Q. Describe the working of Commercial banks?
Fact that currency inside commercial banks isn't money may strike you as odd though it is an important principle. 100 dollar bill in the ATM will become money only at the instant you withdraw it. The reason is this. We want the money supply to measure how much is available for immediate consumption. Though currency inside a bank can't be used for consumption and this is why it isn't counted in the money supply. Cash in the bank isn't money though the binary bits in the bank's computer system representing the balance in your checking account are?
An illustration may also explain this important fact:
- Eric has 100 euro - this amount is obviously part of the money supply as it's immediately available for consumption.
- Eric deposits 100 euro into his checking account. He still has 100 euro available for immediate consumption employing his debit card and money supply shouldn't be changed by this deposit (it's not - deposits are included in the money supply).
- Eric's bank now has 100 euro more than before deposit. If we count currency inside the bank as money, money supply would have increased by 100 euro by his deposit. This doesn't make sense as amount available for immediate consumption hasn't changed.
- similarly withdrawing money from ATM doesn't affect the money supply. When you withdraw money, currency outside banks increases whereas your checking balance decreases by same amount.
Although currency inside a bank isn't money, it's still part of the monetary base. 100 euro inside the bank is clearly still worth 100 euro to the bank although we don't include it in the money supply.