In studying the reserve policy of banks it is worth while to devote some attention to what is called inflation and deflation. By the former term, when used in banking discussion, is meant the undue or disproportionate increase of bank credit. By deflation may be meant either the curtailment or destruction of inflation, or the term may be used to mean the reduction of bank credit below the normal permanent level. How is it that inflation grows up, and what is its relation to the reserve question? Suppose the existence of a bank which stands alone in its community, and which is maintaining a safe business with a reasonable balance between income and outgo. We may assume that this bank has on hand at all times a reserve fund of 25 per cent of demand deposits. This bank has many calls upon it from customers about whose operations it feels some doubt. It, however, becomes gradually more liberal and makes a considerable number of loans which, although well secured, are not paid at maturity, but are renewed. The effect is to increase the deposit line of the bank and, relatively speaking, to decrease its reserve balance. For example, it may be supposed that on July 1 of a certain year the bank has outstanding $500,000 of deposits and has $500,000 of customers' notes, of which, let us say, $50,000 are falling due. Of the makers of this $50,000 of paper, however, one-half, represented by $25,000, ask for renewal. The bank, however, has to meet on the 1st of July obligations of one kind or another which require $50,000 cash. Evidently if it obtained the payment of the $50,000 of notes it might cut down its deposits to $450,000 or might meet the obligations presented by the use of the payments made to it. In the one case, its position would be stronger than ever because it would have its 25-per-cent reserve (25 per cent of $500,000) intact, though it would have cut its discount line to $450,000. But the bank, we may assume, yields to demands for renewal to the extent of $25,000 and hence has to lose $25,000 in cash. Here it has increased its deposit liability relatively to reserve in order to extend a longer credit to its customers. When this kind of operation occurs on an increasing basis, and especially when it occurs as the result of loans made by the banks upon long-term securities such as bonds, mortgages, stocks, etc., and not as a result of commercial transactions, the result is usually described as an inflation of bank credit. The effect of it may be in some instances to cause an increase of prices through the action of the owners of the deposit accounts in demanding goods for which they pay in checks on the bank. If there has been no corresponding enlargement of the amount of goods in the community, and if the goods thus bought with bank credit are unproductively employed, the result is to decrease the amount of goods in the community relatively to purchasing media, and the tendency toward an upward movement of prices is then evident. In such a case we have what is called price inflation, and in the instance cited such price inflation may be more or less directly associated with bank-credit inflation. This situation evidently touches closely upon the reserve condition, since the latter usually acts as a kind of barometer, indicating when the outstandings of the bank are liquid. If the reserve ratio falls off, showing that the supply of cash on hand is smaller as compared with outstanding deposits, that may be due to inflationary operations on the part of the bank. While this is not always true, it is likely to be so when the decline in reserve occurs over a large area or group of banks or at a central bank. Such a decline is then in fact an index of inflation, and it usually follows that such inflationary conditions are associated with a rise of prices.

Deflation is a word less frequently heard than inflation, but is correlative with the latter term. As employed in banking it means the elimination from bank portfolios of loans which have been made on an unduly long or unquestionably investment basis. It should be remarked at this point that the line of distinction between sound or normal bank loans and those which are inflationary in whatever degree is not absolute, but the result of experimental observation in any particular circumstances. It is a matter which calls ordinarily for a discriminating study before positive conclusions can be reached in any given case. Generally speaking, deflation, however, is usually employed as a term which denotes the restoration of a safe or satisfactory balance between outstanding demands upon banks and their reserve protection. In countries which are organized on a central banking system this process of deflation may involve the reduction of rediscounts carried by commercial banks with the central reserve bank. In such circumstances there is ordinarily a decline in the bill holdings of the central reserve bank, and at the same time a decline in the assets and deposits of the rank and file of the banks. The result of deflation is thus to leave a smaller amount of credit at the disposal of the public as measured in dollars. It should be remembered, however, that the significance of inflation or deflation is found primarily in connection with the price level. For instance, if with the price level denoted by about 100 there is in existence one million units of bank credit, it may be roughly true that a decline in the price level to, say, 50 would permit a decline in the number of credit units employed to five hundred thousand without causing any relatively lessened use of bank credit. Of course it should be remembered that it would be rarely, if ever, true that any such close arithmetic correspondence as is indicated by these figures could be established between credit and the volume of business, but the general trend would be in the direction suggested.

Inflation and deflation are therefore relative terms which can have a direct meaning only in comparison with price levels. Since bad banking or inflation itself reacts upon a price level, a rather complex problem is presented at any given moment in the effort to ascertain how far inflation has proceeded beyond the amount indicated by prices. So also in the case of deflation it is difficult to decide at any moment whether there is a "shortage of credit" or whether what has happened has been merely the diminution of the aggregate number of units of credit rendered possible by the decline in prices followed by a lessened demand for credit to carry goods.

This whole subject may be summed up in broad terms by saying that there is at any given moment a general level of prices which has been determined by a comparison between goods on the basis of their relative values as expressed in terms of money. Departures from this level, either above or below, may be due to any one or several of a number of factors working upon the price level. When a change in the method of granting credit operates as such a factor the result is spoken of as inflation or deflation, as the case may be.