12.5: Money Creation- Banking Limits

How much money can a bank create?  Money creation is limited by the amount of reserves on hand.  Just as the goldsmiths discovered, private banks know that depositors will only require a fraction of their total deposits from time to time.  Think about it. Do you typically withdraw your entire checking about every time you visit your bank?  This reality allows banks to make loans with deposits.  However, if banks lend all reserves there will be no cash on hand to handle the day-to-day needs of their customers. Imagine if you stopped by your local branch to withdrawal some cash and they told you they were all out. 

So, banks need some fraction of total deposits to be kept as reserves. Let’s walk through a very simple example of how banks create money and see how reserve requirements limit banking activity.  

Table 1 illustrates the process of deposit (a.k.a. money) creation in a one-bank world with a reserve requirement ratio of 20%.

Definition: Reserve Requirement Ratio

The percentage of reserves that must be held against customer deposits of banks and other depository institutions. 

Let’s say Martin opens a checking account with Bank A and deposits $100.  He now has a $100 checkable deposit at the bank, which shows up as a $100 liability on the bank’s balance sheet. The bank puts the $100 deposit into its vault so that the bank’s assets rise by $100.  This $100 bank asset is now considered bank reserves (Table 1 – Step 1). So far, the money supply has not increased.  Only the composition of M1 has changed ($100 cash is converted into $100 of demand deposits – see table 1). 

Table 1

Step 1: Martin deposits $100 cash in his new checking account. This registers as a liability on Bank A's balance sheet. On the asset side of the balance sheet the deposit creates $100 of reserves, $20 of which has to be kept as reserves.
Bank A
Assets	Liabilities
Required reserves                            $20	Deposit                                            $100	There has been no money creation. Cash has simply changed to a transaction account. Both are components of M1.
Excess reserves                               $80
Total                                             $100	$100
Step 2: The bank uses its excess reserves $80 to make a loan to Jane. Jane then deposits the loan*. Total deposits now equal $180. The money supply has increased.
Bank A
Assets	Liabilities
Required reserves                            $36	Deposit                                            $100
Excess reserves                               $64	Jane's account                                    $80	increased by $80.
Loans*                                           $80
Total                                             $180	$180

*Each bank may lend an amount equal to its excess reserves and no more.

Because Bank A is required to hold a certain percentage of its deposits as reserves to satisfy the banking needs of its depositors, only a portion of the total deposits can be loaned out.  Since the reserve requirement is 20% of total deposits, Bank A must keep $20 as required reserves. The remaining assets are excess reserves and can be loaned out.  

Definition: Required Reserves

The portion of customer deposits that banks and other depository institutions are required to hold as reserves. Prior to March 2020, the Federal Reserve set reserve requirements (within limits specified by law) for all depository institutions holding transaction accounts or nonpersonal time deposits. On March 26, 2020, the Federal Reserve reduced the required reserve ratio to zero percent.

Definition: Excess Reserves

Commercial bank reserves in excess of those they are legally required to hold. 

Required reserves = (minimum reserve ratio) x (total deposits)

Since bank reserves pay no interest, Bank A is eager to loan all excess reserves to cover its expenses and, hopefully, earn a profit.   

Let’s say Bank A chooses not to hold any excess reserves, and loans $80 to Jane.  Also assume that Jane opens an account with Bank A and deposits her $80 (Step 2). The loan alters both sides of Bank A’s balance sheet.  On the right-hand side, the bank creates a new deposit for Jane; this item represents a promise to pay (i.e., liability). On the left-hand side of the balance sheet two things happen. First, the bank registers that Jane owes it $80 (“loans”). Second, the bank recognizes that it’s required to hold $36 in required reserves ($36 = .2 x $180).  And since the total amount of reserves is still $100, the bank can loan out all excess reserves ($64 = $100 - $36). 

The money creation process occurs during Step 2.  In making a loan, Bank A increases the money supply by $80. This is because someone (Jane) now has more money (a transaction deposit) than she did before.   

This process of money creation will continue as long as there are excess reserves.  This means that the $100 initial deposit still has some money creation potential.  How much more? The bank's money creating potential can be estimated using a concept known as the deposit multiplier. 

\[\text { Deposit multiplier }=\quad \frac{1}{\text { reserve requirement ratio }} \nonumber \]

The deposit multiplier indicates how many dollars of deposits (and loans) will result from an interjection of excess reserves.  In the previous example, the original deposit of $100 created $80 of excess reserves.  Using the deposit multiplier (1/.2 or 5) we can estimate its money-making potential. 

\[\begin{aligned}
&\text { Excess reserves } \mathrm{x} \text { deposit multiplier }=\text { potential deposit/money creation }\\
&\quad \quad  (\$80) \quad  \quad \quad \quad \quad \quad 5 \quad  \quad \quad \quad \quad \quad \quad \quad (\$ 400)
\end{aligned} \nonumber \]

The deposit multiplier (or money multiplier) has become less relevant in the current monetary policy framework because the Federal Reserve no longer uses reserve requirements or reserve quantities as tools to regulate the money supply. Instead, the Fed operates under an ample reserves regime, using interest rates - particularly the Interest on Reserve Balances (IORB) - as its primary policy tool. There will be more on this topic in the Modern Monetary Policy Implementation chapter.