If LRR is 25%, what is the credit multiplier?

4. Credit Multiplier = 1 ÷ LRR = 1 ÷ 0.25 = 4. An initial deposit of ₹1,000 with LRR 25% would create total deposits of ₹4,000.

What are Open Market Operations (OMO)?

OMO is a monetary policy tool where RBI buys or sells government securities in the open market. Selling withdraws money from the economy (credit contracts); buying injects money (credit expands).

What is the difference between CRR and SLR?

CRR (Cash Reserve Ratio) is the percentage of a bank's deposits that must be kept as cash with the RBI. SLR (Statutory Liquidity Ratio) is the percentage of deposits that must be kept in liquid assets — cash, gold, or approved government securities — within the bank itself. Both are quantitative tools the RBI uses to control credit; raising either reduces the funds banks can lend.

What is the difference between Repo Rate and Bank Rate?

Repo Rate is the rate at which RBI lends short-term funds to commercial banks against collateral (government securities). Bank Rate is the rate at which RBI lends long-term funds to banks without collateral. Repo Rate is the key policy rate today; Bank Rate is used less frequently. Raising either makes credit costlier.

What is the formula for the credit multiplier?

Credit Multiplier (or Money Multiplier) = 1 ÷ LRR, where LRR is the Legal Reserve Ratio. For example, if LRR = 20% (0.20), the multiplier = 1/0.20 = 5. Total deposits created in the banking system = Initial Deposit × Credit Multiplier. Lower LRR means a higher multiplier and more credit creation.

What are the main functions of the RBI as central bank?

RBI functions: (1) Bank of Issue — sole authority to issue currency notes; (2) Banker's Bank — accepts deposits from and lends to commercial banks; (3) Lender of Last Resort — provides emergency funds during liquidity crises; (4) Government's Bank — manages government accounts and public debt; (5) Credit Control — regulates credit through monetary policy; (6) Clearing House — settles inter-bank transactions.

What is the difference between Repo Rate and Reverse Repo Rate?

Repo Rate is the rate at which RBI lends to commercial banks (banks borrow from RBI). Reverse Repo Rate is the rate at which RBI borrows from commercial banks (banks park funds with RBI). When Reverse Repo rises, banks prefer parking funds with RBI rather than lending, so credit contracts.

Are Banking MCQs important for CBSE Class 12 board exams?

Yes. Banking is part of Unit 2 (Money & Banking) of CBSE Class 12 Macroeconomics, which carries 6 marks weightage. Credit multiplier numericals, CRR/SLR/Repo Rate distinctions, and RBI functions are tested every year as 1-mark, 3-mark, and 4-mark questions.

How many MCQs does Just Practice offer on Banking?

Just Practice has 76 free MCQs on Banking for CBSE Class 12 Economics, covering commercial bank functions, credit creation numericals, RBI roles, and all monetary policy tools (CRR, SLR, Repo Rate, Bank Rate, OMO). Each question includes the correct answer and explanation. No signup required.

76 MCQs 50 Flashcards Unit 2 · 6 marks weightage Updated April 2026

Unit 2 · Macroeconomics

Chapter 6: Banking

Q: What is credit creation by commercial banks?

Credit creation is the process by which commercial banks expand the money supply by lending. Banks keep only a fraction of deposits as reserves (the Legal Reserve Ratio, LRR) and lend out the rest. Each loan becomes a new deposit somewhere, generating further lending. Total deposits created = Initial Deposit × Credit Multiplier, where Credit Multiplier = 1 ÷ LRR.

Commercial banks, credit creation, the RBI as central bank, and monetary policy tools — CRR, SLR, Repo Rate, Bank Rate, and Open Market Operations.

▶ Practice Test — Ch 6 All Macro Chapters

Commercial Banks — Functions

Commercial banks are financial institutions that accept deposits from the public and provide loans. Their key functions are:

Accepting Deposits: Demand deposits (current/savings — withdrawable anytime) and time deposits (fixed deposits — for a specified period).
Advancing Loans: Provide loans to individuals and businesses in the form of overdrafts, cash credit, term loans, and discounting bills of exchange.
Credit Creation: The most important function. By keeping only a fraction of deposits as reserves (LRR), banks lend out the rest, which gets re-deposited, enabling a chain of credit creation.
Agency Functions: Transfer funds, collect cheques, pay insurance premiums, act as trustees.
General Utility Functions: Locker facilities, foreign exchange, letters of credit.

Credit Creation and the Credit Multiplier

Banks do not keep 100% of deposits as cash. They keep only a minimum fraction — the Legal Reserve Ratio (LRR) — and lend out the rest. Each loan becomes a new deposit somewhere, generating further lending. This chain process is called credit creation.

Numerical Example (LRR = 20%, Initial Deposit = ₹1,000):

Bank A receives ₹1,000 → keeps ₹200 (20%) → lends ₹800
Bank B receives ₹800 → keeps ₹160 → lends ₹640
Bank C receives ₹640 → keeps ₹128 → lends ₹512 …and so on.

