On 30 Dec 99 16:03:15, Roberto Verzola wrote:
>I've posed this question so many times, even to economists, and have
>almost always gotten the wrong answer: ASSUMING A RESERVE REQUIREMENT
>OF 10%, HOW MUCH ADDITIONAL MONEY CAN THE BANKING SYSTEM LEND, IF YOU
>DEPOSIT 100 DOLLARS IN YOUR BANK?
>
>If your answer is 90, which is what I also thought a year ago, you --
>like almost everyone else -- are underestimating the power of banks.
>
>The correct answer is 900. Please read that again: from your 100
>dollar deposit, the banking system can lend a maximum of 900, not 90,
>dollars.
Actually, both answers are wrong. Sort of. And both are right. Sort
of.
Assume I earn US$1,000 in Peru (the foreign source is important here,
since when I bring it into the States I'm *increasing* the money supply
by exactly $1000 because it is *new* money to the economy). I deposit
the $1,000 in currency in my local bank. Under a 10% reserve
requirement, my bank can subsequently lend $900 to someone who uses it
to buy a flat-panel computer screen.
The screen vendor deposits the $900, and voila, the money supply has
increased by another $900 ! And the bank (following the same 10%
reserve requirement) may lend $810 of it to someone else. When that
$810 is spent and deposited, the cycle repeats at the $730 level, and
so on.
If you keep on doing this all the way down to the $50 level, the total
increase in the money supply will be about $9,550 from the original
$1,000. If continued down to the last theoretical dime, the increase in
the money supply will be just about $10,000 (including the original
$1,000). This is where that figure of lending $900 against $100 comes
from. What most people don't realise is that the cycle repeats itself,
which is what jacks the theoretical numbers up so high.
In *practice,* however, the multiplier is only around 3.5 to 4.0 ----
each new $1,000 brought in cycles far enough to increase the money
supply by $3,500 to $4,000 depending on circumstances. What happens is
that people hold cash for their businesses or for personal purposes;
people spend cash overseas; and so on, truncating the cycle and
eliminating the multiplication effect onward from that point.
Deflationary environments do funny things to this dynamic. People pour
their money into savings (because it will be worth more); people hoard
cash (because there is no inflation penalty for doing), and people
demand payment in cash (keeping it out of the banking system
altogether). On top of it all, few people want to *borrow* money,
because the rate of *real* interest is high and they'll have to repay
the loan with money that't worth more than what they borrowed --- while
what they bought becomes worth less and less. Ouch.
The net result is that banks have trouble lending money, even at 0%
interest! This is called a 'liquidity trap,' and the Japanese have
been struggling with one for several years. Shrinks your money supply
in a heck of a hurry. Shrinking money supply is in itself
deflationary, reinforcing the effect. Cash is King. Too many goods that
nobody wants to buy. Only way to move 'em is drop the price.
Most interesting to note, however, is that for every strong deflation
in the last 1100 years, the phenomenon has been felt *first* in farm
prices.
Bart
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