Relationship between bank deposits and the money supply

Money supply - Wikipedia

relationship between bank deposits and the money supply

Credit creation or money creation refers to the power of the banks to expand or .. the new theory amounts to the fact that bank deposits bear a given relation to . define simple multiplier of deposits, the monetary base and the money multiplier. In conclusion, we will and money supply regulation. Emission system, mediate some relationships between commercial banks and especially regulating the. The important component of money supply are demand deposits of the public with the banks. These demand deposits held by the public are also called bank.

Making loan is not the only way in which deposits can be created.

Monetary Policy#1: Money multiplier, Fractional Reserve, High Powered v. Narrow v. Broad Money

Sometimes, banks buy securities at the Stock Exchange and also buy real assets. When the bank does so, it does not pay the sellers in cash, rather it credits the amount of the price of the security or assets to the accounts of the sellers.

The bank, therefore, creates a deposit with it. It does not matter whether the seller of securities or property is a customer of the purchasing bank or not, as the seller is bound to deposit the cheques he receives in one of the banks. The purchase of security by any banker is bound to increase the deposits either of his own bank or of some other bank, in any case, the deposits of the banking system as a whole.

Multiple Credit or Money Expansion: Z, who is a government employee gets his pay cheque of Rs.

Money Supply and Credit Creation by Commercial Banks

The cheque is used by the government is drawn on R. Let us assume Mr. It does not take out cash and give it to the borrower. It either allows the Borrower X to overdraw his account if he has one with the bank or it Bank A opens an account in his name to the extent of loan taken Rs.

This is only a temporary phase because no one borrows from a bank merely to open an account or maintain it, one borrows to utilise the money.

relationship between bank deposits and the money supply

Let X who has borrowed Rs. The total deposits in the banking system now is Rs. He may further grant a loan of Rs. The balance sheets of Banks A, B, C, will appear as follows: Thus, with an initial deposit of Rs.

It is to be understood that it is not only the individual bank that creates credit many times the original deposit, but also the banking system as a whole can create derivative deposits up to several times the amount of an original addition to its cash holdings. Primary deposits, as we know arise from the actual deposits of cash in a bank. However, the bank can create deposits actively by creating claims against itself in favour of a borrower or of a seller of securities or of property acquired by the bank.

These actively created deposits are derivative deposits, which arise from loans or securities purchased or primary deposits created. An individual bank, when it creates derivative deposits, loses cash to other hanks; this transfer of cash within the banking system creates, in turn, primary deposits, enhancing the possibility for a further creation of derivative deposit, by the banks receiving the cash.

Money Supply and the Money Multiplier

This process of the commercial banking system to expand credit many times more the initial excess reserves is called the multiple credit creation.

For example, let us suppose that Rs. The borrowers make payments of Rs. By substituting these values, we get: Destruction of Bank Credit or Money: Banks destroy credit as easily as they create it. Bank credit can be destroyed by means of a reduction in bank loans and investment. The extent of the destruction depends upon the prevailing cash reserve ratio.

A reduction of cash below the reserves to support demand deposits leads to multiple contraction of bank credit throughout the banking system. Thus, in the previous example, the original reduction of Rs.

The process of contraction of bank credit is the same as that of expansion—only in the reverse direction. The credit creation multiplier process works as easily in the backward direction. It may be mentioned that sometimes the government intervenes directly with the creation and destruction of money by commercial banks.

Under normal circumstances government need not interfere but in the overall interest of economic stability, to avoid both inflation or deflation, the government may create or destroy money. The government may intervene by creating and destroying the legal tender, resorting to printing press, monetary management through treasury, demonetization, etc. Money market deposits are largely used to lend to corporations who issue commercial paper. Consumer loans are also made using savings depositswhich are not subject to reserve requirements.

This means that instead of the value of loans supplied responding passively to monetary policy, we often see it rising and falling with the demand for funds and the willingness of banks to lend. Some economists argue that the money multiplier is a meaningless concept, because its relevance would require that the money supply be exogenousi.

If central banks usually target the shortest-term interest rate as their policy instrument then this leads to the money supply being endogenous. Please update this article to reflect recent events or newly available information. March Neither commercial nor consumer loans are any longer limited by bank reserves.

Nor are they directly linked proportional to reserves. Between andthe value of consumer loans has steadily increased out of proportion to bank reserves. Then, as part of the financial crisis, bank reserves rose dramatically as new loans shrank. In recent years, some academic economists renowned for their work on the implications of rational expectations have argued that open market operations are irrelevant.

Money creation

These include Robert Lucas, Jr. KydlandEdward C. Prescott and Scott Freeman. Keynesian economists point to the ineffectiveness of open market operations in in the United States, when short-term interest rates went as low as they could go in nominal terms, so that no more monetary stimulus could occur.

This zero bound problem has been called the liquidity trap or " pushing on a string " the pusher being the central bank and the string being the real economy. Arguments[ edit ] Historically, in Europe, the main function of the central bank is to maintain low inflation. In the USA the focus is on both inflation and unemployment. A central bank may attempt to do this by artificially influencing the demand for goods by increasing or decreasing the nation's money supply relative to trendwhich lowers or raises interest rates, which stimulates or restrains spending on goods and services.

An important debate among economists in the second half of the twentieth century concerned the central bank's ability to predict how much money should be in circulation, given current employment rates and inflation rates. Search This Site Privacy Policy for thismatter. Information is shared about your use of this site with Google. Details, including opt-out options, are provided in the Privacy Policy.

Note that opt-out choices are also stored in cookies. You can control and delete any information collected by Google on this page, including any information obtained from users of this website. These choices must be made for each browser that you use. Send email to thismatter. Be sure to include the words no spam in the subject.

relationship between bank deposits and the money supply