Fractional Reserve Banking How Banks “Create” Money

BANKS & MONEY SUPPLY Banks hold demand deposits & then make loans which directly increase the money supply Your Money $1,000 $1,000 deposited into a checking account Banks lend more money than initially deposited MS ↑ more than $1,000

Fractional Reserve Banking Reserves- deposits of banks not loaned out –Required Reserves- can not be lent out (10% of deposit) –Excess Reserves- can be lent out (90% of deposit) Fractional-reserve banking- system where banks hold only a small 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 required reserves Reserve Ratio = required reserves / total reserves 10% = $10,000 / $100,000

Bank Balance Sheet Example #1: –$100 Deposit –100% Reserve Ratio Called a T-Account Deposits are recorded as both: Assets & Liabilities AssetsLiabilities $100 Total AssetsTotal Liabilities $100 Deposits Required Reserves Bank can not lend money with 100% r.r. Leads to no change in Money Supply Excess Reserves $0

Bank Balance Sheet #2 Example #2: –$100 Deposit –10% Reserve Ratio AssetsLiabilities $10$100 Total AssetsTotal Liabilities $100 Deposits Required Reserves Excess Reserves can be lent out by bank Excess Reserves $90 Loans This new loan will lead to money creation

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

The Money Multiplier Money Multiplier = 1 / reserve ratio: (M = 1/R) –If reserve requirement = 20% –1/.20 = 5 Determines change in MS with new dollar of reserves ∆ Money Supply = Multiplier X Initial Loan (excess reserves)

Money Multiplier in Action MONEY SUPPLY increase by $100 deposit Total banking deposits increased by this $100 deposit: Multiplier X Initial Loan = ∆ Money Supply 10 x $90 = $900 Multiplier X Initial Deposit 10 x 100 = $1,000

AssetsLiabilities AssetsLiabilitiesAssetsLiabilities 20% Reserve Requirement $100,000 Deposit Bank1 Bank 2 Bank 3 Required Reserves Excess Reserves Deposits Total Reserves ========= ========== Total Liabilities Worksheet total increase in Money Supply total increase in Bank Deposits

1)The U.S. Economy entered a credit crunch during the financial crisis of 2008 Banks reluctant to loan $ Consumers reluctant to borrow $ If Banks don’t make loans => MS can’t increase enough