1. Money and the role of central banks

For centuries, rulers and later governments had coins minted from precious metals (for example, gold), which determined the coins’ value. In the last century, during the gold standard era, central banks were still obliged to exchange money for gold at a fixed rate upon request. The gold was typically stored securely in bank vaults. Ownership of it transferred as money or “gold certificates” changed hands. This is no longer the case. Notes and coins as we know them today are referred to as fiat money. The Latin word “fiat” means “let there be” (as in the biblical phrase “fiat lux”, meaning “let there be light”) and is used in English in the figurative sense to signify a decree by an authority. The term “fiat money” thus refers to money created at the decision of a central authority (“let there be money”) and whose general acceptance is enforced by that authority. Nowadays, cash is mostly backed by securities and other assets owned by central banks.

In the vast majority of countries, a single central authority issues money. There are exceptions, though. In Scotland and Northern Ireland, for example, a number of private banks have the right to issue banknotes. However, these notes must be backed by funds deposited with the Bank of England or by Bank of England banknotes. To facilitate this, the Bank of England issues special very high denomination banknotes (for instance, £1 million notes known as “Giants” and £100 million notes known as “Titans”). However, these notes are not encountered outside the banking system.

There have been instances in the past of “free banking” and the circulation of private banknotes, such as in the United States around the mid-19th century. At that time, various banknotes issued by hundreds of different private banks were circulating in the US economy. While all the banks naturally claimed their banknotes were “as good as gold”, those issued by banks perceived as riskier were traded below their face value or even became worthless pieces of paper. This era is often referred to as “wildcat banking”, with the term “wildcat” used figuratively to signify financial unreliability. The phrase is believed to have originated from the practice of some Michigan banks in the 1830s of establishing branches in remote, inaccessible locations where wild cats roamed. This strategy allowed the banks to make a profit by making it more difficult for holders of their banknotes to exchange them for gold. This in turn enabled the banks to maintain lower gold reserves. However, some modern historians argue that this system was less problematic than previously thought.

Even today, there is a small group of economists who advocate for free banking and private money. They argue, for example, that in the past, countries and central banks have repeatedly abused their privilege of issuing money. However, the views of most economists, as well as global practice, suggest that such an arrangement would not be optimal. Today, advanced economies have in place a system of rules designed to minimise the risk of misuse of the power to issue money. Above all, the central bank is independent of the government and has a mandate to maintain price stability. This is explicitly enshrined in the Constitution of the Czech Republic.

Modern attempts to develop alternatives to central bank money have led to the emergence of digital crypto-assets such as Bitcoin and Ethereum. From the CNB’s perspective, however, these are investment instruments, not money. They do not fulfil the classical functions of money (a unit of account, a medium of exchange and a store of value). Instead, they are used as a risky investment converted into units of conventional currency. Owing to sharp swings in their prices, they do not even function as a store of value. Another weakness is that their price is not based on economic fundamentals, unlike in the case of conventional money.

The main function of money is to facilitate the exchange of goods and services. Another, related function of money is its role as a unit of account for valuing not only goods and services, but also labour, capital, liabilities, taxes and so on. Last but not least, money serves as a store of value.

Since time immemorial, society has been based on the exchange of goods and services. None of us can be fully self-sufficient, using only our own resources and labour to produce everything we consume – from a bread roll to a car. This is why specialisation and the exchange of goods and services have been going on since the dawn of human history. Initially, this exchange was purely physical, such as a blacksmith trading one axe for ten chickens. This form of exchange is known as barter. However, it soon became clear that barter was not particularly efficient and that using a generally accepted means of payment was much easier. This means of payment should ideally be divisible, as storable as possible, rare, and stable in value. Modern money meets all these criteria.

As economies and money systems evolved, more sophisticated transactions, such as loans and taxes, began to emerge, accompanied by the introduction of accounting practices. Nowadays, money is used not only for exchange, but also, for instance, for valuing assets and liabilities, measuring profits and losses and determining tax obligations.

Throughout history, money has been used as a store of value. Since it is typically easy to store and its value tends to remain stable over time, it can be used to store relatively large amounts of wealth “for a rainy day”. Even today, some households keep significant amounts of cash at home, either in hiding places or safes. However, most of us now use other methods of storing money, methods which are safer and offer some return. Nowadays, most money exists in non-cash form and is either held in savings and term accounts or invested in assets such as bonds, shares and other securities, and financial market instruments.

Money exists in several forms in the economy. The first, traditional form of money is currency (cash), i.e. banknotes and coins issued by the central bank. The modern form is non-cash money, i.e. money existing as electronic records in bank accounts. Then there is money in the broader sense of monetary aggregates, which also include, for example, bonds with maturities of up to two years.

