4.4 - Banking and the Expansion of the Money Supply
The Fractional Reserve System
Banks are businesses, and they exist to make a profit, mostly by lending money out and charging interest. Where does that lending money come from? Mostly depositors and shareholders. Banks basically connect savers with borrowers.
The U.S. runs on a fractional reserve system, meaning banks only have to keep a portion of deposits on hand as reserves and can lend out the rest. Bank reserves are whatever the bank hasn’t lent out, sitting either in the vault or at the Federal Reserve.
The Bank Balance Sheet
A bank’s balance sheet (T-account) always has to balance: assets equal liabilities.
- Assets are things the bank owns or that can be converted to cash.
- Liabilities are money the bank owes to someone else.
Interestingly, a customer’s deposit shows up on both sides: the deposit is a liability because the customer can ask for it back anytime, and the cash the bank is now holding (its reserves) is an asset.
- Required reserves (RR): the portion the bank must keep on hand, set by the Fed.
- Excess reserves (ER): anything above the required amount, which banks are free to lend out (and definitely want to, since lending is how they make money).
How Banks Create Money
Excess reserves are the starting point for expanding the money supply. When a bank makes a loan, it’s essentially creating new money electronically, out of thin air. The model assumes that every dollar lent out eventually gets deposited somewhere back in the banking system (not necessarily the same bank).
This creates a chain reaction: the first bank lends its excess reserves, that money gets deposited at a second bank, which creates new reserves to lend out again, and so on. This keeps going until there’s nothing left to lend, and by the end, the total increase in the money supply ends up being bigger than that original deposit.
The Money Multiplier
To find the total money supply created, multiply the initial deposit by the money multiplier. The money multiplier is also the ratio of the money supply to the monetary base, so:
The maximum amount of new loans equals the total money supply created minus the initial deposit.
One important caveat: if the initial deposit was money that was already part of the money supply (like converting cash into a checking deposit), you need to subtract that initial deposit from the final total to find the actual change in the money supply. But if the Fed itself starts the chain reaction by creating brand new money, no subtraction is needed.
Worked Example
Say the reserve requirement is 10%, and Maria deposits $1,000 of cash into her checking account at Bank A. Bank A’s balance sheet changes like this:
Assets | Liabilities |
Reserves: +$1,000 | Demand deposits: +$1,000 |
The deposit shows up on both sides: Maria’s cash becomes reserves the bank holds (an asset), and her checking balance is money the bank owes her (a liability).
- Required reserves: 10% × $1,000 = $100.
- Excess reserves: $1,000 − $100 = $900. This is the most Bank A can lend right now, since a single bank can only lend out its excess reserves.
- Money multiplier: 1 / 0.10 = 10.
- Total money supply created: $1,000 × 10 = $10,000 in deposits.
- Maximum new loans by the whole banking system: $10,000 − $1,000 = $9,000 (the same as the $900 of excess reserves × 10).
- Change in the money supply: $9,000. Maria’s $1,000 was already part of the money supply as cash, so depositing it doesn’t add anything by itself. Only the new loans do.
Why the Real Multiplier Is Smaller
The formula 1/RR gives the maximum money multiplier (also called the simple money multiplier). It assumes every bank lends out all of its excess reserves and every dollar lent out gets deposited back into a bank. In real life the money supply grows by less than that, for two reasons:
- Banks hold excess reserves: a bank may keep some extra reserves instead of lending them all, for example in a recession when it’s worried borrowers won’t pay it back. Reserves that sit in the bank don’t get loaned out again.
- The public holds more cash: if people keep part of a loan or paycheck as cash instead of depositing it, that cash leaves the banking system and can’t be loaned out again.
Either way, less money gets re-lent in each round, so the real money multiplier (and the real change in the money supply) is smaller than 1/RR predicts. That’s why questions ask for the maximum change in the money supply.
Bottom line: money creation happens through the fractional reserve system, where banks create money by lending out their excess reserves. Any deposit gets magnified by the money multiplier (1/RR), so the money supply grows by more than the original deposit.