Question

how to create money when currency holding is proportional to demand deposits?please explain with an example

Answer 1

Currency holding is the amount of cash the bank requires to maintain out of the demand deposit for maintaining liquidity.

Creation of money depends on currency holding ratio and reserve ratio.

Reserve ratio is the proportional amount of deposit that should be kept aside by the bank for the central bank regulation.

Example: Suppose a demand deposit of $100 is created in a bank. Proportional currency holding is 8% and the reserve ratio is 10%. What is the supply of money?

Solution:

Money multiplier = (1 + Currency holding) / (Reserve ratio + Currency holding)

                             = (1 + 0.08) / (0.10 + 0.08)

                             = 1.08 / 0.18

                             = 6

Supply of money = Demand deposit × Money multiplier

                            = $100 × 6

                            = $600

Now if there is no “currency holding”, the money supply would be higher as below:

Money supply = Demand deposit / Reserve ratio

                        = $100 / 0.10

                        = $1,000

Therefore, currency holding is a currency drain that reduces the creation of money. Here supply restricted by ($1,000 - $600 =) $400 because of currency holding.