Money, Money Supply and the Banking System

Most Economy preparation starts at monetary policy: repo, CRR, the MPC. That skips a layer. Before you can say what raising the repo rate does, you need to know what counts as money in the first place, who measures it, how a bank creates more of it than it holds, and whose money a deposit actually is. Prelims tests that layer directly, and it tests it with definitions rather than opinions, which makes it some of the most reliably scoreable material in the whole subject.

This note covers the foundations. The RBI and monetary policy note picks up from here with the toolkit, banking regulation with NPAs and Basel, and financial inclusion and digital payments with the payments rails.

What makes money "money": legal tender, and the limits on coins

Legal tender is a coin or banknote that is legally tenderable for the discharge of a debt or obligation. The operative idea is compulsion on the creditor: a person owed money cannot refuse legal tender offered in settlement of that debt. It is not a rule that a shopkeeper must sell you something, and it is not a rule that covers foreign transactions. That distinction between "a creditor must accept it in settlement" and "nobody can ever refuse it" is the single most common way this is tested.

Every banknote issued by the RBI is legal tender at any place in India for the amount expressed on it, and is guaranteed by the Central Government, under sub-section (2) of Section 26 of the RBI Act, 1934. The same section is why a note carries the words "I promise to pay the bearer the sum of Rupees", which denotes the Bank's own obligation to the holder.

Coins are different, and the difference is examinable. Coins are issued by the Government of India under Section 6 of the Coinage Act, 2011, and they are legal tender only up to a ceiling:

• A coin of denomination not lower than one rupee: legal tender for any sum not exceeding one thousand rupees in a single transaction.
• A fifty paise coin: legal tender for any sum not exceeding ten rupees.
• In both cases the coin must not be defaced and must not have lost weight below what is prescribed.

Nobody can be forced to accept coins beyond those limits, but voluntarily accepting more is not prohibited. Note also that the one-rupee note is issued by the Government of India rather than the RBI and is legal tender too, a carve-out covered in the RBI note's own section on it.

Two more facts sit close by and get tested. The RBI has the sole right to issue banknotes under Section 22; coins are minted by the Government and are issued into circulation only through the RBI, under Section 38. And demonetisation is a legal-tender event, not a physical one: the ₹500 and ₹1,000 Mahatma Gandhi series notes issued up to 8 November 2016 ceased to be legal tender from midnight that day. The ₹2,000 note, by contrast, was withdrawn from circulation in 2023 but continues to be legal tender, which is a genuinely different status and a favourite trap.

How the RBI actually measures money: M0 to M4

The RBI publishes these every fortnight, and the definitions are additive rather than alternative. Start at the base.

Reserve Money (M0), also called high-powered money or the monetary base, is the RBI's own liability:

M0 = Currency in Circulation + Bankers' Deposits with the RBI + 'Other' Deposits with the RBI

Then the money stock measures, which start from money in the hands of the public rather than in circulation overall:

• Currency with the Public = Notes in Circulation + Circulation of Rupee Coin + Circulation of Small Coins minus Cash on Hand with Banks. Cash sitting in a bank's own till is not in the public's hands, so it is subtracted.
• Deposit Money of the Public = Demand Deposits with Banks + 'Other' Deposits with the RBI.
• M1 (narrow money) = Currency with the Public + Deposit Money of the Public.
• M2 = M1 + Post Office Savings Bank Deposits.
• M3 (broad money) = M1 + Time Deposits with Banks.
• M4 = M3 + Total Post Office Deposits.

Two things fall straight out of this structure. First, M2 is not between M1 and M3 in the way the numbering suggests: M2 adds post office savings deposits to M1, while M3 adds bank time deposits to M1, so M3 is far the larger of the two and neither contains the other. Broad money runs at roughly four times narrow money in India. Second, one current detail worth carrying: Notes in Circulation now include CBDC-Retail and CBDC-Wholesale, so the digital rupee is inside the currency figure rather than beside it.

Alongside M1 to M4 the RBI also publishes NM1, NM2 and NM3, the "new" monetary aggregates recommended by the Working Group on Money Supply under Y. V. Reddy in 1998. These split time deposits by residual maturity rather than lumping them together: NM2 adds short-term time deposits of residents to NM1, and NM3 adds long-term time deposits plus call and term funding from financial institutions. NM2 and NM3 exclude FCNR(B) deposits. You are not expected to reproduce these, only to know they exist and are not the same series as M1 to M3.

