Indian Currency Guide

1. Types of Money (What is “Fiat”?)

The “value” of money has changed over history. Our Rupee is a modern type called **Fiat Money**.

Type of Money	Basis of Value	Example
Commodity Money	Has intrinsic value. The item is valuable for its own sake.	Gold coins, silver, salt, or grain.
Representative Money	No intrinsic value, but represents a claim on a commodity.	A paper note exchangeable for gold.
Fiat Money	No intrinsic value. Value comes from a government “fiat” (order) and public trust.	The Indian Rupee (INR), US Dollar (USD), etc.

2. Currency Note vs. Banknote

All notes are “currency,” but legally, the ₹1 note is different from all others.

Feature	₹1 Note (and Coins)	₹2 and above Notes
Legal Type	Currency Note / Coin	Banknote
What it is	A sovereign fiat token.	A promissory note from the RBI.
Issuer	Government of India	Reserve Bank of India (RBI)
Signature	Finance Secretary	RBI Governor
Key Text	Does NOT have the “I promise to pay…” clause.	Includes the “I promise to pay…” clause.
Legal Basis	Coinage Act	RBI Act, 1934

3. The One Rupee (₹1) Note Exception

The ₹1 note is special because it’s issued directly by the government.

Issuer: Government of India (Ministry of Finance)
Signature: Finance Secretary
Legal Status: It is not a “promissory note.” It is a direct sovereign liability.

4. Understanding Legal Tender

This is a form of payment that cannot be refused in the settlement of a debt.

Unlimited Legal Tender

Applies to: All banknotes from the RBI (₹2, ₹5, ₹500, etc.).
Rule: Can be used to pay any amount without limit.

Limited Legal Tender

Applies to: Coins (and the ₹1 note).
Rule: Payments are limited. You can only pay a debt up to ₹1,000 using coins (or ₹1 notes).

5. Currency Guarantee & Backing (RBI Act, 1934)

Section 26: The Government Guarantee

Guarantee: Confirms every banknote (₹2+) is legal tender and “guaranteed by the Central Government.”
Promissory Text: This is the legal basis for the “I promise to pay…” text.
Key Provision: Sec 26(2) gives the Government the power to demonetize banknotes.

Section 33: The Asset Backing (MRS)

System: India uses a Minimum Reserve System (MRS).
Total Minimum: RBI must hold ₹200 crore in minimum assets.
Breakdown:
- At least ₹115 crore must be in gold.
- The remaining ₹85 crore must be in foreign currencies.

Indian Money Supply Guide

1. The Foundation: Reserve Money (M0)

Reserve Money (M0) is the money created directly by the Reserve Bank of India (RBI). It is the “base” or “foundation” upon which the entire money supply of the country is built.

It’s also called:

High-Powered Money
Base Money
Central Bank Money

M0 represents the total monetary liability of the RBI—the money the RBI is responsible for.

2. Why is M0 “High-Powered”?

M0 is called “high-powered” because it has a multiplier effect on the total money supply (like M3).

The Base (M0): The RBI creates a certain amount of M0 (e.g., by printing currency).
Banking System: This M0 money enters commercial banks (e.g., when you deposit cash).
The Multiplier: A bank doesn’t keep 100% of your deposit. It keeps a fraction (the Cash Reserve Ratio, or CRR) and lends out the rest.
Credit Creation: The person who gets that loan deposits it in *another* bank. That bank keeps a small reserve and lends the rest. This repeats again and again.

This chain reaction, the money multiplier, means a small initial increase in M0 leads to a much larger increase in the money supply (M3).

Simple Analogy: Think of M0 as the “seed money.” A single seed (M0) doesn’t just produce one fruit; it grows a tree (the banking system) that produces many fruits (M3).

3. What’s Inside M0? (The Formula)

The official formula for M0 is:

M0 = Currency in Circulation + Bankers’ Deposits with RBI + ‘Other’ Deposits with RBI

Currency in Circulation (CiC):

This is the largest component. It includes all physical notes and coins issued, including:
- (a) currency held by the public (you and me)
- (b) cash held in the vaults of commercial banks (“vault cash”).
Bankers’ Deposits with RBI:

Deposits commercial banks (SBI, HDFC) must hold with the RBI. This is mainly to meet the Cash Reserve Ratio (CRR).
‘Other’ Deposits with RBI:

A very small component. Includes deposits from foreign central banks, IMF, World Bank, etc.

4. M0 vs. M1: A Common Confusion

This is the simplest way to tell them apart:

Measure	M0 (Reserve Money)	M1 (Narrow Money)
Formula	Currency in Circulation + Bankers’ Deposits with RBI	Currency with the Public + Demand Deposits
Who Creates It?	Entirely by the RBI.	By the RBI and commercial banks.
What it represents?	The “base” money. The liability of the RBI.	The “transactional” money. Money to spend now.
Key Difference	M0 includes bank reserves.	M1 excludes bank reserves but includes demand deposits.

