Indian Money and Financial Markets and Their Linkages with the Economy for RBI Grade B ESI
Last updated: 2026-11-11 · MockMentor
"Indian Money and Financial Markets: Linkages with the economy" is part of the Indian Economy unit of the RBI Grade B Phase 2 Economic and Social Issues (ESI) syllabus. The topic overlaps with the Finance paper, but the ESI angle is different: how money and financial markets move savings into investment, carry monetary policy to the real economy, and affect growth, inflation and stability. This chapter covers money and its measures, the money market, the capital, bond and foreign exchange markets, the regulators, and the links between finance and the economy.
In one line: financial markets connect savers with borrowers; in India, the money market carries RBI's policy signals, the capital and bond markets fund long-term investment, and the health of these markets shapes growth and stability.
Basic concepts
- Money: anything generally accepted as a medium of exchange, a unit of account, a store of value and a standard of deferred payment.
- Financial market: a market where financial assets such as shares, bonds, bills and currencies are traded.
- Money market: the market for short-term funds, with maturities of up to one year.
- Capital market: the market for long-term funds, through shares (equity) and bonds (debt) with maturities of more than one year.
- Primary and secondary markets: the primary market is where new securities are issued for the first time; the secondary market is where existing securities are bought and sold among investors.
- Liquidity: how quickly and cheaply an asset can be turned into cash without losing value.
- Financial intermediation: the work of banks, mutual funds, insurers and other institutions in collecting savings and lending or investing them.
Why in News?
- Unique investors with demat accounts crossed 12 crore, according to the Economic Survey 2025-26, with about 2.35 crore new demat accounts added in 2025-26 up to December.
- UPI handled over 24,162 crore transactions worth more than ₹314 lakh crore in 2025-26, against about 2 crore transactions in 2016-17, its first year.
- RBI's Financial Stability Report of June 2026 put the gross non-performing assets (NPAs) of scheduled commercial banks at 1.8% of loans at the end of March 2026, a multi-decade low.
Money and its measures
Functions of money
| Function | Meaning |
|---|---|
| Medium of exchange | Removes the need for barter, where goods are traded directly for goods |
| Unit of account | A common measure of value for all goods and services |
| Store of value | Wealth can be held in money for future use |
| Standard of deferred payment | Loans and future payments can be expressed in money |
Money supply in India
RBI publishes measures of the stock of money held by the public.
| Measure | Components | Liquidity |
|---|---|---|
| Reserve money (M0), or high-powered money | Currency in circulation + bankers' deposits with RBI + other deposits with RBI | The base on which banks create money |
| Narrow money (M1) | Currency with the public + demand deposits with banks + other deposits with RBI | Most liquid |
| M2 | M1 + savings deposits with post office savings banks | |
| Broad money (M3) | M1 + time deposits with banks | The main measure used in policy |
| M4 | M3 + all deposits with post office savings organisations (excluding National Savings Certificates) | Least liquid |
M2 and M4 are no longer emphasised. Following the Y.V. Reddy Working Group (1998), RBI also publishes new monetary aggregates (NM1, NM2, NM3) and liquidity aggregates (L1, L2, L3), which include deposits with financial institutions and post offices.
The money multiplier
Banks create money by lending. When RBI injects ₹100 of reserve money, banks keep a part as reserves (CRR) and lend the rest, which is deposited again and lent again. The ratio of broad money to reserve money is the money multiplier. It rises when CRR falls and when people hold less cash relative to bank deposits. A lower CRR, like the cut to 3% in 2025, therefore raises the money-creating capacity of banks.
The money market
The money market deals in short-term funds. Banks, financial institutions, companies and the government use it to manage day-to-day liquidity. RBI acts in this market through its Liquidity Adjustment Facility, and its policy rate first affects money market rates. A deep and efficient money market is therefore essential for monetary policy to work.
