Fractional-Reserve Banking and Money Creation

Introduction

Welcome back! In our previous lesson, we established a clear economic definition of money by exploring its three essential functions: a medium of exchange, a unit of account, and a store of value. We concluded by noting that while central banks issue physical currency, the vast majority of the money supply in a modern economy—specifically, the money held in checking accounts—is actually created by commercial banks.

This might sound like a strange and powerful ability, but it's a natural outcome of normal banking operations. This lesson will demystify this process. Our goal is to describe how commercial banks create money through the fractional-reserve banking system. We will unpack the mechanics of how a simple deposit can lead to a multiplied expansion of the money supply.

1. The Foundation: Fractional-Reserve Banking

The entire process of money creation by banks rests on a system called fractional-reserve banking. The concept is straightforward: banks are not required to keep all of their depositors' money locked away in a vault. They know that on any given day, only a small fraction of customers will come to withdraw their funds. Therefore, they are legally required to hold only a fraction of their deposits in reserve and are free to lend out the rest.

To get comfortable with the core terminology, let's turn to a clear, foundational text.

To summarize these crucial definitions:

• Required Reserve Ratio (rrr): The percentage of total deposits that the central bank mandates a commercial bank must hold in reserve, unable to be loaned out. Let's assume for our examples that this is 10% (or 0.10).
• Required Reserves (RR): The actual dollar amount of reserves a bank must hold. If a bank has $1,000 in deposits and the rrr is 10%, the required reserves are $100.
• Excess Reserves (ER): The amount of reserves a bank holds over and above its required amount. This is the money the bank is free to lend. In our example, ER = $1,000 (Deposits) - $100 (RR) = $900.

It is a bank's ability to lend its excess reserves that allows it to create money.

2. The Ripple Effect: How a Deposit Creates Money

Now let's trace the journey of a new deposit through the banking system to see the "magic" of money creation in action. The process is a chain reaction, where one bank's loan becomes another bank's deposit, which then allows for another loan.

The following video provides an excellent step-by-step walkthrough of this process. It uses simple balance sheets (T-accounts) to show how assets and liabilities change at each step, which is a very clear way to track the flow of funds.

As the video demonstrates, money is created the moment the first loan is made. Let's break it down:

1. Initial Deposit: You deposit $1,000 into Bank A. The money supply hasn't changed yet; you've just converted $1,000 of currency into a $1,000 checkable deposit.
2. First Loan (Money is Created): Bank A holds 10% ($100) as required reserves and lends out its excess reserves ($900) to a borrower. At this moment, new money has been created. Why? Because you still have your $1,000 deposit (which you consider your money), and the borrower now has $900 (which they consider their money). The money supply has increased by $900.
3. The Process Continues: The borrower spends the $900, and the recipient deposits it into Bank B. Bank B now has a new deposit of $900. It keeps 10% ($90) as required reserves and can lend out the remaining $810. This second loan creates another $810 of new money.

This cycle of lending and redepositing continues, with each round creating a smaller amount of new money than the last.

The image below provides a great visual summary of this cyclical process.

3. Calculating the Total Change: The Money Multiplier

Adding up all the individual rounds of money creation would be tedious. Fortunately, there's a simple formula to calculate the maximum possible expansion of the money supply from a new injection of reserves. This is known as the simple money multiplier (or deposit multiplier).

The formula is simply the reciprocal of the required reserve ratio:

$$\text{Money Multiplier}=\frac{1}{\text{Required Reserve Ratio (rrr)}}$$

Using our 10% reserve ratio example:

$$\text{Money Multiplier}=\frac{1}{0.10}=10$$

This multiplier of 10 means that an initial new deposit can cause the total money supply to expand by a maximum of 10 times that amount. So, our initial $1,000 deposit can lead to a total of up to $10,000 in checkable deposits throughout the banking system.

The following video provides a quick, energetic explanation of this concept and works through a practice problem.

A Critical Distinction

As Jacob Clifford points out, there's a subtle but important detail. When an individual deposits existing cash into a bank, the initial deposit itself isn't "new" money; it was already part of the money supply. The new money created is the result of all the subsequent loans.

• Total Increase in Deposits: Initial Deposit * Multiplier
• Total Increase in Loans (New Money): Initial Excess Reserves * Multiplier

In our example with the $1,000 deposit and a 10% rrr:

• Initial Excess Reserves = $900
• Total Increase in Loans = $900 * 10 = $9,000
• Total Increase in Deposits = $1,000 * 10 = $10,000

Notice that the total increase in deposits ($10,000) is equal to the initial deposit ($1,000) plus the total new loans created ($9,000).

For a more detailed textual explanation of these calculations, you can refer back to the resource "Money creation and contraction" (LINK), specifically sections "3. The Money Creation Process" and "4. The Banking Multiplier".

4. Theory vs. Reality: Why the Multiplier is a "Maximum"

The simple money multiplier gives us the theoretical maximum money creation. In the real world, the actual amount of money created is usually less. This is because the model makes two key assumptions:

1. All money is redeposited: It assumes that every dollar loaned out is immediately deposited back into the banking system. In reality, people might choose to hold some of their money as cash (a "cash drain").
2. Banks lend all excess reserves: It assumes banks will always lend out every dollar of their excess reserves. In reality, a bank might choose to hold voluntary excess reserves, perhaps if it's cautious about the economic climate and the creditworthiness of borrowers.

When either of these "leakages" occurs, the money creation process is dampened, and the actual multiplier effect is smaller than the simple formula suggests.

Conclusion

In this lesson, we have demystified the process of money creation by commercial banks. It is not an act of printing currency, but rather a consequence of the fractional-reserve banking system.

Key Takeaways:

• Banks are required to hold only a fraction of deposits as required reserves, determined by the required reserve ratio.
• The remaining excess reserves can be loaned out.
• The act of making a loan creates new money, as the loan becomes a new deposit in the banking system.
• This process creates a ripple effect, where an initial deposit leads to a multiplied increase in the total money supply.
• The simple money multiplier (1 / rrr) allows us to calculate the maximum possible expansion of deposits from a new injection of reserves.
• Real-world "leakages," like people holding cash or banks holding excess reserves, mean the actual money creation is typically less than the theoretical maximum.

Preview of the Next Lesson:

Now that you understand the mechanics of money creation and have been introduced to the simple money multiplier, we will dedicate our next lesson to mastering its calculation. We will work through various scenarios to solidify your ability to use the multiplier to determine the impact of changes in reserves on the money supply.