In short: M0 is the cause (the high-powered base), and M1/M3 are the effect (the broader money supply built on that base).

5. The Money Ladder (M1, M2, M3, M4)

These are ranked from most liquid (easiest to spend) to least liquid.

M1 (Narrow Money):

Measures money for immediate transactions.

M1 = Currency with the Public + Demand Deposits
M2:

M2 = M1 + Savings Deposits with Post Office
M3 (Broad Money):

The most common measure of total money supply.

M3 = M1 + Time Deposits with banks (FDs, RDs)
M4:

The broadest and least liquid measure.

M4 = M3 + Total deposits with Post Office

The Money Multiplier: How Money is Made

Introduction: From Seed to Tree

The money in your bank isn’t just printed. It’s largely *created* through a process called the **Money Multiplier!**

Reserve Money (M0 or H): This is the base money created directly by the RBI. Think of it as the “seed.”
Broad Money (M3): This is the total money in the economy (M0 + all the credit created by banks). Think of it as the “tree with all its fruit.”

The **Money Multiplier (m)** is the crucial process that turns the seed (M0) into the vibrant, fruit-bearing tree (M3).

1. The ‘Leaks’ That Control the Multiplier

The money creation process isn’t infinite. Money “leaks” out of the bank’s lending cycle in two main ways, which limit how much money can be multiplied:

📈 The Currency Deposit Ratio (cdr)

What it is: This measures the public’s behavior. It’s the ratio of cash people hold in their wallets versus the money they deposit in banks.
cdr = Currency with Public (C) / Demand Deposits (DD)
Impact on Multiplier: A high `cdr` means people prefer to hoard cash. This reduces the multiplier because cash in a wallet cannot be lent out by a bank. It has “leaked” from the system.

🏦 The Reserve Deposit Ratio (rdr)

What it is: This measures the banking system’s policy. It’s the fraction of deposits that banks must hold in reserve and *cannot* lend out.
rdr = Total Bank Reserves / Demand Deposits (DD)
Impact on Multiplier: This ratio is set by the RBI’s rules (like CRR and SLR) and banks’ own choices. A high `rdr` reduces the multiplier because banks have less money available to lend.

2. The Complete Money Multiplier Formula

When we account for these two “leaks” (from the public and the banks), we get the full formula for the money multiplier (`m`):

m = ^{1 + cdr}⁄_{cdr + rdr}

This leads to the final, most important equation that ties everything together:

Total Money Supply (M) = Money Multiplier (m) × Monetary Base (H)

3. Who Really Controls the Money Supply?

This equation shows that the money supply isn’t controlled by just one entity. It’s a powerful partnership:

The Central Bank (RBI):
- Controls the Monetary Base (H) (by printing money or using Open Market Operations).
- Heavily influences the rdr (by setting CRR and SLR).
The Public:
- Controls the cdr by deciding whether to hold cash or deposit it.
Commercial Banks:
- Influence the rdr by deciding how many *excess reserves* to hold for safety, beyond what the RBI mandates.

4. Key Insight: How ‘cdr’ Affects the Multiplier

A common point of confusion is how the Currency Deposit Ratio (`cdr`) impacts the multiplier. Let’s clarify!

The Rule: A decrease in the `cdr` (people holding *less* cash) will INCREASE the money multiplier.

The Logical Explanation:

Low `cdr` means: People have “good banking habits.” They deposit money instead of keeping cash.
Result: Banks get more deposits, which means they have more money to lend out (after keeping their reserves).
Chain reaction: That loaned money gets deposited in *another* bank, and the lending cycle continues, multiplying the money supply.

Therefore, when money stays in the banking system (a **low `cdr`**), the multiplier becomes **HIGH**.

When money “leaks” into people’s wallets (a **high `cdr`**), the multiplier effect stops, making the multiplier **LOW**.

Mathematical Proof:

Let’s use the formula: `m = (1 + cdr) / (cdr + rdr)`

Assume the Reserve Ratio (`rdr`) is fixed at 10% (0.1).

Case 1: HIGH cdr (Poor banking habits)

People hold a lot of cash. Let `cdr = 0.5`

m = (1 + 0.5) / (0.5 + 0.1) = 1.5 / 0.6 = 2.5

Case 2: LOW cdr (Good banking habits)

People deposit most of their money. Let `cdr = 0.2`

m = (1 + 0.2) / (0.2 + 0.1) = 1.2 / 0.3 = 4.0 Conclusion: As the `cdr` decreased (from 0.5 to 0.2), the money multiplier increased (from 2.5 to 4.0).

