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Chapter 12 257
Money and the Banking System

Changes in the Balance Sheet of Bank-a-mythica

(a) (b)
Assets Liabilities Assets Liabilities
Reserves deposits Reserves No Change
2$100,000 2$100,000 1$80,000
outstanding 2$80,000
Addendum: Changes Addendum: Changes
in Reserves in Reserves
Actual Actual
reserves reserves
2$100,000 1$80,000
Required Required
reserves reserves No Change
Excess Excess
reserves reserves
2$80,000 1$80,000

How would the bank react to this discrepancy? As some of its outstanding loans are rou-
tinely paid off, it will cease granting new ones until it has accumulated the necessary $80,000
in required reserves. The data for Bank-a-mythica™s contraction are shown in Table 7(b),
assuming that borrowers pay off their loans in cash.5
But where did the borrowers get this money? Probably by making withdrawals from
other banks. In this case, assume that the funds came from First National Bank, which
loses $80,000 in deposits and $80,000 in reserves. It finds itself short some $64,000 in
reserves, as shown in Table 8(a), and therefore must reduce its loan commitments by
$64,000, as in Table 8(b). This reaction, of course, causes some other bank to suffer a loss
of reserves and deposits of $64,000, and the whole process repeats just as it did in the case
of deposit expansion.

Changes in the Balance Sheet of First National Bank

(a) (b)
Assets Liabilities Assets Liabilities
Reserves deposits Reserves No Change
2$80,000 2$80,000 1$64,000
outstanding 2$64,000
Addendum: Changes Addendum: Changes
in Reserves in Reserves
Actual Actual
reserves reserves
2$80,000 1$64,000
Required Required
reserves reserves No Change
Excess Excess
reserves reserves
2$64,000 1$64,000

After the entire banking system had become involved, the picture would be just as
shown in Figure 3, except that all the numbers would have minus signs in front of them.
Deposits would shrink by $500,000, loans would fall by $400,000, bank reserves would be
reduced by $100,000, and the M1 money supply would fall by $400,000. As suggested by

In reality, the borrowers would probably pay with checks drawn on other banks. Bank-a-mythica would then

cash these checks to acquire the reserves.

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Part 3
258 Fiscal and Monetary Policy

our money multiplier formula with m 5 0.20, the decline in the bank deposit component
of the money supply is 1/0.20 5 5 times as large as the decline in reserves.
One of the authors of this book was a student in Cambridge, Massachusetts, during
the height of the radical student movement of the late 1960s. One day a pamphlet
appeared urging citizens to withdraw all funds from their checking accounts on a pre-
scribed date, hold them in cash for a week, and then redeposit them. This act, the circu-
lar argued, would wreak havoc upon the capitalist system. Obviously, some of these
radicals were well schooled in modern money mechanics, for the argument was basi-
cally correct. The tremendous multiple contraction of the banking system and subse-
quent multiple expansion that a successful campaign of this sort could have caused
might have seriously disrupted the local financial system. But history records that the
appeal met with little success. Apparently, checking account withdrawals are not the
stuff of which revolutions are made.

So far, our discussion of the process of money creation has seemed rather mechanical.
If everything proceeds according to formula, each $1 in new reserves injected into the bank-
ing system leads to a $1/m increase in new deposits. But, in reality, things are not this sim-
ple. Just as in the case of the expenditure multiplier, the oversimplified money multiplier is
accurate only under very particular circumstances. These circumstances require that
1. Every recipient of cash must redeposit the cash into another bank rather than hold it.
2. Every bank must hold reserves no larger than the legal minimum.
The “chain” diagram in Figure 3 on page 255 can teach us what happens if either of these
assumptions is violated.
Suppose first that the business firms and individuals who receive bank loans decide to
redeposit only a fraction of the proceeds into their bank accounts, holding the rest in cash.
Then, for example, the first $80,000 loan would lead to a deposit of less than $80,000”
and similarly down the chain. The whole chain of deposit creation would therefore be
reduced. Thus:
If individuals and business firms decide to hold more cash, the multiple expansion of
bank deposits will be curtailed because fewer dollars of cash will be available for use
as reserves to support checking deposits. Consequently, the money supply will be
The basic idea here is simple. Each $1 of cash held inside a bank can support several dol-
lars (specifically, $1/m) of money. But each $1 of cash held outside the banking system is
exactly $1 of money; it supports no deposits. Hence, any time cash moves from inside the
banking system into the hands of a household or a business, the money supply will
decline. And any time cash enters the banking system, the money supply will rise.
Next, suppose bank managers become more conservative or that the outlook for loan
repayments worsens because of a recession. In such an environment, banks might decide
to keep more reserves than the legal requirement and lend out less than the amounts
assumed in Figure 3. If this happens, banks further down the chain receive smaller
deposits and, once again, the chain of deposit creation is curtailed. Thus:
If banks wish to keep excess reserves, the multiple expansion of bank deposits will be
limited. A given amount of cash will support a smaller supply of money than would be
the case if banks held no excess reserves.
The latter problem afflicted Japan for many years in the 1990s and continuing into this
decade. Because they had so many bad loans on their books, Japanese bankers became
supercautious about lending money to any but their most creditworthy borrowers. So
even though bank reserves soared, the money supply did not. Something similar hap-
pened in the U.S. in 2007 and 2008, when banks got jittery.

