Money & Money Supply for UPSC: M0, M1, M3, Money Multiplier, Legal Tender & 2025-26 Data

Functions of Money, Fiat Money and Legal Tender

🎯 Exam priority: Important. The money-supply block is asked in small, precise bites — what counts as legal tender, what moves M1, what raises the money multiplier. Learn the definitions exactly; the 2025-26 numbers show how the CRR cut worked its way through the system.

Money looks obvious until a question asks whether a cheque is "money" or whether withdrawing cash from your account changes the money supply. This note builds the vocabulary from the ground up.

What money does

• Barter — exchanging goods directly — needs a double coincidence of wants: the person who has what you want must also want what you have. Money removes that friction.

• Four functions: medium of exchange, unit of account (prices are quoted in it), store of value and standard of deferred payment (debts are settled in it).

• Demand for money springs from the transactions motive (money to buy things; rises with income) and the speculative motive (holding money instead of bonds when you expect bond prices to fall — i.e. interest rates to rise). Keynes added the precautionary motive.

Fiat money, legal tender and what is NOT legal tender

• Currency notes and coins are fiat money — they have no intrinsic value (unlike gold or silver coins); they work because the state declares them acceptable.

• Legal tender means it cannot be refused by anyone in settlement of a debt or transaction. Notes and coins are legal tender (coins only up to prescribed limits); cheques and demand drafts are not — they are "money" in the sense of the money supply but anyone may refuse a cheque. That is the point of the 2018 question on legal tender.

• Who issues what. The RBI is the sole issuer of banknotes (the ₹1 note and all coins are issued by the Government of India and distributed through the RBI). Note issue operates under a Minimum Reserve System (since 1957): the RBI must hold gold and foreign securities worth at least ₹200 crore, of which gold at least ₹115 crore, against any size of note issue.

• Demonetisation — on 8 November 2016 ₹500 and ₹1,000 notes ceased to be legal tender; the idea was to shift transactions out of the cash economy into the formal payment system and curb black money. The 2021 UPSC question asked which effect of black money is the Government's main worry — the loss of tax revenue and distortion of the formal economy, not the cash itself.

Measuring Money: Reserve Money and M1–M4

Money supply is the stock of money in the hands of the public at a point in time. Because "money" can be defined more or less broadly, the RBI publishes a ladder of measures.

The ladder: reserve money, M1, M2, M3, M4

• The measures are in decreasing order of liquidity — M1 is the easiest to spend, M4 the hardest to convert.

• "Net" deposits means only deposits of the public are counted; interbank deposits (one bank's deposit in another) are excluded. Cash held inside banks is also not part of the money supply — only currency with the public is.

• What moves M1? If you withdraw ₹1 lakh in cash from your demand-deposit account, currency with the public rises by ₹1 lakh and demand deposits fall by ₹1 lakh — no immediate change in M1 (the 2020 UPSC question). Moving money from a savings or current account into a fixed (time) deposit reduces M1 but leaves M3 unchanged.

• Money supply is a stock; its causes are on the "sources" side. The RBI also analyses broad money by what creates it: net bank claims on the government (RBI plus banks), bank lending to the commercial sector, net foreign-exchange assets of the banking sector, and so on. When the RBI buys dollars it injects rupees — which is why large forex purchases raise money supply unless the RBI "sterilises" them by selling securities.

• Bitcoin (a 2016 question) is not issued or tracked by any central bank and is not legal tender or part of any official money-supply measure; the RBI has repeatedly cautioned users.

The RBI's modern aggregates — NM and L series

• Following the Working Group on Money Supply (1998, chaired by Y.V. Reddy), the RBI compiles new monetary aggregates from the banking sector's balance sheet: NM1 = currency with the public + demand deposits with banks + other deposits with the RBI; NM2 = NM1 + short-term time deposits of residents (maturity up to one year); NM3 = NM2 + long-term time deposits of residents + call/term funding from financial institutions. NM3 is the modern "broad money" figure.

• The same group introduced liquidity aggregates L1, L2 and L3 — NM3 plus progressively wider non-bank liabilities (post-office deposits in L1; term deposits with financial institutions and certificates of deposit in L2; NBFC public deposits in L3) — to track how much liquidity the whole financial system provides, not just banks.

Credit Creation, the Money Multiplier and RBI's Tools

Banks do not just hold money — they create it. This is the engine behind the multiplier that UPSC has asked about twice.

