THE SIMPLE CASE OF 100-PERCENT-RESERVE BANKING

To see how banks influence the money supply, it is useful to imagine first a world without any banks at all. this simple world, currency is the only form of money. To be concrete, let’s suppose that the total quantity of currency is $100. The supply of money is, therefore, $100. Now suppose that someone opens a bank, appropriately called First National Bank. First National Bank is only a depository institution-that is, it accepts deposits but does not make loans. The purpose of the and is to give depositors a safe place to keep their money. Whenever a person deposits some money, the bank keeps the money in its vault until the depositor comes to withdraw it or writes a check against his or her balance. Deposits that banks have received but have not loaned out are called reserves. In this imaginary economy, all deposits are held as reserves, so this system is called 100-percent-reserve banking. , We can express the financial position of First National Bank with a  account, which is a simplified accounting statement that shows changes in a bank’s assets and liabilities. Here is the  account for First National Bank if the economy’s entire $100 of money is deposited in the bank:

THE SIMPLE CASE OF 100-PERCENT-RESERVE BANKING

THE SIMPLE CASE OF 100-PERCENT-RESERVE BANKING

On the left side of the T-account are the bank’s assets of $1OO (the reserves it  holds in its vaults). On the  right side are the bank’s liabilities of $100 (the amount it owes to its depositors). Notice that the assets and liabilities of First National Bank exactly balance. Now consider the money supply in this imaginary economy. Before First National Bank opens, the money supply is the $100 of currency that people are holding. After the bank opens and people deposit their currency, the money supply is the $100 of demand deposits. (There is no longer any currency outstanding, for it is all in the bank vault.) Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount, leaving the money supply unchanged. Thus, if banks hold all deposits in reserve, banks do not influence the supply of money.