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Whenever currency is deposited in a commercial bank, cash goes out of circulation and, as a result, the supply of money is reduced." Explain just why this statement is valid or not by illustrating the series of events that take place when a bank deposit is made.

User Giga
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Final answer:

Depositing currency in a commercial bank actually increases the money supply due to the practice of fractional-reserve banking, where banks loan out a portion of deposits, creating new checkable deposits that count towards the M1 money supply.

Step-by-step explanation:

Contrary to the initial suggestion that depositing currency in a commercial bank takes money out of circulation and reduces the supply, the process of making bank deposits actually has the potential to increase the money supply in the economy.

When a deposit is made into a commercial bank, these funds become part of the bank's reserves. The bank then uses these reserves to make loans, subject to reserve requirements set by the central bank. A portion of the deposit must be kept as reserves, but the rest can be loaned out to other customers.

This process is part of the fractional-reserve banking system, where banks hold a fraction of deposits in reserve and loan out the rest. As the bank loans out money, it is creating new checkable (demand) deposits which are considered part of the M1 money supply. This increases the quantity of money available as these new deposits can be used as a medium of exchange for goods and services.

An example of this in action might be a scenario where a bank with $10 million in deposits loans out $9 million (assuming a 10% reserve requirement). The money supply, in this case, would effectively increase by $9 million due to the additional money created through the loans.

This is known as the money multiplier effect, which demonstrates how commercial banks play a significant role in the expansion of the money supply through lending practices.

User TCC
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