Instruments of the money market
| Instrument | Features |
|---|---|
| Call money, notice money and term money | Unsecured borrowing and lending between banks: call money for one day, notice money for 2 to 14 days, term money for 15 days to one year. The weighted average call rate is RBI's operating target. |
| Treasury bills (T-bills) | Short-term government securities of 91, 182 and 364 days, issued at a discount and repaid at face value. They carry no default risk. |
| Cash Management Bills (CMBs) | Very short-term T-bills (under 91 days) issued by the Centre to meet temporary cash gaps |
| Commercial Paper (CP) | Unsecured short-term promissory notes issued by companies and financial institutions with good credit ratings, for 7 days to one year |
| Certificates of Deposit (CDs) | Negotiable term deposits issued by banks (7 days to one year) and financial institutions (one to three years) |
| Repo and reverse repo (market repo) | Borrowing against government securities with an agreement to buy them back. Banks and others trade repos among themselves as well as with RBI. |
| Tri-party repo (TREPS) | A repo where a third party (the Clearing Corporation of India) manages collateral and settlement; now the largest segment of the overnight market |
Features of the Indian money market
- Dominated by banks, with RBI as the central player.
- Overnight segments (TREPS and market repo) have grown, while uncollateralised call money has shrunk.
- Interest rates are market-determined within RBI's policy corridor.
- An unorganised segment of moneylenders, indigenous bankers and chit funds still serves many small borrowers at high interest.
The capital market
The capital market raises long-term funds for companies and the government.
Equity market
Companies raise money through Initial Public Offerings (IPOs), follow-on offers, rights issues and qualified institutional placements in the primary market. Shares are then traded on the BSE (Bombay Stock Exchange, founded in 1875, Asia's oldest) and the National Stock Exchange (NSE, 1992), which introduced screen-based trading in 1994. NSE is the world's largest derivatives exchange by number of contracts traded.
Retail participation has risen sharply since the pandemic, through direct investing and mutual funds. Systematic Investment Plans (SIPs), in which investors put a fixed sum into mutual funds every month, have made domestic investors a steady source of buying, reducing the market's dependence on foreign portfolio investors.
Debt (bond) market
| Segment | Features |
|---|---|
| Government securities (G-secs) | Dated securities issued by the Centre and State Development Loans issued by states, managed by RBI. The largest part of the bond market. |
| Corporate bonds | Issued by companies; dominated by top-rated public sector and financial firms. Small compared with bank loans. |
| Municipal bonds | Issued by city corporations for infrastructure; still very small |
Since June 2024, Indian government bonds have been included in global bond indices (J.P. Morgan in 2024, and later Bloomberg and FTSE), bringing in foreign investment and lowering borrowing costs.
India's corporate bond market remains shallow. Most companies rely on bank loans, which puts the burden of long-term infrastructure lending on banks and creates a mismatch between their short-term deposits and long-term loans.
Derivatives and other segments
Futures and options on shares, indices, currencies, interest rates and commodities are traded on stock and commodity exchanges. The rapid rise of retail trading in equity options led SEBI to tighten rules in 2024 and 2025, after studies found that most individual traders lost money. Commodity derivatives are traded on exchanges such as the Multi Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange (NCDEX).
The foreign exchange market
The forex market is where rupees are exchanged for foreign currencies. India follows a managed float: the rupee's value is set by the market, but RBI buys and sells dollars to curb excessive volatility. The rupee is fully convertible on the current account (for trade, travel, remittances) since 1994, but only partly convertible on the capital account. Authorised dealers (mainly banks) handle transactions under the Foreign Exchange Management Act (FEMA), 1999. Offshore trading in rupee contracts, the non-deliverable forward market in places such as Singapore and Dubai, also influences the rupee.
