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Money Creation and Fractional Reserve Banking: November 12, 2014

Banks can create money through fractional reserve banking. When a central bank issues new currency, it is deposited in commercial banks which are required to hold only a portion in reserves. They loan out the remaining funds, expanding the money supply. This process repeats as loan amounts are redeposited and again partially lent out, leading to a multiplied increase in the total money supply. With a 10% reserve requirement, a $1 increase in reserves can expand the money supply to $10 through repeated lending and depositing of loan amounts.

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56 views7 pages

Money Creation and Fractional Reserve Banking: November 12, 2014

Banks can create money through fractional reserve banking. When a central bank issues new currency, it is deposited in commercial banks which are required to hold only a portion in reserves. They loan out the remaining funds, expanding the money supply. This process repeats as loan amounts are redeposited and again partially lent out, leading to a multiplied increase in the total money supply. With a 10% reserve requirement, a $1 increase in reserves can expand the money supply to $10 through repeated lending and depositing of loan amounts.

Uploaded by

keyyongpark
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Money creation and fractional reserve

banking

November 12, 2014

Money supply,
M = CU + DEP.

Monetary base,
BASE = CU + RES.

Divide one equation by another


CU + 1
M
cu + 1
CU + DEP
DEP
=
=
= CU
RES
BASE
CU + RES
cu + res
+
DEP
DEP

cu + 1
M = BASE
> BASE
cu + res

Example: cu = 0 CU = 0.
Central bank issues $1 currency.
People have $1 additional money. If cu = 0, they deposit the entire
amount in banks.

1st round: Bankss deposit goes up by a $1.


Suppose res = 0.1. Banks then keep 0.1 $1 = $0.1 as RES and
loan out the rest ($0.9).

Somebody (household or firm) gets a loan of $0.9. Given cu = 0, that


person deposits the entire amount in banks.

2nd round: Bankss deposit goes up by a $0.9.


Given res = 0.1. Banks then keep 0.1 $0.9 = $0.09 as RES
and loan out the rest ($0.90.9 = $0.81).

Somebody (household or firm) gets a loan of $0.81. Given cu = 0,


that person deposits the entire amount in banks.

3rd round: Bankss deposit goes up by $0.81.


Given res = 0.1. Banks then keep 0.1 $0.81 = $0.081 as RES
and loan out the rest ($0.810.9 = $0.729).

The process continues...


Deposits increase by
1 + 0.9 + 0.92 + 0.93 + ... = 1

1
1
=
= 10
1 0.9
0.1

In general with cu = 0,
M = DEP = BASE

1
= 10.
res

The amount of RES


0.1 + 0.9 0.1 + 0.81 0.1 + ...

2
3
= 0.1 1 + 0.9 + 0.9 + 0.9 + ...

0.1
=1
0.1

In general, with CU = 0,
BASE = CU + RES = RES = 1

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