Fractional Reserve Banking
How Banks “Create” Money
BANKS & MONEY SUPPLY
• Banks directly influence the quantity of demand
deposits in the economy & the money supply
Fractional Reserve Banking
• Reserves- deposits of banks not loaned out
– Required reserves- can not be lent
– Excess reserves- can be lent
• 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 required reserves
Reserve Ratio = required reserves / total reserves
10% = $10,000 / $100,000
Bank Balance Sheet
• Called a T-Account Example:
• Deposits are recorded as both: – $100 Deposit
Assets & Liabilities – 100% Reserve Ratio
Assets Liabilities
Bank can not lend
Required Reserves $100 Deposits $100 money with 100% r.r.
Excess Reserves $0
Total Assets Total Liabilities
Leads to no
$100 $100 change in Money Supply
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
Bank Balance Sheet
Example:
– $100 Deposit
Excess Reserves can
– 10% Reserve Ratio be lent out by bank
Assets Liabilities
Required Reserves $10 Deposits $100
Excess Reserves
Loans $90 This new loan will
lead to money
creation
Total Assets Total Liabilities
$100 $100
Money being created!
Increase in Deposits = $190.00!
First National Bank Second National Bank
Assets Liabilities Assets Liabilities
Reserves Deposits Reserves Deposits
$10.00 $100.00 $9.00 $90.00
Loans Loans
$90.00 $81.00
Total Assets Total Liabilities Total Assets Total Liabilities
$100.00 $100.00 $90.00 $90.00
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: 1/.20 = 5
Money Multiplier in Action
Original deposit = $100.00, Reserve Ratio of 10%
• 1st Natl. Lending = 90.00 (=.9 x $100.00)
• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)
• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)
• … and on until there are just pennies left to lend! X Deposit
Multiplier
10 x 100 = $1,000
• Total reserves increased by this $100 deposit:
• Total MONEY SUPPLY (M1) by this $100 deposit
Multiplier X Excess Reserves
$90 x 10 = $900
Worksheet
• $1,000 Deposit
Multiplier ∆ in Reserves ∆ in Money Supply
10% Reserve Requirement
20% Reserve Requirement
50% Reserve Requirement
Money not Wealth
• An increase in money supply does not lead to
more wealth
Wealth
MS Unchanged
Friedrich
Hayek
Economist from School of Austrian Economics
Friedrich Hayek
Believed in:
1899 - 1992
• Free Markets,
• Limited central bank action
• artificially low interest rates lead to Malinvestment
Hayek vs. Keynes Rap
• http://econstories.tv/2010/06/22/fear-the-
boom-and-bust/