What is MONEY SUPPLY?

What will be the impact of an unlimited or abundant money supply?

• Today I was listening to a debate on the topic "Can we have unlimited  money supply" and "Effect of unlimited money supply on an economy".  There were two schools of thought: 1. If Central Bank reduces the reserve requirement (as it is currently  zero in some countries) and allow commercial banks to issue as much  loans as possible, this will fuel economic growth. 2. If Central Banks reduce the reserve requirement (as it is currently  zero in some countries) and allow commercial banks to issue as much  loans as possible, this will increase prices too much and bring  inflation. I have just a basic understanding of economics, and cannot myself reach  to a conclusion as to which of the above is correct (if any). Can you  please explain the scenario in the light of any popular theory? Please can you also explain the impact of Interest in the above scenario, if: 1. All the increased loans are interest based. 2. All the increased loans are free of cost.

• Answer:

  You're confusing three things: the money multiplier, required reserves, and voluntary reserves. Money Multiplier The money multiplier provides a shorthand expectation of how large an increase in base money has on the overall money supply. So if I, the Fed, put $100 into circulation, that money will be deposited. But then it will be lent out again. And the person borrowing that money will deposit it in his bank... who will lend that deposit out again, too. For the sake of simplifying, let's assume that all banks reserve 50% of their deposits. So when the Fed creates $100 new dollars, the banking system lends it out. Borrowers deposit $100. Banks keep $50 on premises in the event a depositor wants to make a withdrawal, and lend $50 out. Deposit $50... reserve $25 / lend $25. Deposit $25... reserve $12.5 / lend $12.5. You get the idea. Add everything up, and the $100 new base dollars equals $200 in deposits. So the money multiplier is 2; or 1/.5; which is 1/Reserve Ratio, where the reserve ratio is the proportion of all new deposits that banks keep on hand to satisfy depositor's desires to withdraw funds. Required Reserves These are the mandated minimums the Fed requires financial institutions to carry. Voluntary Reserves These are the reserves financial institutions keep on hand in excess of the required reserves. ---- It seems to make sense that if banks were not required to hold any reserves on premises, then as the Required Reserve Ratio approaches zero, the money multiplier approaches infinity. Voila, we have an infinite money supply. Implicit in your question is the assumption that banks would not voluntarily hold onto any reserves; to the extent that they did not lend all deposits out, the money supply would not approach infinity. The multiplier may be rather large (a multiplier of 100 for a voluntary reserve of 1%), but hardly infinite. So it begs the question: do banks have a reason besides Fed regulations to keep money on hand? The answer? Of course! Depositors want to be able to access the money in their account. If you don't have money available to give to them, you'll upset them; think about what you would do if you went to your bank and they said, "Sorry, you can't have any of your money. Come back tomorrow." I would come back tomorrow, close the account, withdraw all my funds, and deposit them in some other bank that allowed me to gain access. So theoretically there's little reason to expect that a bank, which has profit motive to please its customers and source of revenue: their depositors, would lend out 100% of deposits if the Federal reserve requirements were eliminated. Historical evidence backs this up: the free banking period in Scotland (~1700 to 1850ish) lacked any sort of reserve requirements and banks voluntarily held onto about 3% of their deposits. This period marks one of the most stable monetary regimes in history, with sustained economic growth, stable purchasing power, and relatively few monetary-created business cycle booms and busts. All of this suggests that it is possible to eliminate reserve requirements without experiencing rampant inflation. (Though it's admittedly a possible consequence to have rampant inflation with no reserve requirements, but it's not a necessary consequence.)