June 16, 2021, | AtoZ Markets – Around 500 to 1500 AD, money is not yet in cash, but rather gold. Gold is heavy and a hassle to bring from place to place. People went to goldsmiths to store their money.
Goldsmiths are experts when it comes to gold. They can tell its purity and accurate weight. When people go to them for their gold’s safe-keeping, they will issue a receipt that indicates the value of the gold given. After some time, the people understood that the gold receipts themselves could stand for the same amount of gold. It was more convenient than bringing gold everywhere they went.
Goldsmiths realized that people eventually preferred carrying their receipts better in their daily transactions with the idea that they can always exchange these receipts for gold anytime. So, they now thought of issuing receipts to people who want to borrow money but in proportion to the actual amount of gold they have in store so that they won’t panic if ever a gold depositor came in and wanted to withdraw their gold. This idea of the medieval European goldsmiths became the pioneer of the modern-day banking system.
From the medieval European goldsmith’s system, gold now represents government-issued coins and bills. And since modern-day banking has immensely evolved, issuing money is now beyond just coins and bills as banks now offer checks and checking accounts in giving out loans.
For example, Mr. A deposits $1,000 in Bank A. Assuming the required reserve is 10%, Bank A will keep $100. Bank A maximizes the $900 to Ms. B, a loan applicant, by giving her a checking account with a $900 credit. Now, Ms. B writes a $900 check to a baking supplier where she shopped for her baking needs to jumpstart her baking business. The baking supplier will now deposit the money to Bank B, where she has an account. Bank B will now keep $90 because of the 10% required reserve law and make loans out of the $810. This cycle will continue until the initial $1,000 finishes.
Given these facts, we can say that bank reserves say a lot about the economy’s overall status.
Required reserves vs. excess reserves
Bank reserves are the cash on hand the bank keeps. Daily, there will be many individuals who will go into the bank to deposit money. The bank does not store all of it but instead uses it to make loans for borrowers. This act is to make more profit since loans come with interest. However, they must balance giving out loans since some depositors may withdraw money and be ready for these instances.
There is a requirement for banks to keep a specific amount or percentage of bank reserves called required reserves. For example, a country’s required reserve is 20 percent. If the total amount of deposits is $1,000,000, then the bank can only give out $800,000 for loans and keep $200,000 in their vaults or their central banks for depositors who may wish to withdraw.
An excess reserve is an amount beyond the required reserve that the banks keep. The bank can make this amount into loans for borrowers.