.
(a) fresh deposits with banks become zero
(b) legal reserve ratio becomes zero
(c) money multiplier becomes zero
(d) total reserves equal initial deposits

Answer 4
(d) total reserves equal initial deposits

Question 5
State, giving reason, whether the following
statement is true or false:
Higher the Legal Reserve Ratio (LRR), greater
would be the money creation in the economy.

Answer 5
False: Value of money multiplier is inversely related to
LRR since money multiplier = 1/LRR. Therefore, higher
the LRR, lower would be the value of money multiplier
and hence, money creation will be less in the economy.

Question 6
LRR and money creation has ____________.
(a) positive relation
(b) negative relation
(c) No relation
(d) Both (a) and (b)

Answer 6
(b) negative relation

Question 7
The value of credit multiplier will be high when ______.
(a) Legal reserve ratio is high
(b) Legal reserve ratio is low
(c) Legal reserve ratio is zero
(d) Legal reserve ratio is infinity

Answer 7
(b) Legal reserve ratio is low

NUMERICAL 1
Calculate the value of credit multiplier if the legal reserve

deposit ratio is 20%.
(CBSE Sample Question Paper 2019) (1 mark)
Solution: Credit Multiplier = 1/Legal Reserve Deposit
Ratio = 1/0.2 = 5
Do it yourself 1
Calculate the value of money multiplier if Required Reserve
Ratio is 12.5%. (1 mark)
[Ans. 8]
NUMERICAL 2
If the Reserve Ratio is 20% and the primary deposits are

`100, what is the value of deposit multiplier and total
lending by the banking system?
Given the same amount of initial deposits, if the RBI
increased the Reserve Ratio to 25%, what would happen in
the economy? Explain.
(NCERT) (4 marks)
Solution: Deposit multiplier (or Money multiplier or
Credit multiplier) = 1/Reserve ratio = 1/20% = 1/0.2 = 5
Credit creation (or Money creation or Deposit creation) =
Primary Deposits × 1/Reserve ratio = `100 × 5 = `500
Total lending by the banking system = 500 –100 = `400
If the RBI increases the Reserve Ratio to 25%, total money
creation = `100 × 1/0.25 = `100 × 4 = `400
Thus, the banking system would now be able to loan `300
only (`400 – `100). It would have to call back some loans to
meet the increased reserve requirements. Hence, money
supply would fall.
Do it yourself 2
If the Reserve Deposit Ratio is 25% and the initial deposits
of the public are `2,000, what is the value of deposit
multiplier, total deposit creation and total lending by the
banking system? (4 marks)
[Ans. Deposit multiplier = 4; Total deposit creation =
`8,000 and total lending by the banking system `6,000]
NUMERICAL 3
If the total deposits created by commercial banks is `50,000

crore, and CRR is 12% and SLR is 8%, then calculate the
amount of initial deposit with the bank. (3 marks)
Solution: LRR = CRR + SLR = 12 + 8 = 20% = 0.2
Therefore, Money Multiplier = 1/LRR = 1/0.2 = 5
Deposits creation = Initial deposit × 1/LRR
50,000 = Initial deposit × 5
Initial deposit = 50,000/5 = `10,000 crore
Do it yourself 3
Total deposits created by commercial banks is `12,000 crore
and LRR is 25%. Calculate the amount of initial deposits.
[Ans. `3,000 crore] (3 marks)
NUMERICAL 4
Calculate the legal reserve ratio if the initial deposit of

