How Printed Currency enters Market and How Banks Work

The money you deposit in your bank’s savings account is actually the loan which you give to the bank, and the interest that the bank credits in your SB account is the interest the bank pays you for this loan you gave to the bank.

The bank lends back this money in the form of loans like personal loan, housing loan, etc to other customers in need at a higher interest than what they give you in your savings account. This is how banks make profit.

This is not the complete picture, but this is how it fundamentally works.

Now what if all the loans which the bank gives out is not paid back by those who took the loan? Then all your money in savings is gone as well, isn’t it? This is what happened in US subprime crisis causing banks to go bankrupt because of bad loans. Greedy banks lent out all the money which people had deposited as savings in the form of bad loans. The loans were not paid back, banks went bankrupt, people’s money was gone!

But in India we have a strict cash-reserve ratio (CRR) which the banks have to maintain with RBI, which means banks cannot give away all the savings money they have as loans and should always maintain good amount of cash balance with them. So there are little chances of Indian banks going bankrupt.

Additionally, banks also can borrow money from the Reserve Bank of India (RBI) at an interest rate, and can also deposit their money with the RBI at an interest rate. These interest rates are what we normally hear as repo and reverse-repo rates.

In other words, just like we are the customers of our banks, our banks are customers of the Reserve Bank of India. All the currency notes printed enter the market through the Reserve Bank of India into our banks and from there reach the market through us.

Reserve Bank gives loans to banks at an Interest rate. This is how money printed by the government enters the market via Reserve Bank of India in the form of loans given to banks. These banks then give loans to its customers at a higher interest and thus make profit.

RBI also takes money from banks and gives an interest on these deposits to banks. This is how RBI controls the money flow  in the market by giving loans to banks and taking deposits from banks. The interest at which RBI gives loans to banks is called the Repo rate and the interest which RBI pays to banks for their deposits with RBI is reverse repo rate.

If the Reserve Bank gives more interest to the money which the banks deposit with it, then the banks will prefer to keep their cash with the RBI instead of lending it to their customers as loans. This will tighten the outflow of money from the banks into the market, which has a negative impact on inflation or price rise. The less the money in the market, the less the money people have to spend, and the less chances of price rise because of decreased demand.

Similarly if the RBI gives very less interest to the money which the banks deposit with it, then the banks prefer to lend out their money as loans to their customers at a higher interest. This will cause more flow of money into the market. The more the money flow in the market, the more money people have to buy things, the more the purchasing power the more the demand for goods and services, and there will be rise in prices because of increased demand.

Here ends your simple crash course on how the banking system works.

  • SR

    Guru, you are defining how RBI controls money in the market. However the title of this thread is how printed money enters market.

    Printed money is cash which is only a small percentage of the total money in the system. So I would be interested to know how RBI defines how much cash to be printed ( Ie controlling cash in the market) and how they launch it into the market. Can banks request how much of their loans can be given away in print form.

  • guest

    Hello, I am still not clear. what makes RBI to print currency? and when?

  • Karthikeyan vg

    clean and simple basic money flow. Thanks

  • sheshank

    I think this is where Money blockage also comes into picture. If more people take loans in less totals, then we have healthy economy where marketing and manufacturing can be done exactly planning for the money in the market and demand. From Manufacturing follows the demand-supply theorem for many other Raw materials and Industries. Money is distributed implies healthy economy.

    If heavy loans are taken by single personal, and that usually has associated low interest rates, yields less income followed by, inability to pay loans, bankruptcy, scarcity of goods, and finally inflation. Am I right GuruDev ?

    • itzguru

      Very much, smaller loans by many people signify income equality rather than one or two mega loans. Capitalism should move towards small scale industries and independent small businesses than mega industries with salaried employees. Big MNCs suck up everything from human labor to environment to smaller players to influencing political decisions to implementing their greed.

  • Sumaithri Mukkamalla

    people saved money in banks – banks indiscriminately have given away all money to ‘other’ people — at least these other people had money right?
    If this is the case, wouldn’t only the people who deposited should be at loss? How did this result in collapse of complete system? I know I am missing on something here!

    • itzguru

      No, those other people weren’t able to pay back the money because they lost it, the loans were bad loans. Bad loans are loans given for greedy high interests without any surety or assessment of buyer’s ability pay back the loans. Imagine a bank giving loans only to drunkards who spend all the money they get on liquor. The money would end up with bar owners, but will they pay back to the bank? Obviously no.

      • SR

        In your example you compare the bar owners with real estate guys in the sub-prime ?

        If yes the realtors got rich ? Or at least the seller of the houses got all the money ? So that means there were some gainers in the crisis.

        Or was government selling these houses ?

  • Shaswat

    what is the major differences between the nationalised and the other banks?

    • itzguru

      Nationalized banks are public sector banks meaning they are owned by the government of India, while the private sector banks are owned by private players.

  • ajay

    very informative but how does the currency printed by the govt. reach people

    • itzguru

      The printed currency first enters RBI, then from there it enters the Banks and from there it reaches the markets.