Fractional Reserve Banking

When you put $100 in the bank. All of your money does not have to stay in the bank. Some is kept in RESERVE (kept in the bank’s vault). The rest of it can be loaned out. Banks make money by investing your dollars somewhere else.

Fractional Reserve Banking Reserves= Any money that has been deposited in a bank, but not loaned out yet. Required Reserves (required ratio)= the percentage of money banks are required by law to keep in reserves Fractional-Reserve Banking= A banking system where banks only must hold a fraction of all deposits in reserve

Assets vs. Liabilities Assets- What the bank owns Liabilities- What a bank owes

First Bank of Econville AssetsLiabilities Reserves- $Deposits- $100 Loans- $ Let’s pretend that you deposit $100 into the First Bank of Econville. The required ratio is 10% (.10 as a fraction) You would see the following statement for the bank.

Second Bank of Worchester First Bank of Econville deposits $90 into the Second Bank of Worchester. The SBoW now must keep some in reserve (10%) and can loan out the rest. We have now created money that did not exist. – WHAAAAAAAATTT????? AssetsLiabilities Reserves- $Deposits- $90 (from 1BoE) Loans- $

Money Creation The only money that ACTUALLY exists is the first $100 you deposited in the 1BoE. The rest of the money was created. The 1BoE created $90 and the SBoW created another $81. This can continue on until banks are loaning each other just pennies. But there is an easier way to do find out just how much money has been created…the multiplier

Multiplier The Money Multiplier- the amount of money that the banking system can create given an initial deposit The Fed uses the Money Multiplier to prescribe exact Monetary Policy actions and changes in the money supply.

Money Multiplier M=1/R M-money multiplier R- reserve ratio In our problem from before, the reserve ratio was 10%. M=

Money Supply Increase Money Created From our initial deposit of $100, using the multiplier, we can conclude that the increase in the money supply was $________________________ And therefore, $____________ was created from the initial increase in reserves