The Mystery of Banking

decrease
in the total
money supply of $2 million. In short, under central banking, a
demand for cash—and the subsequent issue of new cash—has the 
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Martin Bank
Assets
Equity & Liabilities
IOUs
$2 million
Demand deposits $2.5 million
Reserves at Central
Bank
$500,000
Total Assets
$2.5 million
F
IGURE
9.3 — U
LTIMATE
R
ESULT OF
D
RAWING
D
OWN
R
ESERVES
paradoxical effect of 
lowering
the money supply, because of the
banks’ need to maintain their reserve/deposit ratios. In contrast,
the deposit of cash by the public will have the opposite inflation-
ary effect, for the banks’ reserve/deposit ratio will rise, and the
banks will be able to expand their loans and issues of new
deposits. Figure 9.4 shows how this works. Let us take the origi-
nal Martin Bank balance sheet of Figure 9.1. People decide to
deposit $500,000 of their previously issued Central Bank notes
and get the equivalent in checking accounts instead. The Martin
Bank’s balance sheet will change as follows (Figure 9.4): 
Step 1: Martin Bank
Assets
Equity & Liabilities
IOUs
$4 million
Demand deposits $5.5 million
Central Bank notes
$500,000
Demand deposits at
Central Bank
$1 million
Total Assets
$5.5 million
F
IGURE
9.4 — D
EPOSITING
C
ASH
: P
HASE
I 
Central Banking: Removing the Limits
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But then, the Martin Bank will take this bonanza of cash and
deposit it at the Central Bank, adding to its cherished account at
the Central Bank, as shown in Figure 9.5: 
Step 2: Martin Bank
Assets
Equity & Liabilities
IOUs
$4 million
Demand deposits $5.5 million
Demand deposits 
at Central Bank
$1.5 million
Total Assets
$5.5 million
F
IGURE
9.5 — D
EPOSITING
C
ASH
: P
HASE
II 
But now, in Step 3, the banks will undoubtedly try to main-
tain their preferred 1/5 ratio. After all, excess reserves beyond the
legal or customary fraction is burning a hole in the bank’s pocket;
banks make money by creating new money and lending it out.
After Step 2, the Martin Bank’s fractional reserve ratio is
$1.5/$5.5, or a little over 27 percent, as compared to the pre-
ferred 20 percent. It will therefore expand its loans and issue new
deposits until it is back down to its preferred 1/5 ratio. In short,
it will pyramid 5:1 on top of its new total reserves of $1.5 mil-
lion. The result will be Step 3 (Figure 9.6). 
Step 3: Martin Bank
Assets
Equity & Liabilities
IOUs
$6 million
Demand deposits $7.5 million
Demand deposits 
at Central Bank
$1.5 million
Total Assets
$7.5 million
F
IGURE
9.6 — D
EPOSITING
C
ASH
: P
HASE
III 
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The Martin Bank has expanded its contribution to the money
supply by $2.5 million over its original $5 million. As for the
Central Bank, its own notes outstanding have declined by
$500,000. This amount was received in cash from the Martin
Bank, and the Martin Bank account at the Central Bank is cred-
ited by an increased $500,000 in return. The Central Bank notes
themselves were simply retired and burned, since these obliga-
tions were returned to their issuer. The Central Bank balance
sheet has changed as follows (Figure 9.7):