Monday, July 6, 2009

pyramiding of the money supply

Several major assets and liabilities of commercial banks are given here on skeleton balance sheets, or T-accounts, for these three banks. The problem is to see how an increase in cash reserve can be pyramided by a number of commercial banks into a money supply that is considerably greater than the original increase in cash reserve. This pyramiding of the money supply by the banks, on the basis of a given amount of cash reserve, is possible because in our banking system commercial banks are required only to have legal reserves that are a fraction of their outstanding demand and time deposits. In this exercise we assume that all banks must maintain legal reserve equal to 20 per cent of their demand deposits. Because we are omitting any reference to time deposits in this example, we do not need to take account of the fact that legal reserve ratios against time deposits are always lower than those required against demand deposits.

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