Money is currently created in non-cash form when a commercial bank credits an amount to a customer’s account without receiving cash from the customer in return or without the same or another bank simultaneously debiting an equivalent amount from another account. This happens most often when a bank provides a loan. However, the same thing can occur, for example, when a commercial bank purchases securities or foreign currency from a customer. The subsequent conversion of part of this money into cash only affects the structure of money in circulation, not the total quantity; the amount of money in bank accounts decreases, while the amount of cash increases. The CNB ensures the smooth circulation of banknotes and coins. Nowadays, however, cash only accounts for a small part of the money supply. The majority is held as deposits in bank accounts (non-cash money).

The quantity of money in the economy is measured using monetary aggregates. In the Czech Republic, we distinguish between three monetary aggregates, referred to as M1, M2 and M3.

• M1 (narrow money) comprises currency in circulation (banknotes and coins) and balances that can be immediately converted into currency or used for non-cash payments, such as overnight deposits.
• M2 (intermediate money) includes narrow money (M1) plus deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months.
• M3 (broad money) includes M2 plus marketable instruments issued by the monetary financial institutions sector.

Central banks as we know them today came into being relatively recently, mostly during the 20th century. At the start of that century, central banks existed in only a third of countries. The oldest central bank is thought to be the Swedish central bank, Sveriges Riksbank, founded in 1668. The main reason for the emergence of central banks in the 20th century was the development of the international financial market and countries’ efforts to attract foreign capital. Foreign investors tended to favour countries with a central bank, especially those operating under the gold standard.

With some brief interruptions, the gold standard formed the basis of the international monetary system from the end of the 19th century until the early 1970s. This system was based on gold-backed currencies, with all dollars, francs, pounds and other gold currencies initially covered by an equivalent amount of gold held in the central bank’s vault. The gold coverage ratio then determined the exchange rates between the gold standard currencies.

The gold standard was abandoned after the Great Depression of the 1930s but was reintroduced after World War II in the form of the Bretton Woods system. This system was based on a gold-backed US dollar, with all other currencies pegged to it. Over time, however, it became evident that fixed exchange rates were not sustainable in the long term, and in 1971, the Bretton Woods system collapsed. This marked the beginning of the era of floating exchange rates, which continues to this day.

The main role of central banks in advanced economies today is typically to maintain price stability, not a fixed exchange rate. Price stability is interpreted as low and stable inflation, usually at 2%. Many central banks also perform other tasks, such as ensuring financial stability, supervising the financial market, issuing currency and administering interbank payments.

In the contemporary banking system, central banks are also the “bank of banks”. This means that if commercial banks run into liquidity problems, the central bank will provide them with loans. This mechanism helps to prevent bank runs and stop problems spreading from one financial institution across the entire financial system. Such situations are very rare, as modern central banks use their regulatory and supervisory tools to actively prevent crises at the level of both individual financial institutions and the financial market as a whole.

More information on the history and establishment of the Czech National Bank is available at Historie ČNB (in Czech only).

In the modern monetary system, money is created in the economy not by printing banknotes and minting coins, but by crediting funds to a bank customer’s account. This happens, for example, when a bank grants a customer a loan. The bank does not need to have new deposits to match the new loan. In reality, when a bank provides a loan, it creates entirely new money – money that was not previously circulating in the economy – with the stroke of a pen or the tap of a keyboard. This sets banks apart from non-bank lenders and explains why they have traditionally been subject to much stricter regulations.

In today’s monetary system, money creation is based on the decisions of specific economic agents (households, businesses, governments) on whether it is necessary and profitable to buy property, to invest in production, or, in the case of the government, to borrow to fund projects such as motorway construction. The expected future income of the household or profitability of the business plays an important role in these decisions. Another key factor in the decision is the price the applicant has to pay for the loan – the interest rate. Demand for loans is higher when interest rates are low and lower when rates are high. Thus, the central bank can indirectly influence the amount of new money created by commercial banks in the economy through the level of interest rates.

Let us assume that an economic agent (say, a household) decides to apply for a housing loan. Understandably, commercial banks do not approve every loan application but carefully assess whether to grant the loan for the declared purpose. Key factors in this evaluation include the applicant’s credit history and risk profile, their income and debt servicing ability and the collateral they can provide. If the applicant successfully passes the loan approval process and meets the additional regulatory requirements set by the CNB, the commercial bank will credit the applicant’s account. This creates new money, which the buyer can use to pay for the property.

