The Fractional Reserve Banking System: How Banks Create Money YOUR 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)

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 reserves 2. Loans 3. 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

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.