Currency Deposit Ratio

The currency–deposit ratio equals the total circulating currency divided by checkable bank deposits. Checkable bank deposits are deposits that are used in transactions. Also called “demand deposits,” checkable deposits represent claims on currency that the public can exercise freely and with minimal delay. The total circulating currency counts only currency held by the nonbank public. It excludes currency held as vault cash at banks. Both currency and checkable deposits act as a form of money.

The currency–deposit ratio reflects public preferences for holding currency relative to bank deposits. It undergoes some seasonal variation. During the Christmas shopping season, the ratio tends to rise as the public carries more currency. The public can raise the currency– deposit ratio by withdrawing currency from banks, and it can reduce the currency–deposit ratio by depositing currency in bank accounts.

The currency–deposit ratio is important because currency is part of what economists call “high-powered money.” Highpowered money includes circulating currency and bank reserves. It is called high-powered money because a banking system expands deposits by some multiple of bank reserves. Bank reserves are either vault cash or commercial bank deposits with Federal Reserve Banks. Since circulating currency deposited in a bank account becomes part of bank reserves, banks can expand bank deposits by some multiple of the amount of a new deposit of currency. When bank lending multiplies bank deposits, the money stock expands accordingly. A mass withdrawal of currency from banks will cause a contraction in bank deposits several times greater than the amount of currency withdrawn.

A sudden shift in the public’s preferences for holding currency as opposed to bank deposits can induce a change in the money stock independent of actions by official monetary authorities. During the early 1930s, the United States saw the public suddenly increase its preference for currency over deposits (Boughton and Wicker, 1979). The public was reacting to a large increase in the numbers of bank failures. At the beginning of the 1930s, the United States had not established deposit insurance, and when a bank failed, depositors lost their money. An outbreak of bank failures persuaded many people that they would rather keep their money stashed in mattresses or buried in coffee cans.

The mass withdrawal of currency from banks not only added to the number of bank failures but also caused the money stock to contract. When an economy is sinking into recession or depression, it needs an increase in the money stock to stem the tide of economic retrenchment. To regain depositor confidence, banks started holding larger reserves relative deposits, further reducing the amount of bank lending. Between depositors withdrawing currency from banks, and banks trying to bolster reserve holdings, the money stock contracted significantly even though the Federal Reserve increased the amount of high-powered money. To ease the crisis, the United States government established the Federal Deposit Insurance Corporation. By mid-1934, 97 percent of all commercial bank deposits were protected by deposit insurance (McCallum, 329). Bank failures subsided, and the currency–deposit ratio began a steady decline.