Credit creation and the money multiplier

• A bank keeps only a fraction of deposits as reserves: the Cash Reserve Ratio (CRR) — the share of deposits it must keep with the RBI — plus the Statutory Liquidity Ratio (SLR) in liquid assets. It lends the rest. The borrower spends the money; the seller deposits it in a bank, which again lends a fraction — and total deposits swell.

• NCERT's numbers: with a CRR of 20%, a first deposit of ₹500 lets the bank lend at most ₹400 (keeping ₹100). Across the whole system, ₹100 of reserves can support deposits of ₹500 — a money multiplier of 1 ÷ 0.20 = 5. If the RBI raises the CRR to 25%, ₹100 of reserves supports only ₹400 — the multiplier falls to 4.

• The rounds, with a 20% reserve ratio (each loan is spent and re-deposited):

• Formula with cash holding: money multiplier = (1 + c) ÷ (c + r), where c is the currency–deposit ratio (how much the public keeps as cash) and r the reserve–deposit ratio. So the multiplier rises when the reserve ratio (CRR/SLR-type requirement) falls or when people hold less cash — and falls in the opposite cases. UPSC asked exactly this in 2019 and again in 2021 — the answer: an increase in the banking habit of the people (more deposits, less cash) raises the multiplier, while a higher CRR or SLR lowers it.

• Money supply = money multiplier × reserve money (high-powered money). The RBI controls the base; banks and the public determine the multiplier. Because cash that leaks out of the banking system (people hoarding notes) does not get re-lent, a large currency-deposit ratio weakens the process.

How the RBI controls money supply

• Quantitative tools change the amount of money: the CRR, the SLR, the bank rate, open market operations (outright purchase/sale of government securities — permanent liquidity — or repo/reverse-repo, which are temporary) and the Liquidity Adjustment Facility.

• Qualitative tools influence who gets credit: moral suasion, margin requirements (the share of an asset's value a borrower must put up) and selective credit controls.

• Why money supply matters: by the quantity theory (Fisher: MV = PT), if the velocity of money (V) and the volume of transactions (T) are steady, more money chasing the same goods raises the price level (P). Central banks therefore watch broad money, though today inflation-targeting relies chiefly on policy interest rates.

• The RBI is the lender of last resort — banks can always turn to it for funds, which is what keeps the system stable. The tools are examined in depth in Article 4.

2025-26: CRR Cut, Reserve Money and the Multiplier

The Economic Survey's 2025-26 numbers are a live demonstration of the multiplier at work after the RBI cut the CRR.

2025-26: what the data show

• CRR cut. The CRR was cumulatively reduced by 125 basis points between December 2024 and November 2025 (to 3.0% of net demand and time liabilities). Cutting the CRR lowers bankers' deposits with the RBI — a component of reserve money — so reserve money growth looks weak even though policy is easing.

• Reserve money (M0) grew just 2.9% by 31 December 2025 (4.9% a year earlier) — but adjusted for the first-round effect of the CRR change it grew 9.4% (6.2% a year earlier). The Survey stresses that the CRR-adjusted M0 shows the true expansionary stance. Currency in circulation grew 10.2%.

• Broad money (M3) grew 12.1% (9.0% a year before; the figure includes the effect of the 1 July 2023 merger of a non-bank with a bank). Aggregate deposits — the largest component of M3 — grew 12.3%, and on the sources side bank lending to the commercial sector grew 14.1%.

• Money multiplier (M3 ÷ M0) was 6.21 on 31 December 2025 against 5.70 a year earlier (6.0 after adjusting for the reverse repo/SDF balances, which are analytically akin to bankers' deposits with the central bank). The rising multiplier means banks effectively used the liquidity released by the CRR cut.

Why this matters for UPSC

• Typical traps: treating cheques as legal tender; counting cash held by banks in M1; forgetting that M1 does not change when cash is withdrawn from a demand deposit; reversing the direction in which CRR moves the multiplier. Memorise the definitions and the directions.

• Current-affairs angle: why does a CRR cut reduce reserve money but increase broad money? (Because it frees funds for banks to lend, and lending multiplies deposits.)

Further Reading

• NCERT Economics textbooks (Class 11–12), the Economic Survey, the Union Budget documents and RBI publications cited in this note — the primary sources behind every figure above.

Test Yourself: Practice Questions & PYQs

Eight practice questions on legal tender, the money-supply ladder and the multiplier, followed by real UPSC questions.

Practice Questions

Q1. Which one of the following is NOT 'legal tender' in India?

