4.4 - Banking & Expansion of the Money Supply
Key terms related to the banking system
Depository institutions are financial organizations, such as commercial banks, that accept deposits from the public and use those funds to make loans. These institutions play a central role in managing money within an economy by handling both incoming and outgoing funds.
Balance sheets in banking
A balance sheet is a financial statement that summarizes a bank's assets and liabilities at a specific point in time. It provides a snapshot of what the bank owns and owes, helping to track its financial health.
Components of a balance sheet:
- Assets - Items of value owned by the bank, such as cash reserves, loans made to customers, and investments.
- Liabilities - Obligations the bank owes, primarily deposits from customers that can be withdrawn.
The balance sheet must always balance, meaning total assets equal total liabilities plus the bank's equity. This structure allows banks to organize their operations and assess their ability to lend money.
How fractional reserve banking enables money creation
Fractional reserve banking is a system where banks are required to hold only a portion of customer deposits as reserves, allowing them to lend out the rest. This practice enables the banking system to create new money through lending, as the loaned funds can be deposited elsewhere and lent again.
The process of money creation
Banks create money when they issue loans from deposits. For example, if someone deposits money in a bank, the bank keeps a fraction as reserves and lends the remainder. The borrower then spends the loan, and the recipient might deposit it in another bank, repeating the process. This leads to a chain reaction where the initial deposit generates additional money in the economy through multiple rounds of lending and depositing.
As a result, the total money supply expands beyond the original deposit amount. This system relies on banks not needing to hold 100% of deposits in cash, which would limit lending and economic growth.
The role of required and excess reserves
Reserves are the portion of customer deposits that banks hold either in cash or as deposits with the central bank. They are divided into two categories to ensure stability while allowing for lending.
Types of reserves
- Required reserves - The minimum amount of reserves a bank must hold, set as a percentage of deposits by the central bank (known as the required reserve ratio). This ensures banks have enough cash for withdrawals.
- Excess reserves - Any reserves held beyond the required amount. These can be used for lending, forming the basis for expanding the money supply.
Excess reserves are crucial because they allow banks to create loans, which in turn create new deposits in the system. If a bank has no excess reserves, it cannot expand the money supply through additional lending.
The money multiplier and its calculation
The money multiplier measures how much the money supply can increase from an initial deposit through the banking system's lending process. It is the ratio of the total money supply to the monetary base, which includes currency in circulation and bank reserves.
The size of the money supply expansion depends on the money multiplier. Its maximum value is calculated as the reciprocal of the required reserve ratio, assuming all excess reserves are lent out and no money is held as currency by the public.
Formula for the maximum money multiplier
Where:
- Required reserve ratio = The fraction of deposits that must be held as required reserves (expressed as a decimal)
For example, if the required reserve ratio is 0.10 (10%), the maximum money multiplier is 10, meaning an initial deposit could potentially expand the money supply by up to 10 times.
Formula for money supply expansion
This shows how an initial amount of excess reserves can lead to a multiplied increase in the overall money supply through repeated lending.
Worked example - Calculating the maximum money supply expansion
Suppose the required reserve ratio is 0.10 (10%), and a bank receives a new deposit of $2,000, all of which becomes excess reserves after meeting the required reserve amount. Calculate the maximum money multiplier and the potential expansion of the money supply.
Step 1: Identify the values
- Required reserve ratio = 0.10
- Initial deposit = $2,000
- Required reserves from deposit = $2,000 × 0.10 = $200
- Excess reserves = $2,000 - $200 = $1,800
Step 2: Calculate the maximum money multiplier
Step 3: Calculate the maximum money supply expansion
Step 4: Interpretation
The initial $1,800 in excess reserves could lead to a total increase of $18,000 in the money supply if all funds are lent out and redeposited in the banking system.
Factors that limit the actual expansion of the money supply
While the money multiplier provides a maximum potential for expansion, the actual increase in the money supply is often smaller due to real-world behaviors.
Key factors reducing the money multiplier
- Banks holding excess reserves - Banks may choose to keep more reserves than required for safety or liquidity reasons, reducing the amount available for lending.
- Public holding currency - If people withdraw and hold cash instead of depositing it back into banks, less money is available for the lending-deposit cycle.
These factors mean the simple money multiplier often overstates the expansion, as not all excess reserves translate into new loans and deposits.