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In some economics textbooks, the supply-demand equilibrium in the markets for money and reserves is represented by a simple so-called money multiplier relationship between the monetary base of the central bank and the resulting money supply including commercial bank deposits. This is a short-hand simplification which disregards several other ...
However, because the depositor can ask for the money back, banks have to maintain minimum reserves to service customer needs. If the reserve requirement is 10% then, in the earlier example, the bank can lend $90 and thus the money supply increases by only $90. The reserve requirement therefore acts as a limit on this multiplier effect.
The term "money supply" commonly denotes the total, safe, financial assets that households and businesses can use to make payments or to hold as short-term investment. [11] The money supply is measured using the so-called "monetary aggregates", defined based on their respective level of liquidity. In the United States, for example:
The acceptance and value of commercial bank money is based on the fact that it can be exchanged freely at a commercial bank for central bank money. [20] [21] The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some ...
Central banks implement policy primarily through controlling short-term interest rates. The money supply then adapts to the changes in demand for reserves and credit caused by the interest rate change. The supply curve shifts to the right when financial intermediaries issue new substitutes for money, reacting to profit opportunities during the ...
The period when major central banks focused on targeting the growth of money supply, reflecting monetarist theory, lasted only for a few years, in the US from 1979 to 1982. [16] The money supply is useful as a policy target only if the relationship between money and nominal GDP, and therefore inflation, is stable and predictable.
Since the increase in bank reserves may not immediately increase the money supply if held as excess reserves, the increased reserves create the danger that inflation may eventually result when the reserves are loaned out. [107] QE benefits debtors; since the interest rate has fallen, there is less money to be repaid.
The reserve ratio is sometimes used by a country’s monetary authority as a tool in monetary policy, to influence the country's money supply by limiting or expanding the amount of lending by the banks. [1] Monetary authorities increase the reserve requirement only after careful consideration because an abrupt change may cause liquidity ...