Total deposits created = Initial Deposit × Credit Multiplier = ₹1,000 × 5 = ₹5,000

The Credit Multiplier (also called Money Multiplier) = 1 ÷ LRR. With LRR = 20% = 0.20, multiplier = 1/0.20 = 5.

A lower LRR means a higher multiplier and more credit creation; a higher LRR reduces credit creation. The RBI controls the LRR through CRR and SLR.

RBI as the Central Bank of India

The Reserve Bank of India (RBI), established in 1935, is the apex monetary institution. Its key functions include:

Bank of Issue (Note Issue): Sole authority to issue currency notes (except ₹1 coin/note, issued by Ministry of Finance). Maintains currency stability.
Banker's Bank: Accepts deposits from and lends to commercial banks. Sets CRR — commercial banks must keep a portion of their deposits with RBI.
Lender of Last Resort: Provides emergency funds to commercial banks when they face a liquidity crisis, preventing bank failures.
Government's Bank: Manages the government's accounts, public debt, and foreign exchange reserves. Acts as financial adviser to the government.
Credit Control: Uses quantitative and qualitative tools to regulate credit and money supply in the economy (monetary policy).
Clearing House: Facilitates interbank settlements and clearing of cheques.

Monetary Policy Tools — Quantitative & Qualitative

Quantitative (General) Tools affect the overall volume of credit:

Cash Reserve Ratio (CRR): The percentage of a commercial bank's net demand and time liabilities (NDTL) that must be kept as cash reserves with the RBI. ↑ CRR → less funds to lend → credit contracts.
Statutory Liquidity Ratio (SLR): The percentage of NDTL that banks must maintain in liquid assets — cash, gold, or approved government securities — within the bank itself. ↑ SLR → less funds available for lending.
Bank Rate: The rate at which RBI lends funds to commercial banks for the long term, without any collateral. ↑ Bank Rate → borrowing from RBI becomes costlier → banks raise lending rates → credit contracts.
Repo Rate: The rate at which RBI lends short-term funds to commercial banks against government securities (collateral). It is the key policy rate. ↑ Repo Rate → costlier for banks to borrow → credit contracts.
Reverse Repo Rate: The rate at which RBI borrows short-term funds from commercial banks (RBI pays this interest). ↑ Reverse Repo Rate → banks park more money with RBI → less money available for lending → credit contracts.
Open Market Operations (OMO): RBI buying or selling government securities in the open market. Selling securities → withdraws money from economy → credit contracts. Buying securities → injects money → credit expands.

Qualitative (Selective) Tools affect the direction of credit:

Margin Requirements: The difference between the loan amount and the market value of the collateral. ↑ Margin → less loan against same collateral → credit for specific sectors contracts.
Moral Suasion: RBI persuades banks informally to follow certain lending guidelines.
Direct Action: RBI takes punitive action against banks not following guidelines.

Key Concepts at a Glance

Formula

Credit Multiplier = 1 ÷ LRR If LRR = 20%, multiplier = 1/0.20 = 5. An initial deposit of ₹1,000 creates total deposits of ₹5,000. Lower LRR → higher multiplier → more credit.

Key Distinction

CRR vs SLR CRR: % of deposits kept as cash with RBI (not in the bank). SLR: % of deposits kept in liquid assets (cash, gold, govt securities) within the bank itself. Both are quantitative credit controls.

Key Distinction

Repo Rate vs Bank Rate Repo Rate: short-term lending by RBI to banks, with collateral (govt securities). Bank Rate: long-term lending by RBI to banks, no collateral required. Both: ↑ rate → credit contracts.

Policy Tool

Reverse Repo Rate Rate at which RBI borrows from commercial banks (i.e., banks deposit with RBI). When RBI raises it → banks prefer parking funds with RBI → money supply in economy falls → credit contracts.

Sample MCQs — Chapter 6: Banking

1. Which institution acts as the 'banker's bank' in India?

SBI
NABARD
RBI ✓
SEBI

Correct answer: C — The Reserve Bank of India (RBI) is the central bank and acts as the banker's bank. It accepts deposits from and lends to commercial banks, sets reserve requirements (CRR), and acts as lender of last resort. SEBI regulates capital markets; NABARD focuses on agriculture finance.

2. If LRR is 25%, the value of the credit multiplier is:

2
4 ✓
5
25

Correct answer: B — Credit Multiplier = 1 ÷ LRR = 1 ÷ 0.25 = 4. This means an initial deposit of ₹1,000 with LRR of 25% would create total deposits of ₹1,000 × 4 = ₹4,000 in the banking system.

3. Open Market Operations refer to:

Opening new bank branches
RBI buying/selling govt securities in the open market ✓
Commercial banks lending to the public
Setting of bank rates by RBI

Correct answer: B — Open Market Operations (OMO) is a monetary policy tool where RBI buys or sells government securities in the open market. When RBI sells securities, money is withdrawn from the economy (credit contracts). When RBI buys securities, money is injected (credit expands).

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