Initially, the Republic of Gorgonzola has no commercial banking system. To make trading easier and eliminate the need for barter, the government directs the central bank of Gorgonzola to put into circulation 3,000,000 identical paper notes, called guilders. The central bank prints the guilders and distributes them to the people. At this point the Gorgonzolan money supply is 3,000,000 guilders.

In order to keep the money safe, some Gorgonzolan entrepreneurs set up a system of commercial banks. When people need to make a payment, they can either withdraw their guilders or write a check on their account. Checks give the banks permission to transfer guilders from the account of the person paying by check to the account of the person to whom the check is made out. With a system of payments based on checks, the paper guilders need never leave the banking system, although they flow from one bank to another as a depositor of one bank makes a payment to a depositor in another bank. Deposits do not earn interest in this economy.



Let’s suppose for now that people prefer bank deposits to cash and so deposit all of their guilders with the commercial banks. Assume that (1) initially, the Gorgonzolan central bank puts 3,000,000 guilders into circulation and (2) commercial banks desire to hold reserves of 20 percent of deposits. Assume that the public holds no currency.