Saturday, October 23, 2010

Who decides and how does it work?

Either in the form of notes, coins or credit we use money daily for one or the other purpose. I always used to wonder how people came up with this currency model and where does it start and how does it flow. The answer for this question may be as simple as we need something to value each and every item, so that a transaction takes place smoothly.

Every country prints its own currency, then why can't it print more rupees/dollars and give it to people. One obvious answer will be if we print more currency people will start having more dollars/rupees and hence the price of commodities will go up and the value of the currency will go down. This is a single line answer, but there lot to it.

Who decides how much currency to print, how do they decide and how does it flow?

I tried to find out answer for these questions and this is what I understood.

Government is the head of the family:

Let’s think government like a family, we get money from salary, interests, rents, profit from business etc. Similarly government gets it from taxes, investments, selling lands etc. But when we need more money like when we have to buy home start a business etc we borrow from bank. That’s what governments also do they borrow from their federal or reserve banks.

Government’s banker:

Within almost all modern nations, special institutions such as the Federal Reserve System in the United States, Reserve Bank in India etc, exist, which are called central banks. They have the responsibility of executing the monetary policy and often have other responsibilities such as supervising the smooth operation of the financial system.

Best safety measure [ :) ]

Countries mostly separate the Reserve Bank from the rest of the government to prevent politicians from just trying to solve economic problems by printing money, which really can mess up an economy.

This is how it works in worlds oldest democracy [USA] and worlds largest democracy [India]:

United States:

It's entirely up to the country to decide how much currency to print. Most currencies today are called 'fiat money'. That is, it's not backed by anything of value such as gold or silver. It's simply worth whatever we say it's worth it. In the United States, the US Dept. of Printing and Engraving prints the money. It seems like it costs about $.03 to print a single bill, no matter what number is on the bill. So, a $1 bill costs just as much to print as a $100 bill.

Federal Reserve takes those bills and then “loans” these dollars back to the U.S government at the face value and the government puts the bills into circulation. That's why every bill you have in your wallet says that it's a "note". It literally represents a debt that the U.S. government owes the Federal Reserve.

The interesting thing is that the Federal Reserve charges interest on the loans. Think about that one for a while. If all the money were paid back to the Fed....what would be left over to pay the interest?. Interesting topic. 


I found this in Reserve Bank of India’s website, they did a pretty good job at explaining how they works.

A) What and who decides the money (currency) in circulation in Indian money market ?

a) The Reserve Bank of India (RBI) manages currency in India. The Government, on the advice of the Reserve Bank, decides on the various denominations. The Reserve Bank also co-ordinates with the Government in the designing of bank notes, including the security features. The notes received from the presses are issued and a reserve stock maintained.

b) To facilitate the distribution of notes and rupee coins, the Reserve Bank has authorized selected branches of banks to establish currency chests. These are actually storehouses where bank notes and rupee coins are stocked on behalf of the Reserve Bank. At present, there are over 4368 currency chests. The currency chest branches are expected to distribute notes and rupee coins to other bank branches in their area of operation.

B) Can reserve bank of India or Indian government bodies decide to print additional currencies to meet public expenditure?

a) The Reserve Bank estimates the demand for bank notes on the basis of the growth rate of the economy, the replacement demand and reserve requirements by using statistical models. The Reserve Bank decides upon the volume and value of bank notes to be printed. The quantum of bank notes that needs to be printed broadly depends on the annual increase in bank notes required for circulation purposes, replacement of soiled notes and reserve requirements.

b) The Government of India decides upon the quantity of coins to be minted. The designing and minting of coins in various denominations is also attended to by the Government of India

c) Only external control on the value of Indian money in the international circulation is the “Exchange rate”, with reference to various other national currencies. Indian money is tied to Euro. The exchange rate parity of rupee fluctuates based on the Indian balance of payment to the world, exports/imports and the parity of Euro in the international market.

Gold Standard:

The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold and all currency issuance is to one degree or another regulated by the gold supply. To protect the public and guarantee the nation against any bankruptcy, the RBI keeps a certain percentage of gold in their own safe deposit vault, in proportion to the additional currency minted and directed into the circulation. The quantum percentage of gold kept in the deposit is not exposed in any documents or in the Websites of RBI or the Government of India. 

Today gold standard is considered undesirable because it is associated with the collapse of the world economy in the late 1920's. 

References: RBI, Wikipedia and yahoo answers websites. Images from Businesscafeonline.


  1. superb analysis... i wonder when did u start looking at finance related things.You written the article like a professional analyst...keep it up buddy... :-)

  2. Hahaha, thanks ra. My love with financial issue started very recently after I got my smart phone. But, I had this question since BTech.

  3. professional article boss! great work.

  4. Thanks bhayya, just following your footsteps.

  5. arun gud work brother..... but what u said about 1920 economy collapse is related to gold backed system do u know wht you are saying please explain it??