5. Summary of Effects on Money Multiplier

Change in Variable	Variable Affected	Impact on Multiplier (m)	Why?
RBI raises CRR or SLR	rdr increases	DECREASES	Banks are forced to hold more and lend less.
People deposit more money	cdr decreases	INCREASES	Banks have more money to lend out.
People hold more cash	cdr increases	DECREASES	Money “leaks” from the banking system.
RBI buys bonds (OMO)	M0 (Base) increases	NO CHANGE	The base increases, not the rate of multiplication. (This increases the total Money Supply).

Monetary Policy Notes

Monetary Policy (RBI)

1. Monetary Policy: Definition & Objectives

Definition

Monetary Policy is the process by which the monetary authority of a country (the RBI in India) controls the creation and supply of money in the economy.

Evolved Objectives

Primarily, to maintain price stability.
To support economic growth.
To ensure an adequate flow of credit to productive sectors.
To achieve financial stability.

2. The Monetary Policy Framework (MPF)

This is a new framework that evolved from the MPF Agreement signed between the Government of India (GoI) and the RBI in February 2015.

Primary Goal

The main objective is to maintain price stability while keeping in mind the objective of growth.

                    Inflation Target
                    Metric: Consumer Price Index (CPI) – Combined.
Target: 4%
Tolerance Band: +/- 2% (i.e., a range of 2% to 6%).
Set by: GoI in consultation with the RBI once every five years.
Current Target: Valid until March 31, 2026.

                

Failure Clause

The RBI is considered to have failed if inflation remains above 6% or below 2% for three consecutive quarters.

Consequence of Failure:

The RBI must submit a written report to the GoI explaining:

The reasons for the failure.
The remedial actions to be taken.
An estimated time frame to return to the target.

3. The Monetary Policy Committee (MPC)

The MPC was constituted by the GoI in September 2016 to implement the new framework.

Main Mandate

The MPC’s primary job is to determine the Policy (Repo) Rate required to achieve the inflation target.

Composition (6 Members)

3 Members from the RBI (including the RBI Governor, who is the chairperson).
3 Members appointed by the GoI.

Voting

Each member has one vote.
In the event of a tie (3-3), the Governor has a second or casting vote.

Meetings

Must meet at least four times per year.
Currently, meets 6 times per year (bi-monthly).
“Off-cycle” meetings can be held if needed.

                    Authority & Limitations
                    The MPC’s decision is binding on the RBI.
The MPC has the authority to decide the Repo Rate ONLY.
It does not decide other rates like the Reverse Repo, CRR, or SLR.
Decisions are based on “twin objectives” of Inflation and Growth, with primacy given to price stability.
The MPC does not consider currency fluctuations (e.g., rupee depreciation/appreciation) in its decisions.

                

The RBI’s Big Dilemma

Balancing Price Stability (Inflation) vs. Economic Growth

You’ve identified the central dilemma of monetary policy. You are correct:

To control inflation (price stability), the RBI must increase the repo rate.
To promote economic growth, the RBI must decrease the repo rate.

These two goals are in direct conflict in the short term. Here is an explanation of how the RBI manages this balancing act.

Scenario 1: Fighting Inflation

(“Hawkish” or “Contractionary” Stance)

Problem: Inflation is high (e.g., above 6%). Too much money is chasing too few goods.

Action: The RBI increases the Repo Rate ⬆️

Mechanism:

Banks find it more expensive to borrow from RBI.
They pass this cost to customers.
Home, car, and business loans become more expensive.

Result:

People & businesses borrow and spend less.
This reduces overall demand.
Inflation comes under control.

The Trade-off: This action slows down the economy and can hurt economic growth.

Scenario 2: Promoting Growth

(“Dovish” or “Accommodative” Stance)

Problem: Economic growth is low, unemployment is rising, and inflation is low.

Action: The RBI decreases the Repo Rate ⬇️

Mechanism:

It becomes cheaper for banks to borrow from RBI.
They pass this benefit to customers.
Home, car, and business loans become cheaper.

Result:

People & businesses are encouraged to borrow and spend.
This increases overall demand.
Economic growth is stimulated.

The Trade-off: Pumping too much money into the economy risks causing high inflation later.

How Does the MPC Decide?

The “Flexible Inflation Targeting” Framework

This framework, adopted in 2016, gives the RBI a clear, rule-based hierarchy for its decisions.

Primary Mandate (Job #1): Maintain Price Stability

The government has mandated the RBI to keep CPI inflation within the 2% to 6% band. This is their non-negotiable, primary objective.

Secondary Mandate (Job #2): Support Growth

While achieving Job #1, they must also support economic growth.