The withdrawal question

Here is the payoff, and it is a real past question. If a depositor withdraws cash from their demand deposit account, what happens to the money supply immediately?

Nothing. Demand deposits with banks fall by the amount withdrawn, and currency with the public rises by the same amount. Both are components of M1, and therefore of M3. The aggregate has not been added to or taken from, only reshuffled between two of its own line items. No new money was created, because creating money requires either the RBI expanding its base or a bank making a new loan, and a withdrawal does neither.

The money multiplier: one base, many possible money supplies

The RBI directly controls M0. It does not directly control M3. The ratio between them is the money multiplier:

money multiplier (m) = M3 / M0

In India this currently runs a little above 6, meaning each rupee of reserve money supports a bit more than six rupees of broad money. The figure moves, so treat it as an order of magnitude rather than a fact to memorise.

The multiplier is not a policy lever the RBI sets. It emerges from two behavioural ratios, and it moves inversely to both:

1. The reserve ratio, how much of each deposit a bank must hold back rather than lend. Raising the CRR does this directly; raising the SLR does it in effect, by forcing banks to park more in prescribed safe assets. Higher reserve ratio, smaller multiplier.
2. The currency-drain ratio, how much cash the public holds outside the banking system rather than depositing it. Cash under a mattress cannot be re-lent by anyone. Higher currency drain, smaller multiplier.

That second ratio is what makes an apparently soft-sounding option the correct one in a hard-looking question. An increase in the banking habit of the population means a larger share of money passes through deposits rather than staying as cash, which lowers the currency-drain ratio and therefore raises the multiplier. If you are offered that alongside "a rise in CRR" and "a rise in SLR", the banking-habit option is the one that increases the multiplier and the two ratios are the ones that cut it.

The simplified textbook version, m = 1 / CRR, is a special case that assumes the public holds no cash at all. It is useful for intuition and wrong as a description of India, which is exactly why the currency-drain ratio has to be in your answer.

A bank's balance sheet: your deposit is the bank's liability

This is one line of understanding that is worth a guaranteed mark.

A deposit is a liability of the bank. The bank owes that money back to you on demand or on maturity. It is not something the bank owns.

A bank's assets are the claims it holds on others:

• Loans and advances to customers
• Investments, principally in government securities
• Money at call and short notice, very short-term lending to other banks
• Cash in hand and balances with the RBI

Its liabilities are what it owes:

• Deposits (demand and time)
• Borrowings
• Capital and reserves, owed to shareholders

So the classic question, "which of the following is NOT an asset of a commercial bank", is answered by spotting the deposit in the list. The mental model that fixes it permanently: a bank's business is to borrow from depositors and lend to borrowers, so deposits are on the borrowing side by construction.

Co-operative banks and the duality of control

The co-operative structure has its own vocabulary and one defining regulatory feature.

The short-term rural co-operative credit structure is three tiers: Primary Agricultural Credit Societies (PACS) at the village level, Central (District Central) Co-operative Banks at the district level, and State Co-operative Banks at the state level. PACS are outside the Banking Regulation Act, 1949 entirely and are therefore not regulated by the RBI. StCBs and DCCBs are regulated by the RBI, with NABARD delegated the power to inspect them under Section 35(6) of the Act as applicable to co-operative societies.

Urban Co-operative Banks (UCBs), formally Primary Co-operative Banks, serve urban and semi-urban customers. They are registered as co-operative societies, either under a State Co-operative Societies Act or, where they operate across state lines, under the Multi State Co-operative Societies Act, 2002.

Duality of control is the fact to hold. The Banking Regulation Act came into force in 1949, but banking laws were applied to co-operative societies only in 1966, through an amendment to that Act. Since then control has been split:

• Banking functions are regulated by the RBI, under Sections 22 and 23 of the Banking Regulation Act as applicable to co-operative societies.
• Management functions, including registration, elections and administration, sit with the Registrar of Co-operative Societies of the state, or the Central Registrar for multi-state banks.

