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The Creation of Money by Banks: Demystifying Fractional Reserve
Uncover the fascinating process of money creation by banks. Our easy-to-follow video guide breaks down fractional reserve banking, helping you grasp this essential economic concept and make informed financial decisions.

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Now Playing:Creation of money from banks – Example 0a
Intros
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  1. Making Loans to Create Deposits
    • Transactions that Make Loans & Deposits
    • Monetary Base
    • Desired Currency Holdings
    • Desired Reserves
  2. The Process of Creating Money
    • Excess Reserves
    • 8 Steps of the Process
Money definitions
Jump to:NotesConceptFAQsPrerequisites
Notes

Making Loans to Create Deposits

How do banks essentially create money? Assume that there are two banks: bank A and bank B.

Let’s say that bank A has an excess of reserves, and bank B is short on reserves. Bank A decides to use some of its reserves to pay bank B. What has exactly happened?

For bank A:
  1. The reserves have decreased.
  2. The loans have increased.

For bank B:
  1. The reserves have increased.
  2. The deposits have increased

If we were to look at the whole banking system, we see that the amount of reserves has not changed, but the amount of loans has increased the amount of deposits. In other words, we have just created money.

There are 3 factors which limit the quantity of loans and deposits.

  1. The Monetary Base: is the sum of Federal Reserve notes, coins, and deposits at the Fed. The size of this limits how much money the banks can make. This is due to banks having a desired reserve, and households having a desired amount of currency to hold.

  2. Desired Reserves: is the amount of reserves that a bank plans to hold. The desired reserves are determined by the desired reserve ratio, which is the ratio of reserves to deposits that a bank plans to hold. In other words,

    Desired Reserve Ratio = Desired  ReservesDeposits=RD\frac{Desired\;Reserves} {Deposits} = \frac{R} {D}

    Note: This is different from the required reserves, which is the minimum amount of reserves that a bank must hold.

  3. Desired Currency Holding: is the amount of currency a household or firm plan to hold.

    How much currency a household or a firm plan to hold or put in the bank deposits depends on how they choose to make payments. For example, would they rather use cash, a debit card or a credit card to make payments? Payment changes happen slowly and will also slowly change the ratio of desired currency to deposits.


    Desired Currency Holding Ratio = Desired  CurrencyDeposits=CD\frac{Desired\;Currency} {Deposits} = \frac{C} {D}

At any given time, this ratio is fixed. So,
  1. If bank deposits  ↑  \, \uparrow \, , then desired currency  ↑  \, \uparrow \, .
  2. If bank deposits  ↓  \, \downarrow \, , then desired currency  ↓  \, \downarrow \, .

Note: Since an increase in bank deposits increases desired currency holdings, then some of the currency leaves the bank, which decreases reserves. We call this leakage of bank reserves the currency drain.


The Process of Creating Money

The process of creating money occurs when there is an increase in monetary base, which happens when the Fed buys securities from banks and other institutions. The process of creating money has a total of 8 steps:

  1. Banks have excess reserves

  2. Banks lend excess reserves

  3. Loans and deposits increase, so the quantity of money increases.

  4. New money is used to make payments

  5. Some of the new money remains in deposit

  6. Some of the new money is a currency drain.

  7. Desired reserves increase because of the increase in deposit.

  8. Excess reserves decrease.

Note: the opposite of the 8 steps happens when the Fed sells securities.


Money Multiplier

The money multiplier is the following formula:

Money Multiplier = Change  in  quantity  of  MoneyChange  in  Monetary  Base=ΔMΔMB\frac{Change\;in\;quantity\;of\;Money} {Change\;in\;Monetary\;Base} = \frac{\Delta M} {\Delta MB}


Example: If a $1 million increase in the monetary base increases the quantity of money by $3 million, then

Money Multiplier = 3  million1  million=\frac{3\; million} {1\;million} = 3


Note: The smaller the desired reserve ratio and the smaller the currency drain ratio, the larger the money multiplier is.
Concept

