1. Functions of Money

• In economics, the concept of money refers to any commodity or token that is generally accepted as a method of payment. 0
• Money performs several essential functions:
• Medium of Exchange: Money is widely accepted in exchange for goods and services, eliminating the need for barter and the double coincidence of wants. 1
• Unit of Account: Money provides a common measure in which prices and debts are expressed, making comparison and valuation possible. 2
• Store of Value: Money allows individuals to transfer purchasing power from the present to the future (though inflation can reduce the real value). 3
• Standard of Deferred Payment: Money is used to settle debt obligations that are payable in the future. 4

2. Demand for Money and Supply of Money

2.1 Demand for Money

The demand for money refers to the desire of households and firms to hold money balances rather than other assets. Key motives include:

• Transactions Demand: Holding money to carry out everyday purchases of goods and services. 5
• Precautionary Demand: Holding money for unforeseen contingencies or emergencies. 6
• Speculative Demand: Holding money to take advantage of future investment opportunities when interest rates may change (or to avoid losses). 7

Determinants of money demand:

• Price Level – higher prices lead to greater demand for money for transactions. 8
• Real Income – as income increases, transaction demand for money generally rises. 9
• Interest Rate – the opportunity cost of holding money instead of interest-earning assets; higher interest rates reduce money demand. 10
• Expectations about future economic conditions – if people expect higher inflation or interest rate changes, money-holding behaviour shifts. 11

2.2 Supply of Money

The supply of money is the total stock of money available in the economy at a given point in time. It is largely determined by the central bank (and banking system) though commercial banks and the public’s behaviour also matter. 12

Money supply is often represented by monetary aggregates such as M1, M2, “broad money”, etc. 13

2.3 Money Market Equilibrium

In the money market, equilibrium occurs where money demand equals money supply, and this determines the interest rate and quantity of money held. 14

3. Money Creation by the Banking System

The banking system creates money through the processes of accepting deposits and granting loans, under a fractional reserve regime.

3.1 Balance Sheet of a Fictional Bank

• When a bank receives a deposit, it holds a fraction as reserves and lends out the remainder.
• The created loan becomes a deposit in another bank, which again holds reserves and lends, repeating the process.

3.2 Limits to Credit Creation and Money Multiplier

The concept of the money multiplier explains how an increase in the monetary base leads to a multiplied increase in the money supply. 15

Or allowing for currency-holding by the public:

Where MB is the monetary base and rr is the reserve-deposit ratio. 16

Key constraints:

• If banks hold excess reserves, the multiplier falls.
• If the public holds more currency (not depositing), the multiplier also falls. 17
• The central bank’s control of the monetary base (high-powered money) is essential for money supply control. 18

4. Policy Tools to Control Money Supply

The central bank uses several instruments (tools) to influence the money supply, credit creation, interest rates and thereby aggregate demand in the economy. 19

• Open Market Operations (OMO): Buying or selling government securities to increase/decrease the monetary base (reserves) and hence the money supply. 20
• Reserve Requirement Ratio (CRR / Reserve Ratio): Changing the fraction of deposits banks must hold as reserves — a higher ratio reduces lending, a lower ratio increases it. 21
• Discount or Bank Rate: The rate at which commercial banks borrow from the central bank; changing this cost affects bank lending. 22
• Statutory Liquidity Ratio (SLR): In some economies (e.g., India) banks must hold a portion of deposits in specific liquid assets which influences available funds for lending. 23
• Interest-Rate Policy: Through setting policy rates (repo/discount), the central bank influences market interest rates, borrowing cost and money creation. 24
• Quantitative Easing / Tightening: Unconventional tools where the central bank buys/sells large asset quantities to adjust reserves and money supply. 25

5. Demand and Supply for Money : A Detailed Discussion

This section brings together the demand and supply sides of money, illustrating how monetary policy affects interest rates, investment, consumption and hence aggregate demand.

• When the central bank increases the money supply (shifts Ms to the right), interest rates fall (other things equal), leading to higher investment and consumption → aggregate demand rises. 26
• Conversely, when the money supply is reduced (Ms shifts left) or money demand increases, interest rates rise → borrowing falls, consumption/investment drop → aggregate demand falls. 27
• The interaction of money market changes with the goods market is part of the monetary transmission mechanism. 28

6. Supply of Money : Various Measures

Modern economies use various monetary aggregates (narrow to broad) to measure the supply of money and monitor monetary policy. 29

In the context of India, definitions such as narrow money (M1) and broad money (M3/M4) are used by the Reserve Bank of India (RBI) to assess liquidity and inflation risks.

7. Legal Definitions: Narrow and Broad Money

Legal definitions of money refer to those categories which a country’s central bank recognises for policy-monitoring and reporting purposes.

• Narrow Money: Money that is very liquid – e.g., currency in circulation plus demand/deposit accounts. It closely approximates money used for immediate transactions.
• Broad Money: Includes narrow money plus less-liquid assets such as time deposits, savings deposits, and other near-money assets.
• The separation into narrow and broad money helps policymakers understand liquidity in the economy, how banks are lending, and how money might impact inflation and growth. 31

8. Demonetisation

Demonetisation refers to the withdrawal of legal tender status of currency notes and coins, usually to purge counterfeit currency, reduce black money, or shift monetary and fiscal behaviour.

• When high-value currency notes are demonetised, people must deposit or exchange them within a stipulated time, which can reduce currency in circulation and change money supply composition (e.g., higher bank deposits, lower cash holdings).
• The impact on the money supply depends on how much of the dematerialised currency ends up as bank deposits (which can then multiply via credit creation) versus being withdrawn permanently from circulation.
• In the Indian context, the 2016 demonetisation (withdrawal of ₹500 and ₹1,000 notes) is a key example; the policy had effects on currency in circulation, bank deposits, and liquidity. (You may include local data for Class 12 if required.)

9. Summary Table of Key Formulas & Concepts

10. Concluding Insights

Chapter 3 gives a comprehensive view of how money functions in an economy, how demand and supply for money are determined, and the key role of the banking system and monetary policy in shaping the money supply. It links the macro-economic significance of money (interest rates, investment, aggregate demand) with the institutional mechanisms (banks, central bank, reserves, credit creation).

For students of Class 12, it is important to relate these theoretical concepts to real‐life monetary events (such as demonetisation, changes in policy rates, credit growth) and to understand the significance of monetary aggregates (narrow vs broad money) for policy, inflation and growth in the Indian economy.