Question

Define clearing drain and currency drain. What effect do these two items have on the multiple expansion of deposits for(i) a particular bank and (ii) the banking system as a whole?

Answer 1

Clearing Drain : Loss of cash reserves from one bank to another.

Currency Drain : Currency means, the cash used in transactions. The withdrawal of currency from the banking system into public circulation is called currency drain. A currency drain is an increase in currency held outside the banks. A currency drain decreases the amount of money that banks can create from a given increase in the monetary base because cash drains from their reserves and decreases the excess reserves.

Multiple expansion of deposits: The multiple expansion of deposits, better known as the deposit multiplier, is how banks make money out of thin air. When you deposit $100 in your bank account in the US, legally the bank has to keep 10% of it on hand, which is the required reserve ratio. The other 90% the bank can lend out to other customers(excess reserves) via student loans, or a business loan, a mortgage, a car loan. In this case, that's $90 your bank can lend out to someone else. And in this way, banks keep multiplying the excess reserves through lending.

So the multiple expansion of deposits tells us the maximum possible amount of money that could be created from a given amount of money.

Effects of Clearing Drain and Currency Drain on the Multiple expansion of deposits for

i. a particular bank :

Clearing Drain: Banks gain and lose deposits constantly as customers write cheques (clearing operation). These cheques are later deposited in rival institutions. A favorable clearing balance over time will allow a bank to expand their reserves, whereas other banks will have a clearing drain. Every bank has its own unique situation for deposit expansion that depends on credit-worthy customers and ratio of cheques to savings deposits. So, a clearing drain decreases the multiple expansion of deposits of a particular bank though increases for the another bank.

Currency Drain: The bank only has to hold a percentage of their deposits in reserve(cash). Theoretically, if customers never took money out, the money supply would expand indefinitely as banks continually loaned out their reserves. If the public had no confidence in the banks they would liquidate all their deposits. So, the currency drain reduces the amount the banks have to work with and expand the money supply.

ii. The banking system as a whole:

Banking as whole is affected less by clearing drain as it is just the loss of cash reserves from one bank to another.

Currency Drain affects the whole banking system as cash is withdrawan from the banking system into public circulation. The currency drain reduces amount the banks have to work with and expand the money supply.