4.4 Banking and the Expansion of the Money Supply

Banks Create Money Through Lending

Banks operate on fractional reserve banking: they keep a fraction of deposits as required reserves and lend out the rest (excess reserves). When a bank loans money, that money gets deposited elsewhere, creating new deposits. This process repeats, expanding the money supply far beyond the original deposit.

The Money Multiplier

The money multiplier shows how much the money supply can expand from an initial deposit: 1 / required reserve ratio (RRR). If RRR = 10%, the multiplier is 10. A $1,000 deposit can eventually create up to $10,000 in new money through repeated lending and depositing.

T-Accounts and Bank Balance Sheets

T-accounts show a bank's assets (reserves, loans) and liabilities (deposits). When a new deposit arrives, required reserves = deposit × RRR; the rest becomes excess reserves available to loan. Banks maximize profit by lending out all excess reserves, driving the multiplier process.

Key terms

Fractional Reserve Banking

A system where banks hold only a fraction of deposits as reserves and lend out the rest.

Required Reserve Ratio (RRR)

The percentage of deposits banks must hold as reserves, set by the central bank.

Money Multiplier

1 / RRR; shows the maximum amount the money supply can expand from an initial deposit.

Excess Reserves

Reserves held beyond the required amount; available for banks to loan out.

T-Account

A simple balance sheet showing a bank's assets (reserves, loans) and liabilities (deposits).

Try an AP-style question

What is the money multiplier?

1. 1
2. 100
3. 0.1
4. 10