Class XII

TIME 1 HOUR
Unit Title : Money and Banking
TEACHING AIDS :- Story Telling and Use of Tables
Key Concept: Credit Creation by Commercial Bank ; deposit or money multiplier and
difference between primary and secondary deposits.
The monetary policy of the country has been designed to regulate the supply of money as it
ensures the credit requirement of different sectors and ensure stabilize the
economy.
General objectives:-
1) Understanding of some basic economic concepts and development of economic reasoning
which the learners can apply in their day-to-day life as citizens, workers and consumers.
2) Realisation of learners’ role in nation building and sensitivity to the economic issues that
the nation is facing today.
3) Development of understanding that there can be more than one view on any economic
issue and necessary skills to argue logically with reasoning.
Specific objectives:-
1) Analyse the role of commercial banks as creator of money supply in the economy.
2) To be Able to critically appraise the monetary policies introduced by central government.
3) Compute the deposit multiplier with given initial deposit and reserve ratio
4) Comprehend the significance of commercial banks in implementing the monetary policy
issued by central government..
Introduction:-
Imagine a village where there is no bank. After some time, Rajan, an inhabitant of the village opens a
bank called New Bank. The purpose of the bank is to allow depositors a safe place to deposit their
money. This new bank only accepts deposits but cannot give loans to its people. In this imaginary
village, all deposits are held as reserves and so there is no credit creation by the bank. Rajan’s friend
Sanju deposits Rs. 1000 in the New Bank.
Presentation:-
I. TWO ASSSUMPTIONS:-
1) Entire commercial banking system as one BANK.
2) All transactions routed through banks only. [all payments & transactions are done
through cheques
3) The Bank gets an initial deposit of Rs. 1000.
4) The legal reserve ratio is 20 %
For the process of credit –
Banks receive deposits; Out of the total deposits they first maintain reserve for LRR
[CRR+SLR]. The rest amount of deposits is lent out for loans.

II. The RBI decides percentage of CRR + SLR, which every bank must keep as reserves.
This is done to ensure that no bank is ‘over lending’. This is a legal requirement and is
binding on the banks.
 Deposit Reserve = LRR [20%] Loan

Initial deposit 1000 200 800

Lent out funds will be spent in the economy worth Rs. 800. As one person expenditure another
person income it will result in creation of new deposits worth 800.
III. One person spending [ cheques ]= other individuals Income [recd. cheques]
800 spent = 800 income and addition to deposit
Deposit Reserve [20%] Loan

Initial deposit 1000 200 800

Round II 800 160 640
ROUND II 640 128 512
Round III 512 .. ..
TOTAL _________ _____________ ___________

Total deposits = 1000+800+640+512+………………………………………………………

 Total deposits = INITIAL DEPOSIT X DEPOSIT MULTIPLIER

 Deposit Multiplier = 1
LRR

Deposit Multiplier = 1 =5
20%

Total deposits = INITIAL DEPOSIT X DEPOSIT MULTIPLIER

= 1000 X 5
= 5000
Conclusion :-
Thus, the total deposits of Rs. 5,000 have been created by the banking system. Out of the initial
deposits of Rs. 1,000; the remaining Rs. 4,000 deposits have been made by the banking system itself.
We found that bank created money by lending money. They accept deposits, and then lend a
portion of those deposits in order to earn interest income. The portion of the deposit left with the
bank is a reserve to meet the demand for withdrawals. In a fractional reserve banking system,
banks may keep 10 to 20 percent of their deposits as a reserve. Rest of the money is given on loan.
When any bank loan these deposits, money is created.

Recapitulation:-
 1) The money multiplier and legal reserve ratio are inversely related
2) Demand deposits are composite of primary deposit created out of original currency and
secondary deposits crearted out of loans given by commercial banks resulting in multiplier
effect.
Assess yourself:
Numerical questions
1) Calculate the value of money multiplier and total deposit created if initial deposit is to
Rs.500 Crores and LRR is 10 %.
2) Calculate the legal reserve requirements if initial deposit of Rs.200 crores lead to creation
of total deposits of Rs.1,600 crores.
3) If the total deposits created by commercial banks id Rs. 12,000 crores and legal reserve
requirements is 25%, then calculate the amount of initial deposits.
Theory questions
Q –1 Can the commercial banks be considered as the creator of money supply in the economy?
(3)
Q – 2 Explain how the credit creation/ money creation process impacts the national income of
the economy?(3)
Q- 3 How central bank can stabilize money supply against the exogenous shocks in the
economy? (3)
Q – 4 Briefly explain the impact of demonitisation by RBI on the process of credit creation in
the economy? (5)