In this lesson summary review and remind yourself of the key terms and calculations related to fractional reserve banking, required reserves, excess reserves, and the money multiplier.
Lesson Summary
Money is created when the government prints it, right? That’s only partially true because banks create money too. Banks don’t literally print their own currency (save for a few banks in Scotland, who do just that). So how does a bank “create” money?
Recall that the narrowest definition of the money supply is M1, which includes money in circulation (not held in a bank) and demand deposits held inside banks. In the United States, less than half of M1 is in the form of currency—much of the rest of M1 is in the form of bank accounts.
Every time a dollar is deposited into a bank account, a bank’s total reserves increases. The bank will keep some of it on hand as required reserves, but it will loan the excess reserves out. When that loan is made, it increases the money supply.
This is how banks “create” money and increase the money supply. When a bank makes loans out of excess reserves, the money supply increases. We can predict the maximum change in the money supply with the money multiplier.
Key Terms
Key term | Definition |
---|---|
Bank | (sometimes called a commercial bank) A financial institution that accepts deposits and makes loans; banks are sometimes referred to as “depository institutions.” |
Central bank | (sometimes called a reserve bank or banking authority) an institution that manages a country’s money supply and monetary policy |
Financial intermediary | a middle-person in a financial transaction; a bank is an intermediary that coordinates borrowing and lending by combining the deposits of many agents into loans. |
Assets | something of value to the agent that holds it; a bank’s assets include real assets owned by the bank (such as a building), the money they hold, and financial assets such as bonds and loans. |
Liabilities | obligations to pay back; to a bank, your savings account is a liability because you might show up one day and want the money you deposited back. |
Fractional reserves | the practice of keeping a percentage of deposits on hand but loaning out the rest |
Reserve requirement | a legal obligation to keep a minimum amount of reserves; if the reserve requirement is |
Excess reserves | the remainder of the deposited money that banks are not required to keep on hand; banks can make loans out of excess reserves or choose to keep excess reserves in their vaults. |
Fully loaned out | a situation in which a bank has only required reserves and keeps no excess reserves; when a bank is fully loaned out it cannot make any additional loans. |
T-account | a tool for describing the financial position of a business by showing assets (on the left) and liabilities (on the right) in a table; each side of the table must equal the other side. |
Money multiplier | the ratio of the money supply to the monetary base (money in bank vaults and money in circulation); the money multiplier tells us how many additional dollars will be created with each addition to the monetary base, such as when there is a |
Key Takeaways
Assets and Liabilities
Banks, like any other business, need to keep track of their assets and liabilities. T-accounts are tables that banks use to keep track of assets and liabilities.
Let’s create a T-account for a bank that has just opened for business, First Bank of Pulitzer. Nobody has deposited any money yet, so other than its obligations to the bank owners and the real assets that the bank has (like the bank building itself), the bank’s T-account is empty:
Assets | Liabilities |
---|---|
Now suppose you win
The bank’s balance sheet now looks like this:
Assets | Liabilities |
---|---|
Cash |
Fractional reserve banking
Banks are more than just a vault to keep money in. If banks just acted as a storage facility for money, that wouldn’t be a very profitable business. The
But the new First Bank of Pulitzer has a problem. They want to make loans (because that is how they earn a profit). But at some point, they also need to pay back the money that people have deposited into the bank. This is where reserves come in.
Reserves are the amount of money that banks keep in vaults, and they are a fraction of all deposits made. In most countries, banks are heavily regulated and are required to keep a minimum percentage of all deposits, just in case someone wants to withdraw some money. This minimum percent is the reserve requirement.
For example, suppose the reserve requirement is
Assets | Liabilities |
---|---|
Required reserves | |
The rest of the cash |
Excess reserves allow expansion of the money supply
To understand how banks create money, let’s take a step back. What if that poetry competition money was the only money that existed in the economy. Before you deposit the money in the bank, let’s calculate the money supply:
Once you deposit your money in the bank, M1 doesn’t change; only the composition of the money supply changes:
How does the First Bank of Pulitzer bank create more money out of this
- Keep it in the bank (just in case you want to withdraw more than
) - Loan it out
In the real world, your deposit wouldn’t be the only deposit in the bank. Usually, only a small number of people want to withdraw their money on a given day. So, the bank might want to loan out that money to earn a profit.
Now, suppose Sylvia shows up at the bank and wants to borrow
Assets | Liabilities |
---|---|
Required reserves | |
Loan to Sylvia | |
Excess reserves |
M1 has changed as well. Remember, your
By loaning out from excess reserves, the bank has added to the money supply.
The money multiplier determines the size of the expansion
Banks can’t create an unlimited amount of money. The money multiplier determines the limit of how much money a bank can create. The money multiplier is how much the money supply will change if there is a change in the monetary base.
