Money, banks and the money multiplier

Money is whatever is generally accepted in payment. It does three jobs (CUET 2026): it is a medium of exchange, a unit of account in which prices are quoted, and a store of value that carries purchasing power into the future.

Without it, trade is barter, which needs a double coincidence of wants: the baker who wants shoes must find a shoemaker who wants bread. Barter also needs a price for every pair of goods: with n goods, n(n − 1)/2 exchange ratios, against n money prices. With three goods both come to 3 (UGC NET 2025); with 100 goods it is 4,950 against 100. So barter has higher costs for each transaction (Hyderabad 2019).

• Commodity or full-bodied money is worth as much as a commodity as it is as money: its intrinsic value equals its face value. None of token, quasi or fiat money fits that (Hyderabad 2011).
• Fiat money has no intrinsic value and is accepted because of trust and legal backing (CUET 2019). Paper currency is token money (UGC NET 2025).
• Gresham’s law: bad money drives good money out of circulation. When two coins have the same face value, people spend the worn one and keep the good one (Hyderabad 2019).

The word itself comes from Latin, from the temple of Juno Moneta in Rome, where coins were minted (UGC NET 2025).

Different measures draw the line at different degrees of liquidity. Ranked from most to least liquid: currency, demand deposits, money market mutual funds, time deposits (CUET 2025). The RBI’s measures:

So M3 − M1 is time deposits (Hyderabad 2015), and M3 is currency, demand deposits and time deposits (Hyderabad 2014). Currency in circulation is currency with the public plus cash held by banks.

In 1998 the RBI’s Working Group on Money Supply (chaired by Y. V. Reddy) proposed new aggregates, NM1, NM2 and NM3. NM1 is currency with the public, demand deposits and ‘other’ deposits with the RBI; short-term time deposits of residents enter only at NM2 (GATE 2023).

High-powered money, H, is the money the RBI itself creates: the currency it has issued and the deposits banks and others hold with it. These are the RBI’s liabilities (GATE 2026). Held by the public it is cash; held by banks it is reserves. So H = currency with the public + bank reserves + other deposits with the RBI (CUET 2019; Hyderabad 2015).

H rises when the RBI acquires assets, since it pays for them by creating liabilities: when it buys government securities, lends to banks, or buys foreign currency. A capital inflow that the RBI buys up raises H, and then the money supply by a multiple, so by an amount that depends on the multiplier (JNU 2016). If the RBI does not want that, it sterilises: it sells government bonds at home to mop up the rupees it created buying foreign exchange (Hyderabad 2010).

A bank knows that not every depositor will want cash on the same day, so it keeps only a fraction of deposits as reserves and lends the rest. That is fractional reserve banking (Hyderabad 2020). The loan is spent; the seller deposits the proceeds, some in another bank; that bank keeps its fraction and lends the rest; and so on. Each loan creates a new deposit, and deposits are money.

The process stops because of two leaks at every round: banks keep reserves (rr per rupee of deposits) and the public keeps some cash (cu per rupee of deposits). Step through it:

Credit creation is limited by what banks must hold back: reserves with the central bank and cash in hand (UGC NET 2026), together with the public’s taste for cash. A “run on the bank” is what happens when many depositors want their money at once (Hyderabad 2020), which is why central banks enforce reserves and act as lender of last resort. Galbraith’s account of this history, set by JNU in 2010, makes the same points.

The bank stepper adds up two geometric series. The shortcut: money is cash plus deposits, and high-powered money is cash plus reserves.

The multiplier falls when either ratio rises: a higher cash reserve ratio (JAM 2025) or a stronger preference for cash (Hyderabad 2015). It rises with the “banking habit”, as people hold less cash (JNU 2011). To get more money from a given H, the RBI would cut reserve requirements and discourage cash withdrawals (JNU 2018). With no cash held, the multiplier is 1/rr: with rr = 0.5, it is 2 (GATE 2026).

The central bank, not the finance ministry, formulates monetary policy (CUET 2026). Its instruments work either on the quantity of reserves or on their price. Tax rates are fiscal policy, not a monetary instrument (UGC NET 2024).

“Tight” monetary policy means actions that contract the money supply (Hyderabad 2018). When interest rates are near zero and the usual tools run out, central banks turn to unconventional policy: quantitative easing, buying securities on a large scale to lower long-term interest rates and expand the money supply, at the risk of higher inflation (JNU 2019; GATE 2025).

Monetary transmission is how a policy decision reaches the economy (JNU 2019): a change in the real money supply, then portfolio adjustment, then changes in asset prices and interest rates, then spending responding to interest rates, and finally output responding to aggregate demand (CUET 2026). High non-performing assets and generous small-savings rates can slow it.