Fractional Reserve Banking How Banks “Create” Money

BANKS & MONEY SUPPLY Banks directly influence the quantity of demand deposits in the economy & the money supply

Fractional Reserve Banking Reserves- deposits of banks not loaned out Fractional-reserve banking- system where banks hold only a fraction of deposits & lend out the rest this system allows banks to “create money” (i.e. expand money supply) Reserve Ratio - % of deposits banks must hold as reserves Reserve Ratio = required reserves / total reserves 10% = $10,000 / $100,000

Bank Balance Sheet Example: $100 Deposit 100% Reserve Ratio Called a T-Account Deposits are recorded as both: Assets & Liabilities Example: $100 Deposit 100% Reserve Ratio Assets Liabilities Bank can not lend money with 100% r.r. Required Reserves $100 Deposits $100 Excess Reserves $0 Total Assets Total Liabilities Leads to no change in Money Supply $100 $100

How Money is created When one bank loans money => the money is generally deposited into another bank This creates more banking reserves which can be lent One initial deposit of $100 will flow through the banking system multiple times

Bank Balance Sheet Example: $100 Deposit 10% Reserve Ratio Excess Reserves can be lent out by bank Assets Liabilities Required Reserves $10 Deposits $100 Excess Reserves This new loan will lead to money creation Loans $90 Total Assets Total Liabilities $100 $100

Increase in Deposits = $190.00! Money being created! Increase in Deposits = $190.00! Assets Liabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets Total Liabilities Second National Bank Assets Liabilities Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00

The Money Multiplier Determines the amount of money the banking system generates with each dollar of new reserves Money Multiplier = the reciprocal of the reserve ratio: M = 1/R Example: With a reserve requirement, R = 20% (.20) The money multiplier is: 1/.20 = 5

Money Multiplier in Action Original deposit = $100.00, Reserve Ratio of 10% 1st Natl. Lending = 90.00 (=.9 x $100.00) 2nd Natl. Lending = 81.00 (=.9 x $ 90.00) 3rd Natl. Lending = 72.90 (=.9 x $ 81.00) … and on until there are just pennies left to lend! Total reserves increased by this $100 deposit: Total MONEY SUPPLY (M1) by this $100 deposit Multiplier X Deposit 10 x 100 = $1,000 Multiplier X Excess Reserves $90 x 10 = $900

Worksheet $1,000 Deposit Multiplier ∆ in Reserves ∆ in Money Supply 10% Reserve Requirement 20% Reserve Requirement 50% Reserve Requirement

Money not Wealth An increase in money supply does not lead to more wealth Wealth Unchanged MS

Friedrich Hayek Believed in: Free Markets, Limited central bank action Economist from School of Austrian Economics Believed in: Free Markets, Limited central bank action artificially low interest rates lead to Malinvestment Friedrich Hayek 1899 - 1992

Hayek vs. Keynes Rap http://econstories.tv/2010/06/22/fear-the-boom-and-bust/