CBSE Class 12 Economics (Macroeconomics)
Chapter 2: Money and Banking
20 Important Questions and Answers
(As per CBSE 2026–27 Syllabus )
Q1. What is money? Explain its primary functions.
Answer:
Money is anything that is generally accepted as a medium of exchange and a means of payment. It eliminates the difficulties associated with the barter system. The two primary functions of money are: (i) Medium of Exchange – Money facilitates the buying and selling of goods and services without requiring a double coincidence of wants. (ii) Measure of Value – Money acts as a common unit for expressing the value of all goods and services. It enables easy comparison of prices and simplifies economic transactions. These functions make money an indispensable part of a modern economy and support efficient market operations.
Q2. Explain the medium of exchange function of money.
Answer:
The medium of exchange function is the most important function of money. In a barter system, exchange could take place only when two parties possessed goods desired by each other. This problem is known as the double coincidence of wants. Money solves this issue by acting as an intermediary in transactions. People sell goods and services to earn money and then use that money to purchase what they need. Thus, money separates the acts of sale and purchase. This function promotes specialization, increases market efficiency, and facilitates smooth economic activities by making exchange convenient and universally acceptable.
Q3. What is the store of value function of money?
Answer:
Money serves as a store of value because it allows individuals to save purchasing power for future use. Unlike many goods, money does not perish quickly and can be held for future transactions. People can accumulate wealth in the form of money and use it whenever required. This function encourages savings and helps individuals meet future needs and emergencies. Although inflation may reduce the purchasing power of money over time, it still remains one of the most convenient forms of storing value. Therefore, money acts as a bridge between present income and future expenditure.
Q4. What are demand deposits? Why are they considered money?
Answer:
Demand deposits are deposits kept by individuals and businesses in commercial banks that can be withdrawn on demand without prior notice. These deposits are generally held in savings and current accounts. Demand deposits are considered money because they are highly liquid and can be used directly for making payments through cheques, debit cards, or electronic transfers. They perform the functions of money, especially as a medium of exchange. Since people can access these funds whenever required, demand deposits form an important component of the money supply in an economy.
Q5. Differentiate between barter system and money economy.
Answer:
The barter system involves the direct exchange of goods and services without using money, whereas a money economy uses money as a medium of exchange. Barter suffers from problems such as double coincidence of wants, lack of a common measure of value, difficulty in storing wealth, and indivisibility of goods. In contrast, a money economy overcomes these limitations by providing a common unit of account, store of value, and standard of deferred payments. Money facilitates trade, promotes specialization, and increases economic efficiency. Therefore, modern economies rely on money rather than barter for conducting transactions.
Q6. What is the supply of money?
Answer:
The supply of money refers to the total amount of money available in an economy at a particular point in time. It includes currency held by the public and demand deposits with commercial banks. The central bank measures money supply through different monetary aggregates. Money supply is important because it influences spending, investment, and economic activity. An increase in money supply generally increases purchasing power, while a decrease may reduce spending. The central bank regulates the money supply through various monetary policy instruments to maintain economic stability and control inflation.
Q7. Define commercial banks and state their primary functions.
Answer:
Commercial banks are financial institutions that accept deposits from the public and provide loans and advances to individuals, businesses, and organizations. Their primary functions include accepting deposits, granting loans, creating credit, and facilitating payments. Banks provide various deposit accounts such as savings, current, and fixed deposits. They also offer services like cheque facilities, fund transfers, and electronic banking. By mobilizing savings and channeling them into productive investments, commercial banks play a significant role in economic development. They act as intermediaries between savers and borrowers and contribute to financial stability.
Q8. Explain the process of credit creation by commercial banks.
Answer:
Credit creation refers to the ability of commercial banks to create deposits through lending activities. When a bank receives deposits, it keeps a portion as reserves and lends the remaining amount. The borrower spends the loan, and the money eventually gets deposited into another bank. This bank again keeps a reserve and lends the rest. The process continues, resulting in multiple expansions of deposits in the banking system. Thus, the total money supply increases beyond the original deposit. Credit creation is influenced by reserve requirements and the willingness of banks and borrowers to participate.
Q9. What is the Reserve Bank of India (RBI)?
Answer:
The Reserve Bank of India (RBI) is the central bank of India responsible for regulating the country’s monetary and financial system. Established in 1935, it performs functions such as issuing currency notes, controlling credit, managing foreign exchange reserves, and acting as the banker to the government and commercial banks. RBI formulates and implements monetary policy to maintain price stability and support economic growth. It also supervises financial institutions and ensures the smooth functioning of the banking system. Through these activities, RBI plays a crucial role in maintaining economic stability and financial confidence.
Q10. Explain the function of RBI as the banker to the government.
Answer:
As the banker to the government, the Reserve Bank of India maintains the accounts of both the Central and State Governments. It receives government revenues, makes payments on behalf of the government, and manages public debt. RBI also provides temporary financial assistance to the government when required. It helps in issuing government securities and managing borrowing programs. By performing these functions, RBI ensures smooth financial operations of the government. This relationship enables efficient management of public funds and contributes to the effective implementation of government policies and developmental programs.
Q11. What is the banker’s bank function of RBI?
