Banking and Finance

Banking and finance

Development of central banks

Maciej Turaa, Ph.D.

Development of central banks

The development of commercial banking activities is tied with the evolution of money.
In the medieval times gold and silver coins were the dominant form of money. Later paper money appeared. As time went on several processes were occurring:
the banking system was becoming increasingly concentrated; the privilege of issuing notes was being gradually limited; convertibility of paper money was also being reduced.

Development of central banks

Initially all banks were issuing their own banknotes. As of the XIX century the authorities began to gradually restrict the right of issuing banknotes. Finally, only one bank was entitled to issue banknotes in each country. These banks are called issuing banks. The authorities were gradually adding some new tasks that the issuing banks were to perform, thus transforming them into central monetary institutions. Issuing banks became responsible for:
issuing internal paper money, servicing financial as well as credit operations of the treasury (the state), supervising international transactions, keeping central currency reserves, controlling the currency exchange rate.

And so central banks were created.

prepared by: Maciej Turaa, Ph.D.

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Functions of central banks

The central bank typically:
settles accounts between commercial banks and other financial institutions, is the Treasurys bank it runs deposit accounts of the state, is the ultimate creditor it is the ultimate source of credits for commercial banks, runs the monetary policy of the state, issues cash, holds and manages the foreign currency reserves of the state, performs supervision over the activities of commercial banks.

Money creation
In an economy with a two-tier banking system (composed of a central bank and subordinate private banks), there are two types of money circulating:
Money issued by the central bank (cash); Money issued by private banks (bank money // deposit money);

However only the central banks have the right to issue currency (coins and banknotes). The money issued by private banks is derived from central bank money.

Money creation
in the banking system

prepared by: Maciej Turaa, Ph.D.

Banking and Finance

Money creaton
step 1

Assets Cash (reserve) Total

100 100

Equity + liabilities Demand deposit 100 Total 100

Money creaton
step 2

Assets Cash (reserve) Credits issued Total 100 90 190

Equity + liabilities Demand deposits Total 190 190

Money creaton
money creation multplier

D =

CR r

D demand deposits; CR Cash reserves; r obligatory reserve index;

prepared by: Maciej Turaa, Ph.D.

Banking and Finance

Money creation
in the banking system
What if more banks are involved?

prepared by: Maciej Turaa, Ph.D.