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“The process by which banks create money is so simple that the mind is repelled.” John Kenneth Galbraith My favorite economist. Money Creation. Chapter Objectives. Why the U.S. Banking System is Called a “Fractional Reserve” System

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“The process by which banks create money is so simple that the mind is repelled.”John Kenneth GalbraithMy favorite economist



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Chapter Objectives

  • Why the U.S. Banking System is Called a “Fractional Reserve” System

  • Distinction Between a Bank’s Actual Reserves and Its Required Reserves

  • How a Bank Can Create Money Through Granting Loans

  • The Multiple Expansion of Loans and Money by the Entire Banking System

  • The Monetary Multiplier and How to Calculate it

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Creating MoneyFractional Reserve Banking

  • Only part (a fraction) of checkable deposits are backed up by cash in bank vaults or in bank’s accounts at the Fed.

    • Size of the “fraction” held in reserves is regulated by Fed.

  • Characteristics of a Fractional Reserve System:

    • Banks Create Money Through Lending

    • Fractional Reserve Banks are Subject to “Panics” or “Runs” (why don’t we have bank runs today?)

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Creating MoneyBanks Increase Money Supply

  • Banks are required to keep a certain percentage of checking account balances on hand in their vault or in their account at the Federal Reserve Bank.

  • The reserve requirement is a percentage established by the Federal Reserve.

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Creating MoneyBanks Increase Money Supply

  • For example, if the reserve requirement is 10%, and Wachovia Bank has $10 million deposited into checking accounts at their banks, Wachovia must always have at least $1 million ($10 million x 10%) on hand in vault cash or in their cash account at the Fed.

    • Banks can then make loans to consumers and businesses with the other 90% of their checking deposits, thereby creating money in the money supply.

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What banks have in vaults and accounts at Fed.

What banks are required to have in vaults and Fed accounts.

Amount that banks can loan out.


Creating Money

Excess Reserves = Loanable Funds

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Creating MoneyBanks Increase Money Supply


  • a 10% reserve requirement,

  • banks loan all excess reserves (“loaned up”), and

  • borrowers deposit entire amount back into a bank (no leakages).

  • We can calculate the increase in the money supply created by a new deposit (money supply covered in Ch 14).

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    Final impact on money supply

    Creating MoneyBanks Increase Money Supply

    Injection into the money supply by the Federal Reserve Bank

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    Creating MoneyBanks Increase Money Supply

    With fractional reserve banking, the initial injection into the banking system has a multiplier effect on the money supply.

    Amount of the impact depends on the reserve requirement.

    Money (deposit) multiplier = reciprocal of reserve requirement

    If reserve requirement is 10%, money multiplier = 1/0.10 = 10

    Deposit of $100,000 can increase the money supply by

    10 x $100,000 = $1 million

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    Creating MoneyBanks Increase Money Supply

    • In order to increase the effect a deposit would have on the money supply, would we raise or lower the reserve requirement? What if reserve requirement is 5%?

      If reserve requirement is 5%, money multiplier =

      1/0.05 = 20

      Deposit of $100,000 can impact the money supply by

      20 x $100,000 = $2 million

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    Required Reserve Ratio








    The Monetary MultiplierOr Checkable Deposit Multiplier

    • Suppose the required reserve ration is 20%

    = 5

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    The Monetary Multiplier


    • Making Loans Creates Money

    • Loan Repayment Destroys Money

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    Bank Panics of 1930-1933



    • Series of Bank Panics

      Before Deposit Insurance (FDIC)

    • Mass Withdrawals From Fear

      More than 9,000 banks failed in one year

    • Move to Cash Reduced Money Supply Through Reduction in Loans (money destruction)

    • Multiple Contraction Slowed Lending and the Economy

    • 1933 National Bank Holiday for One Week

      Resulted in FDIC and 25% Drop in Money Supply

    • Contributed to the Great Depression

      Regulation Protects the System Today (your author said this, not me!)

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    Key Terms

    • fractional reserve banking system

    • vault cash

    • required reserves

    • reserve ratio

    • excess reserves

    • actual reserves

    • monetary multiplier

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    Wrap-UpMoney Creation

    Banks Create Money

    Reversible Process

    Fractional Reserve Banking

    Amount of Change in the Money Supply

    Excess Reserves Are Loanable


    Money (Deposit) Multiplier