10.2 International funds transfer and credit expan...
The borrowing and lending activity of banks has the effect of expanding or contracting the money supply in domestic markets.The limit to the expansion or contraction is determined by the reserve ratio.The lower the reserve ratio the higher the possible multiplicative effect.The same principle was applied to the Eurocurrency market and it was argued that since the Eurocurrency markets were outside the jurisdiction of the regulatory authorities, the reserve ratio is zero and therefore the money supply multiplier is infinite or at least very high.Other authors criticized this view.They pointed out that the reserve ratio multiplier works in a domestic market because the domestic markets essentially a closed circuit, and they argued that the Eurocurrency system is not a closed system.Potential borrowers and lenders have the choice between the Eurocurrency market and the domestic market.In order for the Eurocurrency market to increase its transactions, it has to offer advantages in price and service.Otherwise, funds will leak out of the system and the multiplier will break down.The general conclusion is that although money and credit expansion through the Eurocurrency system is possible, it is incorrect to suppose that the expansion will occur through a fixed multiplier.
The question is interesting because it highlights the fundamental characteristics of the Eurocurrency system, its interaction with the individual domestic markets and the international transfer of funds.