The Monetary System Part 2: Banks and the Money Supply

The Role of Banks in the Money Supply

Overview of Part Two: This discussion focuses on the mechanics of the monetary system, specifically addressing how banks "make money out of thin air" and their crucial role in the money supply.
Relationship with the Federal Reserve: While the Fed maintains control over the total money supply, private banks are the primary vehicles through which that money moves through the economic system.
The Fundamental Rule of Bank Lending: When a bank issues a loan, the money supply increases. Banks are considered essential to the system because their lending activity directly correlates to the expansion or contraction of available money.

Essential Terminology for Monetary Application

To understand how banks influence the money supply, four distinct but related terms must be mastered:

Reserves: These are deposits that a bank has received from customers but has not yet loaned out to borrowers. These are funds being held by the bank, regardless of whether they are required to hold them or not.
Reserve Requirement / Required Reserve Ratio: This is the specific fraction or percentage of total deposits that a bank is legally mandated to hold in its vaults or at the Fed and cannot utilize for loans. - The Standard Rate: In the United States, the typical reserve requirement is set at $10\%$ .
Required Reserves: This term refers to the actual dollar amount of deposits that the bank must hold and is forbidden from lending out. - Calculation Example: If the reserve requirement is $10\%$ , and a customer deposits $\$1,000$ , the required reserves would be $\$100$ ( $1,000 \times 0.10 = 100$ ).
Excess Reserves: This is the remaining portion of reserves after the required reserves have been subtracted from total reserves ( $\text{Excess Reserves} = \text{Total Reserves} - \text{Required Reserves}$ ). - Lending Significance: Banks make loans exclusively from their excess reserves. If a bank possesses zero excess reserves, it loses the ability to issue new loans.

The Fractional Reserve Banking System

Definition: The United States operates under a fractional reserve banking system, meaning banks are only required to keep a small portion (fraction) of their deposits on hand.
Economic Mechanics: - Banks earn profits by paying low interest rates on savings and checking accounts and lending those same funds at higher interest rates to borrowers. - This system allows banks to "work" the money they hold rather than keeping it idle.
Cash on Hand Realities: Because of the fractional system, banks do not have enough physical cash to pay out every depositor at once. A typical neighborhood bank branch may only keep approximately $\$150,000$ in actual cash on hand.
100% Reserve Banking Comparison: In a hypothetical 100% reserve banking system, banks would be required to hold every dollar deposited. In such a system, banks would be unable to make any loans because no excess reserves would exist.
Variations by Economic Cycle: The behavior of banks regarding their reserves changes based on the economic climate (e.g., recession vs. expansion). During historical recessionary periods, banks have been known to hold onto more money and lend less than their maximum capacity due to the perceived risk of defaults.

T-Account Mechanics and Financial Intermediation

T-Account Structure: A basic accounting tool used to visualize bank finances. - Left Side (Assets): Includes required reserves and the loans the bank has issued. - Right Side (Liabilities): Includes deposits, representing money the bank owes back to its customers.
Balancing the T-Account: The total value of assets must always equal the total value of liabilities.

Practical Application: Demonstrating Money Creation

To prove that money is created "out of thin air," a two-step scenario involving two banks is used, assuming a $10\%$ reserve requirement and that banks lend all excess reserves.

Step 1: Initial Deposit in Bank One

Scenario: The Fed buys an $\$8,000$ bond, and the money is deposited into Bank One.
Bank One T-Account: - Liabilities: Deposits = $\$8,000$ . - Assets (Required Reserves): $10\%$ of $\$8,000 = \$800$ . - Assets (Loans): The remaining excess reserves of $\$7,200$ are lent out.
Balance: Both sides equal $\$8,000$ .

Step 2: Deposit into Bank Two

Scenario: A borrower named Tim takes the $\$7,200$ loan from Bank One to buy a car from Mike. Mike then deposits that $\$7,200$ into Bank Two.
Bank Two T-Account: - Liabilities: Deposits = $\$7,200$ . - Assets (Required Reserves): $10\%$ of $\$7,200 = \$720$ . - Assets (Loans): The bank lends out the remaining excess reserves, which is $\$7,200 - \$720 = \$6,480$ .
Balance: Both sides equal $\$7,200$ .

Proof of Expansion

Initial physical money introduced to the system was only $\$8,000$ .
However, through just two banks, the total amount of money lent into the system already equals $\$13,680$ ( $\$7,200$ from Bank One + $\$6,480$ from Bank Two).
This process continues as the $\$6,480$ is deposited into a third bank, which then lends out $90\%$ of it, further increasing the total money supply beyond the initial $\$8,000$ .

The Money Multiplier and Reserve Dynamics

Definition: The money multiplier is the amount of money the banking system generates with each dollar of reserves.
The Formula: The multiplier is calculated as the reciprocal of the reserve requirement ratio: $\text{Money Multiplier} = \frac{1}{\text{Reserve Requirement}}$
Calculation Example: With a reserve requirement of $10\%$ ( $0.1$ ): $\text{Money Multiplier} = \frac{1}{0.1} = 10$ - This indicates that for every $\$1$ held in reserves, $\$10$ of money can be generated in the system.
Inverse Relationship: There is an inverse relationship between the reserve requirement and the money multiplier: - As the Reserve Requirement increases, the Money Multiplier decreases. - This occurs because banks are forced to hold more money, leaving fewer excess reserves available for the lending process that drives the multiplier effect.