Fractional Reserve Banking How Bank Lending Creates Money

Fractional Reserve Banking How Bank Lending “Creates” Money

BANKS “Create Money” • Banks receive a demand deposit & lend most of the deposit – this will ↑ money supply (MS) Your Money $1, 000 deposited in checking account In total, banking system lends more than $1, 000 MS ↑ By multiple of 1 st deposit

Fractional Reserve Banking • Reserves- deposits of banks not loaned out – Required Reserves- can never 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 = 10% If Total Reserves = $100, 000 Required Reserves = $10, 000 Excess Reserves = $90, 000

Bank Balance Sheet • Called a T-Account Example #1: • Deposits are recorded as both: Assets & Liabilities Assets Required Reserves Excess Reserves $100 – $100 Deposit – 100% Reserve Ratio Liabilities Deposits $100 Bank can not lend money with 100% r. r. $0 Total Assets $100 Total Liabilities $100 Leads to no change in Money Supply

Bank Balance Sheet #2 Example #2: – $100 Deposit – 10% Reserve Ratio Assets Required Reserves $10 Excess Loans Reserves $90 Total Assets $100 Excess Reserves can be lent out by bank Liabilities Deposits $100 Total Liabilities $100 This new loan will lead to money creation

Money being created! Increase in Deposits = $190. 00! First National Bank Assets Required Reserves $10. 00 Liabilities Deposits $100. 00 Loans $90. 00 Total Assets Total Liabilities $100. 00 Second National Bank Assets Liabilities Required Reserves $9. 00 Deposits $90. 00 Loans $81. 00 Total Assets $90. 00 Total Liabilities $90. 00

The Money Multiplier • Money Multiplier = 1 / reserve ratio: (M = 1/R) – If reserve requirement = 10% => 1/. 10 = 10 • Calculate the change (∆) in money supply, bank deposits and bank reserves for a $100 Deposit: +$900 ∆ Money Supply = Multiplier X Initial Loan (excess reserves) +$1, 000 ∆ Bank Deposits = Multiplier X Initial Deposit +$100 ∆ Bank Reserves = Initial Deposit

Worksheet 20% Reserve Requirement $100, 000 Deposit Bank 1 Assets Bank 2 Assets Liabilities Required Reserves Deposits Excess Reserves ===== Total Liabilities total increase in Money Supply total increase in Bank Deposits Bank 3 Liabilities Assets Liabilities