Regulators of the financial system
| Regulator | Area |
|---|---|
| Reserve Bank of India (RBI) | Banks, non-bank financial companies (NBFCs), money, G-sec and forex markets, payment systems |
| Securities and Exchange Board of India (SEBI) | Stock exchanges, brokers, mutual funds, listed companies, commodity derivatives (since 2015) |
| Insurance Regulatory and Development Authority of India (IRDAI) | Insurance companies |
| Pension Fund Regulatory and Development Authority (PFRDA) | National Pension System and Atal Pension Yojana |
| International Financial Services Centres Authority (IFSCA) | Financial services in GIFT City, Gujarat |
| Financial Stability and Development Council (FSDC) | Chaired by the Finance Minister; coordinates regulators on financial stability |
Linkages with the economy
1. Mobilising savings for investment
Households in India save a large part of their income, but much of it was traditionally held in gold and land. Financial markets turn savings into investment by channelling them to firms and the government. The shift of household savings into bank deposits, mutual funds, insurance and pensions makes more money available for productive investment.
2. Transmission of monetary policy
RBI's repo rate first changes money market rates, then bond yields and bank lending and deposit rates. The deeper and more competitive these markets are, the faster and fuller the transmission. Our chapter on monetary policy explains the channels in detail.
3. Financing government
The G-sec market funds the fiscal deficit. Large government borrowing can push up yields and crowd out private borrowers, so fiscal policy and bond markets are closely linked.
4. Price discovery and allocation
Share and bond prices signal which firms and sectors are expected to do well. Capital flows towards them, improving the allocation of resources.
5. Wealth effect
Rising share and property prices make households feel richer, and they spend more. Falling prices have the opposite effect.
6. Risk sharing
Insurance, derivatives and diversified funds let households and firms manage risks such as crop failure, price swings and currency moves.
7. External sector
Foreign portfolio and direct investment flow through financial markets. Large inflows raise the rupee and reserves; sudden outflows, as in 2013 and 2022, put pressure on the rupee and markets.
8. Financial stability
Bubbles in asset prices or excessive borrowing can end in crises that damage the whole economy, as the 2008 global financial crisis and the stress in Indian banks and NBFCs in 2015 to 2019 showed.
Development of financial markets since 1991
- Deregulation of interest rates and the end of automatic monetisation of the deficit.
- Statutory powers for SEBI (1992), the start of NSE (1994) and dematerialisation of shares through depositories (NSDL in 1996, CDSL in 1999).
- Auctions for government securities, the primary dealer system and the Negotiated Dealing System.
- The Liquidity Adjustment Facility (2000) and the move to a single policy rate.
- The Clearing Corporation of India (2001) for settlement of G-secs, forex and money market deals.
- The Insolvency and Bankruptcy Code (2016) and the Unified Payments Interface (2016).
- Inclusion of Indian bonds in global indices (2024 onwards).
Challenges
- A shallow corporate bond market and dependence on bank credit.
- Concentration of household savings in physical assets.
- High retail losses in speculative options trading.
- Limited access to formal finance for small firms and rural households.
- Volatile foreign portfolio flows.
- Gaps in financial literacy and risks from digital fraud.
Way forward
- Deepen the corporate bond market through credit enhancement, a strong market for repos in corporate bonds and simpler issuance.
- Develop municipal bonds to fund city infrastructure.
- Expand financial literacy and investor protection.
- Strengthen oversight of NBFCs, fintech lending and digital fraud.
- Build long-term savings through pensions and insurance.
- Keep developing GIFT City as an international financial centre.
Possible exam and interview questions
- Explain the structure of the Indian money market and its role in the transmission of monetary policy. (420 words)
- How do financial markets contribute to economic growth? Why does India need a deeper corporate bond market? (620 words)
- Distinguish between M1 and M3. What is the money multiplier, and how does a change in CRR affect it?
- What are the risks of rising retail participation in stock and derivatives markets?
- Interview: What does the inclusion of Indian government bonds in global indices mean for India?
Related reading: monetary policy, banks and RBI in development, and our RBI Grade B Phase 2 Finance guide.
More in ESI
Prepare with MockMentor
RBI Grade A/B 2027 Super-Elite Course (₹7,500) – Complete Phase 1 and Phase 2 preparation with the Descriptive Writing Programme. 365 days validity.