Money supply and bank credit relationship

Money creation - Wikipedia

money supply and bank credit relationship

Bank credit creates bankmoney. of the money supply, while cash is currently down. respect, the supply of money and credit may be affected understanding developments in banks' behaviour prime relevance when assessing the relationship. and deteriorating relationship between Federal. Reserve actions and the supply of bank credit. WI-lilT IS “THE CREDIT VIEW?” The credit view of monetary.

What if commercial banks, despite high excess reserves, start calling in maturing loans and contract the credit supply?

money supply and bank credit relationship

This would actually lead to a shrinking of the money stock — and cause deflation. Commercial Banks Purchase Assets from Nonbanks If politically desired, the central bank can prevent the fiat-money supply from shrinking.

For instance, it can purchase assets from nonbanks private households, pension funds, insurance companies, etc. In this case the central bank hands over the money directly to the seller, who holds his account with commercial banks.

If the central bank monetizes newly issued government bonds by purchasing them in the primary or secondary marketthe same effect results: Some Effects of Preventing the Fiat-Money Stock from Shrinking If the central bank purchases bonds, the original issuers of the bonds will have to keep paying interest and principal to the central bank.

Money Supply and Credit Creation by Commercial Banks

Such payments reduce the money supply in the form of M1 and M2 over time. In other words, by purchasing bonds, the central bank just postpones the inevitable — namely, the shrinking of the fiat-money supply through contractual debt re payments on the part of borrowers "deleveraging".

For upholding the outstanding fiat-money stock once and for all, the central bank could buy debt in the amount of the money stock say M1 — and then forgive the debt. This, of course, would favor those borrowers whose debt would be forgiven over all other economic actors. Alternatively, the central bank could start purchasing noncredit assets such as stocks, housing, etc. This, however, would amount to nationalizing the assets purchased — with all the well-known, detrimental consequences of socialist policies.

One should note in this context that a rise in the money stock is never neutral. Those receiving the newly created money first will benefit at the expense of those who receive the new money at a later point in time or not at all.

Having said that, it becomes obvious that a policy of preventing the fiat-money supply from shrinking which it would in the absence of such measures entails coercive redistribution effects. It favors holders of goods and services at the expense of money holders: The Way toward High Inflation Technically speaking, a policy of upholding or expanding the fiat-money stock in an environment where banks are no longer willing to extend credit and issue new fiat money appears to be technically possible.

However, the Austrian School of economics points out that an economy's production structure will be turned upside down once the hitherto relentless rise of fiat money, injected by bank circulation credit, slows down, or even starts contracting. Once the credit growth dries up, the fiat-money-induced "boom" will turn into "bust," as the Austrian trade-cycle theory shows.

A bust will cause market interest rates to go up as people's time preference and required risk premiums increase. Rising interest rates threaten to bring down leveraged banks. Defaulting banks would reduce the fiat-money stock.

So to prevent the fiat-money stock from declining in a bust, the central bank has to keep market interest rates low. However, the outlook of ongoing debt monetization through the central bank could provoke selling pressures in bond markets: The banks can multiply a given amount of cash to many times of credit.

If the public would demand no cash, credit would go on expanding indefinitely.

money supply and bank credit relationship

But the reserve ratio is a sort of leakage from the Stream of credit creation. We can, thus, think of a credit creation multiplier. The higher the reserve ratio, the smaller is the credit creation multiplier. In our example above, with an original deposit of Rs. In general, the credit creation multiplier is related to the reserve ratio in the following way: Making loan is not the only way in which deposits can be created. Sometimes, banks buy securities at the Stock Exchange and also buy real assets.

When the bank does so, it does not pay the sellers in cash, rather it credits the amount of the price of the security or assets to the accounts of the sellers. The bank, therefore, creates a deposit with it.

It does not matter whether the seller of securities or property is a customer of the purchasing bank or not, as the seller is bound to deposit the cheques he receives in one of the banks. The purchase of security by any banker is bound to increase the deposits either of his own bank or of some other bank, in any case, the deposits of the banking system as a whole.

Multiple Credit or Money Expansion: Z, who is a government employee gets his pay cheque of Rs. The cheque is used by the government is drawn on R.

Let us assume Mr. It does not take out cash and give it to the borrower. It either allows the Borrower X to overdraw his account if he has one with the bank or it Bank A opens an account in his name to the extent of loan taken Rs. This is only a temporary phase because no one borrows from a bank merely to open an account or maintain it, one borrows to utilise the money.

money supply and bank credit relationship

Let X who has borrowed Rs. The total deposits in the banking system now is Rs. He may further grant a loan of Rs.

  • Money creation
  • Money Supply and Credit Creation by Commercial Banks

The balance sheets of Banks A, B, C, will appear as follows: Thus, with an initial deposit of Rs. It is to be understood that it is not only the individual bank that creates credit many times the original deposit, but also the banking system as a whole can create derivative deposits up to several times the amount of an original addition to its cash holdings. Primary deposits, as we know arise from the actual deposits of cash in a bank. However, the bank can create deposits actively by creating claims against itself in favour of a borrower or of a seller of securities or of property acquired by the bank.

These actively created deposits are derivative deposits, which arise from loans or securities purchased or primary deposits created. An individual bank, when it creates derivative deposits, loses cash to other hanks; this transfer of cash within the banking system creates, in turn, primary deposits, enhancing the possibility for a further creation of derivative deposit, by the banks receiving the cash.

This process of the commercial banking system to expand credit many times more the initial excess reserves is called the multiple credit creation.

For example, let us suppose that Rs.

money supply and bank credit relationship

The borrowers make payments of Rs. By substituting these values, we get: Destruction of Bank Credit or Money: Banks destroy credit as easily as they create it. Bank credit can be destroyed by means of a reduction in bank loans and investment.

money supply and bank credit relationship

The extent of the destruction depends upon the prevailing cash reserve ratio. A reduction of cash below the reserves to support demand deposits leads to multiple contraction of bank credit throughout the banking system. Thus, in the previous example, the original reduction of Rs. The process of contraction of bank credit is the same as that of expansion—only in the reverse direction. The credit creation multiplier process works as easily in the backward direction.

It may be mentioned that sometimes the government intervenes directly with the creation and destruction of money by commercial banks.

Under normal circumstances government need not interfere but in the overall interest of economic stability, to avoid both inflation or deflation, the government may create or destroy money. The government may intervene by creating and destroying the legal tender, resorting to printing press, monetary management through treasury, demonetization, etc.

Out of the various tools to create or destroy money, the choice of any particular tool will depend on the nature of the situation, objectives of monetary policy, monetary and banking convention, etc. The traditional approach to the determination of the volume of bank deposits modified by an alternative approach.

Bankers have always made out a case that they lend only the deposits they receive or out of it. Thus, their ability to attract deposits is the chief constraint on their work.

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Economists, on the other hand, assert that bank lending itself creates deposits. Economists say bank deposits result or arise because of bank lending and not because lending is done because bank deposits are received. Bank deposits do not constitute a precondition for lending. If a banking system works to a minimum ratio of reserves in this case cash to deposit liabilities— we say it is a fractional reserve system.

Thus, so far fractional reserve system has been based on fixed cash reserve ratio. In other words, the new theory amounts to the fact that bank deposits bear a given relation to the bank reserves and a change in the reserve base which includes cash plus assets of various types will lead to a multiple change in bank deposits. It is, therefore, essential to study the factors which determine the supply of reserves.

If banks adhere to a fixed reserve ratio and if the supply of reserves is determined without any reference to the level of bank deposits, then it is reasonable to regard reserves as a proximate cause in the determination of bank deposits.

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