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The question asks what is the immediate effect of the cash deposit on the M1 measure of money supply. The official answer is "There is no change in the M1 measure of the money supply. (Demand deposits increase by the same amount that cash holdings fall.)." However, I think the some of the money deposited into the bank will be lend out and deposit into other banks and so on. So the multiplier also applies here, so the money supply should increase by the multiplier times the cash deposited minus the cash deposited(minus because cash holding has decreased). Why is that not true?

Please suggests if anything is not clear.

My guess: maybe it is because the question asks "immediate" effect and hence does not include the process of money being lend out again etc.?

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2 Answers 2

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It's best to always check the exact definitions for M questions, because they can vary a little between countries. I'll use the US Federal Reserve's here, viz. "M1 is defined as the sum of currency held by the public and transaction deposits at depository institutions (which are financial institutions that obtain their funds mainly through deposits from the public, such as commercial banks, savings and loan associations, savings banks, and credit unions)."

The reason M1 doesn't increase is essentially semantic. Before the deposit occurs, M1 is the sum of currency held outside the banking system ("held by the public") and deposits at banks etc. Notice that currency held by the banks is not included in the M1 definition.

When the deposit occurs, the accompanying double entry book keeping is [debit cash, credit customer deposit]. Now the cash is held by the bank, so not included in M1, but the customer deposit that was created by the cash deposit is - so there's no change. This is the best way to handle this btw., since once the cash is deposited at a bank, it's no longer playing an active role in the money supply.

As far as the potential impact on the reserve requirement, and multiplier effect. As you're quite rightly suggesting, the question is trying to avoid that by saying "immediate". However, if you're in the USA, reserves no longer control the money supply the way the text book tries to describe, so there would not be expected to be a long term impact either. (reserve requirements only cover a fraction of bank deposits, and capital requirements actually dominate in terms of regulatory impact.)

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  • $\begingroup$ And to add: cash currency taken by your bank must be handed over to the central bank. The central bank would then increase your bank's reserves held with them and then your bank can credit your increased deposit equal in value to the cash you just handed over. Your bank doesn't keep the cash. $\endgroup$ Oct 16, 2023 at 14:47
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M1 is liquid money immediately available in the commercial banking system, etc. M2 is near cash money that can be converted quickly into liquid form.

When a new dollar is introduced into the economy it will typically grow M1 by $901 over 18 months through the action of lending/depositing/lending over and over. This is true of what we see from open market operations conducted by the Federal Reserve bank. I think this is where the confusion is coming from. It takes 18 months because when a treasury bond is bought back, it takes time for that new dollar to filter into a reserve banking deposit.

If you deposit cash into the bank, it will have no immediate effect on M1. It needs to be engaged first. Politicians like Gorge W Bush and Trump have exploited this to create short term economic over stimulation by bypassing open market operations and stuffing cash into the reserve banking system more directly. Bush stuffed a ton of money into Freddie and Fannie, preaching wanting to make America an ownership society where more Americans owned their homes. This in turn caused Freddie and Fannie to have to lower the standards for loans in order to engage the money. This in turn, triggered a mass of lending and reserve deposits as housing sales skyrocketed and interest rates dropped. The ultimate result was more Americans owning homes, which many lost 6 years later in spectacular fashion. Fast forward to trump who lined everyday American's pockets with stimulus, PPP loans, extra unemployment, and housing assistance. A chart of M1 clearly shows a 3x increase in January 2020 when the metric was released 2 weeks after Biden was inaugurated. The M1 increase stimulated activity, but it triggered some runaway inflation.

So best way to answer your question is that the deposit would have no immediate effect. To have an effect, which can be substantial, you need to not only deposit the money, but have a way to engage it and enough time for the effect to multiply.

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