Chapter 32: Role of Central Bank and Money Supply

Understanding Money Supply

• Central banks manage the money supply in the economy.
• Only a small portion (~6%) of the money supply is physical money issued by the central bank.
• Majority (~94%) is created by banking institutions under a fractional reserve banking system.

Fractional Reserve Banking System

• This system allows financial institutions to create money beyond the physical reserves (currency/coins) they hold.
• Originates from historical practices during the Goldsmith Era, where gold receipts were used as currency.

Goldsmith Era

• Gold was heavy and unsafe to carry; thus, people deposited gold with Goldsmiths (early bankers).
• Receipts issued by Goldsmiths were used for transactions, representing physical gold.
• Initially, this was a 100% reserve system; receipts equaled the gold deposited (fully backed).

Transition to Fractional Reserve System

• Goldsmiths realized not all gold was redeemed simultaneously, prompting them to issue more receipts than the gold held.
• This marked the shift to fractional reserve banking, where only a fraction of money (receipts) is backed by physical reserves (gold).

Modern Implications

• Banks today operate similarly by lending out deposited money, creating more money in the system.
• Physical money vs. digital/virtual money: Banks create digital money through lending.
• Central banks must control the money creation ability of banks to manage overall money supply.

Key Concepts

• Actual Reserve: The physical reserve (gold or currency) held by the bank.
• Required Reserve: The minimum reserve banks must hold, regulated by central banks.
• Excess Reserve: Any reserve above the required amount, which can be used for lending.
• Monetary Multiplier: Concept explaining how banks can multiply money supply through lending.

Historical Context and Banking Risks

• Fractional reserve banking poses risks like bank panics or bank runs.
  • Bank runs occur when many depositors withdraw simultaneously, fearing bank insolvency.

Historical Examples

• 1999 Malaysia: MBF Finance faced a bank run due to bankruptcy rumors.
• 2019 UK: Rumors affected Metro Bank, resulting in significant withdrawals.

Safety Measures

• Deposit Insurance: Systems like Malaysia's PIDM ensure deposits are insured, providing security against bank failures.
• Established post-1999 bank runs to protect depositor money.

Conclusion

• Understanding fractional reserve banking is crucial for grasping central bank roles in monetary policy.
• The interplay between central banks and commercial banks in money creation affects economic stability.
• Ensuring sound banking systems and depositor confidence is vital for economic investments and growth.