The Mystery of Banking

All Commercial Banks
A
E & L
IOUs
$40 billion
Demand deposits $50 billion
Reserves
$10 billion
Total Assets
$50 billion
Total Liabilities 
$50 billion
Central Bank
A
E & L
Demand deposits
to banks
$10 billion
F
IGURE
9.10 — B
ANKS
, R
ESERVE
R
EQUIREMENT AT
20 P
ERCENT
The banks are fully loaned up, with total reserves of $10 billion
in legal reserve requirement at 20 percent, and demand deposits
therefore at $50 billion. 
Now, in Figure 9.11, we see what happens when the Fed low-
ers the reserve requirement to 10 percent. Because of the halving
of reserve requirements, the banks have now expanded another
$50 billion of loans and investments (IOUs), thereby increasing
Central Banking: Removing the Limits
137
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demand deposits by another $50 billion. Total demand deposits
in the country are now $100 billion, and the total money supply
has now increased by $50 billion. 
All Commercial Banks
A
E & L
IOUs
$90 billion
Demand deposits $100 billion
Reserves
$10 billion
Total Assets
$100 billion
Total Liabilities $100 billion
Central Bank
A
E & L
Demand deposits
to banks
$10 billion
F
IGURE
9.11 — L
OWERING THE
R
ESERVE
R
EQUIREMENT
One way for the Central Bank to inflate bank money and the
money supply, then, is to lower the fractional reserve require-
ment. When the Federal Reserve System was established in 1913,
the Fed lowered reserve requirements from 21 percent to 10 per-
cent by 1917, thereby enabling a concurrent doubling of the
money supply at the advent of World War I. 
In 1936 and 1937, after four years of money and price infla-
tion during an unprecedentedly severe depression under the New
Deal, the Fed, frightened at a piling up of excess reserves that
could later explode in inflation, quickly doubled bank reserve
requirements, from approximately 10 percent to 20 percent. 
Frightened that this doubling helped to precipitate the severe
recession of 1938, the Fed has since been very cautious about
changing reserve requirements, usually doing so by only 1/4 to
1/2 of 1 percent at a time. Generally, true to the inflationary
138
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nature of all central banking, the Fed has lowered requirements.
Raising reserve requirements, then, is contractionary and defla-
tionary; lowering them is inflationary. But since the Fed’s actions
in this area are cautious and gradual, the Fed’s most important
day-to-day instrument of control of the money supply has been to
fix and determine total bank reserves. 
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X.
C
ENTRAL
B
ANKING
:
D
ETERMINING
T
OTAL
R
ESERVES
T
he crucial question then is what determines the level of
total bank reserves at any given time. There are several
important determinants, which can be grouped into two
classes: those controlled by actions of the public, or the market;
and those controlled by the Central Bank. 
1. T
HE
D
EMAND FOR
C
ASH
The major action by the public determining total bank
reserves is its demand for cash.
1
We saw (in chapter IX and in Fig-
ures 9.1–9.7) how the public’s increased demand for cash will put
contractionary pressure on a bank, while decreased desire for
cash will add to its inflation of the money supply. Let us now
repeat this for the aggregate of commercial banks. Let us assume
that the public’s demand for cash in exchange for its demand
141
1
In this chapter, we will assume that cash is the notes of the Central
Bank.
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deposits increases. Figure 10.1 shows a hypothetical banking sys-
tem, and Figure 10.2 shows the immediate effect on it of an
increase in the public’s demand for cash, that is, their redeeming
some of its deposits for cash.