10.3 How Banks Create Money

Notes

Under fractional reserve banking, lending creates new money.

• When a bank lends part of a deposit, the borrower spends it and the money is deposited in another bank, which lends part of it again.
• The required reserve ratio (rr) is the fraction of deposits a bank must hold. In the simple model, the money multiplier $\displaystyle = \frac{1}{rr}$.
• Worked example: with $rr = 10\%$, the multiplier is $\displaystyle \frac{1}{0.10} = 10$. A new $1,000 deposit can support up to $1{,}000 \times 10 = 10{,}000$ dollars in total deposits. The first bank keeps $100 and lends $900; the next bank keeps $90 and lends $810; and so on.
• Actual money creation is smaller if people hold cash or banks keep excess reserves instead of lending.
• In 2020 the Fed lowered reserve requirements to zero. Banks still keep reserves for safety and to meet other rules, so the multiplier is best seen as a model of how lending spreads money through the system.