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 lendmore 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

Assets Liabilities

$100 $100

Total Assets Total Liabilities

$100 $100

Deposits Required ReservesBank can not lend

money with 100% r.r.

Leads to nochange in Money Supply

Excess Reserves $0

Bank Balance Sheet #2 Example #2:– $100 Deposit– 10% Reserve Ratio

Assets Liabilities

$10 $100

Total Assets Total Liabilities

$100 $100

Deposits Required Reserves

Excess Reserves can be lent out by bank

Excess Reserves $90Loans This new loan willlead to money

creation

Money being created! Increase in Deposits = $190.00!

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Assets Liabilities

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

Assets Liabilities Assets Liabilities Assets Liabilities

20% Reserve Requirement$100,000 Deposit

Bank1 Bank 2 Bank 3

Required Reserves

ExcessReserves

Deposits

Total Reserves

========= ==========TotalLiabilities

Worksheet

total increase in Money Supplytotal 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