What Determines the Amount

of Currency in Circulation?

What determines the amount of currency outstanding? The answer is, to repeat, the Federal Reserve always prints up enough money to give bank depositors all they want in exchange for their deposits. Thus, it is the stock of bank deposits that basically determines the size of the nation’s money stock. Once the public has deposits, it can obtain more currency at will. If for some reason the public has more currency than it wants to hold, it simply puts the currency back in the bank and receives a deposit in exchange.

Thus, basically, it is the public’s demand for currency that determines how many coins are minted and how much paper money is printed. Remember, though, that although most people probably think of currency as the main form of money, in fact it plays a minor role in our monetary system. People ordinarily keep about onefifth of their total money holdings in the form of currency, and about four-fifths in demand deposits. Although this ratio varies from time to time, as a general rule the monetary authorities can predict that if households and businesses receive $100 of additional deposits, they will withdraw about $20 of it in the form of new currency.

THE SUPPLY OF BANK MONEY:

CHECKING DEPOSITS

Commercial Banks and the “Creation” of Deposits

Currency is government money issued directly by the Treasury and the Federal Reserve. But the great bulk of our money is not issued by the government at all. Rather, it is provided by the commercial banks in their day-to-day business of making loans and “investments.” The distinguishing feature of modern commercial banking is its ability, through making loans and investments, to “monetize” the debts of others, and thereby in effect to create demand deposits (checking accounts) which serve as money.

Thus, the commercial banks (that is, the banks we all know and deal with) in good times generally lend out more than we have deposited in them. In bad times, they may insist on repayment of the same loans, wiping out the deposits created when the loans were made. Far from being a passive link in the savings-investment process, commercial banks may drastically affect the flow of funds from, savers into real investment.

To understand this rather startling statement that commercial banks “create” checking deposits, you need to know something about how. a commercial bank works. The easiest way to get this picture is to look at a simplified balance sheet of a bank, and then to trace through a few trarisactions. This will give you an understanding of the nature of deposits and how they get created.

The Bank’s Balance Sheet

Banks, like other business institutions, keep a running financial record of what they own and what they owe to other people. What they own and what is owed to them are their “assets.” What they owe to other people are their “liabilities.” The difference between the two is the “net worth” of the business to its owners, the stockholders. When these three main categories are put together in one statement, they are called a “balance sheet.”

A typical bank balance sheet looks like the one below, except we have omitted a lot of minor items to make the essential categories stand out.

What this balance sheet says is that on June 30, 1968, the bank owned cash of $400,000, bonds valued at $800,000, and a building and fixtures valued at $50,000. In addition, it had loaned out $400,000 to customers, who owed the money back to the bank. These are its assets.

Offsetting these assets, the bank had deposits of $1,500,000, partly demand and partly time deposits. These deposits are liabilities, because they are sums the bank promises to pay to the depositors on demand or on due notice.

The difference between the assets and liabilities is $150,000, which is the estimated net worth of the bank. Part of this net worth was originally paid in by the stockholders as “capital” when they bought stock to start the bank. The rest is “surplus and undivided profits,” which are mainly the profits made by the bank and not paid out to the, owners. This breakdown of net worth is not shown on our simplified balance sheet.