Money: 2

To continue from Money:1, how does the money supply expand?   Before getting to what I gleaned out of my introductory economics text (I took my introductory economics course in 1980 at Harvard University’s Extension.), I will write a little about goods and money.

I can think of no reason against a conclusion that all money spent for all goods and services ultimately ends up as someone’s income.  For example, think about buying a car.  You are not buying a car, you are buying the labor and services of the persons who mined the ore to make the metal in the car, who created the machine to mold the plastic parts, who stood on the salesroom floor and sold you the car, and so forth.  No iron ore receives any payment, no petroleum, from which plastic is made, gets any income.

Okay, how does the money supply expand?  Let’s create a simple economy.  There are banks that hold all of the money.  When people buy something, they use their debit cards.  Say that when something is bought, money is instantly transfered from one bank to another.  No matter how many transactions there are, the overall stock of money does not change.  What comes out of one account goes into another.  This is a system in which money is conserved.

Now let us say the business of the bank is to lend out the money that has been deposited in the bank.  We will have the government mandate that the banks keep a certain percentage of the banks’ deposits in the banks.  The government mandate helps protect banks from runs on the bank by persons worried the bank will fail and the persons will lose their money.  (Before the Federal Reserve System came into existence in 1914, banks issued our paper money and there definitely were runs on banks and bank failures, where people lost their savings.)

Say there are three banks in the system.  Say the first two banks each have $10,000 deposited (this is an ant economy) and that the reserve rate is 20%, so each bank has $8,000 in loans and $2,000 in reserves.  Say that the third bank that only receives loans, so all of the third bank’s assets are reserves.  We will assume there is no interest payed.  Clearly, the first and second banks both have lent $8,000 to the third bank.  The total of the assets of the three banks together is $36,000.  Say that the second bank moves $1,000 to the first bank (say, because a depositor in the second bank owes money to a depositor in the first bank).  Then, the assets of the first bank are $11,000 and the assets of the second bank are $9,000.  The first bank will increase the amount loaned to get the bank to the correct reserve rate.  The second bank will have called in $1000 worth of loans from the third bank to pay the first bank, but will put some money back in the third bank, since the second bank then has more reserves than the bank needs.

Twenty percent of $11,000 is $2,200 dollars, which is $200 more than the first bank has in reserves.  The first bank will lend out 80% of $1,000, or $1,000 – $200 = $800 to the third bank and put $200 in the bank’s reserves.  Twenty percent of $9,000 is $1,800, which is $200 less than the second bank has in reserves.  The second bank will take $200 out of reserves and loan the money to the third bank.  In the end, the first bank has $2,200 in reserves and $8,800 loaned to the third bank or $11,000 in assets.  The second bank has $1,800 in reserves and $7,200 loaned to the third bank for $9,000 in assets.  The third bank still has $16,000 of loaned assets.  The over all amount in the system, $36,000 –  counting both the loaned money in the third bank and the credit for the loans in the first and second banks, does not change.

Now, let’s say that the government gives the first bank $1,000.  Say that the reserve rate is still equal to 20 percent.  The first bank now has $12,000 in assets.  Twenty percent of $12,000 is $2,400, which is what the bank needs for reserves.  The bank already has $2,200 in reserves, so the bank puts $200 of the $1000 the bank received into reserves and loans the rest of the money ($800) to the third bank.  The third bank then has $16,800 in assets.  The assets of the second bank remain the same, at $9,000.  The sum of the assets of the three banks is now $37,800, $1,800 greater than before the government gave the first bank $1,000.  The extra $800 comes from the loan to the third bank being on both the first bank and the third banks’ books.

Say we have a bank that receives from outside the banking system $1,000.  Say the banking system is made up of many banks and that there is no interest charged for loans and all of the money above the reserve rate is loaned out.  Say the reserve rate is 20 percent.  Then the bank will loan out $800.  The bank that receives the loan will loan out 0.8 time $800, or $640.  The lending continues until there in no more to lend ($512, $410, $328, $262, $210, $168, $134, $107, $86, $69,  $55, $44, $35, $28, $23, $18, $14, $12, $9, $7, $6, $5, $4, $3, $2, $2, $2, $1, $1, $1, $1, $1, which, including the $640, $800, and original $1,000, sums to $5,000.)  Five thousand dollars is 1 divided by .2 times $1,000.  So, the original deposit from outside the system created $1000/0.2 = $5000 worth of assets in the system.  If all money from outside the system is lent out to the reserve rate, the assets in the system will increase by the original money divided by the reserve rate, where the reserve rate is measured in proportion (20% being a rate of 0.2).

I do not know if there are other ways to expand the money supply.  My introductory text just gave the method above.  So the money supply expands by banks lending out money that stays on the banks’ books as assets.  If the method above is the only way of expanding the money supply, given a given amount coming from outside the system, the money supply can only expand so far, based on the reserve rate.

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