The following is a rather clear explanation of the process that leads to the creation of new money by banks, written by Econ educator Dick Brunelle. I find this much more straightforward and easier to understand than your text.
How is money created? In addition to currency that is printed by the government and put into circulation by the FED, money is created through the fractional reserve banking system. Banks when they receive a checkable deposit from a customer will keep some of that money in reserve and lend the balance. The bank is required to keep a certain amount in required reserves. Any additional reserves are referred to as excess reserves. Let’s follow a $10,000 deposit of a customer. We will assume a 10% reserve requirement. The T account for the bank will look like this:
Assets: Required reserve = $1,000 and Excess reserve = $9,000Liabilities: Checkable deposits = $10,000
The bank will now have a liability to the customer of $10,000. It will also have required reserves of $1,000 and excess reserves of $9,000. It can choose to make a loan of $9,000 with the excess reserves. Let’s take a look at what happens if the bank makes that loan.
Assets: Required reserves = $1,000, Excess reserves = $0, and Loans = $9,000
Liabilities: Checkable deposits = $10,000
Now what happens to that $9,000 that was lent to another customer? Let’s assume that person deposits the $9,000 into her bank and creates the following change in the T account for that bank:
- Assets: Required reserves = $900, Excess reserves = $0 and Loans = $8,100
- Liabilities: Checkable deposits = $9,000
We have assumed that the bank has made loans with the full additional $8,100 available from Excess reserves. This process will continue in the banking system until there is no more to lend from the initial deposit. We can calculate the entire amount of money created from the initial deposit by using the banking or money multiplier. The following is the formula:
Money Multiplier (m) = 1 / RR (reserve requirement)
Our reserve requirement is 10%. The money multiplier is 1/.1=10
The initial deposit of $10,000 will lead to a total in money supply of $100,000. Now here is where we need to be careful semantically. Since the original $10,000 was already a part of the money supply, the additional amount of money created is $100,000 minus the original $10,000 or $ 90,000.
If the original $10,000 came from the FED then the total amount of money creation would be $100,000 since money at the FED is not part of the money supply.
The banking multiplier leakages
There are two events that can minimize the banking multiplier:
- Banks keeping excess reserves
- Borrowers keeping currency and not redepositing the amount of the loan.
Note: Students will frequently be asked to compute how much money will be created given a certain circumstance. If the banking multiplier is 5 and the FED adds new money into circulation by buying bonds, lowering discount rate or lowering the reserve requirement, then multiply the amount by: Example Fed buys $10,000 of bonds, how much money is created? $10,000 X 5 = $50,000
But if the question states that the Bank has excess reserves and uses this money to make a $10,000 loan, how much money is created? $10,000 X 5 = $50,000 minus $10,000 (original amount already in reserves) = $40,000. The same would hold true if a person took $10,000 of cash in put it in the bank. Students must account for the fact that the original $10,000 was already in existence.
