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Cash reserves work like brakes on money supply

Cash reserves work like brakes on money supply
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First Published: Mon, Mar 24 2008. 12 31 AM IST

Updated: Mon, Mar 24 2008. 12 31 AM IST
If storks supposedly deliver babies, then who delivers money? Some believe money storks work to bring more money into our lives. Otherwise, how is it that we hear about the increase in money supply? Our friend Johnny has been pondering over these questions for the last one week, but has not been able to find any answers. Finally, he decides to take the help of his friend Jinny.
Johnny: I have been trying to figure out what could cause increase in money supply. My guess is that the real stork working behind the bush must be our government, which has the power to print more currency notes. Right?
Jinny: Governments are blamed everywhere for delivering more and more money. To some extent, that could also be true. We have seen governments indulge in the worst kind of note printing sprees, leading to ever-increasing currency in circulation. But, that cannot be sustained in the long run. If governments start printing notes like pamphlets, then you and I will be left with no other job than to count worthless notes. You can print “fiat currency” as much as you want, but printing more notes reduces their value. So, a government has to exercise restraint in printing notes. However, printing notes is not the only factor that could lead to an increase in money supply. Our banks also have the power to “create” money by their lending activities.
Johnny: I could never have guessed that. Tell me how that happens. Last week, you told me that depositing money in a bank does not lead to either increase or decrease in money supply.
Jinny: Yes, that is true. Depositing money in a bank does not lead to either increase or decrease in money supply because, the moment you deposit your currency in the bank, it ceases to be in circulation and a corresponding demand or term deposit comes into existence and becomes part of the money supply. But, a bank lending money has a different effect. It increases money supply by creating new money. Let us try to understand how.
Johnny: Please explain by giving an example.
Jinny: Okay, let us take an example. Suppose you deposit Rs100 in
Illustration: Malay Karmakar / Mint
your savings bank account. Your savings bank account will reflect the Rs100 as deposit, and the same will be treated as part of the money supply. Now, what is your bank going to do with the money you have deposited? It is surely not going to keep all of your money with itself till the time you come back to claim it. All our banks work on what is known as fractional reserve system. They keep part of the deposits as reserves for meeting the day-to-day redemption of their depositors and lend the remainder to their borrowers. This is how banks are able to earn money, a part of which they pay you as interest.
Now, you must have started figuring out what your bank is going to do with the Rs100 that you deposited. Suppose the bank maintains a reserve of 10%, then it will keep Rs10 with itself and lend Rs90 to someone else. The borrower can either take the loan of Rs90 in cash or he can keep it as a deposit in his account. If he takes cash, then the currency component of the money supply will increase and, if he keeps it as deposit, then the deposit component of the money supply will increase. In either case, the money supply will increase. Remember that lending of Rs90 by the bank in any way does not lead to reduction of Rs90 from your demand deposit, which also continues to be part of the money supply. In this manner, banks increase money supply by credit expansion.
Johnny: Oh, I see. Banks really enjoy the power to create money. How is such power controlled?
Jinny: Well, lending by banks leads to more lending. The Rs90 that your bank has lent, in all probability, will end up as a deposit with your bank or with some other bank. This deposit coming out of borrowed money can again be lent to somebody else. In this manner, the credit expansion can go on and on.
But, cash reserves work like brakes. The higher the cash reserve, the lower the money available for lending. Every time the borrowed money comes into deposit, the bank has to keep a part of it as reserves, thereby reducing credit expansion. That is why central banks increase the requirement of cash reserves whenever they feel the need to control money supply.
Johnny: That’s good. The central bank is always around to take care of the storks that deliver money.
What: Money supply could increase due to various reasons.
Who: Actions of both government and banks can lead to an increase in money supply.
How: The government can increase money supply by printing more currency. Banks can increase money supply by their lending activities.
Why: Maintaining a balanced growth of money supply is important because an uncontrolled increase may destabilize the whole economy.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com
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First Published: Mon, Mar 24 2008. 12 31 AM IST
More Topics: Money | Bank | Interest | Money Matters | Equities |