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Part 20. How notes and coins circulate

Although any bank could theoretically issue notes and coins, generally it is the central bank that is responsible for this. In the UK this is normally the responsibility of the Bank of England, although there are also Bank of Scotland notes circulating. Notes and coins are liabilities of the bank that issues them, and assets to those that hold them. They usually have little or no intrinsic value compared to their face value - the amount the note or coin represents. Coins made from precious metals, such as silver and gold, clearly do have intrinsic value, but these are usually not in general circulation. They also tend to have greater intrinsic value than their face value (UK silver 50 pence coins are an example), in which case they aren't really a liability, although the issuer would probably happily oblige. Some old UK copper coins also have greater intrinsic value than face value.

To see how notes and coins circulate, we will carry out various cash and digital transactions. Let's continue with the banks from Part 19 and assume that 1st Bank needs £5,000 of notes and coins for cash withdrawals from deposit account holders. 1st Bank will swap digital reserves for the notes and coins. This can effectively be thought of as a withdrawal of notes and coins from Central Bank by 1st Bank. A record of withdrawals and deposits will be recorded in two new accounts both called Notes and Coins, one at 1st Bank and one at Central Bank. The first double entry of the withdrawal of notes and coins transaction is shown in Figure 20.1.

Notes and Coins Central Bank Description Debits Credits Balance Starting balance £0 Notes and coins issued £5,000 £5,000 (CR) Notes and Coins 1st Bank Description Debits Credits Balance Starting balance £0 Withdrawal of notes and coins £5,000 £5,000 (DR)

Figure 20.1 Withdrawal of notes and coins by 1st Bank from the central bank.

The notes and coins will be physically delivered to 1st Bank and held in a cashier's draw or a bank vault. The second part of the transaction, the double entry to reduce digital reserves, is shown in Figure 20.2.

Digital Reserves 1st Bank Description Debits Credits Balance Previous balance £45,000 (DR) Transfer reserves £5,000 £40,000 (DR) 1st Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £45,000 (CR) Transfer reserves £5,000 £40,000 (CR)

Figure 20.2 Double entry to reduce 1st Bank's digital reserves.

After the delivery and the account entries, the balance sheets of all banks is shown in Figure 20.3. 2nd Bank remains unchanged, but is shown for convenience since we will be using it later.

Central Bank's Assets Mortgage-backed Securities £50,000 Government Bonds £20,000 Total assets £70,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £25,000 1st Bank's Digital Reserves £40,000 Notes and Coins £5,000 Total liabilities £70,000 1st Bank's Assets Mortgage Loan Account #1 £90,000 Mortgage-backed Securities £40,000 Digital Reserves £40,000 Notes and Coins £5,000 Total assets £175,000 1st Bank's Liabilities Deposit Account #2 £40,000 Mortgage Loan Account #1 Security £90,000 Deposit Account #3 £10,000 Government's Deposit Account £35,000 Total liabilities £175,000 2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £25,000 Total assets £75,000 2nd Bank's Liabilities House Seller's Deposit Account £70,000 Deposit Account #4 £5,000 Total liabilities £75,000

Figure 20.3 Balance sheets after the issuance of notes and coins.

The amounts of deposits, reserves and debt in circulation is unchanged by this transaction. The only difference is that bank reserves now consist of £65,000 of digital reserves and £5,000 of physical cash reserves — the latter in the form of notes and coins.

Now suppose that a cash withdrawal of £1000 is made by the account holder of Deposit Account #2. This is recorded as a double entry between Deposit Account #2 and Notes and Coins as shown in Figure 20.4. But this also involves handing over the physical cash to the account holder. It's an exchange of digital money for physical money.

Deposit Account #2 1st Bank Description Debits Credits Balance Previous balance £40,000 (CR) Withdrawal of notes and coins £1,000 £39,000 (CR) Notes and Coins 1st Bank Description Debits Credits Balance Starting balance £0 Withdrawal of notes and coins £5,000 £5,000 (DR) Notes and coins issued £1,000 £4,000 (DR)

Figure 20.4 Cash withdrawal from Deposit Account #2.

The debit and credit double entry reduces both the deposit account balance and the notes and coins balance. This should be expected since assets are used to pay for liabilities, and by handing over the physical cash, the bank has reduced its cash holding assets as well as its deposit liabilities. The balance sheet of 1st Bank is shown in Figure 20.5 (Central Bank and 2nd Bank remain unchanged).

