3.2.2. Supply of Money

In a modern economy, money comprises cash and bank deposits. Depending on what types of bank deposits are being included, there are many measures of money. These are created by a system comprising two types of institutions: central bank of the economy and the commercial banking system.

Money in a modern economy isn't just physical cash but also includes bank deposits. The definition of money can vary depending on which types of deposits are included. Essentially, money supply refers to the total amount of liquid cash and cash equivalents available in an economy and it is regulated by institutions like the central bank and commercial banks.

Think of money supply like the water in a reservoir. Just as the water level can rise or fall based on inflow and outflow, the money supply can change based on how much cash is created and how much is withdrawn from circulation.

Central Bank is a very important institution in a modern economy. Almost every country has one central bank. India got its central bank in 1935. Its name is the ‘Reserve Bank of India’. Central bank has several important functions.

The central bank, like the Reserve Bank of India, plays a critical role in managing a nation's economy. It is responsible for issuing currency, controlling the money supply, and acting as a banker to the government. It uses various methods to regulate how much money is in circulation, impacting overall economic activity.

Consider the central bank as the conductor of an orchestra; just as a conductor ensures all musicians are playing together in harmony, the central bank works to maintain the stability of the economy by managing money supply and maintaining a balance.

Commercial banks are the other type of institutions which are a part of the money-creating system of the economy. In the following section we look at the commercial banking system in detail. They accept deposits from the public and lend out part of these funds to those who want to borrow.

Commercial banks accept deposits (money) from the public and use a portion of these deposits to lend to borrowers. This process creates new money through the loans given, as borrowers can spend this money, effectively bringing it back into circulation, thereby increasing the total money supply.

Imagine a baking factory where flour is the money. When flour is deposited (deposited in a bank), some is used to bake bread (loans), which is then consumed. This cycle shows how deposits turn into new money through lending.

In order to understand this process, let us discuss a story. Once there was a goldsmith named Lala in a village. In this village, people used gold and other precious metals in order to buy goods and services. People in the village started keeping their gold with Lala for safe-keeping.

The story illustrates how banking operates. Lala, acting as a goldsmith, accepted gold deposits and issued receipts (representing 'money'). These receipts gradually became accepted as money for transactions. This scenario simplifies the concept of how banks create money by issuing more receipts than the actual gold, reflecting real-world lending practices.

This model can be related to how modern banks operate today. When you deposit money, the bank does not keep all of it in the vault but lends a portion out, thus increasing the effective money supply available for everyone.

However, Lala could decide that everyone with gold deposits will not come to withdraw their deposits at the same time and so he may as well give the loan to Ramu and charge him for it.

Lending money involves a risk as banks must ensure that they have enough liquidity—the capability to meet withdrawal demands. Lala believes not everyone will demand their deposits at once, allowing him to extend a loan without losing deposits. This principle is foundational in banking where banks operate on a fractional reserve basis.

Think of a restaurant that seats 100 people, but the chef prepares only enough food to serve 80. If the restaurant is careful and only 40 guests show up, the chef can manage. However, if suddenly 100 people arrive, the restaurant cannot fulfill all orders, representing the liquidity risks banks face.

The modern banking system works precisely the way Lala behaves in this example. Commercial banks mediate between individuals or firms with excess funds and lend to those who need funds. People with excess funds can keep their funds in the form of deposits in banks and those who need funds, borrow funds.

The banking system creates money through the lending process. When banks lend, they essentially create new money because they are not physically handing out the deposits in cash but rather ensuring that these funds are used in transactions, thus expanding the money supply.

It's like a library system where books (money) can circulate. When one person checks out a book, they can read it, share insights, and discuss with others, thereby multiplying the influence of that one book. Similarly, the way banks lend out money boosts economic activity.

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