Banks and the Creation of Money

1. Banks and the Creation of Money • Financial Intermediary: Go between borrowers and lenders. • Take deposits and give out loans. • But can banks create money??? • People deposit $$$ into banks. • Reserve Ratio: the % of deposits held in reserve • The Required Reserve Ratio, or 'RR', is a percentage of that $$$ that banks must keep. • Any part of the deposit that banks hold above the required reserves is called excess reserves. • Fractional Reserve Banking • The banks may loan out excess reserves or buy government securities (bonds.) • When a bank makes a loan, it creates a checkable deposit for the borrower to be re-deposited in another bank, increasing the money supply! 

2. Money Multiplier The money multiplier measures the potential amount the money supply can increase when new deposits enter the system. Money Multiplier = 1/Reserve Requirement (RR) Expansion of the Money Supply = Excess Reserves x Multiplier. Example: a deposit of $100 with the RR as 10%, the money supply will increase by $________________. $900? M1 increased to $1,000. Total increase in Money Supply may be less than predicted by money multiplier if: • Borrowers do not spend all they borrow • Banks do not lend out all excess reserves • People hold part of their money as cash