Deposit of notes and coins

A condition under which the above is plausible is if the original deposit was made in N&C. Let us explore this. If HNW Mrs A deposits LCC 100 million in N&C (which she had in a large tin box under her bed) at the bank her balance sheet will change as indicated in Balance Sheet 41.

The bank's balance sheet in Balance Sheet 42 shows Mrs As deposit and an asset in the form of N&C. The bank now has a deposit on which it is paying interest and an asset that does not earn interest.

Because the N&C are surplus to their requirements (in tills and ATMs) and are liabilities of the CB, the bank will deposit them immediately with the CB; the results are shown in (continuous) Balance Sheets 43-44 (note that they balance).

Because bank deposits increased by LCC 100 million, RR is +LCC 10 million. The balance of LCC 90 million is reserves that are in excess of that required, i.e. the bank now has LCC 90 million in excess reserves (ER). As in the case of holding LCC 100 million in non-interest-bearing N&C, the bank now also has an asset (ER) that also bears no interest (RR does not either but it is not a "free" asset). If this situation was sanctioned by the CB (assuming there were no BR before this transaction), interest rates would fall sharply and the bank will feverishly make loans in order to create a balance sheet that will produce an income.

How can it do this? It can only be done by making loans, which creates bank deposits (= money); and this can take place up to the point where all the ER are absorbed in RR. This level is reached when total bank deposits created are equal to:

The start (the deposit of N&C) and final outcomes are shown in Balance Sheets 45-48.

The above is just a pleasant and neat exercise, and it is presented in the interests of completeness and as an introduction to what follows. As we saw earlier, N&C make up a small part of money, and while the above example is possible, it is misleading to present it as the model of money creation. However, it did demonstrate a critical point: that the banks can only "get rid of" ER in the manner shown. Just as they cannot create CBM, they cannot "get rid of" it, except in the manner shown, which is changing the dividing line between ER and RR (by lending and creating deposits). We will touch upon this later again.

Government spending

It is sometimes expounded that government spending (when government uses the CB as its banker) leads to money creation. Let us assume that government spends LCC 100 million on goods bought from the NBPS (see Balance Sheets 49-52).

After government spends, the banks have ER of +LCC 90 million. They can now lend up to the point where ER are fully transmuted / absorbed into RR. The end point is the same as in the N&C example above: M3 can increase up to a total of:

As in the above N&C example, this exposition is misleading, and it is so because the original transaction is omitted from the story. It is a critical part of the story. The original transaction is that government either receives revenue from taxes or borrows the money. We will explore the latter case: government borrows LCC 100 million by the issue of bonds (bought by the banks) and spends this on goods bought from the NBPS (see Balance Sheets 53-56).

Note the difference from the previous example where the original transaction was omitted: M3 (deposits of NBPS) increased by LCC 100 million and the BSSoC is bank loans (buying new bonds = new loans extended). The previous example gives a starkly different picture: the creation of ER.

In fact the correct story is that the banks are actually short of reserves - because bank deposits have increased (that carry a 10% RR). We omitted this issue in the interests of simplicity. We now correct it in Balance Sheets 57-58.

As we have said before, the banks are not able to create CBM; only the CB itself can do this. The bank is therefore obliged to take a loan from the CB at the KIR.