Question

“Whenever currency is deposited in a commercial bank, cash goes out of circulation and, as a result, the supply of money is reduced.” Explain just why this statement is valid or not by illustrating the series of events that take place when a bank deposit is made.

Answer 1

The statement is not valid, that is whenever currency is deposited in a commercial bank the cash doesn't goes out of circulation as a result neither the money supply is reduced. If at all commercial banks increase the money supply through credit creation in other words lending. When a person deposits money in a commercial bank, The bank doesn't withhold the money which gets deposited it in fact lends the part of money to a borrower and keep some part of it as a reserve with itself. The money a bank can lend out is generally decided by the reserve requirement imposed by the fed on banks, Which is knowns as reserve ratio.

Let's suppose the Reserve ration is 10% and you a 1000$ in a commercial bank. The bank then takes 1000$ from you and keeps its 10% as reserve that is 100% and lends 900$ out to someone, let's assume wanted to a refrigerator and was looking for a loan. He gets his loan of 900$ and he pays the dealer of refrigerator. The refrigerator dealer then deposits this 900$ in another bank which again keeps 10% of it as reserve that is 90$ and then lends the rest of 810$ out. The same process is followed and this money again comes into bank as deposit and then again bank keeps 10% 810$ that is 81 as reserve and lends out rest of 729$. This process gets repeated several times and each time the money supply in the economy is increased. The total money supply that's get increased due to this effect is given the following formula

1/ reserve ratio times change in initial deposit

Here its equal to 1/.10x1000$ = 10. 1000$

=10,000$.

Hence the total increase in money supply from 1000$ currency deposit in bank is 10,000$ therefore currency deposit in bank doesn't reduce the money supply in the economy it increases it via multiplier effect explained above.