`10,000 crore lead to a creation of total deposits of `1,00,000
crore. (3 marks)
Solution: Deposits creation = Initial deposits × 1/LRR
1,00,000 = 10,000 × 1/LRR
1/LRR = 1,00,000/10,000
1/LRR = 10
LRR = 1/10 = 0.1 or 10%
Do it yourself 4
Calculate the legal reserve ratio if the initial deposit of `25,000
crore lead to a creation of total deposits of `1,25,000 crore.
[Ans. 20%] (3 marks)
2.3 Central Bank and Its Functions
Central Bank – Meaning
The Central Bank is the apex institution of a
country's monetary system. The design and the
control of the country's monetary policy is its
main responsibility.
India got its Central Bank in 1935. Its name is the
'Reserve Bank of India (RBI)'. It is the apex bank
engaged in regulating commercial banks in India.
Functions of the Central Bank
1. Authority of Currency Issue/Bank of issue
The Central Bank is the sole authority for the issue of
currency in the country. It promotes efficiency in the
financial system. Firstly, because this leads to uniformity
in the issue of currency. Secondly, because it gives
Central Bank direct control over money supply.
2. Banker to the Government/Government's
Bank
The Central Bank acts as a banker to the government
(both Central government as well as State governments).
Banker to the government means that the Central Bank
gives the same banking facilities to the government
which commercial banks give to the general public. The
Central Bank does not give such facilities to the general
public.
 As the banker to the government, the central bank
provides a large number of routine banking
functions to the government like maintaining the
balances, arranging and managing funds of the
government and so on.
 It gives loan to the government.
 It accepts receipts and makes payments for the
government.
 It works as agent of the government in matters of
collection of taxes, etc.
 It manages public debt.
 It also acts as a financial advisor to the government.
3. Bankers' Bank
 As the banker to the commercial banks, the Central
Bank holds surplus cash reserves of commercial banks.
 It also gives loans to the commercial banks when
they are in need of funds.
 The Central Bank also provides a large number of
routine banking functions to the commercial banks,
like cheque clearing, remittance facilities, etc.
 It also acts as a supervisor and a regulator of the
banking system. It makes rules regarding their
licensing, branch expansion, liquidity of assets,
amalgamation (merging of banks) and liquidation
(the winding up of banks), etc. The control is
exercised by periodic inspection of banks and the
returns filed by them.
What role of RBI is known as 'lender of last resort'?
When commercial banks need more funds in order to be
able to create more credit,they may go to market for
such funds or go to the Central Bank. Central bank
provides them funds through various instruments.
‘Lender of Last Resort' refers to the role of the Central
Bank (RBI), of being ready to lend to banks, especially
when a bank is faced with unanticipated severe financial
crises, and due to this central bank is said to be the
‘lender of last resort’.
If the central bank refuses to extend this help, there is
no option for the bank but to shut down.
 Top Tip
Commercial banks are legally required to keep only a
fraction of deposits as cash reserves. This is because not all
depositors approach the banks for withdrawal of money at
the same time, and also that normally they withdraw a
fraction of deposits. Secondly, there is a constant flow of
new deposits into the banks. Therefore, to meet the daily
demand for withdrawal of cash, it is sufficient for banks to
keep only a fraction of deposits as cash reserves. However,
if suppose all the account-holders want to withdraw their
deposits at the same time, the bank will not have enough
funds to satisfy the need of every account holder. This
situation is called 'bank run'. The bank may approach the
Central Bank, which then lends money to meet its emergent
needs.
4. Controller of Credit
'Credit control' is the most crucial function played by
any Central Bank in the modern times. The primary
objective of credit control is to remove causes
responsible for instability in price fluctuations which
in turn are related to the supply of money. By
controlling credit, the Central Bank can exercise an
effective control over economic activity and mobilise it
in the desired direction.
In India, The RBI controls the money supply in the
economy in various ways. The tools used by the Central
bank to control money supply can be quantitative or
qualitative.
 Quantitative tools control the extent of money
supply by changing the Cash Reserve Ratio (CRR)
or Statutory Liquidity Ratio (SLR) or Bank Rate or
Repo Rate or Reverse Repo Rate, or through Open
market operations (OMO).
 Qualitative tools include persuasion by the
Central Bank in order to make commercial banks
discourage or encourage lending which is done
through margin requirement, moral suasion, etc.
 Top Tip
The policy adopted by the Central Bank of a country in the
direction of credit control or money supply is known as Monetary
Policy. Instruments of Monetary Policy are Bank Rate, Cash
Reserve Ratio (CRR), Open Market Operations (OMO), etc.
Key Term
Central Bank – Central Bank is the apex institution of a country's
monetary system. The design and the control of the country's
monetary policy is its main responsibility.
Bank of issue – The Central Bank is the sole authority for the issue
of currency in the country.
Lender of Last Resort – It refers to the role of the Central Bank
(RBI), of being ready to lend to banks, especially when a bank is
faced with unanticipated severe financial crises.
Monetary Policy – The policy adopted by the Central Bank of a
country in the direction of credit control or money supply is
known as Monetary Policy.
Credit Control – The central bank controls the money supply and
credit in the best interests of the economy by taking recourse to
various quantitative and qualitative tools.
RECAP
Functions of the Central Bank

