Fractional Reserve Banking

1. Fractional Reserve Banking How Bank Lending “Creates” Money

2. BANKS “Create Money” • Banks receive a demand deposit & lend most of the deposit • this will ↑ money supply (MS) $1,000 deposited in checkingaccount Your Money $1,000 MS ↑ By multiple of 1st deposit In total,banking system lends more than $1,000

3. Fractional Reserve Banking • Reserves- deposits of banks not loaned out • Required Reserves- can never be lent out (10% of deposit) • Excess Reserves- can be lent out (90% of deposit) • 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) • Reserve Ratio - % of deposits banks must hold as required reserves Reserve Ratio = 10% If Total Reserves = $100,000 Required Reserves = $10,000Excess Reserves = $90,000

4. Assets Liabilities Excess Reserves $0 Bank Balance Sheet • Called a T-Account • Deposits are recorded as both: Assets & Liabilities Example #1: • $100 Deposit • 100%Reserve Ratio Bank can not lend money with 100% r.r. Required Reserves $100 $100 Deposits Total Assets Total Liabilities Leads to no change in Money Supply $100 $100

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

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

7. The Money Multiplier • Money Multiplier = 1 / reserve ratio: (M = 1/R) • If reserve requirement = 10% => 1/.10 = 10 • Calculate the change(∆) in money supply, bank deposits and bank reserves for a $100 Deposit: +$900 ∆ Money Supply = Multiplier X Initial Loan (excess reserves) +$1,000 ∆ Bank Deposits = Multiplier X Initial Deposit +$100 ∆ Bank Reserves = Initial Deposit

8. Assets Assets Assets Liabilities Liabilities Liabilities Required Reserves Deposits Excess Reserves ========= ========== Total Liabilities Total Reserves Worksheet 20% Reserve Requirement $100,000 Deposit Bank1Bank 2Bank 3 total increase in Money Supply total increase in Bank Deposits