So a statement claiming UCBs are regulated by state boards independently of the RBI is wrong, and it is wrong specifically because the split is functional, not institutional. Both regulators apply, to different things. The RBI has signed memoranda of understanding with the Centre and every state with UCBs, from Andhra Pradesh in June 2005 to Telangana in December 2014, to converge the two.

On capital, the Banking Regulation (Amendment) Act, 2020 is the reference: co-operative banks may issue equity shares, preference shares or special shares, at face value or at a premium, to members or to persons residing in their area of operation, and may issue unsecured debentures or bonds of ten years or longer maturity, all with prior RBI approval. The same Act bars anyone from demanding payment on surrender of such shares and bars a co-operative bank from reducing its share capital except as the RBI specifies, which is the point of the provision: capital that cannot walk out of the door in a crisis.

Who coordinates the regulators: the FSDC

India has several financial-sector regulators, and something has to sit above them without becoming one.

The Financial Stability and Development Council (FSDC) was constituted by a Government of India notification dated 30 December 2010, an executive decision rather than an Act of Parliament. Three facts carry most of the marks:

• It is chaired by the Union Finance Minister and sits under the Ministry of Finance.
• Its mandate covers financial stability, financial sector development, inter-regulatory coordination, financial literacy, financial inclusion and macro-prudential supervision of the economy, including the functioning of large financial conglomerates.
• It has a Sub-Committee chaired by the Governor of the RBI.

Its original membership was the RBI Governor, the Finance Secretary and Secretary of the Department of Economic Affairs, the Secretary of the Department of Financial Services, the Chief Economic Adviser, and the heads of SEBI, IRDAI and PFRDA; the list has been widened since, so treat the composition as "the financial regulators plus the Finance Ministry's top officials" rather than a fixed roster. The Council is allocated no separate funds of its own.

The trap is affiliation. The FSDC is not an organ of NITI Aayog and is not an RBI body. It is a Finance Ministry council chaired by the Finance Minister, which is why "headed by the Finance Minister" and "macro-prudential supervision" are both correct while "an organ of NITI Aayog" is not.

Merchant Discount Rate, and the change coming to UPI

The Merchant Discount Rate (MDR) is the fee a bank charges a merchant for accepting a customer's payment by card, deducted from what the merchant actually receives. It is not interest on a loan, not a discount owed to the customer, and not a fee the RBI charges banks. The customer never pays it directly.

On cards, the RBI caps it. Under its December 2017 rationalisation, debit card MDR is tiered by the merchant's turnover: small merchants (turnover up to ₹20 lakh in the previous financial year) pay not more than 0.40% on physical POS, capped at ₹200 per transaction, and 0.30% on QR-code acceptance; other merchants pay not more than 0.90%, capped at ₹1,000, and 0.80% on QR.

On UPI, the position is changing, and this is live exam material rather than settled history. Since 1 January 2020, MDR has been zero on RuPay debit cards and BHIM-UPI, effected through Section 10A of the Payment and Settlement Systems Act, 2007 and Section 269SU of the Income-tax Act, 1961. Under a new framework announced on 15 September 2026 and effective from 15 October 2026, MDR returns to UPI in a tiered form. What stays free is as examinable as what does not:

Free

• All person-to-person (P2P) transfers, at any amount, for payer and beneficiary alike. That alone is about 70% of UPI's total transaction value.
• All P2M payments up to ₹2,000.
• Small merchants under the P2PM category, including street vendors, receiving up to ₹1 lakh a month through UPI QR codes, on all their transactions.

Taken together, roughly 96% of merchant transactions are unaffected.

Charged

• P2M above ₹2,000: 0.4%, capped at ₹300 for transactions of ₹75,000 and above.
• Essential and thin-margin sectors (railways, telecom, insurance, fuel, agricultural inputs), above ₹2,000: a flat ₹5 per transaction.
• Capital market payments (mutual funds, securities, stockbrokers and dealers): 0.02%, capped at ₹300.

Three clarifications carry most of the marks. MDR is not a tax and is not collected by the Government or by NPCI; it is distributed among banks, payment service providers and app providers. Customers do not pay it: banks have been advised to ensure merchants do not pass it on, and UPI apps are expressly barred from platform fees or hidden charges. And the daily limits your bank applies, typically ₹1 lakh to ₹5 lakh, are risk-management safeguards, not charging thresholds.

