The Mystery of Banking

Step 2: All Commercial Banks
Assets
Equity & Liabilities
IOUs
$32 billion
Demand deposits
$40 billion
Reserves
$8 billion
Total assets
$40 billion
Total liabilities
$40 billion
Central Bank
Assets
Equity & Liabilities
Demand deposits
to banks
$8 billion
Central Bank notes
$17 billion
F
IGURE
10.3 — I
NCREASES IN THE
D
EMAND FOR
C
ASH
: C
ONCLUSION
The eventual result, then, of an increased demand for cash by
the public is a drop in demand deposits of $10 billion, resulting
from the drop of bank reserves of $2 billion. The total money
supply has gone down by $8 billion. For demand deposits have
fallen by $10 billion, and cash in the hands of the public has risen
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The Mystery of Banking
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by $2 billion, making a net drop of $8 billion in the supply of
money. 
Thus, an increased demand for cash causes an 
equal
drop in
bank reserves, which in turn has a money multiplier effect in
decreasing total demand deposits, and hence a slightly less intense
effect in cutting the total amount of money. 
If the public’s demand for cash drops, on the other hand, and
it puts more of its cash in the banks, then the exact reverse hap-
pens. Suppose we begin with the situation in Figure 10.1, but now
the public decides to take $2 billion out of the $15 billion of Cen-
tral Bank notes in its possession and deposits them in exchange
for checking accounts. In this case, demand deposits increase by
$2 billion, and the banks take the ensuing extra cash and deposit
it in the Central Bank, increasing their reserves there by $2 bil-
lion. The $2 billion of old Central Bank notes goes back into the
coffers of the Central Bank, where they are burned, or otherwise
retired or liquidated. This situation is shown in Figure 10.4. 
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
10.4 — D
ECREASE IN THE
D
EMAND FOR
C
ASH
: P
HASE
I 
In short, the immediate result of the public’s depositing $2
billion of cash in the banks is that, while the total money supply
Central Banking: Determining Total Reserves
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remains the same, only changing the composition between
demand deposits and cash, total bank reserves rise by $2 billion. 
Receiving the new reserves, the banks then expand credit,
lending new demand deposits which they have created out of thin
air. They pyramid deposits on top of the new reserves in accor-
dance with the money multiplier, which in our stipulated case is
5:1. The final result is depicted in the balance sheets in Figure
10.5. 
Step 2: All Commercial Banks
Assets
Equity & Liabilities
IOUs
$48 billion
Demand deposits
$60 billion
Reserves
$12 billion
Total assets
$60 billion
Total liabilities
$60 billion
Central Bank
Assets
Equity & Liabilities
Demand deposits
to banks
$12 billion
Central Bank notes
$13 billion
F
IGURE
10.5 — D
ECREASE IN THE
D
EMAND FOR
C
ASH
: C
ONCLUSION
Thus, the public’s depositing $2 billion of cash in the banks
increases reserves by the same amount; the increase in reserves
enables the banks to pyramid $8 billion more of deposits by
increasing loans and investments (IOUs) by $8 billion. Demand
deposits have therefore increased by $10 billion from the reduc-
tion in the public’s holding of cash. The total money supply has
increased by $8 billion since Central Bank notes outstanding have
dropped by $2 billion.