Money and Interest Rate - The money supply: commercial banks and the creation of money
5 important questions on Money and Interest Rate - The money supply: commercial banks and the creation of money
The determination of the money supply in a modern economy depends in part on the behavior of commercial banks and their depositors. Bank reserves are:
100 per cent reserve banking is:
A fractional-reserve banking system is:
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Deposits will expand through additional rounds of lending as long as the actual ratio of reserves to deposits exceeds the ratio desired by banks. When the actual reserve ratio equals the desired reserve ratio the expansion stops. So ultimately, deposits in the banking system satisfy the following relationship:
This can be rewritten to solve for bank deposits:
bank deposits = bank reserves / (desired reserve - deposit ratio)
or let D denote bank deposits, RES denote bank reserves and rr the banks' desired reserve-deposit ratio:
D = 1/rr * RES
The monetary base (or stock of high-powered money) is:
we assume that the public holds a constant fraction cr (or currency ratio) of deposits in currency, that is: CUR = crD
as bank reserved are fraction rr of deposits:
H = crD + rrD = (cr + rr)D
Rearranging to solve for deposits:
D = 1/(cr + rr) * H
substituting in the stock of money:
M = cr/(cr + rr) * H + 1/(cr+rr) * H
or M = (1+cr)/(cr+rr) * H
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