Introduction: The Creation of Money by Banks

Welcome to our exploration of how banks create money! This fascinating process is a cornerstone of modern economics, and understanding it is crucial for grasping the broader financial system. Our introduction video serves as an excellent starting point, offering a clear and concise overview of this complex topic. Banks play a pivotal role in money creation through a process called fractional reserve banking. When you deposit money, banks keep a fraction as reserves and lend out the rest. This lending creates new deposits, effectively increasing the money supply. It's like magic, but with strict regulations! The video will walk you through this step-by-step, using easy-to-follow examples. By the end, you'll have a solid foundation for understanding how banks influence the economy. Remember, this knowledge is key to making informed financial decisions in your personal and professional life. Let's dive in and demystify the world of money creation together!

FAQs

  1. How do banks create money?

    Banks create money through the process of lending. When a bank makes a loan, it creates a new deposit in the borrower's account, effectively increasing the money supply. This is possible because banks only need to keep a fraction of their deposits as reserves, allowing them to lend out the rest.

  2. What is the fractional reserve system?

    The fractional reserve system is a banking practice where banks are required to keep only a fraction of their deposits as reserves, typically around 10%. This allows banks to lend out the majority of their deposits, which leads to money creation and expansion of the money supply.

  3. What factors limit money creation by banks?

    Three main factors limit money creation: the monetary base (controlled by the central bank), desired reserves (the amount banks choose to hold beyond the required minimum), and desired currency holding (the public's preference for cash over bank deposits). These factors work together to regulate the money supply and prevent excessive money creation.

  4. What is the money multiplier?

    The money multiplier is a measure of how much the money supply increases for each dollar of bank reserves. It's calculated as 1 divided by the sum of the required reserve ratio and the currency drain ratio. A higher money multiplier indicates that more money is being created in the banking system from a given amount of reserves.

  5. How does bank money creation affect the economy?

    Bank money creation has significant implications for the economy. It can stimulate economic growth by providing liquidity for investments and purchases. However, it also needs careful management to prevent inflation and maintain economic stability. Central banks use monetary policy tools to influence bank lending and money creation to achieve economic objectives.

Prerequisites

Understanding the creation of money from banks is a complex topic that requires a solid foundation in various economic concepts. One crucial prerequisite topic that plays a significant role in this understanding is economic growth. This fundamental concept is intricately linked to the process of money creation by banks and its broader economic implications.

Economic growth, which refers to the increase in an economy's production of goods and services over time, is closely related to the creation of money by banks. As an economy grows, there is typically an increased demand for credit and financial services. Banks play a pivotal role in meeting this demand by creating money through the process of lending.

When we examine the relationship between economic growth and money creation, we can see how they mutually influence each other. As banks create money through lending, they provide the necessary capital for businesses to invest, expand, and contribute to economic growth. This growth, in turn, leads to increased economic activity, which often results in a higher demand for loans and financial services, further fueling the money creation process.

Moreover, understanding economic growth helps in grasping the concept of inflation, which is closely tied to money creation. As banks create more money, if not matched by a proportional increase in economic output, it can lead to inflationary pressures. This relationship between economic growth and inflation is crucial for comprehending the broader impacts of money creation by banks on the overall economy.

The study of economic growth also provides insights into the role of central banks and monetary policy in regulating money creation. Central banks often adjust interest rates and implement other monetary tools to influence economic growth and control inflation, directly impacting the ability and willingness of commercial banks to create money through lending.

Furthermore, understanding economic growth helps in analyzing the long-term effects of money creation on an economy. It allows students to grasp how sustained economic growth can lead to increased wealth and living standards, and how the money creation process by banks contributes to this phenomenon.

In conclusion, a solid grasp of economic growth is essential for students aiming to understand the intricacies of money creation by banks. It provides the necessary context for comprehending the cyclical relationship between economic expansion, credit demand, and money supply. By mastering this prerequisite topic, students will be better equipped to analyze the complex dynamics of banking, monetary policy, and their impacts on the broader economy.