1. How Banks “Create” Money
Money & Banking System
How Banks “Create” Money

2. MONEY
Money- anything used to facilitate the exchange of goods & services between buyers and sellers

3. 2 Kinds of Money
Commodity money takes the form of a commodity with intrinsic value
Examples: Gold, silver, cigarettes
Fiat money is used because of Government decree
It does not have intrinsic value
Examples: Coins, currency, check deposits
U.S. money was backed by gold until 1971

4. Fractional Reserve Banking
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)
Banks must hold only 10% as required reserves. They can lend out the rest….
Reserve Ratio = %
Deposit = $10, => Bank must keep $1,000 dollars => lend $9,000

5. How Money is multiplied
When one bank loans money => the money is generally deposited into another bank
This creates more banking reserves which can be lent
an initial deposit of $100 flows through banking system multiple times

6. BANKS & MONEY SUPPLY When banks make loans they create “new” money!
$1,000 deposited into
a checking account
Your Money
$1,000
Banks lend
$ This loan ends up in another bank!
A 2nd loan is
now made

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

8. Increase in Deposits = $190.00!
Money being created!
Increase in Deposits = $190.00!
Assets
Liabilities
First National Bank
Reserves
$10.00
Loans
$90.00
Deposits
$100.00
Total Assets
Total Liabilities
Second National Bank
Assets
Liabilities
Reserves
$9.00
Loans
$81.00
Deposits
$90.00
Total Assets
$90.00
Total Liabilities
$90.00

9. Money Multiplier
Money Multiplier calculates how much “new” money is created when banks lend.
Money Multiplier = 1 / reserve ratio: (M = 1/R)
If reserve requirement = 10% multiplier is 1/.10 = 10
Change in Money Supply = Multiplier X Initial Loan

10. Money Multiplier in Action
MONEY SUPPLY increase by $100 deposit
Multiplier X Initial Loan = Change in Money Supply:
x $90 (1ST loan) = $900 new money created

11. Worksheet
$1,000 Deposit
Multiplier
Change in Money Supply

12. Money not Wealth
An increase in money supply does not lead to more wealth
Wealth
Unchanged MS