The Central Bank is the apex institution of a country’s
monetary system. India’s central bank is the ‘Reserve Bank of
India’. It is the apex bank engaged in regulating commercial
banks. Four main functions of Central Bank are:
1. Authority of Currency Issue/Bank of issue: The Central
Bank is the sole authority for the issue of currency in the
country. It promotes efficiency in the financial system.
Firstly, because this leads to uniformity in the issue of
currency. Secondly, because it gives Central Bank direct
control over money supply.
2. Government’s Bank: The Central Bank acts as a banker to
both central as well as state governments. • The Central
Bank keeps accounts of government and accepts deposits
from government.
• The Central Bank accepts receipts and makes payments
for the government. • It carries out exchange, remittance
and other banking operations for the government. • It
advances credit/loan to the government to meet its
requirements in case of crisis. • It also acts as an agent to
buy and sell government securities and advises the
government on various financial matters.
3. Bankers’ Bank: • As the banker to the banks, the Central
Bank holds surplus cash reserves of commercial banks. • It
also lends to commercial banks when they are in need of
funds. • Central Bank also provides a large number of
routine banking functions to the commercial banks. • It also
acts as a supervisor and a regulator of the banking system.
Central Bank acts as the ‘Lender of Last Resort’: It refers
to the role of the Central Bank (RBI), of being ready to lend
to banks, especially when a bank is faced with unanticipated
severe financial crises, and due to this central bank is said to be
the ‘lender of last resort’. If the central bank refuses to extend
this help, there is no option for the bank but to shut down.
4. Controller of Credit: The primary objective of credit control
is to remove causes responsible for instability in price
fluctuations which in turn are related to the supply of money.
By controlling credit, the Central Bank can exercise an
effective control over economic activity and mobilise it in the
desired direction. Central Bank regulates the volume and use
of credit by using quantitative and qualitative tools.
Quantitative tools control the extent of money supply by
changing the Cash Reserve Ratio (CRR) or Statutory
Liquidity Ratio (SLR) or Bank Rate or Repo Rate or Reverse
Repo Rate, or through Open market operations (OMO).
Qualitative tools include persuasion by the Central Bank in order
to make commercial banks discourage or encourage lending
which is done through margin requirement, moral suasion, etc.
Question 1
When commercial banks need more funds in order to
be able to create more credit, they may go to market for
such funds or go to the Central Bank. Central Bank
provides them funds through various instruments. This
role of RBI, that of being ready to lend to banks at all
times is a important function of the central bank, and
due to this central bank is said to be the __________.
(Fill in the blank)

Answer 1
lender of last resort

Question 2
The RBI controls the money supply in the economy in
various ways. The tools used by the central bank to
control money supply can be quantitative or qualitative.
____________ tools include persuasion by the central
bank in order to make commercial banks discourage or
encourage lending. ________ tools control the extent of
money supply. (Quantitative/Qualitative)

Answer 2
Qualitative; Quantitative

Question 3
Match the following:
(a) CRR, Bank rate, open (i) Quantitative credit control
market operations, etc. techniques
(b) Moral suasion, margin (ii) Qualitative credit control
requirements, etc. techniques

Answer 3
(a) — (i), (b) — (ii)

Question 4
Monetary policy is the policy of
(a) Government
(b) Central Bank
(c) Commercial Bank
(d) NABARD

Answer 4
(b) Central Bank

Question 5
The bank that operates without any profit motive in
public interest is
(a) Central Bank
(b) Nationalised Commercial Bank
(c) Canara Bank
(d) Punjab National Bank

Answer 5
(a) Central Bank

Question 6
CRR stands for
(a) Credit Reserve Ratio
(b) Cash Reserve Ratio
(c) Commercial Reserve Ratio
(d) Central Reserve Ratio

Answer 6
(b) Cash Reserve Ratio

Question 7
Which of the following is the function of the Central
Bank?
(a) Accepting deposits from the general public
(b) Giving loans to general public
(c) Bankers’ Bank
(d) Credit Creation

Answer 7
(c) Bankers’ Bank

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 Money – meaning and supply of money –

Money and Supply of Money

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