Answer:
The Reserve Bank of India acts as the banker’s bank by maintaining accounts of commercial banks and providing them with financial assistance when needed. Commercial banks are required to keep a portion of their deposits with RBI as reserves. RBI provides loans and advances to banks during financial difficulties and acts as the lender of last resort. It also facilitates inter-bank transactions and settlements. Through this function, RBI ensures liquidity and stability in the banking system. The banker’s bank role strengthens public confidence and helps maintain the smooth functioning of financial institutions.
Q12. What is CRR? How does it affect money supply?
Answer:
Cash Reserve Ratio (CRR) is the percentage of a bank’s total deposits that must be maintained as cash reserves with the Reserve Bank of India. It is an important monetary policy instrument used to control liquidity in the economy. When RBI increases CRR, banks have less money available for lending, reducing credit creation and money supply. Conversely, when RBI decreases CRR, banks can lend more, increasing money supply. Thus, CRR helps RBI regulate inflation, maintain financial stability, and influence the overall level of economic activity in the country.
Q13. What is SLR? Why is it important?
Answer:
Statutory Liquidity Ratio (SLR) is the minimum percentage of deposits that commercial banks must maintain in the form of liquid assets such as cash, gold, or approved government securities. SLR is prescribed by the Reserve Bank of India to ensure the financial soundness of banks. A higher SLR reduces banks’ lending capacity, while a lower SLR increases the availability of credit. It helps maintain liquidity in the banking system and safeguards depositors’ interests. SLR also supports government borrowing by encouraging banks to invest in government securities.
Q14. What is the bank rate?
Answer:
The bank rate is the rate at which the Reserve Bank of India lends money to commercial banks for long-term purposes without repurchase agreements. It is a quantitative tool of monetary policy. When RBI increases the bank rate, borrowing becomes more expensive for banks, leading to reduced lending and lower money supply. Conversely, a decrease in the bank rate encourages banks to borrow more and increase lending. Through changes in the bank rate, RBI influences credit availability, controls inflation, and promotes economic stability. It serves as an indicator of the central bank’s monetary policy stance.
Q15. Explain open market operations.
Answer:
Open Market Operations (OMO) refer to the purchase and sale of government securities by the Reserve Bank of India in the open market. This tool is used to regulate the money supply in the economy. When RBI purchases securities, money flows into the banking system, increasing liquidity and credit availability. When RBI sells securities, money is withdrawn from circulation, reducing liquidity and money supply. OMO helps RBI manage inflation, stabilize financial markets, and achieve monetary policy objectives. It is an effective instrument for controlling liquidity conditions in the economy.
Q16. What is a repo rate?
Answer:
The repo rate is the rate at which commercial banks borrow short-term funds from the Reserve Bank of India by selling securities with an agreement to repurchase them later. It is a key monetary policy instrument. When RBI increases the repo rate, borrowing becomes costlier for banks, leading to reduced lending and lower money supply. When the repo rate is reduced, banks can borrow at lower costs and increase credit availability. Therefore, changes in the repo rate influence investment, consumption, inflation, and overall economic activity in the country.
Q17. What is a reverse repo rate?
Answer:
The reverse repo rate is the rate at which the Reserve Bank of India borrows funds from commercial banks. It encourages banks to deposit surplus funds with RBI. When RBI increases the reverse repo rate, banks prefer keeping more money with RBI because they earn higher returns, reducing the amount available for lending. This helps decrease money supply and control inflation. Conversely, a lower reverse repo rate encourages banks to lend more to the public. Thus, the reverse repo rate is an important tool for managing liquidity and maintaining economic stability.
Q18. Distinguish between central bank and commercial bank.
Answer:
A central bank, such as RBI, regulates the monetary system of the country, whereas commercial banks primarily provide banking services to the public. The central bank issues currency, controls credit, and acts as the banker to the government and commercial banks. Commercial banks accept deposits, grant loans, and facilitate payments. RBI does not deal directly with the general public for ordinary banking services, while commercial banks do. The central bank aims to maintain economic stability, whereas commercial banks focus on earning profits while providing financial services to customers.
Q19. What is monetary policy?
Answer:
Monetary policy refers to the policy formulated and implemented by the Reserve Bank of India to regulate the supply of money and credit in the economy. Its objectives include controlling inflation, promoting economic growth, maintaining price stability, and ensuring adequate liquidity. RBI uses various instruments such as repo rate, reverse repo rate, CRR, SLR, and open market operations to achieve these goals. Expansionary monetary policy increases money supply to stimulate economic activity, while contractionary monetary policy reduces money supply to control inflation. Monetary policy plays a crucial role in economic management.
Q20. How does RBI control inflation through monetary policy?
Answer:
The Reserve Bank of India controls inflation by adopting a contractionary monetary policy. It increases policy rates such as the repo rate and bank rate, making borrowing more expensive for banks and customers. RBI may also increase CRR and SLR, reducing banks’ ability to create credit. Additionally, it can sell government securities through open market operations to absorb excess liquidity. These measures reduce money supply and aggregate demand in the economy, helping stabilize prices. By controlling excessive spending and credit expansion, RBI maintains price stability and supports sustainable economic growth.