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Chapter 12 259
Money and the Banking System

If we pursue these two points a bit farther, we will see why the government must regulate
the money supply in an effort to maintain economic stability. We have just suggested that
banks prefer to keep excess reserves when they do not foresee profitable and secure oppor-
tunities to make loans. This scenario is most likely to arise when business conditions are
depressed. At such times, the propensity of banks to hold excess reserves can turn the
deposit-creation process into one of deposit destruction, as happened recently in the U.S.
and elsewhere. In addition, if depositors become nervous, they may decide to hold on to
more cash. Thus:
During a recession, profit-oriented banks would be prone to reduce the money sup-
ply by increasing their excess reserves and declining to lend to less creditworthy
applicants”if the government did not intervene. As we will learn in subsequent chap-
ters, the money supply is an important influence on aggregate demand, so such a
contraction of the money supply would aggravate the recession.
This is precisely what happened”with a vengeance”during the Great Depression of
the 1930s. Although total bank reserves grew, the money supply contracted violently
because banks preferred to hold excess reserves rather than make loans that might not be
repaid. And something similar has been happening in Japan for years: The supply of
reserves has expanded much more rapidly than the money supply because nervous
bankers have been holding on to their excess reserves.
By contrast, banks want to squeeze the maximum money supply possible out of any
given amount of cash reserves by keeping their reserves at the bare minimum when the
demand for bank loans is buoyant, profits are high, and secure investment opportunities
abound. This reduced incentive to hold excess reserves in prosperous times means that
During an economic boom, profit-oriented banks will likely make the money supply
expand, adding undesirable momentum to the booming economy and paving the way
for inflation. The authorities must intervene to prevent this rapid money growth.
Regulation of the money supply, then, is necessary because profit-oriented bankers
might otherwise provide the economy with a money supply that dances to and amplifies
the tune of the business cycle. Precisely how the authorities control the money supply is
the subject of the next chapter.

1. It is more efficient to exchange goods and services by outside of banks by investment houses, credit unions,
using money as a medium of exchange than by bartering and other financial institutions.
them directly. 5. Under our modern system of fractional reserve banking,
2. In addition to being the medium of exchange, whatever banks keep cash reserves equal to only a fraction of their
serves as money is likely to become the standard unit of total deposit liabilities. This practice is the key to their
account and a popular store of value. profitability, because the remaining funds can be loaned
out at interest. But it also leaves banks potentially vul-
3. Throughout history, all sorts of items have served as
nerable to runs.
money. Commodity money gave way to full-bodied
paper money (certificates backed 100 percent by some 6. Because of this vulnerability, bank managers are gener-
commodity, such as gold), which in turn gave way to ally conservative in their investment strategies. They
partially backed paper money. Nowadays, our paper also keep a prudent level of reserves. Even so, the gov-
money has no commodity backing whatsoever; it is pure ernment keeps a watchful eye over banking practices.
fiat money. 7. Before 1933, bank failures were common in the United
4. One popular definition of the U.S. money supply is M1, States. They declined sharply when deposit insurance
which includes coins, paper money, and several types of was instituted.
checking deposits. Most economists prefer the M2 defi- 8. Because it holds only fractional reserves, the banking
nition, which adds to M1 other types of checkable system as a whole can create several dollars of de-
accounts and most savings deposits. Much of M2 is held posits for each dollar of reserves it receives. Under

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Part 3
260 Fiscal and Monetary Policy

certain assumptions, the ratio of new bank deposits to 10. Because banks and individuals may want to hold more
new reserves will be $1/m, where m is the required cash when the economy is shaky, the money supply
reserve ratio. would probably contract under such circumstances if
the government did not intervene. Similarly, the money
9. The same process works in reverse, as a system of
supply would probably expand rapidly in boom times if
money destruction, when cash is withdrawn from the
it were unregulated.
banking system.

Run on a bank 242 M2 247 Asset 251
Barter 243 Near moneys 247 Liability 251
Money 244 Liquidity 247 Balance sheet 252
Medium of exchange 244 Fractional reserve banking 248 Net worth 252
Unit of account 244 Deposit insurance 250 Deposit creation 252
Store of value 244 Moral hazard 250 Excess reserves 252
Money multiplier 256
Commodity money 245 Federal Deposit Insurance
Corporation (FDIC) 250
Fiat money 246
Required reserves 251
M1 247

1. Suppose banks keep no excess reserves and no individ- b. Sam finds a $100 bill on the sidewalk and deposits it
uals or firms hold on to cash. If someone suddenly dis- into his checking account.
covers $12 million in buried treasure and deposits it in a c. Mary Q. Contrary withdraws $500 in cash from her
bank, explain what will happen to the money supply if account at Hometown Bank, carries it to the city, and
the required reserve ratio is 10 percent. deposits it into her account at Big City Bank.
2. How would your answer to Test Yourself Question 1 dif- 4. For each of the transactions listed in Test Yourself Ques-
fer if the reserve ratio were 25 percent? If the reserve tion 3, what will be the ultimate effect on the money
ratio were 100 percent? supply if the required reserve ratio is one-eighth (12.5
3. Use tables such as Tables 2 and 3 to illustrate what hap- percent)? Assume that the oversimplified money multi-
pens to bank balance sheets when each of the following plier formula applies.
transactions occurs:
a. You withdraw $100 from your checking account to
buy concert tickets.

1. If ours were a barter economy, how would you pay your 5. Each year during Christmas shopping season, consum-
tuition bill? What if your college did not want the goods ers and stores increase their holdings of cash. Explain
or services you offered in payment? how this development could lead to a multiple contrac-
tion of the money supply. (As a matter of fact, the
2. How is “money” defined, both conceptually and in
authorities prevent this contraction from occurring by


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