5.6: 100-Percent-Reserve Banking

Imagine an economy without any banks; the entire money supply is held by the public in the form of physical currency. This means that the amount of money in the economy is equal to the total value of currency held by households and firms.

Now, a commercial bank is introduced, and the public is assumed to deposit all their currency into the bank. If the bank does not issue any loans and instead holds all the deposited money in reserve, it is known as a 100-percent-reserve banking system. In this case, the bank acts only as a secure place for holding money.

Further assuming that the bank holds no assets other than reserves, the bank’s balance sheet would show an equal value of reserves and deposits. No deposits are used for lending. The deposits can be accessed by the account holders whenever needed. The overall money supply does not increase, as the bank does not create any additional money through lending. The money has simply shifted from one form to another, without changing the total amount in the economy.

Imagine a hypothetical economy with no banks.

The entire money supply consists of currency—paper bills held by the public. The public includes households and firms. Suppose there is exactly $100 in this economy.

Now, a new commercial bank, called Bank A, is introduced.

The public is assumed to deposit the $100 of currency into Bank A for safekeeping.

It is assumed that Bank A accepts deposits but makes no loans. Bank A holds the full $100 as bank reserves, which are liquid assets like vault cash used to meet withdrawals.

This setup is a 100-percent-reserve banking system, where banks hold all deposits as reserves.

Look at Bank A’s balance sheet, which assumes the bank holds no assets other than reserves.

On the assets side, Bank A holds $100 in reserves.

On the liabilities side, Bank A has $100 in deposits, which it owes to its customers.

The money supply, which was initially $100 in currency in circulation, is now $100 in demand deposits.