The Mystery of Banking

Citibank
Assets
Equity & Liabilities
Demand deposits
to Jones & Co.
+ $1,000
Reserves
+ $1,000
Federal Reserve
Assets
Equity & Liabilities
U.S. Government
Demand deposits
Securities
+ $1,000
to Citibank
+ $1,000
F
IGURE
11.1 — T
HE
C
ENTRAL
B
ANK
B
UYS
S
ECURITIES
162
The Mystery of Banking
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At this point, Citibank cannot simply increase demand
deposits by another $4,000 and lend them out. For while it could
do so and remain with a required minimum reserve/deposit ratio
of 20 percent, it could not keep that vital status for long. Let us
make the reasonable assumption that the $4,000 is loaned to
R.H. Macy & Co., and that Macy’s will spend its new deposits on
someone who is a client of another, competing bank. And if
Citibank should be lucky enough to have Macy’s spend the
$4,000 on another of its clients, then 
that
client, or another one
soon thereafter, will spend the money on a nonclient. Suppose
that Macy’s spends $4,000 on furniture from the Smith Furniture
Co. But the Smith Furniture Co. is the client of another bank,
ChemBank, and it deposits Macy’s Citibank check into its Chem-
Bank account. ChemBank then calls on Citibank to redeem its
$4,000. But Citibank hasn’t 
got
the $4,000, and this call for
redemption will make Citibank technically bankrupt. Its reserves
are only $1,000, and it therefore will not be able to pay the
$4,000 demanded by the competing bank. 
Figure 11.2 reveals the straits of Citibank, imposed by the
existence of competing banks: 
Bank A
Bank B
Citibank
Chembank
Assets Equity & Liabilities Assets Equity & Liabilities
from Macy’s
Demand 
Demand 
+ $4,000 deposits to
deposits to
Jones & Co.
Smith
+ $1,000
+ $4,000
Reserves
Demand
Due from
+$1,000
deposits to
Citibank
Chembank
+ $4,000
+ $4,000
F
IGURE
11.2 — R
EDEMPTION OF
O
NE
B
ANK FROM
A
NOTHER
Central Banking: The Process of Bank Credit Expansion
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In short, when Citibank’s demand deposits were owed to
Macy’s, its own client, everything was fine. But now, not from
loss of confidence or from a sudden demand for cash, but in the
course of regular, everyday trade, Macy’s demand deposits have
been transferred to ChemBank, and ChemBank is asking for
reserves at the Fed for redemption. But Citibank doesn’t have any
reserves to spare and is therefore insolvent. 
One bank, therefore, cannot blithely heap 5:1 on top of new
reserves. But if it cannot expand 500 percent on top of its
reserves, what 
can
it do? It can and does expand much more mod-
erately and cautiously. In fact, to keep within its reserve require-
ments now and in the foreseeable future, it expands not by 500
percent but by 1 minus the minimum reserve requirement. In this
case, it expands by 80 percent rather than by 500 percent. We will
see in the figures below how each bank’s expanding by 80 percent
in a central banking system causes all banks, in the aggregate, in
a short period of time, to expand by the money multiplier of 5:1.
Each bank’s expansion of 80 percent leads to a system or aggre-
gate expansion of 500 percent. 
Let us therefore go back to Figure 11.1, and see what
Citibank does in fact do. Instead of lending $4,000 to Macy’s, it
lends out 80 percent of its new reserves, or $800. In Figure 11.3,
we see what happens after this 
first
step in bank credit expansion
across the banking system. 
First, the total money supply, which had increased by $1,000
after the Fed’s bond purchase, has now increased by $1,800.
There has already been an 80 percent further expansion in the
money supply, in the form of demand deposits. 
But Macy’s, of course, has not borrowed money to sit on it.
It uses the $800 to purchase something, say furniture, from the
Smith Furniture Co. The Smith Furniture Co., we assume, has its
account with ChemBank, and deposits its $800 check drawn on
Citibank with ChemBank. ChemBank now calls upon Citibank
for redemption, that is, for shifting $800 of its reserves at the Fed
to ChemBank. But Citibank now has ample reserves, for it can
afford to pay $800 out of its $1,000 new reserves, and it will still