Economics · Ch 3 — Money and Banking
Supply of Money
Supply of Money
The Two Pillars of Money Supply
In a modern economy, money is not just the currency you carry. It also includes bank deposits — the money you hold in your savings or current account. Depending on which types of deposits are counted, economists define several measures of money. The system that creates this money rests on two kinds of institutions: the central bank of the economy and the commercial banking system.
The Central Bank
Almost every country has one central bank. India’s central bank, the Reserve Bank of India (RBI) , was established in 1935. The central bank performs several critical functions:
- It issues the country’s currency.
- It controls the money supply through tools like the bank rate, open market operations, and variations in reserve ratios.
- It acts as a banker to the government.
- It is the custodian of the nation’s foreign exchange reserves.
- It acts as a bank to the banking system — a role we will examine in detail later.
From the perspective of money supply, the most important function is currency issuance. The currency issued by the central bank can be held either by the public or by commercial banks. This currency is called high-powered money, reserve money, or the monetary base. It is called "high-powered" because it serves as the foundation for the entire process of credit creation by commercial banks.
High-powered money (monetary base) = Currency held by the public + Currency held by commercial banks (cash reserves). It is the base on which the banking system builds a much larger total money supply.
Commercial Banks
Commercial banks are the second pillar of the money-creating system. They accept deposits from the public and lend out a portion of those funds to borrowers. The interest rate paid to depositors is lower than the rate charged to borrowers. The difference between these two rates is called the spread, and it represents the bank’s profit.
To understand how banks create money, the textbook tells a story.
The Goldsmith's Tale
Imagine a village where people use gold as money. A goldsmith named Lala offers to keep everyone's gold safe for a small fee. In return, he issues paper receipts. Over time, these receipts begin to circulate as money — people pay for wheat or shoes with Lala's receipts instead of handing over actual gold. The receipts become a medium of exchange because everyone in the village accepts them.
Now suppose Lala has 100 kg of gold deposited with him, and he has issued receipts for exactly 100 kg. One day, Ramu asks Lala for a loan of 25 kg of gold. Can Lala give it? The 100 kg already has claimants. But Lala reasons that not everyone will come to withdraw their gold at the same time. So he lends Ramu 25 kg. Ramu uses that gold to pay Ali, and Ali — trusting Lala — deposits the 25 kg back with Lala in exchange for a new receipt.
What has happened? The total paper receipts in circulation have now risen to 125 kg, even though the actual gold in Lala's vault is still only 100 kg. Lala has created money out of thin air.
This is not fraud. It is the fundamental principle of fractional-reserve banking. The key assumption is that depositors do not all demand their money back simultaneously. If they did, the system would collapse — a "bank run."
How Modern Banks Work
The modern banking system works exactly like Lala. Commercial banks mediate between people with excess funds (depositors) and those who need funds (borrowers). People prefer to keep money in banks for several reasons:
- Banks pay interest on deposits.
- It is safer than keeping cash at home. …