Money and Banking
Class 12 · Economics
4 ideas in Class 12 Economics, explained in plain words, with games and quizzes to practise.
Functions of Money
Part of: Why Money Matters
Barter needs a double coincidence of wants, which is costly to find in a large economy. Money fixes this as a medium of exchange everyone accepts. It also serves as a unit of account for quoting prices, a store of value for the future, and the standard in which loans are fixed. Modern notes are fiat money with no intrinsic value, backed by the issuer's promise and legal tender status.
Why it matters. Every price, wage and loan depends on money doing these four jobs. Learners who grasp them can explain why digital payments work and why a currency collapses when trust in it fails.
Key words
- Barter exchange
- : Direct exchange of goods for goods without using money.
- Double coincidence of wants
- : The rare matching of two people who each want what the other offers.
- Medium of exchange
- : Money's role as the common item everyone accepts in trade.
- Unit of account
- : Money's role as the common measure in which all prices are quoted.
- Store of value
- : Money's role in holding purchasing power for future use.
- Standard of deferred payments
- : Money's role as the item in which loans and future payments are fixed.
- Fiat money
- : Notes and coins with no intrinsic value, accepted on the issuer's promise.
- Legal tender
- : Money that citizens cannot refuse in settlement of transactions.
Try it in two minutes
- Ask the child to trade a pencil for an eraser with a friend.
- Ask what happens when the friend wants a sharpener instead.
- Explain that money removes the need for matching wants.
Try at home. Find one news item about digital payments and say which function of money it uses.
Demand for Money
Part of: Wanting to Hold Cash
Transaction demand rises with income and prices, written as MdT = kPY, because more spending needs more cash in hand. Speculative demand comes from choosing between money and bonds: a bond's price equals the present value of its returns, so it falls when interest rises. Expecting a rise in rates makes people sell bonds for cash. At very low rates everyone hoards cash and extra money cannot push rates lower, a liquidity trap.
Why it matters. Interest-rate news moves savings, loans and asset prices. Learners who link income, prices and interest to money demand can read why central banks cut or raise rates.
Formulas
- Transaction demand MdT = k x T
- Transaction demand MdT = k x P x Y
- Velocity v = T / MdT = 1 / k
- Present value = future payment / (1 + interest rate)
Key words
- Transaction motive
- : Cash held to carry out everyday purchases.
- Speculative motive
- : Holding money instead of bonds on a guess about future interest moves.
- Liquidity preference
- : Wanting cash for its flexibility; another name for money demand.
- Bond
- : A tradable paper promising a future stream of money returns.
- Coupon rate
- : A bond's promised yearly return as a share of its face value.
- Present value
- : Today's worth of a future payment, found by discounting at the interest rate.
- Capital loss
- : Loss suffered when a bond's market price falls.
- Liquidity trap
- : A floor rate below which extra money only piles up as idle cash.
Try it in two minutes
- Ask the child why salary day cash differs from month-end cash.
- Ask what a higher savings rate does to the urge to hold cash.
- Explain that bonds gain when rates fall and lose when rates rise.
Try at home. Track one week's cash spending and estimate the household's average cash balance.
How Banks Create Money
Part of: Lending Creates Deposits
Banks lend most of their deposits because not all depositors withdraw together, and each loan returns as a new deposit. A balance sheet records reserves plus loans as assets against deposits as liabilities. The central bank caps this chain with the Cash Reserve Ratio: with 100 reserves and a 25 per cent ratio, deposits reach 800 and loans 600, a multiplier of 4.
Why it matters. Headlines about credit growth and reserve-ratio cuts move markets. Learners who can run the multiplier understand how one deposit becomes many loans and why limits on lending protect depositors.
Formulas
- Money multiplier = 1 / reserve ratio
- Total deposits = reserves / reserve ratio
- Bank loans = deposits - reserves
- Assets = Reserves + Loans; Liabilities = Deposits
Key words
- Cash Reserve Ratio
- : Deposits a bank must keep as reserves, as a share of its deposits.
- Statutory Liquidity Ratio
- : Extra reserves banks must hold in liquid form for the short term.
- Money multiplier
- : Total deposits supported by each unit of reserves; equals 1 divided by the reserve ratio.
- Balance sheet
- : A record of what a firm owns and owes, with both sides equal.
- Bank assets
- : A bank's reserves plus the loans it has given.
- Bank liabilities
- : What a bank owes, mainly the deposits of the public.
- Net worth
- : Net worth, equal to assets minus liabilities.
- Credit creation
- : New deposits created when a bank lends to a borrower.
Try it in two minutes
- Ask the child why a bank cannot lend every rupee it receives.
- Ask what happens to a loan once the borrower spends it.
- Explain that the reserve rule stops the lending chain at a fixed total.
Try at home. With play money, run three rounds of deposit and loan at a 20 per cent reserve rule.
RBI Tools and Measures of Money
Part of: Steering the Money Supply
M1 (cash plus demand deposits) is narrow money; adding time deposits gives broad M3, the most watched measure. The RBI steers supply with the reserve ratio, open market bond deals, and the bank rate, besides repo operations and moral suasion. As lender of last resort it always stands ready to fund banks. Buying bonds injects reserves and expands supply; selling bonds or raising rates shrinks it.
Why it matters. Rate decisions fill the business pages. Learners who know these tools can explain why loans get cheaper or dearer and how the central bank fights inflation or slumps.
Formulas
- M1 = Currency + Demand deposits
- M3 = M1 + Net time deposits
- Buying bonds raises reserves and money supply
- Raising the reserve ratio lowers money supply
Key words
- M1
- : Currency plus demand deposits; the narrowest money measure.
- M3
- : Currency plus all deposits, including time deposits; broad money.
- Lender of last resort
- : The central bank's readiness to lend to banks in a crisis.
- Open Market Operations
- : Central bank buying and selling of government bonds to change reserves.
- Bank Rate
- : Rate at which the central bank lends to commercial banks.
- Repo rate
- : Rate for short loans against securities with a resale promise.
- Reverse repo rate
- : Rate at which money is withdrawn through reverse bond sales.
- Moral suasion
- : Central bank persuasion urging banks to lend more or less.
Try it in two minutes
- Ask the child which is easier to spend: cash or a fixed deposit.
- Ask what happens to bank reserves when the central bank buys bonds.
- Explain that costlier central loans shrink lending and the money supply.
Try at home. Find the latest repo rate in the news and say whether it pushes lending up or down.
What your child will practise
- Demand for Money: Ocean Quick Fire (Quick Fire)
- Functions of Money: Desert Puzzle (Clue Puzzle)
- Functions of Money: Jungle Quick Fire (Quick Fire)
- How Banks Create Money: Candy Quick Fire (Quick Fire)
- RBI Tools and Measures of Money: Ocean Puzzle (Clue Puzzle)
- Quiz: Demand for Money (8 questions)
- Quiz: Functions of Money (8 questions)
- Quiz: How Banks Create Money (8 questions)
- Quiz: RBI Tools and Measures of Money (8 questions)