1. Fractional Reserve Banking
How Banks “Create” Money

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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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: /.20 = 5

9. Money Multiplier in Action
Original deposit = $100.00, Reserve Ratio of 10%
1st Natl. Lending = (=.9 x $100.00)
2nd Natl. Lending = (=.9 x $ )
3rd Natl. Lending = (=.9 x $ )
… 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 = $1,000
Multiplier X Excess Reserves
$90 x 10 = $900

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

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

12. 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

13. Hayek vs. Keynes Rap