Economics Online Tutor
Different countries throughout the world use different banking systems.  There are differences based on
different government structures, different levels of industrialization, different degrees of globalization,
even different cultures and religions.

Banking systems have been undergoing many major changes in recent years.  New technologies are
being used.  International banking is growing and evolving.  Global currencies, such as the U.S. dollar
and the Euro, have increasingly influenced world banking operations.  Even within the United States, a
relaxation of banking regulations is changing the fundamental ways that the banking system operates.

The purpose here is not to provide details of all of these differences and changes.  Instead, the focus is
on one of the basics of the United States Banking system: How commercial banks create money.


Banks act as financial intermediaries.  They use funds deposited by savers to make loans to borrowers.  
Banks make profit from this activity.  They charge a higher interest rate to borrowers than they pay to
savers.

In the United States, the Federal Reserve System (The Fed) supervises commercial banks.  The Fed sets
rules for commercial banks based on the Fed's
monetary policy.

In addition, the Fed provides services to commercial banks.  The Fed provides currency for banks, makes
loans to banks, holds reserves for banks, and clears checks between banks.

The Fed has been called a banker's bank because of these services.













How Banks Create Money

When people deposit money in a commercial bank in the United States, the amount deposited remains
part of the U.S. money supply.  Checking accounts are part of the M-1 definition of money.  Savings
accounts are generally considered to be part of the M-2 definition of money.
[see the page entitled '
Money (Defined) for more details of these definitions]

Depositors can withdraw their funds on demand.  This creates an equal liability for the banks.  The funds
that the banks accept in deposits belong to the depositors.  The deposits are called reserves for the
banks.

On a typical day, only a very small fraction of the deposits in a bank will be needed to meet the demand
for withdrawals.  The bank will attempt to keep enough currency on hand to meet the demand for
currency transactions.  The rest of the deposits are kept at the Fed for safekeeping.

It is not profitable for banks to have a lot of reserves sitting around, not earning any income.  So banks
loan out the reserves to borrowers and charge interest on the loans.  These loans decrease the amount
of reserves for the banks.

The banks cannot loan out all of the money that is deposited.  It must keep enough reserves on hand to
meet the daily needs for withdrawals.

The Fed determines the level of reserves that banks are required to hold.  This level is a percentage of
total deposits.  This level is called the required reserve ratio, or the reserve requirement.  The Fed
determines what the reserve requirement is based on its monetary policy.  Since this ratio will help
determine the size of the money supply, the reserve requirement becomes a tool that the Fed uses in its
monetary policy.

Since banks cannot loan out 100% of its reserves, this type of banking system is called a fractional
reserve system.  The reserves for an individual bank above the reserve requirement are called excess
reserves.  An individual commercial bank is allowed to loan out money as long as it has excess reserves.

When a bank makes a loan from its excess reserves, it typically will credit funds to the borrower's
account, which is part of the money supply.  The reserves that provided the loan, however, are still
counted as deposits in other customers' accounts, which are also part of the money supply.  So when
banks make loans, they increase the money supply.  Money is created "out of thin air".

For each deposit, an individual bank is allowed to loan out, and increase the money supply by, an amount
equal to:

amount of the deposit times (1 - the reserve requirement)

Relatively widespread misconceptions exist about the amount of this expansion of the money supply, so I
will clarify with an example.  If the reserve requirement is 10%, then banks will be allowed to loan out, in
total, an amount equal to $90 for every $100 dollars on deposit.  This would be $100 times (1 - 0.1), the
formula above using the numbers from the example.  Many people incorrectly believe that a bank with a
10% reserve requirement can loan out 10 times the amount of the deposit, or $1000 for every $100 on
deposit.  This greatly overstates the ability of an individual bank to increase the money supply, and the
effects of the fractional reserve system on the overall economy.

However, that is for individual banks.  When an individual bank makes a loan from excess reserves, it
sets off a chain of events throughout the entire banking system, which multiplies the amount of money
that eventually can be created out of that initial transaction.



Deposit Expansion Multiplier

The money supply in the entire economy, in the entire banking system, can expand by more than the
amount created by an initial deposit in an individual bank.  A typical borrower does not borrow money in
order to leave it sitting in a bank account.  The borrowed money is spent in the economy.  This becomes
income for somebody else.  To the extent that it is then redeposited into an account at a different
commercial bank within the banking system, reserves are created at that other bank.  The other bank can
in turn loan out its excess reserves.  This process then can repeat itself continuously, increasing the
money supply with every additional loan.

The maximum amount that an initial deposit can increase the money supply within the entire banking
system is given by the formula:


Deposit expansion multiplier = 1 / reserve requirement

In the above example, an initial deposit of $100 with a 10% reserve requirement allowed the bank where
the deposit is held to increase the money supply by $90.  If you apply that same $100 deposit to the
deposit expansion multiplier, the entire banking system would be able to increase the money supply by
$1000 ($100 initial deposit times the deposit expansion multiplier, which is 1 / 0.1).

The incorrect assumption mentioned above, about the ability of one bank to increase the money supply,
actually is the same amount as the true maximum amount that the money supply can eventually be
increased by within the entire banking system.  Economics classes in money & banking and
macroeconomics often require students to be able to make calculations based on this formula.  Keep in
mind, however, that this formula is only a mathematical maximum.  The actual amount of money that would
be created within a real world banking system would be somewhat less than the maximum amount.

The reason why the real world expansion of the money supply would be less than the mathematical
maximum calculated using the deposit expansion multiplier formula: It is not realistic to assume that
every individual bank would always keep its excess reserves at exactly zero.  That would be required for
the money supply to increase by the maximum amount.  Not all loan proceeds are deposited in the
borrowers' accounts, although most would be.  When these loan proceeds are spent, they do not always
end up as deposits in another bank.  Also, excess reserves at a given bank are not only increased by
deposits, they are also decreased by withdrawals.

BANKING
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