# 27.3: Creating Money

## The Fractional Reserve System

A fractional reserve system is one in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves.

learning objectives

• Examine the impact of fractional reserve banking on the money supply

Banks operate by taking in deposits and making loans to lenders. They are able to do this because not every depositor needs her money on the same day. Thus, banks can lend out some of their depositors’ money, while keeping some on hand to satisfy daily withdrawals by depositors. This is called the fractional-reserve banking system: banks only hold a fraction of total deposits as cash on hand.

### Reserve Ratio

The fraction of deposits that a bank must hold as reserves rather than loan out is called the reserve ratio (or the reserve requirement) and is set by the Federal Reserve. If, for example, the reserve requirement is 1%, then a bank must hold reserves equal to 1% of their total customer deposits. These assets are typically held in the form of physical cash stored in a bank vault and in reserves deposited with the central bank.

Banks can also choose to hold reserves in excess of the required level. Any reserves beyond the required reserves are called excess reserves. Excess reserves plus required reserves equal total reserves. In general, since banks make less money from holding excess reserves than they would lending them out, economists assume that banks seek to hold no excess reserves.

Because banks are only required to keep a fraction of their deposits in reserve and may loan out the rest, banks are able to create money. To understand this, imagine that you deposit $100 at your bank. The bank is required to keep$10 as reserves but may lend out $90 to another individual or business. This loan is new money; the bank created it when it issued the loan. In fact, the vast majority of money in the economy today comes from these loans created by banks. Likewise when a loan is repaid, that money disappears from the economy until the bank issues another loan. Money Creation in a Fractional Reserve System: The diagram shows the process through which commercial banks create money by issuing loans. Thus, there are two ways that a central bank can use this process to increase or decrease the money supply. First, it can adjust the reserve ratio. A lower reserve ratio means that banks can issue more loans, increasing the money supply. Second, it can create or destroy reserves. Creating reserves means that commercial banks have more reserves with which they can satisfy the reserve ratio requirement, leading to more loans and an increase in the money supply. ### Why Have Reserve Requirements? Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors’ cash withdrawals and other demands for funds. However, banks also have an incentive to loan out as much money as possible and keep only a minimum buffer of reserves, since they earn more on these loans than they do on the reserves. Mandating a reserve requirement helps to ensure that banks have the ability to meet their obligations. ## Example Transactions Showing How a Bank Can Create Money The amount of money created by banks depends on the size of the deposit and the money multiplier. learning objectives • Calculate the change in money supply given the money multiplier, an initial deposit and the reserve ratio To understand the process of money creation, let us create a hypothetical system of banks. We will focus on two banks in this system: Anderson Bank and Brentwood Bank. Assume that all banks are required to hold reserves equal to 10% of their customer deposits. When a bank’s excess reserves equal zero, it is loaned up. Anderson and Brentwood both operate in a financial system with a 10% reserve requirement. Each has$10,000 in deposits and no excess reserves, so each has $9,000 in loans outstanding, and$10,000 in deposit balances held by customers.

Suppose a customer now deposits $1,000 in Anderson Bank. Anderson will loan out the maximum amount (90%) and hold the required 10% as reserves. There are now$11,000 in deposits in Anderson with $9,900 in loans outstanding. The debtor takes her$900 loan and deposits it in Brentwood bank. Brentwood’s deposits now total $10,900. Thus, you can see that total deposits were$20,000 before the initial $1,000 deposit, and are now$21,900 after. Even though only $1,000 were added to the system, the amount of money in the system increased by$1,900. The $900 in checkable deposits is new money; Anderson created it when it issued the$900 loan.

Mathematically, the relationship between reserve requirements ($$rr$$), deposits, and money creation is given by the deposit multiplier (m). The deposit multiplier is the ratio of the maximum possible change in deposits to the change in reserves. When banks in the economy have made the maximum legal amount of loans (zero excess reserves), the deposit multiplier is equal to the reciprocal of the required reserve ratio ($$m=1/rr$$).

In the above example the deposit multiplier is 1/0.1, or 10. Thus, with a required reserve ratio of 0.1, an increase in reserves of $1 can increase the money supply by up to$10.

## Key Points

• The main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected.
• The fraction of deposits that a bank keeps in cash or as a deposit with the central bank, rather than loaning out to the public, is called the reserve ratio.
• A minimum reserve ratio (or reserve requirement ) is mandated by the Fed in order to ensure that banks are able to meet their obligations.
• Because banks are only required to keep a fraction of their deposits in reserve and may loan out the rest, banks are able to create money.
• A lower reserve requirement allows banks to issue more loans and increase the money supply, while a higher reserve requirement does the opposite.
• When a deposit is made at a bank, that bank must keep a portion the form of reserves. The proportion is called the required reserve ratio.
• Loans out a portion of its reserves to individuals or firms who will then deposit the money in other bank accounts.
• Theoretically, this process will until repeat until there are no excess reserves left.
• The total amount of money created with a new bank deposit can be found using the deposit multiplier, which is the reciprocal of the reserve requirement ratio. Multiplying the deposit multiplier by the amount of the new deposit gives the total amount of money that may be created.
• The total supply of commercial bank money is, at most, the amount of reserves times the reciprocal of the reserve ratio (the money multiplier ).
• When banks have no excess reserves, the supply of total money is equal to reserves times the money multiplier. Theoretically, banks will never have excess reserves.
• According to the theory, a central bank can change the money supply in an economy by changing the reserve requirements.
• Some banks may choose to hold excess reserves, leading to a money supply that is less than that predicted by the money multiplier.
• Customers may withdraw cash, removing a source of reserves against which banks can create money.
• Individuals and businesses may not spend the entire proceeds of their loans, removing the multiplier effect on money creation.

## Key Terms

• deposit: Money placed in an account.
• reserves: Banks’ holdings of deposits in accounts with their central bank, plus currency that is physically held in the bank’s vault.
• deposit multiplier: The maximum amount of commercial bank money that can be created by a given unit of reserves.
• currency: Paper money.
• central bank: The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.
• money multiplier: The maximum amount of commercial bank money that can be created by a given unit of central bank money.
• commercial bank: A type of financial institution that provides services such as accepting deposits, making business loans, and offering basic investment products to the public.
• reserve requirement: The minimum amount of deposits each commercial bank must hold (rather than lend out).