Economics Part A

The process by which the bank increases the money supply

A Bank Loan When the Country Is in Situation I

Situation I – all the money of the inhabitants is deposited in checking accounts and they make payments exclusively with checks (or with credit cards).

First Loan

Leonora, a new immigrant, wants to set up a furniture factory. She asks the bank for a $1,000 loan for this purpose. The bank grants the request, and gives her $1,000 in cash. Since the country is in Situation I, Leonora deposits all her money in a checking account.

The situation after these 2 steps (receiving the loan and depositing it in the bank checking account) is shown in Illustration 7.8.

Illustration 7.8

The amount of money in the hands of the public

The amount of money in the hands of the public now totals $11,000, all of it exclusively in checking accounts.

Explanation of Illustration 7.8


Number

Explanation

j

General: The area bordered by the broken line represents the bank premises.

k

Starting condition: the bank cashbox (represented by a vault) contains $10k.

l

Leonora receives a loan of $1k in cash. (The loan is recorded on cards not shown in the illustration).

m

Leonora deposits $k in cash in the bank. This is recorded in her checking account.

n

Leonora receives her checking account statement, which shows a balance of $1k.

  • o

Following steps 3 and 4, the new balance in the bank vault is unchanged at $10k.

Second Loan

Rita, a new immigrant from Argentina, wants to borrow $2,000 to set up a pickle factory. The bank grants her request, and gives her $2,000 in cash. Since the country is in Situation I, Rita deposits all her money in a checking account in the bank. The situation after the deposit in the checking account is shown in Illustration 7.9.

Illustration 7.9

The process by which the bank increases the money supply

The amount of money in the hands of the public now totals $13,000, all of it exclusively in checking accounts. $10,000 remains in the bank vault.

Third Loan

The Golden Hotel wishes to expand, and asks the bank for a $7,000 loan. The bank grants the request, and gives it $7,000 in cash. Since the country is in Situation I, the Golden Hotel Company deposits the cash in its checking account.

The situation after the deposit in the checking account is shown in Illustration 7.10.

Illustration 7.10

The amount of money in the hands of the public

The total amount of currency in the bank vault remains unchanged at $10,000, while the public’s checking account balances continue growing by the amount of each loan.

Comment

The process by which the bank increases the money supply in the country may give the impression that its clients are getting richer and the bank is not, but that is not the whole picture.

For each dollar added to the checking account of each of the borrowers – Leonora, Rita and Golden Hotel Company - or given to them in cash, the borrower owes the bank one dollar. The illusion of wealth is generated by the emphasis on counting their cash, while ignoring their debt.

This section examines how much the bank can increase the money supply in the country by making loans.

The process by which the bank increases the money supply 526The process by which the bank increases the money supply