Commercial Bank Money
Money is defined as any quantifiable asset or usually accepted as settlement for goods and/or services purchased and payment of debts, including interests, in a specific country or socioeconomic context. Money is the basic unit of exchange in the market. It is traded as a means of payment on goods and/or services for an agreed upon price on a regular basis. The supply of money in the economy, i.e., the availability of coins in the economy, determines the level of commodity prices and determines how loans are issued and repaid. Money is a direct form of credit, since it is issued by the government and it normally serves the purpose of redeeming money previously issued by private parties.
Money, unlike currency, is not created out of nothing but is produced by the activities of businesses. The process of creating currency involves first creating money i.e. coins and then money is lent on its basis. Money thus minted is not money itself but the IOU or promissory note that it is a legal and binding contract between a borrower and a lender. As it is no longer in circulation, it depreciates in value and people tend to avoid its purchase because it is not directly convertible into cash.
In an attempt to increase the level of activity in the economy, the central bank usually creates more non-monetary reserves (the additional reserves are called reserves of deposit) to use as debit instruments against certain assets. The role of the central bank in an economy is to control the total volume of money supply. The quantity of active money supply determined by the balance between the liabilities and assets of the economy. Money growth and reduction of the level of bank liabilities in the economy are therefore governed by the state of the general funds of the economy.
Money growth and reduction of the level of bank deposits are controlled by the central banks through interest rates and other monetary policies. Interest rates are usually set by the government of the country. They are usually dependent on inflation indicators such as trade balance, industrial production, budget deficits etc. In most advanced countries, interest rates are regulated by the Federal Reserve Bank, which also controls the amount of bank deposits.
Changes in the level of money supply affect various economic aspects of the economy. Changes in the level of interest rates on bank deposits can affect the economy’s financing requirements. The size of the banks is also determined by changes in the level of inflation. Changes in the composition of banks affect the money supply.
Banks earn interest on bank deposits and other loans by lending money. Most of the money market transactions are done through banks. Commercial bank money is created when banks lend money either to individuals or to businesses. The commercial bank money then gets transformed into bank deposits and other loans. The central banks thus play a vital role in the maintenance of the standard level of money in the economy.