Is a form of currency that exists as balances in bank accounts, such as savings or current accounts.
Unlike physical banknotes or coins, it represents the liabilities of commercial banks to their customers, arising from deposits made by individuals, businesses, or other entities.
Role in the Evolution of Money
In the historical progression of currency, bank money emerged after the establishment of the paper/fiat money standard and serves as a precursor to modern cryptocurrency. While it is a widely recognized form of payment, it is fundamentally different from cash because it is not considered legal tender.
This means that while people generally accept it, a creditor is not legally compelled to accept a cheque or a demand draft in the same way they must accept physical currency notes.
Types and Instruments of Bank Money
Bank money is utilized through various financial instruments defined by the Negotiable Instruments Act, 1881
- Cheques: These are documents issued to a bank, directing it to pay a specific sum to a named person.
- They are used to settle transactions directly from a customer’s account balance.
- Demand Drafts (DD): This is a method used by individuals or banks to transfer money between accounts.
- Unlike cheques, demand drafts do not require the account holder’s signature to be cashed.
Economic Significance
- Money Supply (M1): Bank money is a critical component of the most liquid measure of money supply, known as M1, which includes currency held by the public plus net demand deposits held by commercial banks
- The Money Multiplier: Commercial bank money can be “created” through a process of lending and re-depositing.
- An initial deposit in the banking system can lead to the creation of a larger total amount of money through this process, which is measured by the “money multiplier”
- Aggregate Supply Stability: Because bank deposits and physical cash are both parts of the aggregate money supply, withdrawing cash from a demand deposit account does not immediately change the total amount of money in the economy; it simply shifts the money from one form (bank money) to another (currency)
Challenges and Determinants
The amount of bank money in an economy is influenced by the Currency Deposit Ratio (CDR), which reflects the public’s preference for holding liquid cash versus bank deposits.
If the public prefers holding cash in hand rather than in banks, the bank’s ability to create more money through credit is reduced, leading to a contraction in the money supply
To understand this, you can think of bank money like a score on a digital scoreboard during a game. The score represents real points earned (your deposited wealth), and while you can’t physically hold the numbers on the board, they are used to determine who wins and can be transferred or changed as the game progresses. In contrast, cash is like the physical trophy—it is the tangible proof of value that you can hold in your hands.