Are bank deposits really money?

That was an excellent question. So are banks really creating money out of nothing? If so, does money still represent purchasing power? Let's take one step back. Is there really Rs 180 in the system? Suppose the farmer wants to buy new equipment for his farm and goes to a blacksmith. The blacksmith gives the farmer his new equipment and asks for Rs 50. The farmer pulls out his cheque book and issues a cheque for Rs 50, which the blacksmith deposits in the bank.

This money is immediately deducted from the farmer's account and is credited to the blacksmith's bank account. The farmer now has Rs 50 in the bank and the blacksmith Rs 50(also in the bank). The engineer has by now withdrawn the Rs 80 (loaned to him by the bank) from his account to build his house. The money in the system is still Rs 180. The farmer was able to use his bank deposit to buy goods from the blacksmith. So, yes; bank deposits are actually money and the money in the system did actually grow from Rs 100 to Rs 180 out of well- pretty much nothing.

The very definition of a Ponzi scam

"We have a problem. If a bank can create money out of nothing, then this is a scam and I will prove it to you." said Bindu. "What if the farmer and the blacksmith all want their money from the bank at the same time? The farmer and the blacksmith each have Rs 50 in their accounts- which they are legally allowed to withdraw at any time. So, the bank has to pay out Rs 80 in cash while it has only Rs 20(set aside as per the RBI mandate). So what will the bank give the farmer and the blacksmith? This is the very definition of a Ponzi scam!" trumpeted Bindu with an indignant expression on her face.

The lender of last resort

She had an excellent point, something that most people don't think of. But she was wrong. The scenario that Bindu described is called a "run on the bank". This can happen to any bank and it is for this very reason that the Reserve Bank of India acts as a lender of last resort. I said, "Relax! All the bank has to do in this case is to ask the RBI to loan it some money to pay the farmer and the blacksmith." Bindu asked with a sarcastic expression on her face -"And where will the RBI get new money? Does it have a printing press where it can print new notes as it pleases?"

Yes, money can be printed
Well, I replied, "The RBI actually does have the right to print money at its discretion. So, in this case it will print money and lend it to the bank."

"This just keeps getting better. First you said that any bank can create money from nothing and next, you say that the RBI can literally print money and loan it to banks. What happens to purchasing power then? How can money still have purchasing power if it can be printed at will while no new goods/services are created?" These are all excellent questions but I assure you that you have nothing to worry about. I will tell you more about how money still retains purchasing power despite the RBI's ability to print money at will. I will also cover inflation, wealth creation and lots of other related topics in the next article in this series.

About the author
Ashwini Anand, CFA is the founder of India's best investment portal for beginners - Investopresto.

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