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China’s M2 Still Expanding Despite Reserve Requirement Rate Hikes.

In Money Supply on May 12, 2011 by CQCA

The People’s Bank of China announced that the reserve requirement for Chinese banks will be raised to 21%, effective May 18th.

Reserve requirements indicate how much money banks can loan out in relation to deposits. If $100 is deposited in a bank with a 50% reserve ratio, then $50 can be loaned out. The problem with this that now two people have a claim on that $50, the depositor and the debtor. Since two people have claims on the same amount of money, the total amount of “money” in the system has increased by $50, or 50%. However, it does not stop there. The debtor will most likely use that $50 to purchase a good or service. The person that receives the money for delivering that good or service will most likely deposit it in a bank. Another bank can then take that $50 and loan out $25 (because there is a 50% reserve requirement on the deposit). The money supply now stands at $175. This process will continue until that original $100 turns into $200. This is pure inflation, and represents no real increase in the wealth of the society.

The only way to stop this system is to have a 100% reserve ratio. In this case, the amount of credit in the system represents the amount of savings in the system. However, even a 50% reserve requirement this day and age is unheard of. The current rate for the U.S. is 10%. This means that $100 deposited in U.S. banks turns into $1,000.

China is trying to increase its reserve requirements to decrease inflation. However, this does not seem to be working.

In January, 2010, Chinese M2 stood at 62.5 trillion Renminbi. In March, 2011, after multiple reserve requirement hikes, Chinese M2 stood at 75.8 trillion Renminbi. This represents a 21.28% increase in a little over a year. Where is China’s new money coming from?

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