When a bank accepts a deposit and subsequently grants a loan it is not merely transferring purchasing power from lenders to borrowers but rather, because of the fractional reserve system, it can lend out a multiple of the original deposit and in this way actually create purchasing power. When a bank receives a deposit for Rwf1,000,000 it does not need to keep this deposit entirely in the form of cash. From experience the bank knows that only a percentage of the deposit will be required as cash. For example let us assume that a bank considers 10% of deposits to be a prudent liquidity ratio.
A prudent liquidity ratio is the ratio which the bank retains for sufficient liquid assets to enable it to satisfy the demands made on it for cash.
Although more than 10% of balances are operational only approx.10% involve cash transactions because most transactions are conducted without recourse to cash e.g. through the use of cheques. Thus in our present example of the Rwf1,000,000 in cash deposited with the bank it need hold onlyRwf100,000 to provide it with adequate liquidity and consequently Rwf900,000 can be lent out. This Rwf900,000 which has been lent out will in the course of fulfilling its money function(s) return to the banking system, the person to whom this loan is granted buys from the local office supplier a photocopying machine for Rwf900,000.The office supplier lodges the Rwf900,000 in their bank account in bank B and this bank which also operates a liquidity ratio of 10% seeks to lend outRwf810,000 from the lodgement ofRwf900,000 and so this process continues until the repercussions of the original lodgements peter out. The final effect of the initial lodgement of Rwf1,000,000 would be the creation of Rwf10,000,000 of additional purchasing power. This is an example of the money multiplier in operation. In this example, with a liquidity ratio of 10%, the money multiplier is 10.
In general terms the money multiplier is the inverse of the liquidity ratio. In practice the creation of purchasing power is not as mechanical as the foregoing might suggest, the following factors are also relevant:
• Banks ability to grant loans is related to the magnitude of their deposit base, so it is directly related to their ability to generate deposits.
• All of the money may not find its way back into the financial system.
• Attention must also be focussed on the demand for loans. While banks may have the ability to grant loans, the general public may not wish to borrow all funds which are
available. Similarly banks will only be prepared to loan to those who they consider to be a good risk.
• Banks do not have one liquidity ratio, they know from experience that at particular times of the year e.g. Christmas, there will be an increase in the demand for cash so at such a time they need to hold a higher ratio of assets in cash form.
• Banks must comply with the regulations of the Financial Regulator and the laws of the land.
However, many text books concentrate on
(i) the deposit base,
(ii) the liquidity ratio and
(iii) the demand for loans
As being the salient features in respect of the amount of purchasing power that banks can create.