1st Bank's Assets Mortgage Loan Account #1 £90,000 Mortgage-backed Securities £40,000 Digital Reserves £40,000 Notes and Coins £4,000 Total assets £174,000 1st Bank's Liabilities Deposit Account #2 £39,000 Mortgage Loan Account #1 Security £90,000 Deposit Account #3 £10,000 Government's Deposit Account £35,000 Total liabilities £174,000

Figure 20.5 Balance sheet of 1st Bank after the cash withdrawel of £1000.

Now we have £84,000 of deposits at 1st Bank and £1,000 of notes and coins held by the account holder of Deposit Account #2, probably in a wallet or a safe place. Central Bank still has a liability of £5,000 for the notes and coins issued, since this hasn't changed.

To see how cash circulates, suppose that the account holder of Deposit Account #2 purchases a second-hand bicycle from the account holder of Deposit Account #4 for £500 in cash, and suppose that the account holder of Deposit Account #4 deposits the £500 in their account. For this transaction we will also need a Notes and Coins account at 2nd Bank. The deposit transaction is shown in Figure 20.6.

Notes and Coins 2nd Bank Description Debits Credits Balance Starting balance £0 Deposit of notes and coins £500 £500 (DR) Deposit Account #4 2nd Bank Description Debits Credits Balance Previous balance £5,000 (CR) Deposit of notes and coins £500 £5,500 (CR)

Figure 20.6 Cash deposit of £500 into Deposit Account #4.

In the case of the cash deposit, the debit and credit double entry increases both the deposit account balance and the notes and coins balance. The balance sheet of 2nd Bank is shown in Figure 20.7 (Central Bank and 1st Bank remain unchanged).

2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £25,000 Notes and Coins £500 Total assets £75,500 2nd Bank's Liabilities House Seller's Deposit Account £70,000 Deposit Account #4 £5,500 Total liabilities £75,500

Figure 20.7 Balance sheet of 2nd Bank after the cash deposit of £500.

So, when a deposit of cash is made to a bank, it increases the bank's assets as well as its liabilities in just the same way an electronic deposit transfer does. No second double entry needs to take place since it is not an inter-bank transfer, and £500 of assets, in the form of notes and coins, is handed over by the depositor. 2nd Bank now has £500 of physical cash at the bank which it also has recorded as an asset in its notes and coins account.

Suppose 2nd Bank does not wish to hold all £500 in notes or coins but wishes to hold £250. Then it can return £250 back to the central bank in exchange for digital reserves as shown in Figure 20.8.

Notes and Coins 2nd Bank Description Debits Credits Balance Starting balance £0 Deposit of notes and coins £500 £500 (DR) Returned to Central Bank £250 £250 (DR) Notes and Coins Central Bank Description Debits Credits Balance Starting balance £0 Notes and coins issued £5,000 £5,000 (CR) Received from 2nd Bank £250 £4,750 (CR)

Figure 20.8 Returning £250 of notes and coins back to the central bank.

And the reserves double entry is shown in Figure 20.9.

2nd Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £25,000 (CR) Transfer reserves £250 £25,250 (CR) Digital Reserves 2nd Bank Description Debits Credits Balance Previous balance £25,000 (DR) Transfer reserves £250 £25,250 (DR)

Figure 20.9 Reserves double entry for the exchange of notes and coins.

The balance sheets of all banks is shown in Figure 20.10.

Central Bank's Assets Mortgage-backed Securities £50,000 Government Bonds £20,000 Total assets £70,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £25,250 1st Bank's Digital Reserves £40,000 Notes and Coins £4,750 Total liabilities £70,000 1st Bank's Assets Mortgage Loan Account #1 £90,000 Mortgage-backed Securities £40,000 Digital Reserves £40,000 Notes and Coins £4,000 Total assets £174,000 1st Bank's Liabilities Deposit Account #2 £39,000 Mortgage Loan Account #1 Security £90,000 Deposit Account #3 £10,000 Government's Deposit Account £35,000 Total liabilities £174,000 2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £25,250 Notes and Coins £250 Total assets £75,500 2nd Bank's Liabilities House Seller's Deposit Account £70,000 Deposit Account #4 £5,500 Total liabilities £75,500

Figure 20.10 Balance sheets of all banks.

Returning £250 back to Central Bank has reduced the central bank's liability by £250, meaning there must now be £4750 of notes and coins still in circulation. This is the case since there remains £4000 at 1st Bank, £250 at 2nd Bank and £500 in the physical wallet, or elsewhere, of the account holder of Deposit Account #2.

back to Part 19