Monetarism as a way to maintaining liquidity during crisis

When economy faces downturn, the level of output and employment declines causing a reduction in total saving in the banking system. Additionally, the number of defaults on loans increases, which impairs public confidence on banks leading to bank run. With increasing defaults and bank run, the total money supply shrinks. To understand this phenomenon, we need to explain how we measure total money supply. The simplest measure include total currency on circulation and deposits/ credits created by banks. Under fractional reserve banking system, when someone deposits his/her money into the bank, all of it is not held as reserve by the bank. The bank keeps a fraction (which is generally determined by the central bank) of the money as reserve and lend the rest by creating deposit into the borrower’s account. A fraction of the unwithdrawn money from the borrower’s account is again held as the reserve and the rest is lent out. This process continues and there is an addition to the existing stock of money. Continue reading