Deposit Expansion/Money Creation Basics

· Most of the money in the United States today (measured as M1 or M2) is created by banks

· Banks create money whenever they make loans. The process is that the bank creates a liability (deposit) to pay for an asset (loan)

· The definitive factor that allows banks to create deposits/money is our fractional reserve system

· Whenever cash is deposited into a bank, this leads to an increase in that banks reserves as well as an increase in deposits, but does not increase the money supply—only changes its composition (exchanging deposits for currency)

· While an individual bank can make loans and create deposits only to the extent (on a dollar-per-dollar basis) that it has excess reserves [Note: total reserves less required reserves equals excess reserves], the banking system can create deposits equal to some multiple of its excess reserves. The magnitude of that multiple is expressed as the money multiplier.

· The maximum value for the money multiplier is equal to the reciprocal of the reserve (requirement) ratio, so that

M = 1 / r r

where M = the money multiplier

r r = the reserve (requirement) ratio

· By raising reserve requirements, the Federal Reserve is able to reduce the size of the money multiplier. Conversely, whenever the Fed lowers reserve requirements, that increases the size of the money multiplier.

· To the extent that banks hold excess reserves and/or the public holds currency (as opposed to holding its money balances in the form of checkable deposits), the size of the money multiplier is reduced. The public’s currency holdings (i.e., currency drain) constitute the largest single factor reducing the size of the money multiplier

· Just as money is created whenever banks make loans, money is uncreated/destroyed when bank loans are repaid

· The money multiplier applies to money destruction as well as to money creation