Here is the logic they follow:

IF inflation is above 6% (or at risk of it), the MPC must act to control inflation, even if it hurts growth. They will adopt a “Hawkish” stance. Price Stability wins.

IF inflation is below 2%, the MPC must act to stimulate the economy to push inflation back up. They will adopt a “Dovish” stance. Supporting Growth wins.

IF inflation is “comfortable” (e.g., between 3% and 5%), this is where the “flexibility” comes in. With inflation safely under control, they can focus on Job #2. If growth is weak, they have the “policy space” to decrease the repo rate.

In Summary: The “Safe Lane” Analogy

Think of the 2% – 6% inflation band as the “safe lane” on a highway.

The MPC’s main job is to keep the car (inflation) in that lane. If the car veers out, they must steer it back in. But as long as it’s safely in the lane, they are free to use the accelerator (cut rates) to support growth.

This guide explains the core conflict of modern monetary policy.

cheap=easy=dovish =expansionary=accommodative

RBI Monetary Policy Rates

📝 RBI Monetary Policy Rates

1. The Policy Rate

Policy Rate = Repo Rate

This is the single most important interest rate that the RBI’s Monetary Policy Committee (MPC) uses to signal its stance on the economy (i.e., whether to control inflation or stimulate growth). All other rates in the main framework are “pegged” to this rate.

2. The Modern Monetary Policy Framework

The RBI manages day-to-day liquidity using the Liquidity Adjustment Facility (LAF) corridor. This system has a “floor” (lowest rate), a “ceiling” (highest rate), and the Policy Rate in the middle.

Floor: Standing Deposit Facility (SDF) Rate

What it is: The rate at which commercial banks can park their excess funds with the RBI, typically overnight.
Flow: Banks lend to the RBI (RBI absorbs liquidity).
Key Feature: This is collateral-free. The RBI does not need to provide government securities. This makes it a highly flexible tool to absorb excess money.
Relation: It forms the “floor” of the corridor and is set at a rate below the Repo Rate (e.g., Repo Rate – 0.25%).

Center: Policy Repo Rate

What it is: The rate at which the RBI lends money to commercial banks, typically overnight.
Flow: Banks borrow from the RBI (RBI injects liquidity).
Key Feature: Banks must provide eligible government securities as collateral. This is the main tool for injecting liquidity and signaling the policy stance.

Ceiling: Marginal Standing Facility (MSF) Rate

What it is: An emergency window for banks to borrow overnight funds from the RBI when they are facing an acute shortage.
Flow: Banks borrow from the RBI (RBI injects liquidity).
Key Feature: This is a “penal” (higher) rate. Banks are allowed to dip into their Statutory Liquidity Ratio (SLR) portfolio for collateral, which they cannot do under the normal Repo window.
Relation: It forms the “ceiling” of the corridor and is set at a rate above the Repo Rate (e.g., Repo Rate + 0.25%).

3. Other Key Rates

Bank Rate

What it is: A rate at which the RBI lends money to commercial banks.
Modern Purpose: It acts as a penal rate for shortfalls in reserve requirements (CRR/SLR) and is also used for long-term loans from the RBI.
Key Feature: The Bank Rate is always kept aligned with the MSF Rate.
Relation: Bank Rate = MSF Rate

Reverse Repo Rate

What it is: The rate at which the RBI used to borrow (absorb) funds from banks.
Key Feature: Unlike the SDF, this was collateralized (RBI had to provide securities).
Modern Role: This was the old floor of the LAF corridor. It has now been replaced by the SDF as the primary absorption tool because the SDF’s collateral-free nature is more efficient.

4. Quick Summary Table

Rate Name	Purpose	Flow of Money	Collateral	Place in Corridor
SDF Rate	Banks park excess funds	Banks ➔ RBI	No (Collateral-free)	Floor
Repo Rate	Banks borrow for daily needs	RBI ➔ Banks	Yes (G-Secs)	Center
MSF Rate	Banks borrow in emergency	RBI ➔ Banks	Yes (Can use SLR)	Ceiling
Bank Rate	Penal rate / Long-term loan	RBI ➔ Banks	–	Aligned to MSF
Reverse Repo	Old absorption tool	Banks ➔ RBI	Yes	(Largely replaced by SDF)

5. Overall Purpose of This Framework

To Control Inflation (Tighten Policy)

The RBI increases the Repo Rate.
The entire corridor (SDF, MSF) shifts upwards.
Borrowing becomes expensive for banks.
Banks make public loans (home, car) more expensive.
This reduces spending and controls inflation.

To Stimulate Growth (Loosen Policy)

The RBI decreases the Repo Rate.
The entire corridor shifts downwards.
Borrowing becomes cheaper for banks.
Banks make public loans cheaper.
This encourages spending, investment, and boosts economic activity.