1. Module 25- Fractional Reserve Banking and the Money Multiplier
J.A.SACCO

2. Fractional Reserve Banking
Depository institutions are required by the Fed to maintain a specific percentage (reserve requirement) of their customers deposits as reserves
Three types of reserves!

3. Fractional Reserve Banking
Legal (Total) Reserves- reserves that depository institutions are allowed by law to claims as reserves (deposits held at Federal Reserve District Bank and/or commercial bank vault cash.
Required Reserves- the value of reserves that a depository institution must hold in vault cash or with the Federal District Bank. These reserves are required to back its checkable deposits.

4. Fractional Reserve Banking
Excess Reserves- the difference between legal reserves and required reserves. These reserves can be used as new loans and/or purchase government bonds & securities.
Excess Reserves = Legal Reserves- Required Reserves

5. Fractional Reserve Banking
Example: Total (Legal) Reserves is $20 B. and the Reserve Requirement is 10%.
What is the required reserves? Excess reserves?
RR is $2B in deposits to be held in Fed District Bank or vault cash.
ER is $18 B. in new loans or to buy gov’t securities.

6. Reserves and Total Deposits
SACCO KEY POINT- New reserves are not created when checks written on one bank are deposited in another bank. The bank writing the check will lose reserves, and the bank receiving the check will gain reserves.
Only when the Fed buys/sells securities from banks or the public, or when you put available cash in the bank are reserves increased/decreased and in turn the money supply.

7. Money Expansion by the Banking System
Why is the reserve requirement and excess reserves important?
How much will the money supply increase after you deposit $100,000 cash into a commercial bank.

8. How Money is Created? “Multiple Expansion of Checkable Deposits”
Assume a 10% Reserve Requirement Maximum
New Loans
New Deposits New Required plus Investments
Bank (new reserves) Reserves (excess reserves)
1 $100,000 $10,000 $90,000
2 90,000 9,000 81,000
3 81,000 8,100 72,900
4 72,900 7,290 65,610
All other banks 656,100 65, ,490
Totals $1,000,000 $100,000 $900,000
New money/Inc. in money supply

9. The Money Multiplier = x Money Multiplier
Gives the maximum potential change in the money supply due to a change in reserves
Actual change
in the money
supply =
Actual money
multiplier
Initial change in
excess reserves x

10. Forces that Reduce the Money Multiplier
Leakages
Currency Drains- People hold money in wallet. Don’t put money in bank to allow deposit expansion.
Excess Reserves- Banks keep more as excess reserves.

11. How the Fed Controls the Money Supply
Fed Tools Macro. Effects
Reserve Requirement
Increase Contractionary
Money Supply
Interest rate
Investment
Decrease
Expansionary
Money Supply
Interest rate
Investment

12. How the Fed Controls the Money Supply
Fed Tools Macro. Effects
Discount/Federal Fund Rate
Increase Contractionary
Money Supply
Interest rate
Investment
Decrease
Expansionary
Money Supply
Interest rate
Investment

13. How the Fed Controls the Money Supply
Fed Tools Macro. Effects
Open Market Operations
Sell Securities Contractionary
Money Supply
“Sell Bonds, Small Bucks”
Interest rate
Investment
Buy Securities
“Buy Bonds, Big Bucks”
Expansionary
Money Supply
Interest rate
Investment
Most used by the Fed to
expand the money supply. Why?

14. The Fed and the Money Supply
What has a greater affect on the expansion of the money supply:
$100 deposit of an individual into a commercial bank?
A Fed purchase of a government bond/security from a commercial bank for a $100?
Assume a 20% Reserve Requirement

15. The Fed and the Money Supply
Money Multiplier?
Individual- RR= $20, ER= $80--- Expansion of Money Supply is $400.
Fed- RR= $0, ER=$ Expansion of Money Supply is $500.
Why the difference?