The structural point holds either way: zero MDR was never the absence of a cost, only a decision about who bore it. It was funded by annual government incentive schemes designed as short-term bridge funding, against an industry cost of running the rail estimated at around ₹20,000 crore a year, which is the case now made for a threshold-based commercial model instead.

Two gold schemes, and what they were actually for

The Gold Monetisation Scheme (GMS) and the Sovereign Gold Bond (SGB) scheme, both launched in November 2015, are usually asked together, and the question is almost always about purpose.

Both exist to do two things. First, to bring idle household and institutional gold into the formal financial system, where it can earn a return instead of sitting in a locker. Second, to reduce India's dependence on gold imports, which are a persistent drag on the current account deficit: gold already inside the country, mobilised or substituted by a paper claim, is gold that does not have to be bought from abroad.

What is not a purpose, and is the standard distractor, is promoting foreign direct investment in the gold and jewellery sector. Neither scheme has anything to do with FDI.

The mechanics differ. GMS takes physical gold as a deposit, through Collection and Purity Testing Centres and designated bank branches, and pays interest on it. SGBs are securities denominated in grams of gold, issued by the RBI on behalf of the Government, where the investor never handles metal at all and the government substitutes a paper liability for physical demand.

One current change matters. The Medium Term and Long Term Government Deposit (MLTGD) components of the GMS were discontinued with effect from 26 March 2025, on a review of the scheme's performance. Existing MLTGD deposits run to redemption, renewals stopped, and the Short Term Bank Deposit component continues at each bank's own discretion. The scheme's stated purposes are unchanged; the instrument set has narrowed.

Quick revision points

• Legal tender: the creditor must accept it in discharge of a debt. Not "nobody can ever refuse it".
• Banknotes: legal tender under Section 26, RBI Act 1934, guaranteed by the Central Government. RBI has the sole right of issue (Section 22).
• Coins: Section 6, Coinage Act 2011. ₹1 and above legal tender up to ₹1,000 per transaction; 50 paise up to ₹10.
• ₹2,000 note: withdrawn from circulation, still legal tender. The 2016 ₹500/₹1,000 notes ceased to be legal tender.
• M0 = Currency in Circulation + Bankers' Deposits with RBI + 'Other' Deposits with RBI.
• M1 = Currency with the Public + Demand Deposits + 'Other' Deposits with RBI. M2 = M1 + Post Office Savings deposits. M3 = M1 + Time Deposits. M4 = M3 + Total Post Office deposits.
• Currency with the Public subtracts cash on hand with banks; Notes in Circulation now include CBDC.
• Withdrawing cash from a deposit leaves the money supply unchanged. It moves between two components of the same aggregate.
• Money multiplier = M3 / M0, currently a little above 6. Falls when the reserve ratio (CRR, SLR) rises; falls when the currency-drain ratio rises; rises when the banking habit improves.
• Deposits are liabilities. Loans, investments, money at call and short notice, and cash are assets.
• PACS are outside the BR Act. StCBs and DCCBs are RBI-regulated, NABARD-inspected under Section 35(6).
• UCBs: duality of control since 1966. RBI for banking functions (Sections 22 and 23), Registrar of Co-operative Societies for management. They may issue equity, preference and special shares with prior RBI approval (BR Amendment Act, 2020).
• FSDC: notification of 30 December 2010, chaired by the Union Finance Minister, sub-committee chaired by the RBI Governor, does macro-prudential supervision, not a NITI Aayog organ.
• MDR: charged within the merchant payment ecosystem, never to the customer, and not a tax. Debit card MDR capped since December 2017 (0.40% small merchants, 0.90% others). Zero on RuPay debit and BHIM-UPI since 1 January 2020; from 15 October 2026, 0.4% on P2M UPI above ₹2,000 (₹300 cap above ₹75,000), ₹5 flat in essential and thin-margin sectors, 0.02% on capital market payments. P2P, payments up to ₹2,000 and P2PM small merchants (up to ₹1 lakh a month) stay free: about 96% of merchant transactions are unaffected.
• GMS and SGB: mobilise idle domestic gold and cut import dependence. Not about FDI. GMS's MLTGD components discontinued from 26 March 2025.

Practise the questions mapped to this chapter to see how these definitions are actually set, especially the money multiplier and the legal tender ones, which are almost always definitional rather than analytical.