11.5. How the Banking System "Creates" Money

Like the goldsmiths who created money when they made loans, modern banks also create money. Let's take a closer look at the process. Banks cannot lend all the money deposited with them because their depositors have the right to withdraw their funds at any time. But experience has shown that they could lend nearly all their deposits and still meet the demands of their depositors.

Nevertheless, to play it safe, all banks keep a fixed portion of their deposits on hand. These funds are known as the bank's reserves. The amount of reserves banks are required to keep is expressed as a percentage of their total deposits called the reserve ratio. If the reserve ratio were 15 percent when a bank had $ 1 million in deposits, the bank would be required to hold $150,000 on reserve. The remaining $850,000 would be available for loans.

How Loans Become Additions to the Money Supply. In most instances when a commercial bank makes a loan, the money is credited to the borrow­er's checking account.

Dean's Jeans, Inc. does its banking with the 4th National Bank. Last week Dean's Jeans borrowed $10,000. At the time of the loan, no currency was given to Dean's Jeans. The $10,000 was simply credited to its checking account at the bank.

Demand deposits, you will recall, are checking accounts carried by the commercial banks. Because they can be spent, demand deposits are also part of the money supply. The moment that Dean's Jeans received its $10,000 credit, the nation's money sup­ply was increased by that amount. It follows that any addition to a checking account increases the nation's money supply.

The amount of money that the banking system can create is limited by the reserve ratio. The following example is illustrated in Figure 11-3.

Let's assume your Uncle Walt Matilda opened a new checking account at First National Bank with a deposit of $10,000. If the reserve ratio was 20 percent, the Bank could loan 80 percent, or $8,000, to Wendy Wilcox by crediting her checking account for $8,000. The balance of $2,000 was added to the bank's reserves.

Wendy used the $8,000 to buy a car from the Gonow Auto Company. Gonow Auto deposited the $8,000 in its account at the Second National Bank which loaned out $6,400 of that amount (80 per­cent of $8,000) to the Sports Shop. The $6,400 was credited to the account of the Sports Shop, and the balance, $1,600, was added to the bank's reserves.

The Sports Shop used the $6,400 to buy comput­ers from Commendable Computers, which deposit­ed that amount in its bank account.

Let's freeze the action here and summarize what has happened so far. As a result of the first deposit of $10,000 in the First National Bank, additional demand deposits of $8,000 and $6,400 were made in the Second National Bank and in the bank where Commendable Computers has its account, for a total of $24,400. (See Figure 11-3.) Each new demand deposit added to the money supply. But as you can see, the story would not end there because succes­sive deposits and loans of smaller and smaller amounts could continue to be made until nothing was left to be loaned. We can calculate the totals involved in these transactions by applying the deposit multiplier.

The Deposit Multiplier. The deposit multiplier is equal to 100 divided by the reserve ratio. Therefore, with a reserve ratio of 20 percent, the deposit multi­plier is 5 (because 100-$ 20 = 5). Thus, in our illus­tration, the initial deposit of $10,000 could lead to an expansion of $50,000 in the money supply. Had the reserve ratio been 10 percent, the deposit could have expanded the money supply by $100,000. We shall be returning to this concept in the following chapter. Of course, borrowers must repay their loans, and as they do, the money supply returns to its original level.