Let’s say that the previous owner of the property has an account with a different bank than the buyer. A specialised department of the lending bank, responsible for asset and liability management, must ensure that the transfer can be executed, i.e. that the bank has sufficient liquidity in the form of deposits at the central bank to carry out the transfer. If there is sufficient liquidity, the transaction is executed and the central bank transfers the funds from the buyer’s bank account to the seller’s bank account. If the lending bank does not have enough liquidity, it has to borrow on the domestic interbank market. Therefore, in reality, the bank receiving the customer’s money lends its liquidity surplus to the bank experiencing an outflow of funds. To ensure smooth settlement, the central bank operates a clearing system.

By setting its monetary policy rates, the central bank influences the interest rate at which commercial banks lend liquidity to each other. Client loan and deposit rates are then derived from the interbank interest rate. The central bank thus implements monetary policy by setting interest rates. If the central bank wishes to boost aggregate demand, it lowers interest rates. This in turn supports loan creation and the generation of new money. Lower savings returns also motivate households to increase their consumption expenditure.

The central bank does not directly control the quantity of money in circulation. This quantity adjusts flexibly to the needs of the economy. However, by setting interest rates, the central bank indirectly influences the quantity of money and its rate of circulation in the economy so as to achieve its 2% inflation target in the long term. At the same time, through its regulatory measures and supervision, the CNB ensures that banks behave prudently when granting loans and maintain sufficient capital to cover potential future losses. By applying its macroprudential tools, the CNB aims to ensure that the system described above does not pose risks to overall financial stability.

Over time, property buyers repay their loans to the bank. This has the opposite effect, i.e. it reduces the quantity of money in the economy.

The central bank does not directly determine the amount of banknotes and coins in circulation either, even though it has an exclusive legal monopoly on issuing them. This part of the money supply also moves in line with the needs of the economy. A property seller who has received funds in their account may wish to withdraw this money in cash. The bank must then meet the cash withdrawal needs of its customer or, collectively, of all its customers who wish to withdraw their deposits during that period. If the bank does not have enough cash at its branches, it must send an armoured vehicle to the central bank with a request for cash. If the commercial bank has sufficient liquidity with the central bank, the latter will “release” the requested cash into circulation in the denomination structure specified by the commercial bank or its customer.

Although some digital crypto-assets, such as Bitcoin and Ethereum, can be used to make payments, they do not qualify as money. This is because they do not meet the basic requirement for any money: stable value. The value of crypto-assets is highly volatile, with periods of growth followed by sharp declines. For example, while in May 2010 a pizza would have cost 5,000 bitcoins, today it would cost about 0.00005 bitcoins, i.e. one hundred million times less. “Stablecoins” are closer to money. These crypto-assets feature a stabilisation mechanism designed to maintain a stable value by pegging to one or more legal-tender currencies. The stabilisation mechanism most often aims to keep the stablecoins’ value unchanged against the US dollar (e.g. Tether, USD Coin and Binance USD). This is typically ensured by fully backing stablecoins with assets in the corresponding currency. However, even these currencies are not immune to a sharp collapse, as demonstrated by the case of TerraUSD in 2022.

The credibility of digital currencies can be enhanced by regulation by central banks or directly by the issuance of digital currencies by central banks. An increasing number of central banks worldwide are considering issuing central bank digital currencies (CBDCs), and some have already started. CBDCs would be an official digital form of the national currency, issued and managed by the central bank. They would be legal tender and would be convertible at par with other forms of money (cash and bank deposits).

The following potential benefits are typically cited as reasons for the introduction of CBDCs: maintaining monetary sovereignty amid competition from new forms of private digital money; improving and streamlining payments, particularly cross-border ones; creating a platform that supports innovation, including digitalisation and industry; increasing the resilience and accessibility of electronic payments (financial inclusion); reducing the costs associated with cash circulation and preventing counterfeiting; and enhancing the transmission of monetary policy.

However, alongside their potential benefits, CBDCs give rise to many risks. The introduction of CBDCs could imply a substantial change in the functioning of the central bank and commercial banks in the country concerned. CBDCs could potentially have significant impacts on the conduct of monetary policy and pose far-reaching risks to financial stability. They could lead to a significant amount of deposits being withdrawn from the banking sector, as savers would prefer to deposit their money with the central bank. This could jeopardise the core function of banks – lending and thus money creation – or at the very least make loans more expensive. In times of crisis, the existence of central bank digital money could facilitate bank runs, with depositors quickly withdrawing their funds from a struggling bank by converting deposits into CBDCs. CBDCs would also need to be adequately secured against cyber crime. User privacy and how to safeguard it also remain open questions.

There is currently no consensus on whether the potential benefits of CBDCs outweigh their costs. Central banks are therefore proceeding cautiously and are conducting pilot projects to test their usefulness.

The Czech National Bank has been monitoring the issue of central bank digital money since 2016. In November 2022, it published its first comprehensive report on digital central bank money (in Czech only). The aim of the publication is to improve general awareness of the CBDC concept and contribute to the public discussion on this topic.