ECS4864
ASSIGNMENT 01
DUE DATE: 28 April 2022
UNIQUE NUMBER: 543250
, THE ROLE OF CASH RESERVES IN FRACTIONAL RESERVE BANKING
INTRODUCTION
Money today is completely different today from what it was many years ago. Starting from
moneyless barter, money evolved from commodity money to commodity-based bank money, until
it finally became what we call money today. As the evolution happened, the need for a centralised
exchange of money emerged, which led to the development of the banking system. Fractional
reserve banking is prevalent in the modern era. In this system, banks hold only a fraction of their
deposits as cash reserves to back up the deposits they issue, because deposits may give rise to cash
withdrawals and interbank cash payments. Cash reserves thus play an important role for fractional
reserve banks in maintaining healthy balances sheets – regarding both their liquidity and their
solvency.
In this essay we will look at the difference between cash and money in a commodity-based
banking system by outlining the differences between definitive money and derivative money.
We will further explore how the concept of fractional reserve banking introduces the importance
of liquidity in the banking system. The nature of cash has also changed from the classical gold
standard, banking systems with full blown central banking to the modern fiat system. Still
focusing on commercial banks, the paper discusses how commercial banks create money and
how fractional reserve banking enables them to do so. Like any system, the banking system
faces risks which can be intensified by systemic biases in the pattern of their cash gains and
losses. Central banks also play a key role in the modern economy and we will discuss how they
fulfil their role using an elastic currency policy. Central banks in the fiat money system must deal
with risks to the banking system resulting from the systemic risk biases mentioned previously.
The difference between money and cash under a commodity-based bank money system
without central banking.
In McLeay et al. (2014a, p4) we see that there is no universal agreement on what money can and
cannot be. Various commodities have been used as money over the years to settle transactions –
commodities whose value was anchored in their intrinsic value when used for non-monetary
purposes. The value of modern money, which has no intrinsic value, emanates from the knowledge
that someone else will accept it as form of payment for other goods and services. Below are the
characteristics of money:
a) Money must be a good store value – meaning that during the period between its receipt and re-
spending money can be trusted to retain its value. In this regard, precious metal money has proven
to be an exceptionally good store of value, witness how gold and silver that were mined many
years ago still have a high value today. However, things like food would become worthless as they
can get spoiled. Perishable food items would thus not be good candidates to function as money
(McLeay et al. 2014a, p.4).
b) Money functions as a unit of account – meaning that it keeps track of accounts which gives us
the ability to compare different transactions. Under barter, goods had as many prices as other goods
against which they were traded. A single generally accepted money allows goods to have a single
price, which greatly facilitates economic calculation. In the modern economy, this allowed goods
and services to be priced in a single currency and therefore making their value directly comparable.
ASSIGNMENT 01
DUE DATE: 28 April 2022
UNIQUE NUMBER: 543250
, THE ROLE OF CASH RESERVES IN FRACTIONAL RESERVE BANKING
INTRODUCTION
Money today is completely different today from what it was many years ago. Starting from
moneyless barter, money evolved from commodity money to commodity-based bank money, until
it finally became what we call money today. As the evolution happened, the need for a centralised
exchange of money emerged, which led to the development of the banking system. Fractional
reserve banking is prevalent in the modern era. In this system, banks hold only a fraction of their
deposits as cash reserves to back up the deposits they issue, because deposits may give rise to cash
withdrawals and interbank cash payments. Cash reserves thus play an important role for fractional
reserve banks in maintaining healthy balances sheets – regarding both their liquidity and their
solvency.
In this essay we will look at the difference between cash and money in a commodity-based
banking system by outlining the differences between definitive money and derivative money.
We will further explore how the concept of fractional reserve banking introduces the importance
of liquidity in the banking system. The nature of cash has also changed from the classical gold
standard, banking systems with full blown central banking to the modern fiat system. Still
focusing on commercial banks, the paper discusses how commercial banks create money and
how fractional reserve banking enables them to do so. Like any system, the banking system
faces risks which can be intensified by systemic biases in the pattern of their cash gains and
losses. Central banks also play a key role in the modern economy and we will discuss how they
fulfil their role using an elastic currency policy. Central banks in the fiat money system must deal
with risks to the banking system resulting from the systemic risk biases mentioned previously.
The difference between money and cash under a commodity-based bank money system
without central banking.
In McLeay et al. (2014a, p4) we see that there is no universal agreement on what money can and
cannot be. Various commodities have been used as money over the years to settle transactions –
commodities whose value was anchored in their intrinsic value when used for non-monetary
purposes. The value of modern money, which has no intrinsic value, emanates from the knowledge
that someone else will accept it as form of payment for other goods and services. Below are the
characteristics of money:
a) Money must be a good store value – meaning that during the period between its receipt and re-
spending money can be trusted to retain its value. In this regard, precious metal money has proven
to be an exceptionally good store of value, witness how gold and silver that were mined many
years ago still have a high value today. However, things like food would become worthless as they
can get spoiled. Perishable food items would thus not be good candidates to function as money
(McLeay et al. 2014a, p.4).
b) Money functions as a unit of account – meaning that it keeps track of accounts which gives us
the ability to compare different transactions. Under barter, goods had as many prices as other goods
against which they were traded. A single generally accepted money allows goods to have a single
price, which greatly facilitates economic calculation. In the modern economy, this allowed goods
and services to be priced in a single currency and therefore making their value directly comparable.