• (a) A ₹1 note issued by the Government of India

• (b) Coins issued by the Government of India

• (c) Currency notes issued by the RBI

• (d) A cheque drawn on a savings account

Q2. Consider the following statements:
1. M1 comprises currency with the public and demand deposits with banks.
2. M3 is the sum of M1 and net time deposits of commercial banks.
3. Interbank deposits are included in M3.
Which of the statements given above are correct?

• (a) 2 and 3 only

• (b) 1 and 3 only

• (c) 1, 2 and 3

• (d) 1 and 2 only

Q3. If a person withdraws ₹1,00,000 in cash from her demand-deposit account at a bank, the immediate effect on M1 is

• (a) no change

• (b) a decrease of ₹1,00,000

• (c) an increase of ₹1,00,000

• (d) an increase in M3 but a decrease in M1

Q4. Other things remaining the same, the money multiplier will increase if

• (a) the public holds more cash relative to deposits

• (b) the reserve ratio banks must maintain falls

• (c) banks hold more excess reserves

• (d) the RBI raises the CRR

Q5. With a CRR of 20 per cent, ₹100 of reserves can support deposits of at most

• (a) ₹1,000

• (b) ₹500

• (c) ₹400

• (d) ₹200

Q6. 'Reserve money' (high-powered money) consists of

• (a) foreign exchange reserves + gold reserves of the RBI

• (b) demand deposits + time deposits of banks

• (c) currency with the public + demand deposits with banks

• (d) currency in circulation + bankers' deposits with the RBI + other deposits with the RBI

Q7. Statement-I: Following the CRR cuts of 2024-25, reserve money (M0) growth slowed to 2.9 per cent even though broad money (M3) growth rose to 12.1 per cent.
Statement-II: A CRR cut reduces bankers' deposits with the RBI, a component of reserve money, while releasing funds that banks lend, thereby increasing deposits.
Which one of the following is correct in respect of the above statements?

• (a) Both Statement-I and Statement-II are correct and Statement-II explains Statement-I

• (b) Statement-I is not correct but Statement-II is correct

• (c) Both Statement-I and Statement-II are correct but Statement-II does not explain Statement-I

• (d) Statement-I is correct but Statement-II is not correct

Q8. Which of the following is a qualitative tool of monetary control?

• (a) Open market operations

• (b) Cash Reserve Ratio

• (c) Bank rate

• (d) Moral suasion

UPSC Previous Year Questions (PYQs)

Real UPSC Prelims questions, checked against the official paper and answer key.

Q1. (2018) Which one of the following statements correctly describes the meaning of legal tender money?

• (a) The bank money in the form of cheques, drafts, bills of exchange etc.

• (b) The money which a creditor is under compulsion to accept in settlement of his claims

• (c) The money which is tendered in courts of law to defray the fee of legal cases

• (d) The metallic money in circulation in a country

Q2. (2020) If you withdraw Rs. 1,00,000 in cash from your Demand Deposit Account at your bank, the immediate effect on aggregate money supply in the economy will be

• (a) to leave it unchanged

• (b) to increase it by more than Rs. 1,00,000

• (c) to reduce it by Rs. 1,00,000

• (d) to increase it by Rs. 1,00,000

Q3. (2021) Which one of the following effects of creation of black money in India has been the main cause of worry to the Government of India?

• (a) Investment in unproductive activities and purchase of previous stones, jewellery, gold, etc.

• (b) Loss of revenue to the State Exchequer due to tax evasion

• (c) Diversion of resources to the purchase of real estate and investment in luxury housing

• (d) Large donations to political parties and growth of regionalism

Q4. (2021) The money multiplier in an economy increases with which one of the following?

• (a) Increase in the Cash Reserve Ratio in the banks

• (b) Increase in the banking habit of the people

• (c) Increase in the Statutory Liquidity Ratio in the banks

• (d) Increase in the population of the country

Mains Practice Questions

Use these to frame full-length answers. You don't have to answer one exactly — they show the angles UPSC tests, so let them guide which points you cover.

• Explain the components of reserve money, M1 and M3. Why is M3 called 'broad money' and how does liquidity decline from M1 to M4?

• What is the money multiplier? Explain how a change in the CRR or in the public's preference for cash affects it.

• Why does a cut in the CRR reduce reserve money but increase broad money? Illustrate with the 2025-26 data.

• Distinguish between fiat money and legal tender. Are cheques legal tender? Why does it matter?

UPSC Mains — Previous Years’ Questions on this topic (last 10 years)

No direct GS Mains question has been asked specifically on this topic in the last decade — it is primarily a Prelims area. Use the practice prompts above to stay exam-ready.