Copyright 2008 The McGraw-Hill Companies13-1

The Fractional Reserve System

Money Creation

Monetary Multiplier

Last Word

Key Terms

End Show

13MoneyCreation

“The process by which banks create money is

so simple that the mind is repelled.”

John Kenneth GalbraithMy favorite economist

Chapter Objectives• Why the U.S. Banking System is

Called a “Fractional Reserve” System

• Distinction Between a Bank’s Actual Reserves and Its Required Reserves

• How a Bank Can Create Money Through Granting Loans

• The Multiple Expansion of Loans and Money by the Entire Banking System

• The Monetary Multiplier and How to Calculate it

Creating Money

Fractional Reserve Banking System

– Only part (a fraction) of checkable deposits are backed up by cash in bank vaults or in bank’s accounts at the Fed.

– Size of the “fraction” held in reserves is regulated by Fed.

• Characteristics of a Fractional Reserve System

– Banks Create Money Through Lending

– Fractional Reserve Banks are Subject to “Panics” or “Runs”

How banks create money (increase money supply)

Banks are required to keep a certain percentage of checking account balances on hand in their vault or in their account at the Federal Reserve Bank.

The reserve requirement is a percentage established by the Federal Reserve.

Creating Money

How banks create money

(increase money supply)

For example, if the reserve requirement is 10%, and Wachovia Bank has $10 million deposited into checking accounts at their banks, Wachovia must always have at least $1 million ($10 million x 10%) on hand in vault cash or in their cash account at the Fed.

Banks can then make loans to consumers and businesses with the other 90% of their checking deposits, thereby creating money in the money supply.

Creating Money

Creating Money

Excess Reserves = Loanable Funds

ExcessReserves

Amount

that banks

can loan

out.

What banks have in vaults and accounts at Fed.

-ActualReserves

-

=RequiredReserves

What banks are required to have in vaults and Fed accounts.

=

How banks create money (increase money supply)

Assume a 10% reserve requirement, banks loan all excess reserves (“loaned up”), and borrowers deposit entire amount back into a bank (no leakages).

New DepositsRequired

Reserves (10%)Loanable

Funds

$ 100,000 $ 10,000 $ 90,000

90,000 9,000 81,000

81,000 8,100 72,900

72,900 7,290 65,610

65,610 6,561 59,049

59,049 5,905 53,145

$1,000,000 $100,000 $900,000

Injection into the money supply by the Federal Reserve Bank (we’ll discuss this in Ch 14).

Final impact on money supply

How banks create money (increase money supply)

With fractional reserve banking, the initial injection into the banking system has a multiplier effect on the money supply. Amount of the impact depends on the reserve requirement.

Money (deposit) multiplier = reciprocal of reserve requirement

If reserve requirement is 10%, money multiplier = 1/.10 = 10.

Deposit of $100,000 can impact the money supply by 10 x $100,000 = $1 million.

In order to increase the impact a deposit would have on the money supply, would we raise or lower the reserve requirement?

If reserve requirement is 5%, money multiplier = 1/.05 = 20.

Deposit of $100,000 can impact the money supply by 20 x $100,000 = $2 million.

The Monetary MultiplierMonetary Multiplier or Checkable-

Deposit MultiplierMonetaryMultiplier =

1

Required Reserve Ratio (20%)

m =1

RNew Reserves

$100$20

RequiredReserves

$80Excess

Reserves

$100Initial

Deposit

$400Bank System Lending

Money Created

GraphicExample

= 5

The Monetary Multiplier

• Reversibility–Making Loans Creates

Money

–Loan Repayment Destroys Money

Bank Panics of 1930-1933

• Series of Bank Panics• Before Deposit Insurance (FDIC)• Mass Withdrawals From Fear

– More than 9,000 banks failed in one year• Move to Cash Reduced Money Supply

Through Reduction in Loans (money destruction)

• Multiple Contraction Slowed Lending and the Economy

• 1933 National Bank Holiday for One Week• Resulted in FDIC and 25% Drop in Money

Supply• Contributed to the Great Depression

• Regulation Protects the System Today (your author said this, not me!)

LastWord

Key Terms• fractional reserve banking syste

m• vault cash• required reserves• reserve ratio• excess reserves• actual reserves• monetary multiplier