Principle of Macroeconomics: A Streamlined Approach by unknow

Author:unknow
Language: eng
Format: epub
ISBN: 9781260590760
Google: 3gkNzgEACAAJ
Publisher: McGraw-Hill
Published: 2021-09-15T20:32:41+00:00

Commercial Banks and the Creation of Money

What determines the amount of money in the economy? If the economy’s supply of money consisted entirely of currency, the answer would be simple: The supply of money would just be equal to the value of the currency created and circulated by the government. However, as we have seen, in modern economies the money supply consists not only of currency but also of deposit balances held by the public in commercial, that is, private, banks. The determination of the money supply in a modern economy thus depends in part on the behavior of commercial banks and their ­depositors.

To see how the existence of commercial banks affects the money supply, we will use the example of a fictional country, the Republic of Gorgonzola. Initially, we assume, Gorgonzola has no commercial banking system. To make trading easier and eliminate the need for barter, the government directs the central bank of Gorgonzola to put into circulation a million identical paper notes, called guilders. The central bank prints the guilders and distributes them to the populace. At this point, the ­Gorgonzolan money supply is a million guilders.

However, the citizens of Gorgonzola are unhappy with a money supply made up entirely of paper guilders since the notes may be lost or stolen. In response to the demand for safekeeping of money, some Gorgonzolan entrepreneurs set up a system of commercial banks. At first, these banks are only storage vaults where people can deposit their guilders. When people need to make a payment they can either physically withdraw their guilders or, more conveniently, write a check on their account.

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Checks give the banks permission to transfer guilders from the account of the person paying by check to the account of the person to whom the check is made out. With a system of payments based on checks the paper guilders need never leave the banking system, although they flow from one bank to another as a depositor of one bank makes a payment to a depositor in another bank. Deposits do not pay interest in this economy; indeed, the banks can make a profit only by charging depositors fees in exchange for safeguarding their cash.

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Let’s suppose for now that people prefer bank deposits to cash and so deposit all of their guilders with the commercial banks. With all guilders in the vaults of banks, the balance sheet of all of Gorgonzola’s commercial banks taken together is as shown in Table 8.2.

TABLE 8.2

Consolidated Balance Sheet of Gorgonzolan Commercial Banks (Initial)

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