Economics · Ch 3 — Money and Banking
Balance Sheet of a Fictional Bank
Balance Sheet of a Fictional Bank
The Starting Point: Deposits Create Liabilities
Every bank begins with a simple transaction: someone deposits money. In our fictional bank, Ms Fernandes deposits Rs 100. This deposit is a liability for the bank — the bank owes this money back to her on demand. It is not the bank's own wealth; it is a claim that the depositor holds against the bank.
At this initial moment, the bank's balance sheet has two entries:
- Liabilities: Deposits of Rs 100
- Assets: Reserves of Rs 100
The bank takes the entire Rs 100 and deposits it with the central bank (the Reserve Bank of India, or RBI) as reserves. Why? Because banks are required to hold a fraction of deposits as reserves, and in this simplified example, we assume the bank chooses to hold the full amount as reserves.
In reality, banks hold only a fraction of deposits as reserves (the required reserve ratio). The textbook starts with the extreme case of 100% reserves to make the logic crystal clear before introducing fractional reserves later.
The Balance Sheet: Table 3.1
The textbook presents this situation as Table 3.1. Here is the same information in a clean table:
| Assets | Rs | Liabilities | Rs |
|---|---|---|---|
| Reserves with RBI | 100 | Deposits | 100 |
| Total Assets | 100 | Total Liabilities | 100 |
The balance sheet always balances: total assets equal total liabilities. The bank's net worth (assets minus liabilities) is zero in this simplified case — the bank has no capital of its own yet.
Money Supply in This Simple Economy
The textbook now asks: what is the total money supply in this economy? It uses the narrow definition of money, called M1, which consists of:
- Currency in circulation (notes and coins held by the public)
- Demand deposits (checkable deposits at banks)
The formula is:
In our example, the textbook assumes no currency in circulation — all money is held as bank deposits. So:
- Currency = Rs 0
- Deposits = Rs 100
Therefore:
The total money supply is Rs 100.
This is a critical insight: when a bank holds 100% reserves, the money supply does not expand beyond the original deposit. The bank is merely a safe-deposit box — it does not create new money. The money supply equals the initial deposit, no more.
What This Teaches Us
This simple balance sheet establishes the foundation for understanding how banks can create money. The key lesson so far:
- A bank's deposits are its liabilities — they represent money owed to depositors.
- A bank's reserves are its assets — they represent money held at the central bank. …