There are several reasons that the actual increase in the money supply will be smaller than the simple money multiplier predicts, including:People decide not to deposit money into banks, so money “leaks” out of the banking systemBanks decide not to loan out everything and keep some excess reserves
Sure! Let’s take another look at the bank. Right now, they still have
Assets | Liabilities |
---|---|
Required reserves | |
Loan to Sylvia | |
Loan to Ted |
What impact does that have on the money supply? Well, now Ted also has some money in his pocket:
Sylvia and Ted take the money they borrowed and decide to take a trip to Seamus’s House of Donuts and spend their combined
Assets | Liabilities |
---|---|
Required reserves | |
Loan to Sylvia | |
Loan to Ted | |
Cash |
We can also track the changes in the money supply:
Notice that the money supply hasn’t changed. But, the bank must keep
Each time money is deposited, the reserve requirement (rr) is kept, but the rest can be loaned out.
As we have seen before with other multipliers (like the expenditure multiplier and tax multiplier), this kind of expansion can be simplified to
So, if the bank never keeps any excess reserves on hand, and all money is always deposited into banks, your
Key equations
The money multiplier
The money multiplier determines the maximum expansion of the money supply that will occur when new money is introduced into the banking system. If you know the size of the reserve requirement, you can use this to figure out the largest change in the money supply that is possible if the central bank creates new money. The money multiplier (
For example, if the reserve requirement is 25%, the money multiplier is
So, if I know that the money multiplier is
In reality, however, the money multiplier is more complicated than this, which is why it is sometimes called the simple money multiplier. The simple money multiplier assumes that:
- Banks never keep any excess reserves, and
- People keep all money in banks (in other words, if you get
, you immediately deposit it).
Now suppose instead that you know the actual change in the money supply from a change in the monetary base. With this information, you can find the actual money multiplier, rather than the theoretical maximum change. To find the actual money multiplier, you divide the money supply by the monetary base:
Where:
For example, if M1 is
In this case, the more realistic money multiplier is only 2, rather than the simple money multiplier that is predicted using the reserve requirement.
The maximum predicted change in the money supply from an increase in the monetary base
For example, suppose the First Bank of Pulitzer bank buys a bond from Langston for
Calculating excess reserves
For example, if Maya deposits
Maximum new loans possible from a deposit
For example, if the money multiplier is
Common Misperceptions
- Some learners get confused about what the simple money multiplier represents. The simple multiplier
is the maximum change in the money supply. In all probability, the final increase in the money supply will be far smaller due to leakages from the financial system. - Printing money and creating money is not the same thing. Printing money creates currency, but the amount of money that exists at any point in time (in other words, the money supply) is cash and deposits. The pivotal moment in the creation of money is lending: when loans are made, money is created.
- It might seem strange that a bank account is a liability. To you, the owner of the account, the account is an asset. But to the bank, who has to return that money to you on demand, it is a liability.
- As a new learner, it might be confusing about which stage in this process creates money. It is the loan. If a bank does not loan out from a deposit, no new money is created.
Discussion questions
Question 1
There is currently
Assets | Liabilities |
---|---|
Required reserves | Demand deposits |
Excess reserves | |
Loans |
Assume that this bank has no assets other than cash and loans.
What is the value of the loans that this bank has made? Explain how you know this.
What is the reserve requirement?
If Ted withdraws
from his checking account at the Bank of Rhyme:a. What is the initial effect of the withdrawal on M1?
b. What effect will this have on the bank’s total reserves, required reserves, and excess reserves?
- The bank has
in loans outstanding. The asset and liabilities sides must equal each other on the balance sheet. Required reserves and excess reserves are worth total, so:
- The reserve requirement is
. From the equation to calculate the amount of reserves required:
3a. M1 will not change. Before the withdrawal:
After the withdrawal:
Only the composition of the money supply changes, not the quantity of money. No money is created or destroyed when money is withdrawn from or deposited in a bank
3b. Before the withdrawal, the bank has
When he withdraws
Question 2
The balance sheet for The First Bank of Pulitzer is shown below. Assume the reserve requirement is 5%.
Assets | Liabilities |
---|---|
Total reserves | Demand deposits |
Home loans | |
Government bonds |
a. What is the total amount of new loans that this bank can make? Explain.
b. Now, suppose that the First Bank of Pulitzer, and all other banks in the financial system, loan out all excess reserves. Calculate the maximum total change in deposits throughout the banking system. Show all work.
c. Assume that there are no leakages from the financial system. What will be the change in total reserves throughout the banking system? Explain.
d. Suppose the central bank in this country buys
a. This bank can make
They have
b. To find the total change in demand deposits:
c. The total change in reserves will be
d. The money supply will increase. When the central bank buys the bonds, it pays