The Mystery of Banking

All Commercial Banks
Assets
Equity & Liabilities
IOUs
$40 billion
Demand deposits
$50 billion
Reserves
$10 billion
Total Assets
$50 billion
Total Liabilities 
$50 billion
Central Bank
Assets
Equity & Liabilities
Demand deposits
to banks
$10 billion
Central Bank notes $15 billion
F
IGURE
10.1 — A H
YPOTHETICAL
B
ANKING
S
YSTEM
: 
A
LL
C
OMMERCIAL
B
ANKS
The hypothetical banking system is depicted as one with a 20
percent reserve ratio, fully loaned up. “Reserves” in the commer-
cial banks’ asset column are of course exactly equal to “Demand
deposits to banks” in the Central Bank’s liabilities column, since
they are one and the same thing. The asset side of the Central
Bank balance sheet is not being considered here; in our example,
we simply assume that Central Bank notes outstanding in the
hands of the public is $15 billion. Total money supply in the
country, then, is Demand deposits plus Central Bank notes, or 
$50 billion + $15 billion = $65 billion 
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Now let us assume that the public wishes to draw down its
demand deposits by $2 billion in order to obtain cash. In order to
obtain cash, which we will assume is Central Bank notes, the
banks must go to the Fed and draw down $2 billion worth of 
their
checking accounts, or demand deposits, at the Fed. The initial
impact of this action can be seen in Figure 10.2. 
Step 1: All Commercial Banks
Assets
Equity & Liabilities
Demand deposits
– $2 billion
Reserves
– $2 billion
Central Bank
Assets
Equity & Liabilities
Demand deposits
– $2 billion
Central Bank notes + $2 billion
F
IGURE
10.2 — I
NCREASE IN THE
D
EMAND FOR
C
ASH
: P
HASE
I 
In short, depositors demand $2 billion in cash; the banks go
to the Central Bank to buy the $2 billion; and the Central Bank,
in exchange, prints $2 billion of new notes and gives them to the
banks. 
At the end of Step 1, then, the money supply remains the
same, since demand deposits have gone down by $2 billion but
Central Bank notes outstanding have increased by the same
amount. The composition of the money supply has been changed
but not yet the total. The money supply is still $65 billion, except
that there is now $2 billion less of demand deposits and $2 bil-
lion more of Central Bank notes in the hands of the public. 
But this is only the first step, because the crucial fact is that
bank reserves have 
also
gone down by $2 billion, by the same
Central Banking: Determining Total Reserves
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amount that Central Bank notes in the hands of the public have
increased. 
But since reserves have gone down, and the banks keep fully
loaned up, this means that banks must contract their loans and
demand deposits until the new total of deposits is again brought
down to maintain the legal reserve ratio. As a result, bank loans
and investments must contract by another $8 billion, so that the
fall in reserves can be matched by a fivefold fall in total deposits.
In short, the $2 billion drop in reserves must be matched by a
total of $10 billion drop in demand deposits. At the end of the
completed Step 2, therefore, the balance sheets of the banks and
of the Central Bank look as follows (Figure 10.3).