Banks and the money supply
How fractional-reserve banks create money, the money multiplier, leverage, and the tools a central bank uses to control the money supply.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Show how fractional-reserve banking creates money
- Calculate the money multiplier
- Explain leverage, bank runs and the central bank's tools
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
The economy behind your investments: lesson 3 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 16
What it is
Reserves are deposits a bank holds rather than lends out.
100% reserves. If a bank kept every deposit as reserves, it would just be a safe place for money. Depositing 100 of currency would turn 100 of currency into 100 of deposits: the money supply would not change.
Fractional-reserve banking. Real banks keep only a fraction of deposits as reserves (the reserve ratio) and lend the rest. Mankiw's example, with a reserve ratio of 10%:
- First National Bank receives 100, keeps 10 and lends 90. The depositor still has 100 in the bank, and the borrower now has 90: the money supply has risen by 90.
- The 90 is deposited at Second National Bank, which keeps 9 and lends 81. And so on.
- In total, the original 100 of reserves supports 100 + 90 + 81 + ... = 1,000 of money.
The money multiplier is the amount of money created by each unit of reserves:
money multiplier = 1 ÷ reserve ratio
At 10%, it is 1 ÷ 0.1 = 10. A lower reserve ratio means a bigger multiplier.
Quick check
Tap an answer to check it.
Banks keep 20% of deposits as reserves. What is the money multiplier?
- The multiplier is 1 ÷ the reserve ratio, not the ratio itself
- That is the reserve ratio
Show answer
5. 1 ÷ 0.2 = 5.
Why it matters
Bank capital and leverage. Banks also raise money from their owners (bank capital) and by borrowing. Leverage is using borrowed money to supplement one's own. The leverage ratio is total assets ÷ capital. Mankiw's example bank has assets of 1,000 and capital of 50: a leverage ratio of 20.
- If its assets rise 5%, to 1,050, its capital doubles to 100.
- If they fall 5%, to 950, its capital is wiped out.
High leverage magnifies gains and losses. A capital requirement sets a minimum amount of capital, so banks can still pay their depositors after losses. Mankiw notes that when banks lose capital they lend less, a credit crunch, which was part of the 2008–2009 crisis.
The central bank's tools:
- Open-market operations: buying government bonds adds reserves and money; selling them removes money.
- Lending to banks: at the discount rate (and, in the 2008–2009 crisis, through new lending programmes). Cheaper lending means more reserves and more money.
- Reserve requirements: a higher required reserve ratio lowers the multiplier and the money supply. Mankiw notes this tool is now rarely changed.
- Paying interest on reserves (since 2008 in the US): a higher rate encourages banks to hold more reserves, reducing the money supply.
The Fed's control is imperfect: it can't control how much money people hold as deposits rather than currency, or how much banks lend. In a bank run, depositors rush to withdraw, banks hold more reserves and lend less, and the money supply shrinks. Mankiw describes how this happened in the early 1930s, and how deposit insurance (in the US, the FDIC) has made runs rare, at the cost of giving bankers less reason to avoid risk.
The federal funds rate is the interest rate banks charge one another for overnight loans of reserves. The Fed sets a target for it and uses open-market operations to hit the target, so hitting the target also changes the money supply.
Worked example
A new deposit of 1,000 enters a banking system whose banks keep 25% as reserves.
| # | Deposit | Kept | Lent |
|---|---|---|---|
| 1 | 1,000 | 250 | 750 |
| 2 | 750 | 187.5 | 562.5 |
| 3 | 562.5 | 140.6 | 421.9 |
- Money multiplier: 1 ÷ 0.25 = 4.
- Total deposits created in the end: 1,000 × 4 = 4,000.
- The 1,000 of reserves ends up held across all banks (25% of 4,000 = 1,000).
Common mistake
Thinking banks only pass on money that already exists. When a bank lends out part of a deposit, the depositor still has the full balance and the borrower has new spending power: the bank has created money. It hasn't created wealth, though: the borrower also has a new debt.
Key terms
- reserves
- deposits banks have received but not lent out
- fractional-reserve banking
- a system in which banks hold only a fraction of deposits as reserves
- reserve ratio
- the fraction of deposits banks hold as reserves
- money multiplier
- the amount of money the banking system generates with each unit of reserves
- bank capital
- the resources a bank's owners have put into it
- leverage ratio
- total assets ÷ bank capital
- capital requirement
- a regulation setting a minimum amount of bank capital
- open-market operations
- the central bank's buying and selling of government bonds
- discount rate
- the interest rate on the central bank's loans to banks
- federal funds rate
- the interest rate at which US banks make overnight loans to one another
Practise the key terms
Tap a card to turn it over. 10 cards.
| Front | Back |
|---|---|
| reserves | deposits banks have received but not lent out |
| fractional-reserve banking | a system in which banks hold only a fraction of deposits as reserves |
| reserve ratio | the fraction of deposits banks hold as reserves |
| money multiplier | the amount of money the banking system generates with each unit of reserves |
| bank capital | the resources a bank's owners have put into it |
| leverage ratio | total assets ÷ bank capital |
| capital requirement | a regulation setting a minimum amount of bank capital |
| open-market operations | the central bank's buying and selling of government bonds |
| discount rate | the interest rate on the central bank's loans to banks |
| federal funds rate | the interest rate at which US banks make overnight loans to one another |
Practice
Work it through
The reserve ratio is 5%. The central bank buys 200 of government bonds from the public, who deposit the money in banks.
- 1 ÷ 0.05
- 200 × 20
Quick quiz
Tap an answer to check it.
A bank has assets of 600 and capital of 30. What is its leverage ratio?
- That is capital as a share of assets; the leverage ratio is assets ÷ capital
Show answer
20. 600 ÷ 30 = 20.
What does raising the reserve requirement do to the money supply?
- Banks can lend less of each deposit
Show answer
Lowers it: the money multiplier falls. A higher reserve ratio means a smaller multiplier.
Why does a bank run shrink the money supply?
- A run works through people's and banks' choices
Show answer
Depositors hold more currency and banks hold more reserves, so less is lent and re-deposited. Both effects reduce the money multiplier.
In short
- Fractional-reserve banks create money by lending part of each deposit.
- Money multiplier = 1 ÷ reserve ratio.
- Leverage magnifies a bank's gains and losses; capital requirements guard against it.
- Tools: open-market operations, lending to banks, reserve requirements, interest on reserves; control is imperfect.
Mastery check
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Check yourself
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With a reserve ratio of 10%, how much money can 100 of reserves support?
Show answer
1,000.
What happens to a bank with a leverage ratio of 20 if its assets fall 5%?
Show answer
Its capital is wiped out.
What is the federal funds rate?
Show answer
The interest rate at which US banks make overnight loans to one another.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 16.
- On this site: What money is.
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