Creating Money Through the

Banking System
Multiple Deposit Creation
 Money and Banking
• The largest component of the money supply is bank
deposits.

• To understand how the Central Bank influences the

supply of money in the economy, we need to examine
the linkages between:
– The Central Bank
– The private banking system
– Depositors
– Borrowers

• The interactions between these four groups have direct

effects on the money supply
 The Fed’s Balance Sheet
• We first look at the Central Bank’s (Fed) assets and liabilities

Assets Liabilities
Government Securities Currency in Circulation
Discount Loans Reserves

• Assets
– The Fed purchases securities (mostly those issued by the U.S.
Treasury) from private banks and the non-bank public
– The Fed makes discount loans to private banks that are repaid at the
discount rate
• Liabilities
– Currency in circulation is currency held by the public
– Bank reserves refer to currency held by private banks in their own
vaults or at the Fed.
 The Monetary Base
• We define the monetary base as the Federal Reserve’s
liabilities:
– MB = Currency in Circulation + Reserves = C + R

• The Fed can increase or decrease MB by engaging in

Open Market Operations, the buying and selling of
bonds from/to the public.

– To increase MB, the Fed will buy bonds from the public,
replacing a non-monetary asset (bonds) with a monetary one
(currency)

– To decrease MB, the Fed will sell bonds from the public,
exchanging a monetary public asset (currency) for a non-
monetary asset (bonds)
 Increasing MB through an Open Market Purchase
Federal Reserve
Assets Liabilities
Securities +$100 Reserves +$100

Banking System
Assets Liabilities
Securities -$100
Reserves +$100

• The Fed buys a $100 bond from a bank and pays with a $100 check.
• The bank cashes the check and places the $100 in its vault as reserves.
• The monetary base has increased by $100 with the conversion of the
privately held security into currency (and then into bank reserves)
 Open Market Purchase from the Public
• Suppose the Fed wanted to increase the monetary base and bought
a $100 treasury bill from you.
• You now have two things you can do with your money:
– Hold it as currency
– Deposit it at the bank.

• Suppose you hold onto the $100 as currency.

• The Fed’s balance sheet now looks like:

Federal Reserve
Assets Liabilities
Securities +$100 Currency in Circulation +$100

• The monetary base has increased

 Open Market Purchase from the Public
• Now what would happen if you deposited your $100 in the bank?
• The bank takes your $100 and places it in reserve
• The monetary base still increases by $100, only now because reserves
went up:

Federal Reserve
Assets Liabilities
Securities +$100 Reserves +$100

Banking System
Assets Liabilities
Reserves +$100 Checkable Deposits +$100
 Open Market Sale
Nonbank Public Federal Reserve System
Assets Liabilities Assets Liabilities
Securities +$100 Securities -$100 Currency in -$100
circulation
Currency -$100

• The Fed sells a bond to the public for $100

• Reduces the monetary base by the amount of the sale

• Reserves remain unchanged
• The effect of open market operations on the monetary
base is much more certain than the effect on reserves
 Making a Discount Loan to a Bank

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves +$100 Discount +$100 Discount +$100 Reserves +$100
loans loan

• A bank borrows $100 from the Fed’s discount window

• Monetary liabilities of the Fed have increased by $100

• Monetary base also increases by this amount
 Paying off a Discount Loan from the Fed

Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves -$100 Discount -$100 Discount -$100 Reserves -$100
loans loans

• The bank pays back $100 to the Fed (assume no

interest)

• Net effect on monetary base is a reduction

• Monetary base changes one-for-one with a change in
the borrowings from the Federal Reserve System
 Fractional Reserve Banking
• So far we have been assuming that banks hold the entire
amount of their deposits in reserve.
• Clearly this is a false assumption as banks rarely ever
have enough currency in their vaults (or on reserve at
the Fed) to cover all deposits made with them.

• The banking system operates as a fractional reserve

system in which only a portion of the banks deposits are
held in reserve.
• The Fed sets a lower limit for the fraction of deposits that
must be held in reserve: the reserve requirement ratio
• Since banks earn profit by lending at higher interest
rates than they give on deposits, the reserve
requirement is generally a binding limit.
 Reserve Requirement Ratio
• One way the Fed influences the money supply is by changing the
reserve requirement ratio (r)
• As r increases, bank loans will fall, money in circulation falls

• Suppose you deposit $100 into your account at Bank of America

• The reserve requirement ratio is 20%.
• Bank of America has the following balance sheet:

BANK OF AMERICA

Assets Liabilities

Reserves $20.00 Deposits $100

Loans $80.00

• The money supply is equal to the $100 deposited in the bank plus
the $80 in currency circulating as a loan  M = $180
 Reserve Requirement Ratio
• Suppose the $100 is deposited in Bank of America, but now the bank
maintains a 10% reserve ratio, lending the remaining 90% of deposits.
• Bank of America’s financial statement would then be:

BANK OF AMERICA
Assets Liabilities
Reserves $10.00 Deposits $100.00
Loans $90.00

• The money supply has increased

– There is $90 of currency in circulation and $100 worth of deposits.
– The money supply has increased to $190
– Despite the increase in the money supply, there has been no increase in
wealth. New money has been created, but so has debt.

• Now suppose that the borrower who got the $90 loan uses that
currency to make a purchase.
 Reserve Requirement Ratio

• Suppose the borrower uses that $90 to buy tickets to an Atlanta

Braves playoff game.
• Ticketmaster will then deposit this $90 in their bank, SunTrust.
• Suppose SunTrust maintains a 10% reserve ratio as well:

SUNTRUST BANK
Assets Liabilities
Reserves $9.00 Deposits $90.00
Loans $81.00

• Of the $90 deposited at SunTrust, only 10% ($9) is held as

reserves. The remaining 90% ($81) is loaned out.
• There has been a further increase in the money supply.
• The new value for M is Deposits at Bank of America + Deposits
at SunTrust + Currency in Circulation = $100+$90+$81=$271
 Reserve Requirement Ratio
• Now SunTrust bank loans out $81 to another borrower who uses
that money to buy books from the UCSD bookstore.
• The bookstore deposits this $81 in Wachovia Bank, who also
maintain a 10% reserve ratio.
WACHOVIA BANK
Assets Liabilities
Reserves $8.10 Deposits $81.00
Loans $72.90

• The money supply has increased again:

• M1 = Deposits at BoA + Deposits at SunTrust + Deposits at
Wachovia + Currency = $100 + $90 + $81 + $72.90 = $343.90
• Each time money is deposited and a bank loan is created, more
money is created.
• The amount of money the banking system generates with each
dollar of reserves is known as the money multiplier.
The Formula for Multiple Deposit
Creation
Assuming banks do not hold excess reserves
Required Reserves (RR ) = Total Reserves (R)
RR = Required Reserve Ratio (r ) times the total amount
of checkable deposits (D)
Substituting
r  D=R
Dividing both sides by r
1
D=  R
r
Taking the change in both sides yields
1
D =  R
r
 Critique of the Simple Model
• Holding cash stops the process
• Banks may not use all of their excess
reserves to buy securities or make loans