Question

“Whenever currency is deposited in a commercial bank, cash goes out of circulation and, as a result, the supply of money is reduced”. Do you agree? Explain why or why not.

Short answer

One cannot agree with the given statement. Whenever a currency is deposited in a commercial bank, the total supply of money increases by the process of the money multiplier.

Step-by-step solution

Meaning of money multiplier

Money multiplier defines the relationship between new excess reserves and the magnified creation of new checkable-deposit money.

Money Multiplier (m) = 1 / (Required Reserve Ratio)

Working of money multiplier

Let the initial deposit be $200. This initial deposit creates new reserves of an equal amount. Let the required reserve ratio be 20%. Therefore only 20% of the reserves are needed to back up the initial $200 deposit. i.e., $40. So excess reserves = $200-$40 = $160.

Maximum checkable deposit creation= Excess Reserves x Money Multiplier =

$160 x 1/0.20 = $800. The excess of reserves creates $800 by making loans. Therefore, $200 of reserves creates a total of $1000.

Thus, the currency deposited with the commercial bank increases the money supply in the economy.