The Fractional Reserve Banking System:How Banks Create MoneyYOUR MONEY IS NOT AT THE BANK (AT LEAST NOT ALL OF IT)

When a bank receives a deposit, it does not keep all of it on hand. It faces a tradeoff between:

1. Profit: loaning the money (so it can charge interest and make a profit)2. Liquidity (“capitalization”): Keeping the money as “reserves” (for

safety, in case depositors want to withdraw) At any given time, banks only hold a fraction of total deposits as reserves, so

it’s possible that (with a “run” of too many withdrawals at once) a bank may not be able pay back all deposits.

This would cause the bank to fail, and one bank failure could make depositors nervous about other banks’ safety and cause more runs on banks.

Fractional Reserves

The Required Reserve Ratio (R)

Note that banks’ profit motive gives them a disincentive to hold reserves for safety.

Therefore, the Fed requires banks to keep a percentage of all deposits on hand as reserves. This is known as the “reserve requirement” or the “required reserve ratio” or

just the “reserve ratio” Sometimes abbreviated “R”

Other names for “demand deposits”: “checking accounts”, “checkable deposits”

Excess Reserves = Potential Loans

Note that banks do no always meet their required reserves at the end of each day, so they can borrow excess reserves from one another overnight (the Fed facilitates this).

This means that money deposited at a bank could go three different ways:1. Required reserves2. Loans3. Excess reserves (that a bank chooses to keep over and above the reserve

requirement). Note that banks are allowed to loan their excess reserves, so excess reserves

represent potential loans.

The Multiple Expansion of Demand Deposits

This is important to the money supply because:*Loans create new money. Here’s how:

First, recall that M1 (money) = Cash + demand deposits But only cash with the public counts Cash at the bank (“vault cash”) or on deposit with the Fed does NOT

count as money in the money supply.

The Multiple Expansion of Demand Deposits

Assume the Fed sets a required reserve ratio (R) of 20%, and now a person uses $1000 in cash to create a new demand deposit. Let’s follow the money creation process through a few

loans and observe the “Money Multiplier”. (Works for a withdrawal as well, because the deposit

used to get multiplied but now does not.)

The Money Multiplier

The Money Multiplier is also sometimes called the “Banking Multiplier”.

Using the Money Multiplier

Maximum/total/final money in the money supply = initial deposit x Money Multiplier

or, put another way:

Maximum/total/final creation of NEW money = excess reserves x Money Multiplier

Factors that could weaken the Money Multiplier

1. If banks do not maximize loans (if they hold some excess reserves).

2. If the public holds some loans as cash (if they do not deposit all loans in checking accounts).

3. And, of course, if the Fed raises the required reserve ratio.

A Final Note About the First Deposit

It’s important to remember that the first deposit of cash into a checking account does not actually change the money supply. It simply converts cash ($1000) into a checking account

(of $1000). Money is only created once excess reserves are loaned.

The cash that’s now at the bank is vault cash, so does not count as money.