Topic 4.4 Notes – Banking and the Expansion of the Money Supply

1. How Banks Create Money Through Fractional Reserve Banking

A depository institution (like a commercial bank) accepts deposits and makes loans. In the U.S., banks operate under fractional reserve banking, which means they keep only a fraction of deposits as reserves and lend out the rest.

The fraction they must keep is the required reserve ratio (RRR), set by the Federal Reserve.

Here’s the core loop:

1. A customer deposits cash into a bank.
2. The bank keeps the required portion as required reserves (RR).
3. The rest becomes excess reserves (ER).
4. The bank loans out the excess reserves.
5. That loan is deposited into another bank.
6. The process repeats across the system.

Key insight: Loans create new demand deposits, and demand deposits are part of M1. So the money supply increases even though no new physical currency was printed.

This is why banks are central to monetary policy. When the Fed changes reserve requirements, it changes how much lending can happen.

2. Bank Balance Sheets

Banks track everything on a balance sheet, also called a T-account. Assets must equal liabilities, with assets listed on the left (such as required reserves, excess reserves, loans, and securities) and liabilities listed on the right (such as demand deposits and savings deposits).

Assets (what the bank owns)

• Required reserves
• Excess reserves
• Loans (earn interest)
• Securities (like government bonds)

Liabilities (what the bank owes)

• Demand deposits (checking accounts)
• Savings deposits and other accounts

If someone deposits 2,000 dollars and the RRR is 25%:

• Required reserves = $2000 \times 0.25 = 500$
• Excess reserves = $2000 - 500 = 1500$

Only the 1,500 dollars of excess reserves can be loaned out.

If a bank has zero excess reserves, it cannot create new loans. That shows up constantly in FRQs.

3. The Money Multiplier and Maximum Expansion

The money multiplier (m) is the ratio of the money supply to the monetary base (MB), where Monetary base = currency + bank reserves.

The maximum multiplier is:

$$m = \frac{1}{\text{RRR}}$$

If RRR = 0.20, then $m = 5$.
If RRR = 0.10, then $m = 10$.

Lower RRR → larger multiplier → bigger potential expansion.

Maximum Change in Money Supply

$$\text{Maximum Change} = \text{Excess Reserves} \times m$$

Example:

A bank receives a 5,000-dollar deposit. RRR = 10%.

• Required reserves = 500
• Excess reserves = 4,500
• Multiplier = 10

Maximum change in money supply:
$4500 \times 10 = 45,000$

Be careful with wording:

• If given a deposit, first calculate excess reserves.
• If given excess reserves directly, multiply immediately.
• The multiplier applies to loans, deposits, and total money supply change depending on what they ask.

On past FRQs like the 2016 question about First Superior Bank, students lost points because they multiplied the full deposit instead of the excess reserves. Always separate those two steps.

4. Why the Actual Increase Is Smaller

The simple multiplier gives the maximum possible expansion. Real life is smaller.

Two major leakages:

1. Banks hold excess reserves

After the 2008 financial crisis, banks held large excess reserves instead of lending due to uncertainty. When banks choose not to loan everything, expansion slows.

2. The public holds currency

If people keep cash instead of redepositing it, that money stops circulating through banks. No redeposit means no new loan.

The simple multiplier assumes:

• Banks loan all excess reserves.
• The public redeposits all currency.

That rarely happens.

5. Big Picture Connections

The relationship tying this together:

$$\text{Money Supply} = \text{Monetary Base} \times m$$

The Federal Reserve influences:

• Monetary base (through open market operations)
• RRR
• Bank reserves

This is how policy decisions translate into changes in M1 and the broader money supply.

The banking system is the transmission mechanism between the Fed and the economy.