ECON 2000 Chapter Notes - Chapter 18: Fractional-Reserve Banking, Monetary Base, Money Multiplier
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The money supply is determined not only by Bank of Canada policy, but also by the
behaviour of households that hold money and of banks in which money is held.
Money Supply = Currency + Deposits ... M = C + D
To understand money supply, we must understand the interaction between currency and
deposits and how Bank of Canada policy influences these two components of money
100-percent-reserve banking: the deposits that banks have received but have not lent out
are called reserves. Some reserves are held in the vaults of local banks throughout the
country, but most are held at a central bank such as the Bank of Canada. 100-percent-
reserve banking means that all bank deposits are held as reserves: banks simply accept
deposits, place the money in reserve, and leave the money there until the depositor makes
a withdrawal or writes a cheque against the balance. If banks hold 100 percent of
deposits in reserve, the banking system does not affect the supply of money.
Fractional-reserve banking: now imagine banks start to use some of their deposits to
make loans. The banks must keep some reserves on hand so that reserves are available
whenever depositors want to make withdrawals, but as long as new deposits equals the
amount of withdrawals, a bank need not keep all its deposits in reserve. Fractional-
reserve banking means that banks keep only a fraction of their deposits in reserve. The
reserve-deposit ratio is the fraction of deposits kept in reserve. After a loan is made with
the fraction of deposits not kept in reserve, the money supply has increased by the
amount that the bank loaned out. Thus, in a system of fractional-reserve banking, banks
The person who received the loan goes and deposits the money in their bank, and that
bank loans out a fraction of that deposit, and so on and so forth. With each new deposit
and loan, more money is created. Letting rr denote the reserve-deposit ratio: Total
Money Supply = (1/rr) x Original Deposit. Banks’ ability to create money separates
them from other financial institutions. Financial markets serve the purpose of financial
intermediation; they transfer funds from savers to borrowers. Financial intermediaries
include the stock market, the bond market, mortgage loan companies, credit unions, and
the banking system. Note that the creation of money by the banking system increases the
economy’s liquidity, not its wealth, since borrowers are undertaking a debt obligation to
the bank, so the loan does not make them wealthier.
A model of the money supply under fractional reserve banking
The model has three exogenous variables:
The monetary base (B) is the total number of dollars held by the public as currency C
and by banks as reserves R. It can be directly controlled by the Bank of Canada.
The reserve-deposit ratio rr is the fraction of deposits that banks hold in reserve. It is
determined by the business policies of banks, and used to be regulated by law in the past.
It is R/D, reserves/deposits.
The currency-deposit ratio cr is the amount of currency C people hold as a fraction of
their holdings of deposits D. It reflects the preferences of households about the form of
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