An Increase in Bank Account Balances Makes Growth of the Money Supply Possible

In order to follow this process, consider the example of Country A, Situation 2 (inhabitants keep 50% in cash). Assume that the bank has reached the minimum reserve ratio of 0.25. In this situation, the bank can no longer issue loans.

Unexpectedly, someone named Michael receives a gift of $8,000 from a relative abroad. Since the country is in Situation 2, Michael keeps $4,000, and deposits $4,000 into his bank account.

The situation after the deposit of the money is shown in the following illustration, which relates specifically to the financial consequences of the gift that Michael received.

The gift does not alter the other relevant financial data:

1. Total bank account balance that belongs to the public is still $8,000.
2. Total cash held by the public is still: $8,000.
3. Total cash in the bank vault is still $2,000.

The gift that Michael received increased the money supply in the country by $8,000.  As explained below, the money supply in Country A will continue to grow after the bank issues loans to the public.

First loan

Beverly, a new immigrant, wants to set up a furniture factory, and so she requests a $1,000 loan. The bank grants the request, and gives her $1,000 in cash.

Since the country is in Situation 2, Beverly keeps $500 in cash, and deposits $500 into her bank account. The situation at this stage is demonstrated in the following illustration:

• $3,500 remains in the bank vault ($1,000 was withdrawn and $500 was deposited).
• The country’s money supply grew by $1,000 (0.74 = $3,500/$4,500). 

The bank holds $0.74 for each $1 on deposit in a bank account.

• The bank is entitled to continue to issue loans.

Second loan

Janet, another new immigrant, wants to set up a trouser factory, and asks for a $3,000 loan.

The bank grants the request. Because the country is in Situation 2, Janet keeps $1,500 in cash, and deposits the remainder into a bank account.

The situation at this stage is shown in the following illustration.

• $2,000 remains in the bank vault.
• The country’s money supply has grown by an additional $3,000.
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The bank is therefore able to continue lending.

Third loan

Patricia, another new immigrant, wants to set up a small business. She asks for and receives an $800 loan. The situation at this stage is shown in the following illustration.

• $1,600 remains in the bank vault.
• The country’s money supply has grown by an additional $800.

At this stage, the bank can no longer continue to extend loans.

The final result

As a result of Michael’s $8,000 gift from abroad, the country’s money supply increased by $12,800. 

The increase was recorded by 4 people, as follows: