4.4: Banking & the Expansion in the Money SUpply

Introduction to Banks and Fractional Reserve Banking

  • Banks are defined as financial institutions that:   - Accept deposits.   - Make loans.   - Serve as intermediary bodies facilitating the Federal Reserve's control over the money supply.

Fractional Reserve Banking

  • Definition: Fractional Reserve Banking is a banking system in which banks hold only a fraction of deposits as cash reserves and loan out the rest.

  • Reserve Ratio: The reserve ratio (or reserve requirement) is the percentage of deposits that banks are required to hold as reserves. It is determined by the Federal Reserve. This system enables banks to create money by loaning out deposits.

Terms Related to Fractional Reserve Banking

  • Required Reserves   - Definition: The portion of every demand deposit that banks must hold in cash reserves and cannot lend out.   - Determination: This is dictated by the reserve ratio set by the Federal Reserve.

  • Excess Reserves   - Definition: The remaining amount of demand deposits after required reserves have been set aside. These excess reserves can be loaned out to borrowers.

  • Demand Deposits   - Definition: Money deposited in a bank that can be withdrawn by the account holder without any prior notice.

Operation of Fractional Reserve Banking

  • The table below illustrates how banks manage demand deposits under different reserve ratios:

Demand Deposit

Reserve Ratio

Required Reserves

Excess Reserves

$1,000

0.4

$400

$600

$2,500

0.2

$500

$2,000

$5,000

0.25

$1,250

$3,750

$7,500

0.10

$750

$6,750

$10,000

0.2

$2,000

$8,000

$15,000

0.5

$7,500

$7,500

Money Multiplier

  • Definition: The money multiplier is a measure that demonstrates how banks can multiply the amount of money supply through lending practices using excess reserves.

  • Calculation of the Money Multiplier:   - Formula: extMoneyMultiplier=rac1extRequiredReserveRatioext{Money Multiplier} = rac{1}{ ext{Required Reserve Ratio}}

  • Monetary Base: The monetary base includes the total currency in circulation along with bank reserves.

  • Chain Reaction of Money Creation:   - Excess reserves lead to new loans, which create further deposits and result in an overall increase in the money supply.

Key Implications of the Money Multiplier

  • The maximum potential increase in the money supply can be overestimated due to:   - Banks holding some excess reserves instead of lending them.   - Households choosing to hold some loan proceeds as physical currency instead of redepositing.

  • Example Calculation:   - If the reserve ratio is 0.2, then the money multiplier would be:   - extMoneyMultiplier=rac10.2=5ext{Money Multiplier} = rac{1}{0.2} = 5   - For a new cash deposit of $10,000 with a reserve ratio of 20%:     - Required Reserves = 10,000imes0.2=2,00010,000 imes 0.2 = 2,000     - Excess Reserves = 10,000−2,000=8,00010,000 - 2,000 = 8,000     - Maximum Change in Money Supply: 8,000imes5=40,0008,000 imes 5 = 40,000

Examples of Money Supply Changes

  • Example One:   - Reserve Ratio = 20% (0.2)   - Money Multiplier = 5   - Initial Change in Demand Deposits = +$10,000   - Required Reserves = +$2,000   - New loans = +$8,000   - Total Change in Money Supply = +$40,000

  • Example Two:   - Reserve Ratio = 50% (0.5)   - Money Multiplier = 2   - Initial Change in Demand Deposits = +$10,000   - Required Reserves = +$5,000   - New Loans = +$5,000   - Total Change in Money Supply = +$10,000

  • Conclusion from Examples: The money supply experiences a greater increase when the reserve ratio is lower compared to a higher reserve ratio.

Calculation Steps for Demand Deposits

  1. Calculate required reserves from the demand deposit amount using the reserve ratio.

  2. Determine excess reserves.

  3. Calculate the change in the money supply.

Bank Balance Sheets

  • Definition of Bank Balance Sheets: Bank balance sheets, also known as T-accounts, visually represent the assets and liabilities of a bank within the fractional reserve system.

  • They illustrate how banks utilize deposits to create reserves and loans for lending purposes, maintaining balance between assets and liabilities.

Components of Bank Balance Sheets

  • Assets: Include reserves, loans, and securities.

  • Liabilities: Include checkable deposits (such as demand deposits).

  • Total Assets = Total Liabilities for bank balance sheets.

Example Bank Balance Sheet

  • Assuming: The Second National Bank has a reserve ratio of 10% (0.1).

  • Calculation Based on Demand Deposit:   - Demand Deposit = $1,000   - Required Reserves = 1,000imes0.1=1001,000 imes 0.1 = 100   - Excess Reserves = 1,000−100=9001,000 - 100 = 900   - If all excess reserves are loaned out, the maximum change in the money supply is:     - 900imes10=9,000900 imes 10 = 9,000

Note: As previously established, the excess reserves become an integral part of the money supply when they are loaned out, demonstrating the cycle of money creation within the banking system.