HOW BANKS CREATE MONEY 15
sum. Indeed it will be profitable to do so. It
would be foolhardy to let the whole sum go
in the form of loans, as the bank's depositors
may call on cash at any time. What proportion
then should be lent? Alternatively, what proportion should be kept in cash reserve? We will
call the ratio of reseryes to total demand deposits the bank's required reserve ratio-2
That is,
Reserve ratio
:
tradins bank's required cash reserve
For our analysis we shall supPose that the reserve ratio for all banks is 20 per cent. It is
to be emphasised that reserve requirements are
fractional, that.is, less than 100 per cent. This
-consideration
will be vital in the ensuing analysis of the lending ability of the banking
system.
The Wahoo Bank will just be meeting the
required 20 per cent ratio by keeping $20 000
ln reserve.
But let us suppose that the directors of the
Wahoo bank anticipate that their holdings of
the public's current deposits will grow in the
future. Hence, instead of keeping just the m_inimurn amount, $20 000, they keep an extra
$90000, making a total of $110000. We shall
see shortly that it is upon the basis of extra
reserves 1[a1 fanks can lend and thereby earn
interest income.
The balance sheet of the Wahoo Bank may
now be rewritten as follows:
Balance sheet 4: Wahoo Bank
Liabilities and net worth
Current deBosits $100 000
Capital sto'ck 250 000
Property
A note on terminology: The
amount by which the bank's actual reseryes
Excess reserves
exceed its required reserves is the bank's excess
reserves.3 In this case,
Actual reserves $110 000
Required reserves -20 000
Excess reserves
$
The only reliable way of computing excess reserves is to multiply the bank's current-deposit
liabilities by the reserve ratio ($100000 tirnes
20 per cent, equals $20 000) to obtain required
reseryes, then to subtract this frgure from the
actual reserves listed on the asset side of the
bank's balance sheet. To ensure an understanding of this process, the reader should comPute
excess reseryes for the bank's balance sheet as
it stands at the end of transaction 4 on the
assumption that the roserve ratio is (a) l0 per
cent, (b) 331/tper cenq and (c) 50 per cent.
Because the ability of a trading bank to make
loans depends upon the existence of excess reseryes, this concept is of vital importance in
grasping the money-creating ability of the
banking system.
Transaction 5: A cheque is drawn against
the bank
Now let us tackle a very significant and somewhat more complicated transaction. Suppose
that Bradshaw, a Wahoo farmer who deposited
a substantial portion of the $100 000 in current
deposits which the Wahoo Bank received in
transaction 3, purchases $50 000 worth of farm
machinery. Bradshaw very sensibly pays for
this machiaery by writing a $50 000 cheque,
against his deposit in the Wahcio Bank, in
favour of the machinery company. This cheque
is then deposited in another bank and eventually cleared against the Wahoo Bank. S/hat
happens?
Whenever a cheque is drawn against a bank
and deposited in another bank, the collection of
that cheque will entail a loss of both reserves and
deposits by the bank upon which the cheque is
diawn. Conversely, if a bank receives a cheque
drawn on another bank, the bank receiving the
cheque will, in the process of collecting it, have
its reserves and deposits increased by the
amount of the cheque. In our example, the
Wahoo Bank loses $50 000 in both reserves and
deposits. But there is no loss of reserves or depoiits for the banking system as a whole. What
one bank loses another bank gains.
reserve ratios are in fact determined
and changed will be discussed in the following Chapter
16. For the moment we could assume that the reserve
ratio is either legally determined or an accePted bank'
2 The way ia which
ing convention.
3 This is also called a "margin of free tiquidity''.
90 000
287
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